The Summer of '07 and the Shortcomings of Financial Innovation

Abstract:     
The summer of 2007 saw the interruption of a number of financial innovations developed over the past several decades. The event can best be understood as a manifestation of asymmetric information in an environment of rapid financial innovation. Financial innovations inexorably create conditions of asymmetric information that can lead to financial crises and panics. But not all financial innovations are equally beneficial. Financial instruments that provide heretofore unavailable or expensive diversification opportunities may be considered beneficial, as can financial instruments that complete markets remove arbitrage profits or financial frictions. Financial instruments that are capital deepening are also beneficial in that they allow sales and trading in fundamentally illiquid contracts. Recent experience should stand as a lesson that it is important to move financial innovations through those incipient stages of development before they grow large enough to substantially undermine economic performance should a crisis arise. However, financial innovations that are not fundamentally diversifying, market completing, or capital deepening will not survive to become mature financial market products.

Keywords: subprime crisis, financial innovation

JEL Classification: G00, F40, F20, F30

Accepted Paper Series