Financial innovation vital for reform

Unlike many innovations in technology - such as those made by Apple, for instance, or Tesla, which produces electric cars - people do not get particularly excited about financial innovation.

Culturally, people like innovations that have a "wow" factor, and unfortunately financial innovation rarely creates such excitement. Add in, too, that people often do not really understand financial innovation, and as a result have become hostile and suspicious about it. People like innovation that can bring them instant, tangible benefits.

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But many financial innovations are long term, such as those aimed at retirement, and people find them hard to connect with - after all, hedging and a reduction in portfolio risk is never going to be as exciting as a Tesla roadster. As a result, few are genuinely interested in financial innovation, even though it can bring fundamental changes for the better, to society, an economy, or a financial system.

Be it shadow banking or Internet financing, both very popular in China, an important motivation for financial innovation is to circumvent regulation.

Financial regulation is still strict in China, and a lot of reform is needed, and this may explain why financial innovation is a massive growth area that could transform the regulatory landscape.

On the other hand, one has to bear in mind that financial innovation is particularly prone to risk because it can sometimes fall outside traditional regulatory boundaries.

I hear that some shadow banking products in China are already experiencing rising default levels.

This is exactly what happened during the 2007-08 subprime mortgage crisis in the US.

The key is whether investors themselves are aware of investment risk, and whether they are protected properly.

Pushing forward financial innovation, without incurring substantial and systematic financial risk, may well be critical to China's economic reform, and its development in the decades to come.

The author is a faculty fellow at the International Center for Finance, Yale University, and deputy dean of the Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University. The article is based on his conversation with Robert Shiller, Professor of Yale University, the 2013 Nobel Laureate in Economics. The views do not necessarily reflect those of China Daily.