Which came first, the chicken or the egg?

"Which comes first, the chicken or the egg?" is the commonly known question that would confuse not only a kid, but even an adult. This causality dilemma could be applied in financial market by asking the question: whether financial innovations cause the increase in regulation or are the result of the restrictions imposed by the increased regulation?

One of the most popular topics in the financial news these days is the regulation of the financial (particular banking) sector. The regulation often involves applying restrictions on use of different types of financial innovations (as these are often blamed for causing the recent financial crisis). However, could these restrictions cause further increase in innovations in the financial sector?

According to Edward J. Kane, innovation “…is the act of putting an invention into practice”. In an unregulated sector the use of invention is usually justified by its technical productivity. However, in the regulated sector, implementation of technical invention can be justified by its ­productivity in regulatory avoidance. One of the greatest examples is the electronic funds transfer system (EFT). Beside its productivity gains of substituting (or replacing) cash and cheques, this was mainly driven by avoidance of heavy regulation of cheques.

There is some controversion in the academic literature about the role of circumventive innovation, which makes it harder to answer the initial question of this financial dilemma. However, no matter what comes first, the process of regulation→ regulatee avoidance→ and the following re-regulation is a constant battle between political and market forces, which is hardly ever going to achieve any stationary equilibrium (Kane 1981).