Transparent Financial Innovation in a Post-Crisis Environment

Abstract

The recent stunning failure of banks has put regulatory intervention high on the agenda of governments. Adequate risk monitoring, including by credit rating agencies, as well as measurement and management have proven a daunting task, whereas regulation of innovative financial instruments has not brought about adequate disclosure and transparency. Before the recent financial crisis, financial innovation was regarded as inextricably linked with economic growth and aggregate welfare. In the wake of the crisis, criticism as to the utility of financial innovation became more unequivocal. After reviewing the virtues and pitfalls of financial innovation, the paper analyses the main transparency initiatives undertaken in the EU and the US in the aftermath of the crisis to harness various financial innovations that have marked the history of financial markets in the past three decades, including hedge funds, derivatives and credit ratings. Furthermore, the paper critically assesses the likely impact of such regulations on the future of financial innovation. In addition, the paper reviews the approach to financial innovation that the General Agreement on Trade in Services (GATS) of the World Trade Organization (WTO) adopted in the 1990s and assesses the likely impact of the recent financial crisis on this stance. As the perimeter of regulation grows and countries become more suspicious about home-country financial regulation, trade in financial services is unlikely to remain unaffected. Nevertheless, the GATS appears to be running out of analytical tools, a fact that undermines its global role. The emergence of a new international financial architecture, including the upgrade of the FSB, the BIS and the IMF, exemplifies a shift of power away from the GATS in favour of this new matrix of specialized institutions. Within this new landscape, the GATS is bound to change – or become irrelevant.