Europe's Financial Vulnerability
VIENNA – The most notable innovations of the past two decades have been financial. Like technological innovation, financial innovation is concerned with the perpetual search for greater efficiency – in this case, reducing the cost of transferring funds from savers to investors. Cost reductions that represent a net benefit to society should be regarded favorably. But as the current financial crisis demonstrates, where financial innovation is designed to circumvent regulation or taxation, we need to be more circumspect.
Sadly, the financial revolution has been mostly rent-seeking rather than welfare-enhancing in character. It has been based on eliminating, or at least reducing, two key elements of banking costs closely associated with prudential arrangements.
One is the need for banks and other financial institutions to hold liquid reserves. The less liquid a bank’s assets, the greater the need for such reserves. But the yield on such reserves is small, so economizing on them is profitable. Last year’s Northern Rock debacle in the United Kingdom will long remain an example of how not to manage such risk.