Encouraging the right kind of financial innovation

The experience of the sub prime crisis tells us that, we must encourage the “right” kind of financial innovations. In an interesting paper[1], Joseph R Mason points out that only those financial innovations that facilitate diversification, market completion or capital deepening are useful to society in the long run. Others end up creating more problems than solving them. And this is exactly what seems to have happened during the subprime crisis. Let us understand Mason’s arguments in more detail.

Financial innovations that facilitate diversification are extremely important for investors. A good example is index funds, which allow small investors to hold a portfolio that replicates the index without actually having the money needed to buy all the stocks that make up the index.

Market completion helps to make markets work more efficiently, by removing arbitrage opportunities and financial friction. For example, life settlement products allow life insurance policy holders to sell their policy for the expected present value of the insurance benefits. This value typically exceeds the policy surrender value and the net present value of the premiums contributed to date. If life settlement products succeed, the life insurance industry will have to pay much higher surrender values to compete with life settlement providers. This will remove a financial arbitraging opportunity.

Capital deepening means injecting liquidity by making assets more liquid. A good example is securitization, which enables illiquid loans to be sold. The proceeds of the sale can be used to make more loans. Thus more capital is available in the market.

Why did securitization, positioned as a capital deepening innovation, fail? Mason explains that the key to a capital deepening process is the effective distribution of risk and returns to a wider investor base. But during the sub prime crisis, the risk was either not distributed, i.e., it remained with the banks or was parceled off to unwitting investors without commensurate returns to justify the additional risk involved. Indeed, securitization, during the sub prime crisis became a risk “distillation” rather than a risk “distribution” process. While securitization pooled various loans and made them tradable, it also ended up creating a few very risky securities that ended up bearing all the expected losses in the pool. It was indeed this “toxic waste,” which fuelled the sub prime meltdown.

Regulators must be proactive when it comes to financial innovation. Innovations, when first introduced, may be a black box to many. But as they become popular, they must become more transparent. The features of financial instruments must become standardized so that they can trade freely on OTC markets with adequate liquidity. Commoditized instruments can finally trade on organized exchanges where as we know, the counterparty risk is greatly minimized.

Adequate accounting rules, a proper regulatory framework and widespread understanding of product features are all necessary before an innovation can become broad based. Unfortunately, in the case of complex, opaque instruments like CDOs, the market expansion took off before participants had enough time to understand them and appreciate the risks involved. As Mason sums up, “Recent experience should stand as a lesson that it is important to move financial innovations through those incipient stages of development before they grow large enough to substantially undermine economic performance, should a crisis arise.”

In short, financial innovation must be encouraged within a controlled framework. Giving the financial sector complete freedom to operate in the name of encouraging innovations is a simplistic approach to say the least. Checks and balances are indeed necessary.