The latest in a long series of articles on the Rational Post sharing a common refrain: those who forget economic history are condemned to repeat it…
Originative sin: the future of banking
By John Plender at FT.com, January 4 2009
For the late John Kenneth Galbraith, an acute observer of market folly, finance and innovation were fundamentally incompatible. 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 (source of the earlier quotation) 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.”
From barter to Fuggers’ fall
The double-edged nature of financial innovation has been apparent throughout the ages. Coins improve on barter because they economise on information and transaction costs. Paper money has the additional advantage of being less cumbersome than metal. Yet, as the Chinese found between the 11th and 14th centuries, a paper currency carries inflationary risks.
The most inventive bankers of the 16th century were the Genoese, who developed the equivalent of interest rate swaps in their lending to the Spanish government. They also devised a form of securitisation to use inflows of silver into Spain to finance the delivery of gold in Antwerp to pay Spanish troops in the Low Countries.
According to the historian Fernand Braudel, the Fuggers, pre-eminent bankers of the day in Germany, were profoundly suspicious of this apparent financial sleight of hand. So innovation provided the Genoese with a competitive weapon that helped displace the Fuggers as financiers to the Spanish treasury.
In both these cases innovation was providing a solution to a problem – another long-standing pattern. In China a scarcity of bronze led to the introduction of iron coinage, which was so inconvenient to transport that paper provided an attractive alternative. As for Europe, economic historians William Goetzmann and Geert Rouwenhorst argue that it was the financing requirements of the Crusades that encouraged Italian city-states to develop bond markets.
The cost of hostility to financial innovation may be high. Some historians speculate that a lack of financial development helps explain why the Chinese, who discovered the steelmaking process in the 11th century, did not produce the first industrial revolution.
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, as excess savings in Asia and the petro-economies drove yields down. 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.
In recent testimony to a congressional committee by James Simons of Renaissance Technologies, a hedge fund, said fanciful ratings of mortgage-backed securities facilitated the sale of “sows’ ears … as silk purses”. As well as being mispriced, risk was mismanaged, because the underlying methodologies were fundamentally flawed.
The damage caused by bubbles can be greatly increased where innovation leads to information loss. Computerisation and the internet have improved the transparency of much of the financial system. Yet most of the asset-backed paper in the bubble was traded not on organised exchanges but on dealers’ screens and telephones. Instruments such as collateralised debt obligations helped make the system more opaque and more hostage to counterparty risk – the chance that the person on the other side of a transaction fails to deliver. That is because there was no centralised clearing and settlement in which all contracts were guaranteed.
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”.
If that makes innovation sound subversive, regulatory arbitrage (locating a trading business in a place that has the laxest local laws) can nonetheless have economic and social benefits if directed at bad policy. 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 via the new eurodollar market, which helped rejuvenate the City of London in international finance.
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. By encouraging off-balance-sheet activity, the regime turned banking into a shorter-term, more transactional business.
This “originate and distribute” model – in which banks turned conventional loans into fancy securities and sold them on to a pool of investors – reduced the incentive for banks to monitor the creditworthiness of those to whom they lent. It was a case of churn out the loans and let the devil take the hindmost.
The latest Basel bank capital accords, which failed to avert financial crisis, have been criticised for:
● A poor focus on liquidity.
● Internal risk rating that allowed banks a high degree of discretion.
● Encouraging pro-cyclicality in the system.
● Giving an excessive role to credit rating agencies.
In addition, banks had an incentive to increase leverage – identified by Galbraith as a recurring cause of systemic damage – as they piled more liabilities on to a very slender capital base.
Measures of leverage based on Basel’s “tier one” capital ratio, which were the main focus of analyst attention, appeared less frightening than those based on conventional accounting, which revealed a more disturbing picture that went largely unobserved. The outcome was that banks ended up more highly leveraged than most hedge funds. Nothing illustrates better how the law of unintended consequences can contribute to financial blow-ups.
An endemic difficulty also arises with insurance, whether conventional contracts or hedging instruments such as credit default swaps. It relates to moral hazard, whereby the existence of a safety net causes people to adopt more risky behaviour. The result is that while insurance reduces the risk to the individual, it increases the risk to the overall system.
Perhaps the most dangerous examples of moral hazard are deposit insurance and the readiness of central banks to act as market makers or lenders of last resort. Owners of insured deposits have little incentive to monitor the creditworthiness of banks where they place their money. Large depositors exercise little discipline over banks they see as too big to fail. After the bubble, the Fed’s role as lender of last resort was extended to investment banks and to AIG, the insurer. So moral hazard is now more widely entrenched across the financial system.
Many of these drawbacks can be addressed to ensure that the blessings of innovation outweigh the curses. This is certainly true of the opacity that prevails in over-the-counter markets for securitised financial instruments, where little information about transactions is made public. Banks now see it is in their own interest to shift securitised business to exchange traded markets with centralised clearing houses backed by capital from trading members. This will introduce transparent pricing and volume information while reducing counterparty risk, which is what the regulators want.
But moral hazard can be addressed only by regulation, by penalising management and shareholders when banks are bailed out, or by allowing big banks to go bust. More regulation almost certainly has implications for the rate of innovation, which tends to go in waves. With politicians and watchdogs now preoccupied with the curses rather than the blessings of financial ingenuity, an innovation slowdown is probably inevitable. New and risky financial products may attract higher capital penalties under a revised Basel regime.
Yet there are those, such as Robert Shiller of Yale University, who argue that much of the damage could have been avoided if finance had been democratised and innovation used to manage individual home owners’ risks through, for example, house price futures markets that allow home owners to insure against falls in prices. Others say derivatives could help address problems such as water shortages, since futures markets can smooth imbalances of supply and demand.
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. At the wholesale end, producing a new financial mousetrap gives banks an entrée to corporate clients and institutions.
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.
With an increased burden of regulation, financial innovation will probably provide new forms of regulatory arbitrage to circumvent the new rules, just as it did after the introduction of Basel One in the early 1990s.
Miller found, after predicting a lower rate of innovation back in 1986, that it is always dangerous to forecast any slowdown in what financial ingenuity can bring about. The backlash to today’s financial crisis will inevitably provide tasks for the next generation of regulatory arbitrageurs.
Copyright The Financial Times Limited 2009