Financial innovation

By Felix Salmon
July 20, 2009

In my blog entry this morning about Robert Shiller and his bonkers defense of subprime mortgages, I made an en passant reference to financial innovation being, net-net, a bad thing. I didn’t go into too much detail, because it wasn’t all that relevant to the point at hand, and because, as Sean Matthews pointed out, this question has been debated in the blogosphere in some depth in the recent past.

But Tyler Cowen picked up on the line, and wrote:

I can understand that particular financial innovations might be bad, but financial innovation overall? Surely this claim was false in years 1200, 1900, and also 1950. (Of course you’ll find very harmful financial explosions between those years and the current day but still on net you’ll take the progress.) If the U.S. economy resumes growing at an average rate of about two percent a year, eventually our economy will look very, very different than it does today. It’s hard for me to see running the economy of 2100 with the banking system of…what is the nostalgic year? 1992? 1957?

We’ll need more than better ATMs, which is not to say we need approve of every step along the way.

I think that the case for the positive effects of financial innovation is yes pretty strong if you roll back the clock to 1200 or 1900 or 1950. But over the past 25 years or so, the claim is much harder to make stick.

As for banking systems, Tyler I think concedes that there’s an important distinction which needs to be made here. On the one hand, there’s what you might generally lump into back-office functions — the distribution, clearing, and settlement of exchange. ATMs, charge cards, debit cards, PayPal, online banking, m-banking, etc all fall into this bucket, and advances here are often (although not always) a good thing.

Then there’s the more purely financial innovation. There are good things here too — fractional reserve banking, factoring, common-stock limited-liability companies, tradable fungible bonds, stock-market index funds, that sort of thing. But on this front I think the low-hanging fruit was plucked decades if not centuries ago, and that we’ve long since entered a world of diminishing returns when it comes to the positive developments. Meanwhile, the negative developments, from portfolio insurance to CDO-squareds, have been arriving at an ever-accelerating pace.

I agree with Justin Fox:

I’m with Tyler in that I’d rather have today’s financial system, however flawed it is, than the financial system of 1200. But at the same time, an estimated 97.3% of all financial innovations (I just made that up, but it seems about right) are just new ways to fleece customers or hide risk, and all major financial crises have been associated with some financial innovation or another.

The point is that we’re not in 1200, or 1900, or even 1950. And if you look at how fast the US economy managed to grow in the 50s and 60s without the benefit of Black-Scholes or the Gaussian copula function — or, for that matter, how fast the Chinese economy has grown of late with very strict fetters on financial activities — it looks very much as though most of the financial innovation in recent decades constitutes a history of increasingly-desperate attempts to eke out returns in the context of a naturally-slowing economy. And that history, I think, is doomed to failure.

So yes, in 2100 I’m sure that checks and credit cards — hell, maybe even cash, too — are going to be a thing of the past. But all that falls under the general rubric of “better ATMs”. Are we going to need more than that to run the 22nd-Century economy? I’m not convinced. And even if we do, there’s no reason why we can’t get there from here slowly, and with circumspection.

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Comments
13 comments so far

This screed against financial innovation is still idiotic. If you are going to discuss financial innovations be realistic about them. In the period you castigate we had such innovations as:
*money market investment funds
*NOW accounts
*municipal bond mutual funds
*IRA accounts
*Universal Life insurance policies
*ATM’s
*financial transactions by personal computer
*electronic funds transfer

and many others. You should argue why these are bad to make your net-net argument.

For a serious article on this you can see Van Horne in the Journal of Finance in 1985, http://www.jstor.org/stable/pdfplus/2327 784.pdf.

Shiller has been promoting what he calls radical financial innovation, which is mostly new kinds of risk management for regular people (housing prices, incomes, country risk, etc), which all sounds pretty good.

It might be useful to distinguish between what I’ll call “arm’s race financial innovation” which occurs in response to increases in or changes in the focus of financial regulation, and all other financial innovations. Many of the beneficial financial innovations mentioned by others seem to actually be the harnessing by the financial sector of technological advances occurring in other sectors which make it easier to complete existing types of transactions in a more convenient way. I wouldn’t really call this “financial innovation,” it’s more a spillover into retail finance of innovations in other sectors.

Posted by bdbd | Report as abusive

The second problem with this post, which is perhaps more significant, is that Salmon only thinks about the impact of financial innovation on growth. But many financial innovations are ways to share risks. They may increase welfare without increasing growth. Think of any insurance. Without fire insurance I have to save more to cope with the state where my house burns down. My consumption is lower but my savings is higher. Growth might even be higher without the insurance because of higher savings. But welfare is lower because the goal of an economy is to allow people to consume.

What about the mortgage derivative that, without which, we would have no secondary mortgage market: the collateralized mortgage obligation (CMO)?

Without restructuring the cash flows from a mortgage, the maturity of the underlying pass-through (unstructured) security is hard to predict and potentially highly volatile, making them an awful tool for management of interest rate risk via immunization.

Prior to the advent of the CMO (late 80s??), there was no secondary mortgage market; loans were sold to GSEs and Ginnie, but they ended up being held on their books as there was little demand from institutional investors for unstructured pass-through securities due to the prepayment risk in the pools.

It’s also hard for me to see how these types of structures, without additional slicing and dicing into CDOs, could be the source of the kind of meltdown in the mortgage markets we have just witnessed. Prior to the emergence of the private placement market, the secondary mortgage market was a pretty boring place, filled not with speculators, but with staid institutional investors looking for ways to mitigate their interest-rate risk.

The advent of the CMO lowered the cost of mortgage borrowing by an estimated 50 to 75 bp (I forgot the citation, but can find it, if so desired) on 30-year loans and the default risk was held, and well managed, by the way, through stringent underwriting, by the GSEs.

Yes, modeling prepayment and valuing prepayment options involves lots of geekery, but that doesn’t necessarily imply that they’re weapons of mass destruction, either.

Posted by framed | Report as abusive

Felix, I think you’re underestimating the extent to which the turbulence of the 1970s upended the post-war financial landscape. Robert Merton offered a list of these game-changing events in his Nobel lecture:

“In the 1960s, especially in the United States, financial markets exhibited unusually low volatility: the stock market rose steadily, interest rates were relatively stable, and exchange rates were fixed. Such a market environment provided investors and financial-services firms with little incentive to adopt new financial technology, especially technology designed to manage risk. However, the 1970s experienced several events that caused both structural changes and large increases in volatility. Among the more important events were: the shift from fixed to floating exchange rates with the fall of Bretton Woods and the devaluation of the dollar; the world oil-price shock with the creation of OPEC; double-digit inflation and interest rates in the United States; and the extraordinary real-return decline in the U.S. stock market from a peak of around 1050 on the Dow Jones Industrial Average in the beginning of 1973 to about 580 at the end of 1974.”

Things like interest-rate swaps, currency swaps, and the of the Chicago Board Options Exchange were created to address the uncertainty that was brought about with the collapse of the old financial order. Surely you agree that world has become more volatile since the 1970s and that scores of useful financial instruments were invented to deal with this uncertainty?

Posted by Peter Rudegeair | Report as abusive

The real enemy is Complexity. We can’t handle it. We need a very simple and basic foundation for our Financial System like Narrow Banking. I’ve read a million posts telling me that the main culprit in this crisis was ignorance. If that’s so, then we’d better simplify things very quickly. In fact, I’ll take that excuse seriously when people start looking at Narrow Banking and other more straightforward solutions. Until then, I’m going to assume that the Stupidity Defense is just an excuse, and the people that got everything wrong still believe that they’re the smartest people on earth.

And, yes, I can’t handle complexity either. I like things simple and clear.

complexity begets expertise begets informational asymmetries begets “what happened to my money?”

Posted by bdbd | Report as abusive

The Justin Fox quote estimates (jokingly) that 97.3% of innovations are for fleecing customers and hiding risk. This cannot be accurate, as a fairly large fraction of innovations are simply ways of dodging taxes.

Posted by Ken | Report as abusive

First of all computerization, globalization and telecommunications have driven a lot of financial innovation in order to squeeze costs out of the financial system.

You may not see these savings, but they are there in the form of online trading, ATMs, discount brokers, etc. But also capital markets have become more integrated and global. That is net:net a positive.

Financial information and live data that used to cost $35.000 per year twenty years ago are now either free via the Internet or sometimes with as little as a 15-minute delay. This has made capital markets much more democratic.

There is also nothing inherently wrong with spreading financial risks to those that can genuinely afford to take more risk in return for higher returns. However, regulation and supervision are key to making sure that risks are truly separated and reserve provisions are in place. Accounting rules and government regulations that do not clearly define risk and how to provision it are not proof that risk cannot be spread or reduced through hedging and mitigation. Pure insurance products are a good example of spreading risk.

On the other hand perverse tax incentives and implicit government guarantees that favor homeownership over renting, while distorting the housing market and encouraging would-be homeowners to buy more house than they can realistically afford, is not a market failure, but the failure of government intervention in the market. That is not the fault of financial innovation.

Posted by MrBill, Eurasia | Report as abusive

Of course there is financial innovation. No financial innovations is either completely good or bad. Some financial innovations are good for more people than they are bad. Some yield profits for some. Some improve the quality of life. Some reduce risk. Some allow for abuse and additional risk and some are simply poorly understood. In other words, they are pretty much like any other innovation.

Credit cards were a financial innovation. You could also say that “reward points” and frequent flyer miles were financial innovations. So were ARMs, CDS, options, ETF’s, mutual funds and dark pools.

Saying that financial innovation will lead us to ruin because (to use the example in the post) China has grown so much with an “old” financial system is ridiculous. We (in America) need financial innovation (as we need every kind of innovation) to keep growing. We have to rely on innovation because we don’t have the same resources of China. Our growth isn’t fueld by mass and population, it’s fueled by innovation.

Growth without (financial) innovation isn’t a good reason to give up on financial innovation. People made it by boat across oceans on ships, but we still invented the airplane.

Posted by Tom | Report as abusive

I think that the instantaneous direct connections of the Internet change the game, and potentially make obsolete most of the tools of financial intermediation which you list.

I’ve been working in the area where internet and markets converge these last 10 years (from a background as a director of a global energy exchange fwiw). I can see a new wave of financial products based upon a new approach to the legal and financial structures (“enterprise model”) we take for granted.

It’s what Gillian Tett of the FT calls a “Flight to Simplicity”

eg

http://www.policyinnovations.org/ideas/i nnovations/data/000085

http://www.slideshare.net/ChrisJCook/mon ey-30

As noted earlier, modeling prepayment options on both fixed-rate or adjustable-rate mortgage loans is not a futile exercise. In fact, most in the mortgage finance field would contend the greater good provided by examining in-the-money refi behavior, for one example.

Or, we can just yearn for the days of a 15% fixed-rate home loan with 20% down. The good old days of 3-6-3…

Posted by Griff | Report as abusive
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