Financial Innovation in Detail

Dinosaur Comics is awesome.

(The all caps at the end is great. This is also a good one.)

I tend to focus a lot on retail and consumer issues with Financial Innovation on this blog. To paraphrase T-Rex, it’s fairly easy to discuss, since a general audience will have a feel for it, I can try and solve it at night while I’m blogging, and a lot of it is obnoxious and duplicitous in a way you want to punch in the nose. I think it also links up with a lot of other interests I have, such as labor, inequality, access, etc., as well as seeing the implications for the ‘financialization’ of our economy.

Economics of Contempt (EoC) is mad at the level of discourse over financial innovation, calling out people by name. Since I want to make sure that when people call out others for “playing to the crowd” my name gets mentioned, I’ll throw in some thoughts.

Shorter EoC: It’s all the ratings agencies’ fault. CDOs as a fake alchemy of creating safe bonds from risky bonds? “the rating agencies were handing out AA and AAA ratings to tranches with lower and lower subordination levels.” Securitization creating a problem where the underwriters of risk were not holding the risk? “The weak link in this chain was, again, the rating agencies…It was the rating agencies that absolved the lenders from sensible underwriting by slapping AAA ratings on securitizations with laughably bad mortgages underlying them.” I assume if we got to CDS contracts in that entry, we would have heard that the real problem was AIG’s rating allowed them to not post collateral for their CDS book. And so forth.

Rating

– You should experience a bit of vertigo reading the argument ‘financial innovation would have been great for us except for all those people who told us it was great for us’, akin to it being the 1950s and hearing someone say ‘smoking would be really healthy for us except for all those doctors paid by the cigarette companies who told us it was healthy to smoke.’

– The ratings agencies deserve a large share of the blame. Especially with that CDS issue I mentioned! I hope we find a good way to rate the quality of credit debt, though it wouldn’t surprise me if the smartest way turns out to be having the Fed backstop CDS contracts with a CDS rate set away from market prices.

However putting all the blame on the ratings agencies strikes me as a far over-reach, and something very convenient for Wall Street. And as far as I understand, there’s no smoking gun; the ratings agencies conflict was well known, as it had been for a long time. Declining subordination levels were well known and on the top of every CDO contract – indeed if we had to start discussing attachment points every time we got into this discussion, the blogosphere would be twice as big.

If the innovation in question could be easily derailed by the ratings agencies, we have to stop and seriously consider if it is a matter of innovation instead of confidence selling at that point. If innovation is a matter of making investments more transparent or efficient I’m not sold. And it’s not necessarily about making investments less risky as opposed to making us understand the risk better – what attachment point is what likely to be breached. I’m not sure if the current science of setting attachment points has us there yet.

One level up

But again I talk about consumer/retail here too much. EoC has a list of financial innovations (zero-coupon bonds for one, from 1981 I think and I take for granted, I’d like to hear more about the history) one-level up, so to speak, that more directly impact those within financial markets. Zero-coupon bonds are awesome for insurance companies, for instance, since they don’t have to worry about re-investment risk with interest (duration). So I’m happy to give that to him as a win, though I’ve stated our increased ability to handle interest rate risk, and the instruments like this that came of it in the 1980s, is a genuine innovation, though an achievement I associate with a previous world of finance.

One thing I worry about at this level is that most innovation is zero-sum. The buy side and sell side have been at war forever; they both brings a knife, the sell side innovates and brings a gun, so the buy side has to innovate as well and bring a gun. They are still in check, though it isn’t clear that capital is getting allocated more efficiently. I hope EoC continues forward with this level.

Another level up

I think the real questions for us is how big do we want the financial market to be, and what effects does the current size of the financial market have on our economy. I think this is why the term innovation has such a negative connotation in this context – as others have pointed out, innovation should be consistent with this market share either declining or value for consumers increasing. Instead we are seeing both turn out the other way. It almost seems like the actions of the financial sector are becoming indistinguishable from rent-seeking on the real economy.

Whether or not an insurance company can adjust their coupons this way or that way is tangential to this bigger problem for the real economy, and ultimately for all of us.

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6 Responses to Financial Innovation in Detail

  1. Luis Enrique says:

    “rent-seeking on the real economy” sounds like something the finance sector could do, even if it wasn’t generating crises. Do you see generating crises as distinct from rent-seeking on the real economy?

    Take investment banking, for example. This involves providing all manner of services that have a perfectly sensible role in the economy, but like any oligopoly firms offering services can (and do) make excess profits (rents). But I get the sense you mean something more profound that just “charging too much for what they do”. Or do you?

    It seems natural to think that the dramatic growth of the finance sector had something to do with whatever it was doing that ended up generating the crisis. This could be viewed as an intertemporal transfer, turning losses tomorrow into profit today. . I guess you could call that a species of “rent seeking on the real economy”, in the same way you might call Bernie Madoff a rent seeker on the real economy. In which case, is this “creating crises” business is synonymous with rent seeking, and if you cure one you’ve cured the other?

    Or, is the way you see that even if we managed to devise some set of regulatory reforms that cure the crisis creating behaviour, we’d still have a rent seeking on the real economy problem to solve?

    If you think that rent seeking is a separate issue to crisis-creating and you think that rent seeking is something more fundamental than just charging too much for services rendered, could you provide some examples of things the finance sector does, that do not amount to “making short-run profits by creating long-run losses”, and yet could still be thought of as rent seeking on the real economy?

    If you don’t think that rent seeking is something more fundamental than just charging too much for services rendered, then I guess we need to ask why the pricing power of the finance sector might have increased dramatically over the last decade, and what can be done to make it more competitive.

  2. I think you misunderstood my post. I wasn’t trying to give a comprehensive account of what went wrong with CDOs, or the problems with the securitization markets more generally. I was just saying that two of the ubiquitous arguments about financial innovation—that CDOs are self-evidently ridiculous, and that the securitization process necessarily absolves lenders from sound underwriting—are false. I definitely wasn’t saying that the rating agencies were the only problem with CDOs. My point was simply that Johnson and Kwak’s whole “financial innovation is bad—just look at CDOs!” shtick is misleading and uninformative, and that the problems were a LOT more complicated than they seem to understand. But that said, I don’t know any serious market player who would disagree that the rating agencies topped the list of problems in the CDO market.

    (Regarding CDS, I would have pointed out that it’s not true that AIG didn’t have to post collateral on their CDS trades. I’ve seen terms of several of their cancelled CSAs, and they still had very average thresholds even with the AAA rating.)

    I don’t want to turn into the designated defender of financial innovation, but I guess at this point I’ve committed myself to writing a post defending the specific innovations I mentioned.

  3. Chris says:

    I’ve commented before here that financial innovation transfers risk to the party least able to understand it (since he won’t charge any risk premium, being unaware that he should, and this “comparative advantage” becomes an optimum sought by the market). What, then, can you say about the behavior of the agencies who deliberately concealed risk? Shouldn’t everyone who invested in a “AAA” security be suing them for fraud? If a broker lied to his customers about the rating of a security he encouraged them to buy, nobody would hesitate to say that *he* should be sued for fraud (since the rating indicates the risk, and the broker knows the customers will rely on that). Why is it any different when the ratings agency does it?

    Also, in this frame, one role of innovation becomes obvious: it creates an opportunity to deceive someone who already understands all the existing instruments and how they work. Any new instrument is a new chance for some investors to misunderstand it and pay you too much for it. (If others misunderstand and offer too little, you don’t have to accept.) A large difference of opinion among market participants about the value of what you are selling benefits the seller, if he can accept only the highest bids, and this remains true even if the average estimate is accurate.

  4. Jesse says:

    Don’t we need to look at the benefit side of the innovation in order to determine whether it is worthwhile or not? Some sort of market-wide WACC less fed funds or something? Or is this a case of visible costs and hidden benefits?

    I say that because if you created some similar graph of, say, the IT/Internet industry since 1948, we’d also see a huge uptick in profits, share of GDP, pay, etc. but I think we could argue pretty successfully that they have delivered consumer value. Simply saying that an industry has grown and they are paying people a lot isn’t enough.

    I have a feeling the defenders of financial innovation (I probably put myself tentatively in that camp. Your arguments are compelling, though) would say that there are benefits in terms of capital allocation or something. But that is hard to prove either way, I think. Have we blown that up?

  5. Luis Enrique says:

    Mike,

    I have another question about financial innovation that I’d be interested to hear your response to.

    Consider a cost saving innovation in a standard goods or service providing industry, and assume it is shared across the industry rather than propitiatory to one firm. It is possible that such an innovation would lead to increased profits across the industry, but we we also expect competition between firms to ensure the cost saving is passed on to consumers in the form of lower prices.

    Should some “financial innovations” be seen primarily as cost saving / profit increasing innovations for the banks themselves? I’m now going to veer into territory that’s likely to reveal my ignorance, but things like securitization, default insurance and such like could all be seen as things that reduce the cost of capital for banks and/or allow them to (believe they could) increase leverage safely, increasing profits in an analogous way to a cost saving innovation in a standard firm, can’t they? If so, we might expect some benefits to be passed on to consumers, in the form of lower prices.

    The first question is, of course, whether there is any evidence of anything like lower prices … a question I know many people would regard as absurd – one measure of which I guess would be the spread between the rate at which bank customers borrow and the rate they receive on savings accounts … I have no idea what measure to use for the pricing of investment banking services. I don’t think looking at the share of banking value-add in GDP is a very good indicator, because it may reflect rapidly rising exports of financial services, and rapid expansion of the domestic demand for financial services.

    The second question is, even if cost saving innovations were passed onto customers, is this as an uncomplicated “good thing” in banking as it would be in other sectors? It’s a common criticism that lending rates were too low. I think this might be conflating what the appropriate interest rate is from a macroeconomic perspective, with how much the financial sector charges for what it does. Perhaps the optimal is for the macro rate to be right, and, that being given, the the costs of financial services to be a low as possible. Perhaps it’s a mistake to think of price cuts in banking as lower lending rates – it can equally mean higher savings rates. On the other hand, if these innovations made banking more profitable/less costly, did that encourage the binge?

  6. Chris says:

    Perhaps it’s a mistake to think of price cuts in banking as lower lending rates – it can equally mean higher savings rates.

    Indeed – if financial innovation enables my bank to do so much better things with my money than it could have 20 years ago, why doesn’t it pay me more for the use of my money? If the first answer is just “so that it can take economic profit”, why hasn’t competition between banks squeezed out the economic profit as efficient markets are supposed to do?

    Instead it seems like depositors are getting worse and worse deals over time (look at overdraft “protection”, for example – a great example of a product no rational depositor would buy), while at the same time, banks are making more and more profit. This doesn’t look like an efficiently operating market in which capital is being put to more productive uses.

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