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Financial innovation: blessing or curse?
Every new financial instrument, he said, "is, without exception, a small variation on an established design, one that owes its distinctive character to the ... brevity of financial memory".
- By John Plender/Financial Times
- Published: 23:38 January 7, 2009
Every new financial instrument, he said, "is, without exception, a small variation on an established design, one that owes its distinctive character to the ... brevity of financial memory". The world of finance "hails the invention of the wheel over and over again, often in a slightly more unstable version".
After the devastating collapse of a credit bubble that had seen explosive growth in new financial instruments, many politicians might feel Galbraith, if anything, understates the damage wrought by financial innovation.
So the post-bubble policy agenda is bound to address important questions. Is financial innovation a blessing or a curse? Given, at the very least, that it is double-edged, should innovation in finance be curbed, or kept far removed from the conventional commercial banking sector?
And how possible is it anyway to control the inventiveness of banking's rocket scientists on Wall Street and in London or the eagerness of their employers to make money from their ideas?
The extent of the detritus bears thinking about. Subprime mortgages that promised home ownership to millions on low incomes have inflicted the misery of repossession. Increasingly complex forms of mortgage-backed paper left the banks that invented them at the mercy of both a liquidity and a solvency crunch.
Those such as Alan Greenspan, the former chairman of the US Federal Reserve who claimed that financial innovation was distributing risk to the people in the system best able to shoulder it, have been proved comprehensively wrong.
Instead, the dictum of Warren Buffett, the "sage of Omaha", that derivatives were financial weapons of mass destruction has been vindicated as one bank after another turns to its government for support.
Andrew Hilton, director of the Centre for the Study of Financial Innovation, a London-based think-tank, even argues that "you can make the case that banking is the only industry where there is too much innovation, not too little".
Economic literature offers both passionate advocates and passionate opponents - which is understandable, given that the impact of financial innovation on social welfare is impossible to measure.
Supporters say new instruments, technologies, institutions or markets lower transaction costs, make markets efficient, help solve social problems and contribute to economic growth.
Sceptics highlight obvious costs. Galbraith, in A Short History Of Financial Euphoria emphasised the pervasive role of debt:
"All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets ... All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment."
His verdict captures very precisely the shuffling of asset-backed paper and the slicing and dicing of risk that marked the credit bubble.
A huge debt-powered financial superstructure was built on top of the real economy to the point where high-octane finance became increasingly out of touch with productive enterprise. Yet Galbraith was too sweeping.
The financial system does many things. Among others, it provides a means of payment and exchange; it transfers the spare cash of savers to those with investment opportunities; it allows assets to be traded; and it provides insurance, whether in conventional contracts or in such instruments as swaps, options and other derivatives.
In all these areas, innovation has provided tangible benefits. Computerisation has improved the payments system, while technology such as automated teller machines has been a huge convenience to retail bank customers.
The internet is transforming the availability of financial information and is lowering transaction costs in broking. Like many other innovations in retail finance, these advances do not involve the creation of debt.
Even in those areas that do, the outcome can still be beneficial. The development of the swaps market, for example, led to the new disciplines of treasury and risk management whereby the banks' ability to swap fixed for floating interest rates and vice versa allowed them to insure against rate volatility. Currency swaps fulfilled a similar function.
With the huge increase in market volatility stemming from deregulation and the abandoning of fixed exchange rates in the 1970s, this ability to hedge was a boon to banks.
At the same time, computerised trading increased the efficiency of markets. More often than not, innovation is satisfying genuine demands. Where the curse comes in is that many innovations are double-edged.
Plastic cards, in so many ways a benefit to bank customers, may lead to over--indebtedness, a growing social problem. Derivatives can be used to punt as well as to hedge.
Credit default swaps were developed as insurance to protect investors against a failure to honour loans or bonds. Then came the collapse of Lehman Brothers, which revealed the extent to which people had underestimated the risk of their counterparties defaulting.
As the economist Burton Malkiel points out, a benign instrument designed to reduce risk turned into a monster that came close to destroying the entire financial system.
During the credit bubble, innovation was in one sense satisfying urgent demands all too well. Low-income families wanted mortgages and the banking system provided them. Investors wanted income in the period where even junk bonds offered a diminishing premium over the yield on government bonds.
Yet in the euphoria, would-be home owners overstretched themselves, while banks dropped lending standards and fraudsters made hay.
Another recurring difficulty lies in assessing risk in innovations, which by definition have no lengthy record. By relying on inadequate historical data, credit rating agencies made asset-backed paper look better than it was.
Risk was mispriced as banks provided investors with a toxic solution to the problem of yield compression, whereby the spread between government bond yields and low quality corporate bond yields became absurdly narrow.
A more fundamental explanation of why innovation can be counterproductive reflects a desire to escape the heavy hand of the state. Merton Miller, the late Nobel laureate, declared in a 1986 paper that "the major impulses to successful financial innovations have come from regulations and taxes".
The US in the 1970s, for example, responded to rising inflation by reviving a Depression-era measure called Regulation Q, which put a cap on deposit interest rates in the hope that by keeping banks' cost of funds down, mortgage loans would be less expensive.
This was a classic example of attacking the symptoms of a disease, not the causes. It victimised small depositors, who were left with negative real rates of interest as inflation soared.
The markets' response was to invent negotiable certificates of deposit that escaped the constraint of Regulation Q because they were a paper instrument rather than a conventional deposit.
European banks internationalised this, offering unregulated deposit rates to larger investors. That illustrates how markets can act as an escape valve and an adjustment mechanism.
Yet the outcome is not always so benign. In the credit bubble, much of the impetus for driving loans off bank balance sheets into securitised form came from the risk-weighted capital regime introduced by the Basel committee of international bank regulators.
Certainly the urge to innovate will not go away. For bankers, it offers huge advantages.
In retail banking, patented inventions such as Merrill Lynch's cash management account in the 1970s allowed what was then a securities house to make a big dent in the deposit base of the conventional banking system with a genuinely attractive product.
Yet the biggest spurs to innovation in future may be those identified by Miller. The cost of bailing out banks will put big pressure on public finances.
It would be surprising if governments do not look to increase the tax take from companies to relieve some of that pressure. Companies will look to banks, lawyers and accountants to find novel instruments to mitigate the damage.
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