Why financial innovation IS necessary and useful

Judging by the number of books/articles/blog posts and Steve Job memorial mentions, one would think that innovators are the most valued ones in this economy, and that innovation is good. But recently, two facets of this debate struck me.

• Students's dream jobs are now in tech companies like Apple, Google and Facebook-which are all glorified despite significant concerns about privacy, impact by creatively destroying other industries..
• Occupy Wall Street(OWS) students ambushed recruiting sessions at Yale of Goldman Sachs/Bank of America and harangued them about how their rocket science had resulted in evil.

 It is fashionable to trash the financial sector for creating instruments and structures which induced helpless real world borrowers to spend more, buy homes beyond their reach, and deceived governments to maintain unbalanced budgets. But even leaving aside this simplistic explanation for a moment,  one cannot deny that many financial structures are products of extreme creativity and innovation, and were originally crafted to address real world issues. So why are they now villifed as rocket science/web of illiquid complex assets etc?

Recently, Mr Masaaki Shirakawa, Governor of the Bank of Japan gave a keynote address, at the
Netherlands Bank conference in honour of Mr Nout Wellink on “Welfare effects of financial
innovation” . He focused on the special aspects of financial innovation, and the speech can be read here(http://www.bis.org/review/r111115h.pdf). The main points he made were

1. Innovation means changing the way business is conducted in order to better serve the clients
   of the business.changes, which provide the same or better service to clients at lower cost, are certainly innovations in the usual sense of the word.
2. Innovation can be technology driven or modality driven. Technology-driven innovation
   crystallizes when the application of technology results in a better way of doing business(like ATMs). On the other hand, modalitydriven innovation aims at rearranging business processes for the better(like derivatives risk transfer)
3. Technology-driven innovations are more likely to be beneficial, because, when the innovator is deliberating on the application of technology, the client cannot usually be ignored. On the other hand, in the case of modality-driven innovations, one can easily lose sight of the client when cutting and dicing existing businesses(emphasis added). Very often, modality-driven innovations are the result of efforts to circumvent regulations, taxes, and accounting rules imposed on the financial industry
4. Problems seem to have arisen when a product or service is insufficiently anchored in inter-mediation or facilitation of payments(the core function of banks)

 The above chain of arguments would lead one to the premise that unless the financial innovation is anchored in 'basics of banking' like cheaper intermediation/payments system, then its utility is doubtful, or at the very least, subject to more layers of scrutiny.

However, the financial inclusion agenda of regulators, would require banks to adopt technology driven innovations, while the infrastructure financing needs would probably need modality driven innovations to come up with innovative financial structures, eschrow mechanisms and build in adequate safeguards(like MIGA guarantee etc) so that the players would have rational incentives to keep up to their word. And more modality driven innovations would be needed for risk transfer. One can certainly argue that the basic bank and investment bank should be split, but that may make both individually riskier(no diversification) and increase capital costs.Hence, before trashing the rocket science/quants/legal eagles of banks, one should also think of their positive uses.