There are few words in the business bible more holy than "innovation". And I'm a believer in its great virtue. But, like many things in economics, sometimes what's usually a good thing can be a bad thing - even a terrible thing.
In a speech on banking, the deputy governor of the Reserve Bank, Dr Philip Lowe, drew attention to the dark side of innovation in the financial sector and advocated closer regulation of it. Here's what he said, with my interpolations.
"Over many decades, our societies have benefited greatly from innovation in the financial system. Financial innovation has delivered lower cost and more flexible loans and better deposit products."
It has provided new and more efficient ways of managing risk, he says, helped our economies to grow and our living standards to rise.
"But financial innovation can also have a dark side," he says. "This is particularly so where it is driven by distorted remuneration structures within financial institutions, or by regulatory, tax or accounting considerations."
Ain't that the truth. Distorted remuneration structures go a long way to explain the origins of the global financial crisis. People paid commissions to give home loans to people who couldn't possibly pay them off. People on Wall Street hugely rewarded when their bets pay off, but suffering no great personal loss when their bets blow up.
People who invent toxic products and flog them to their own clients. Credit rating agencies paid handsomely to give toxic products triple-A ratings.
Because (for reasons I'm yet to fully understand - or meet anyone who does) remuneration in the financial sector is so eye-wateringly gargantuan - enough to make chief executives envious - it attracts many of our brightest minds, who could be advancing the frontiers of science or managing the economy, but instead spend their days finding ways around financial regulations, tax law and accounting conventions.
I suppose you'd have to be hugely rewarded to devote your life to making such an antisocial contribution.
Lowe says problems can also arise where the new products are not well understood by those who develop and sell them, or by those who buy and trade them.
"Over recent times, much of the innovation that we have seen has been driven by advances in finance theory and computing power, which have allowed institutions to slice up risk into smaller and smaller pieces and allow each of those pieces to be separately priced," he says.
"One supposed benefit of this was that financial products could be engineered to closely match the risk appetite of each investor. But much of the financial engineering was very complicated and its net benefit to society is debatable."
Many of the products were not well understood, he says, and many of the underlying assumptions used in pricing turned out to be wrong. Even sophisticated financial institutions with all their resources [all those highly paid, super-bright people] didn't understand the risks at a micro-economic nor a system-wide level.
"As a result, they took more risk than they realised and created vulnerabilities for the entire global financial system."
Just so. We live in an era when it's the height of fashion to see much of the management task as managing the many and varied "risks" to which businesses are subject. It's a useful way of thinking.
One way to manage risk is to spread it very thinly between a large number of people. All insurance policies are longstanding examples of this approach. Another approach is to join together people facing opposite risks. For instance, a contract between someone who stands to lose if the dollar falls and someone who stands to lose if it rises.
The market has developed lots of "plain vanilla" derivatives that allow firms to swap their interest-rate or foreign-exchange risks in this way. This is socially beneficial innovation.
But when derivative contracts become far more complicated than that, there can be problems. Risk management can itself be risky. It's hard to escape the risk of human fallibility in all its forms: the risk that people (even professionals, let alone punters) don't really understand the risks they're taking on; the risk of people's judgment being clouded by greed or hubris (nothing's gone wrong so far and that's because I'm so smart).
Then there are all the previously non-existent risks you create when you invent assets for which there's no market price, but for which you calculate a price using a fancy mathematical formula. All such synthetic prices are built on a host of explicit and hidden assumptions.
Forget that small fact and you can come horribly unstuck, as we've already discovered in the global financial crisis to our huge and far-from-over cost - as witness, Europe.
The question is, how can society obtain the benefits that financial innovation delivers while reducing the risks it entails? Lowe concedes this won't be easy, but sees a way forward in greater public sector oversight of areas where innovation is occurring.
"I suspect that the answer is not more rules, for it is difficult to write rules for new products, especially if we do not know what those new products will be, and the rules themselves can breed distortions," he says.
But one concrete approach is for supervisors [such as our Australian Prudential Regulation Authority] and central banks to pay very close attention to areas where innovation is occurring: to make sure they understand what's going on and to test and probe institutions about their management of risks in new areas and new products.
"Ultimately, supervisors need to be prepared to take action to limit certain types of activities, or to slow their growth, if the risks are not well understood or not well managed," he concludes.
