Squelching Innovation -- Good or Bad?

Ben Bernanke gave a speech today on the need to be careful in crafting financial regulations. An appropriate balance must be struck, he said, between consumer protections and the freedom to innovate.

I don't think anyone wants to go back to the 1970s. Financial innovation has improved access to credit, reduced costs, and increased choice. We should not attempt to impose restrictions on credit providers so onerous that they prevent the development of new products and services in the future.

That said, the recent experience has shown some ways in which financial innovation can misfire. Regulation should not prevent innovation, rather it should ensure that innovations are sufficiently transparent and understandable to allow consumer choice to drive good market outcomes. We should be wary of complexity whose principal effect is to make the product or service more difficult to understand by its intended audience. Other questions about proposed innovations should be raised: For instance, how will the innovative product or practice perform under stressed financial conditions? What effects will the innovation have on the ability and willingness of the lender to make loans that are well underwritten and serve the needs of the borrower? These questions about innovation are relevant for safety-and-soundness supervision as well as for consumer protection.

In sum, the challenge faced by regulators is to strike the right balance: to strive for the highest standards of consumer protection without eliminating the beneficial effects of responsible innovation on consumer choice and access to credit. Our goal should be a financial system in which innovation leads to higher levels of economic welfare for people and communities at all income levels.

Bernanke focused on consumer-oriented innovations rather than obscure structured financial products, which should have made the defense of recent financial innovation a little easier. No dice. According to Bernanke, no one, "wants to go back to the 1970s," but neither could Bernanke point to a truly helpful piece of financial innovation developed after that decade. His examples of successful financial products? Credit cards, for one, which date from the 1950s. Policies facilitating the flow of credit to lower income borrowers was another, for which he credited the Community Reinvestment Act of 1977. And, of course, securitization and the secondary mortgage markets developed by Fannie Mae and Freddie Mac in...the 1970s.

To be fair, he does mention one innovation dating from after the great wave of financial deregulation:

[I]n the early 1990s, automated underwriting systems helped open new opportunities for underserved consumers to obtain traditional forms of mortgage credit. This innovation was followed by an expansion of lending to borrowers perceived to have high credit risk, which became known as the subprime market. Lenders developed new techniques for using credit information to determine underwriting standards, set interest rates, and manage their risks. As I have already mentioned, the ongoing growth and development of the secondary mortgage market reinforced the effect of these innovations, giving mortgage lenders greater access to the capital markets, lowering transaction costs, and spreading risk more broadly. Subprime lending rose dramatically from 5 percent of total mortgage originations in 1994 to about 20 percent in 2005 and 2006.

That's right. Tasked with defending deregulation as a source of financial innovation, Bernanke reached for subprime lending. The Fed chairman either has no desire to prevent a wave of new and tight regulations from constraining financial institutions, or he is completely and utterly tone deaf.

At the moment, the public is not at all inclined to believe that financial wizardry has positively contributed to economic growth or social welfare. I can't imagine how Bernanke thinks he's going to convince them otherwise using speeches like this.