Media Briefings

The Overrated Benefits Of Financial Innovation – Even In Normal Times

  • Published Date: June 2011

It is often claimed that innovations in financial markets, particularly around consumer credit
and home mortgages, played an important role in the ‘Great Moderation’, helping to reduce
the severity of business cycles in the two decades leading up to the financial crisis. Writing
in the June 2011 issue of the Economic Journal, Professor Wouter Den Haan and Vincent
Sterk debunk
this widespread view, showing that evidence of the benefits of financial
innovation for the wider economy is extremely weak.
The results of their research cast serious doubt on the hypothesis that financial innovation
played an important role in the Great Moderation. This has significant implications for
discussions about new legislation on financial regulation, such as Basel III, in which the
argument is often heard that we should be careful not to overreact and ‘throw away the
baby with the bathwater’. The authors comment:
‘It may be that financial innovation does have important benefits, but it would be
good to ask ourselves whether we really know what those benefits are and how
important they are.
‘In other words, is there really a baby to be thrown away with the bathwater?’
The financial crisis has made it clear that the changes that took place in the financial
system – such as deregulation, liberalisation, the introduction of complex new securities,
and increased activity and leverage – could not prevent our modern economy from disaster
and most likely played a key role in causing the crisis.
The occurrence of the crisis does not necessarily imply, however, that financial innovation
did not also have benefits. In particular, it may well be that deregulation and liberalisation
were beneficial in dampening the impact on the economy of small and moderate shocks.
For example, financial innovation may have allowed risks to be more widely spread across
the economy.
The view that financial innovation was beneficial was widely held by policy-makers and
academics before the crisis. For example, on 15 May 2007, Nout Wellink, president of the
Dutch central bank and chairman of the Basel committee on banking supervision, claimed
‘… numerous measures have been taken to deregulate and liberalize the financial
sector, although much remains to be done. The need for these changes is evident: a
market oriented and liberal financial sector fosters an efficient allocation of scarce
resources and thereby promotes economic prosperity.
In addition, the financial sector has witnessed rapid technological innovations,
facilitating an increase in new services and products and a growing sophistication in
the way financial institutions manage risks
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It may be the case that such views are correct in the sense that the economy benefits from
deregulation and liberalisation as long as the shocks are not too unusual. And it is certainly
fair to say that the fall in house prices was somewhat unusual in the sense that it occurred
in many regions and countries simultaneously.
Such views may also be correct in the sense that economies can reap these benefits as
long as they protect themselves better against risks such as high leverage and the lack of
transparency associated with the proliferation of new securities.
But did we actually ever enjoy those benefits of financial innovation? Numerous research
papers argue that financial innovation was at least in part responsible for the Great
Moderation – the sustained period with only moderate business cycles. Support for this
hypothesis is claimed in the empirical fact that the ‘co-movement’ of real activity with
consumer loans as well as firm loans had basically disappeared during the Great
Moderation, while it had been quite high before.
Theories in which financial innovation dampen business cycles predict exactly such a drop
in co-movement. The idea is that reductions in loan supply worsen the recession in rigid
financial markets, whereas consumers and firms in need of funds will be able to borrow in
efficient financial markets, which makes it possible to weather the storm.
Den Haan and Sterk show that the co-movement dropped because the economy was hit by
different types of shocks, not because consumer loans responded differently to shocks.
There is one exception. The responses following monetary policy shocks did change
substantially, but not in a way consistent with the view that financial innovation dampened
the impact.
In fact, there is even evidence suggesting that reductions of consumer mortgages following
a monetary tightening became larger. These reductions were due to banks sharply reducing
their holdings of consumer mortgages; other financial institutions actually increased their
holdings of mortgages during such periods.
The authors conclude:
‘Such shifts in ownership between financial institutions may be very attractive for the
financial sector.
‘But one wonders whether it is beneficial for the whole economy that institutions that
know the least about the quality of the borrowers choose to hold more mortgages
during economic downturns.
‘Perhaps this should have been a warning sign.’
Notes for editors: ‘The Myth of Financial Innovation and the Great Moderation’ by Wouter
Den Haan and Vincent Sterk is published in the June 2011 issue of the Economic Journal.
Wouter Den Haan is at the London School of Economics. Vincent Sterk is at University
College London.
For further information: contact Wouter Den Haan via email:; or
Romesh Vaitilingam on +44-7768-661095 (email: