The Summer of '07 and the Shortcomings of Financial Innovation

Journal of Applied Finance (Formerly Financial Practice and Education), Vol. 18, No. 1, 2008

Posted: 23 Apr 2009

See all articles by Joseph R. Mason

Joseph R. Mason

Louisiana State University - Ourso School of Business; University of Pennsylvania - Wharton Financial Institutions Center

Date Written: November, 20 2008

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

Suggested Citation

Mason, Joseph R., The Summer of '07 and the Shortcomings of Financial Innovation (November, 20 2008). Journal of Applied Finance (Formerly Financial Practice and Education), Vol. 18, No. 1, 2008, Available at SSRN: https://ssrn.com/abstract=1304887

Joseph R. Mason (Contact Author)

Louisiana State University - Ourso School of Business

2900 Business Education Complex
Baton Rouge, LA 70803
United States
202-683-8909 (Phone)

University of Pennsylvania - Wharton Financial Institutions Center ( email )

3641 Locust Walk
Philadelphia, PA 19104-6218
United States

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