Now's the time to sing the praises of financial innovation

Whichever way the Paulson plan goes, it is clear that we are in for a period of heavily regulated finance. The questions are: what type of regulations and how heavily will they be administered?

Many commentators have argued that the problem is not one of inadequate or insufficient regulation and that returning to pre-1980s style heavy-handed regulation would be one of the worst mistakes we could make. According to this line of argument, sapping financial innovation would be very costly. 

If so, these advocates owe us a bit more detail about the demonstrable benefits of financial innovation. What I would love to hear are some examples such financial innovation—not of any kind, but of the kind that has left a large enough footprint over some kind of economic outcomes we really care about. What are some of the ways in which financial innovation has made our lives measurably and unambiguously better?

If I had asked this question a little over a year ago, I suppose I would have been hearing a lot about how collateralized debt obligations and structured finance have allowed millions of people to purchase homes that they would not have been able to afford otherwise. Sorry, but you will have to come up with some other examples now.

Comments

[Chui Tey]

Sampling new varieties of magic mushrooms probably should not count as financial innovation. If anything, it is the patent lack of market transparency that has killed stockholder value.

[gappy]

I thoroughly disagree with this posting.

First off, "many commentators" serve as a lame straw man. Which commentators? What is their line of reasoning?

Second: sapping "financial innovation" does not come to mind as the main drawback of financial regulation. My direct experience is in risk management, and I believe that Basel II has increased systemic risk and has produced arbitrary regulatory requirements. It has also played a secondary role in the current crisis. I cannot speak to other regulations, but my fear is that they will cause inefficient capital allocations and generate unexpected risks.

Finally, for the sake of argument, let us stay with the argument that financial innovation is the primary concern. Interest rate, currency and credit swaps have been *extremely* beneficial to corporate risk management. OTC Derivatives on fuel futures have been very useful to manage fuel price risk faced by airlines (which is now over 40% of their operational cost).

Coda: I understand the redde rationem of so many liberal commentators. Yet, I think those same commentators owe us an explanation of how the lack of regulation caused the current crisis, and which kind of regulation may avert the next one.

[Walt French]

Why can't it simply be that individual firms collectively -- we're all familiar with "herd behavior," right? -- all took too much leverage and the nasty decline in assets' value, perhaps even more the shutting off of the cheap credit spigot, collectively blew thru the firms' capital base?

So there's all sorts of second-order hiding of assets like in SIVs that now-they're-nowhere / now-they're-a-stinking-pile-on-our-balance-sheet.

And there's also multiplier effects where the existence of lousier (but still Aaa-rated) credit, with a couple dozen extra basis points, driving out the more carefully documented and underwritten stuff. Read the Nobel paper on used cars if you care about having good markets.

Shareholders, thru their boards, are supposed to take chances, use leverage wisely, and seek the shelter of bankruptcy when they screw up. Here, monster leverage ratios make bankruptcy a weak solution, and lousy accounting transparency allowed trouble to fester far too long.

This simple textbook capitalism explanation is why I like the notion of Uncle Sam getting warrants for senior equities in companies it helps. The FIRST place you let run dry is the equity holders who controlled the company; who cares whether the monster compensation packages were shrewd or unconscionable (maybe, BOTH). There can't have been a clearer signal of who was loving every moment of it; I haven't heard of ANY major effort to reign in Wall Street bonuses because Boards were afraid of losing the "talent" of individuals who disguised leverage as genius.

[saifedean]

I agree that financial innovation is largely the modern version of soothsaying and witchcraft. And that is precisely why I think there should be no regulation whatsoever. If people are stupid enough to trust their life savings to a soothsayer with a Powerpoint, there is absolutely nothing anyone can do about it. All that the government can do is protect other taxpayers from having to foot the bill for other people's idiocy.

This way, when people realize no one will bail them out, they'll actually be careful and probably won't invest so much of their life savings with the next con artist. And those who do will at least only get to make that mistake once. Soon enough, they'd be weeded out of the investor's pool and we won't have to worry about them.

[Poujade]

I dare say I found this post rather populist in the way it despises financial innovation.

Basically, financial innovation has allowed more precise pricing of more products, allowing for a global increase in the amounts invested, as more people found the financing they wanted and banks willing to provide it. All of this has helped the world economy to grow at such a fast pace.

But maybe the point of this article is to chose one innovation in particular? Is this not like asking a nuclear physicist for a precise innovation that has made earth a better place ?

[robertdfeinman]

The one financial innovation over the past several decades was that of allowing originating banks to resell mortgages and start again.

Before this banks could only lend up to the limits of their deposits (minus reserves) and they we also limited in the amount of money they could attract in the form of deposits.

This was because most deposits came from US sources, FDIC insurance is limited and there were regulations on how much interest could be paid.

The reselling of mortgages allowed Fannie and Freddie (et al) to attract funds from elsewhere and increase the overall size of the capital available.

The bundled mortgages they sold were also easy to understand. The buyers of these bonds got a higher return, but were subject to higher risks in terms of a non definite maturity date and the risks of individuals defaulting. This was all factored into the yield.

Fannie and Freddie made sure that they were only buying high quality mortgages and issuing banks who couldn't resell mortgages would be unwilling to keep risky loans on the books, so they wouldn't offer them.

The middle men could have been eliminated if banks had been given the authority to raise capital in other ways, but the players like to stick themselves into the middle of simple transactions and skim off part of the profit.

Everything that followed beyond this was a Ponzi scheme.

[John V]

rdf,

I notice you often tread on the outer boundaries of libertarianism and free-market thinking...yet you turn around in the next breath and blame those people for what's wrong.

Strange.

Are you starting to have those:

"Damn, I sound just like my FATHER"-moments??

[alex]

Poujade: financial innovation has allowed more precise pricing of more products

That explains the state of the secondary mortgage market.

Is this not like asking a nuclear physicist for a precise innovation that has made earth a better place ?

Radiation treatment for cancer. Understanding solar behavior and hence its effect on climate and minimizing the effect of solar storms on the power grid, communications and navigation. Making it possible to protect satellites so that we can use them for weather prediction, communication, navigation, etc.

Your turn.

[Per Kurowski]

No now's the time to make clear the consequences of over-regulation.

Or does anyone here imply that placing minimum capital requirements on banks that solely depend on “risks of default” and thereafter empowering risk kommissars to rate, is not heavy handed regulation?

[robertdfeinman]

John V:
I have no idea what you are talking about, but Dani Rodrik's blog is not the place to discuss my views of the world.

He asked for an example of "innovation" and I offered one.

However, I'm inspired by your comment and I'll formulate my personal view of the world and post it on my web site, sometime in the next few days when I've thought about it enough and have the time to write it down.

[Lord]

Financial innovation has provided a wider range of products and increased flexibility. What it never did was allow anyone to afford what they previously couldn't; that was just wool being pulled over everyone else's eyes. Innovation doesn't free anyone from qualifying assets and incomes in lending. That under most innovations borrowers wouldn't be able to afford as much is just reality. Allowing anyone to print money is a recipe for a perpetual repeat.

[Jonathan C]

Having a failure of imagination day?

Here are just a two from the press in the last couple of days that I've noticed, from Felix Salmon and Bob Shiller. Would you be against innovation like this:

(1) Felix Salmon points to innovation to help countries like Argentina in the face of commodity price declines: "Citigroup Inc., Barclays Plc and Deutsche Bank AG proposed a debt-restructuring plan to Argentina that may help the country raise cash as declining commodity exports curb tax revenue, a government official said.
The proposal aims to get bondholders who refused to participate in Argentina's 2005 debt renegotiation to swap their defaulted securities and to put up fresh cash to buy new debt, said the official, who asked not to be identified because he isn't authorized to speak for the administration."

(2) Bob Shiller, a man with the highest possible credentials when it comes to warning against asset bubbles, sees the way forward as via financial innovation to help AVOID problems like we have today. From this weekend's paper

"Mortgages of the Future": ...“continuous-workout mortgages.” Such mortgage contracts, when originally signed, would specify a program for steady adjustment of the balance and payment schedule over the life of the mortgage, enabling most homeowners to continue to afford to make payments and maintain some home equity, even in harsh economic circumstances. These contracts might become the standard, with automatic adjustments based on shifts in national housing-cost indexes and futures markets (I’ve been involved in creating both), as well as economic indexes like the unemployment rate.

Continuous-workout mortgages would be privately offered. They would not be bailouts; the cost of workouts would be priced into the original mortgage rate. This transparency has a great advantage: when the actual risk to the investor is explicit from the beginning, mortgages are less likely to be initially overvalued in the market, and so the kind of financial crisis we are experiencing now would be less likely."

Links:
http://www.portfolio.com/views/blogs/market-movers/2008/09/23/how-investment-bankers-are-helping-argentina?tid=true

http://www.nytimes.com/2008/09/21/business/21view.html?scp=1&sq=shiller%20&st=cse

[Andy McLennan]

It should be pointed out that corporate risk management is a not obviously a good thing for the shareholders, at least if they are diversified and care about expected profit. If it reduces the variability of input prices, it is a bad thing because it reduces the corporation's incentives to adjust input demands in response to actual scarcity. Note, also, that if the corporation's demand is less variable, the price others face will be more variable.

The people who value corporate risk management are the managers, not the consumers or the shareholders. One can try to tell stories about how this might be a good thing (e.g., by increasing the signal-to-noise ratio we get a better view of the quality of management) but I've never heard of an industry that simply wouldn't exist, or would have much higher costs, if its producers didn't have hedging tools.

[alex]

Jonathan C,

Thanks for an intelligent post. I don't think we've reached the end-of-history in terms of financial arrangements. After all, much of the bedrock of modern economies, like publicly traded corporations, commodities markets, and so forth, were once innovations.

However, I'd avoid calling any idea you advocate "financial innovation". Like "creative financing" the phrase has lost its literal meaning, and come to mean "hiding the risk until we can collect our bonuses and leave town".

[Dani Rodrik]

Jonathan C --

I am asking about financial innovations that have been already put to work--not those that our fertile imagination may be able to dream up for the future.

[Alejandro Hope]

How about tradable carbon credits, as used in the EU's cap-and-trade mechanism? That certainly counts as financial innovation, doesn't it?

[Joe S.]

I'm not sure that any of the posters here--or our genial host--understand the purpose of financial innovation. Poster Poujade compared financial innovation to physics. A fair comparison. I used to be a physicist, and am now in the financial services biz.

Technological innovation (hard technology) is about better products. Better products are win-win. The innovator gets supracompetitive gains; the purchaser gets a--uh--better product.

Financial innovation, not so much. Some financial innovations--e.g. plain vanilla swaps or (in their time) the 30 year mortgage--are indeed better products. But most financial innovations are in sales technology, not product technology. The innovator has a new pitch. The product might be novel, in a way, but that is in support of the pitch.

Take the credit derivative, for example. Looks at its rhetoric. The rubes are called "protection sellers," not "risk buyers." A protection seller sounds sophisticated--sellers always sound more sophisticated than buyers. But the real sophisticates are the folk holding risk and trying to make a buck by offloading onto a person who understands it less well.

So how do we deal with the basic problem? There is some genuine financial innovation. But most of the "innovation" is sales tech.

My formula? Let the niche players do what they want, and be the engine of innovation. If they make a good product, the big guys can convince the regulators that it is good, based on the experience of the niche players. If the innovators go broke, who cares. If they sell poison, they are too small to poison the well.
But only let the big guys sells the stuff that was has been proven by time, or in the niche market.

[Jonathan C]

Thanks for the clarification. You are right that the supposed benefits (e.g. 'better hedging of risks') of most of the financial innovation of the recent past that produced the explosive growth of the shadow banking sector, vaporize when matched against the huge new levels of systemic risk they helped to create.

That said, I rather agree with Shiller and some of the commenters here that the way out of the mess and forward will probably likely involve a fair amount of new financial innovation.

[Sandro Perricelli]

Credit default swaps.

Without credit default swaps, corporates that are exposed to investments in countries following hare-brained macroeconomic policies cannot insure against a "sudden stop" or an act of the sovereign.

Argentina comes to mind.

[Zach]

As someone who is not in the industry, I sometimes have difficulty following the dialogue about arcane financial instruments. I'm sure there is a place for risk management via financial investments, but from a distance it all seems so overly complicated.

When I had a few Finance courses in business school (it was not my focus), my personal take-away was that for all the money and headcount I would have to devote to dealing in these instruments...why not instead employ those resources in designing operational efficiencies, or moving into a new market that would off-set a downturn in my traditional business?

You know, use those resources to actually create value?

[Sven-Erik]

It strikes me that, applied with sufficient prudence and transparency (famous last words...), recent innovations in securitization could be applied to connect the credit-worthy in developing and emerging economies to larger pools of non-microfinance capital in the developed world. With proper risk analytics (which would doubtless have to be innovative unto themselves, situationaly/regionally appropriate and built on the experiences of successful microfinance outfits) couldn't new securitization techniques be used to scale up debt pools from the truly deserving in developing economies so as to connect these pools with a source of conventional capital in a developed economy that would otherwise be unattainable?

[tristan hanson]

What about:

1. interest rate swaps - allow parties to manage interest rate risk

2. tools to hedge exchange rate risks - futures/forwards/FX options

3. weather insurance

4. inflation-indexed bonds (remove inflation risk and provide holders with a guaranteed real return)

These seem useful financial innovations to me for a whole host of actors whose main activities lie outside the financial sector...

[Charles Nota]

Introduced in 2003, the Common Contractual Fund (CCF) is Ireland’s bespoke pooling vehicle, creating the opportunity for pension funds and institutional funds to invest assets in a tax efficient manner. The IFIA state that, “The CCF is an unincorporated body, not a separate legal entity and is transparent for Irish legal and tax purposes.” As discussed in a recent a Finance Week article, there are huge performance implications alone in using a CCF, compared to the same investment via an Irish Variable Capital Company (VCC). In the example given, if a fund manager invested £1bn in the MSCI Euro index and performed only equal to that index, a CCF would have created an additional return of £57.5 million over the past 10 years. Figure 1. shows CCF against VCC performance, for further details http://www.financeweek.co.uk/corporate-finance/how-tax-transparent-pooling-helps-uk-company-pensions

[Per Kurowski]

At the end of the day the simple truth is that the costs of regulatory innovations far exceeded the costs of financial innovations and that the benefit from financial innovations far exceeded the benefits from regulatory innovations.

Try to live with it!