Challenges to Business in the Twenty-First Century

Chapter 2: Challenges of Financial Innovation

Authors

Gerald Rosenfeld, Jay Lorsch, and Rakesh Khurana

Project

Challenges to Business in the 21st Century: The Way Forward

Myron S. Scholes

The potential for financial innovation to provide benefits to individuals and institutions around the world has been threatened by the onset and continuing evolution of the global financial crisis. Today, a rising chorus of regulators, politicians, and academics argue that the freedom to innovate in the financial domain should be curtailed. Their opinion stems most notably from the recent failures in mortgage finance, financial derivatives, and credit default swaps as well as from the need for governments and central banks to bail out failing and failed financial institutions. These observers claim that “bad” innovations in global financial markets have proceeded too rapidly and without controls, operating as part of an incentive system that rewards risk-taking at the expense of government entities. They feel that “throwing sand in the gears” of innovation will reduce these “deadweight costs.”

These same proponents of re-regulation fail to measure the benefits of the myriad financial innovations that have succeeded since regulatory constraints were relaxed some thirty years ago. As a result, they have failed to proffer a new plan for regulation that would balance the benefits and costs of innovation.

THE POTENTIAL OF FINANCIAL INNOVATION

A major benefit of financial innovation is the potential to help solve a large range of global problems. The demographics are not promising. We expect that populations will double during the next ten years, that 50 percent of the nine billion of us will live on less than $2 a day, and that we will experience unprecedented population migrations. The West will face an extreme aging of its population with low pension benefits, and governments will be unable to provide either pensions or health care benefits. While governments are local, these problems are global and need to be addressed by innovations and by flexible financial institutions. Change will happen. How to finance change will be a central focus of innovation.

To understand how financial innovation can address global problems, we must understand the functions of the system. Economist Robert Merton has listed six crucial functions of a financial system¹:

Facilitating transaction processing. Exchanges provide this function to investors and other entities around the world.²
Funding large-scale investment projects that are outside the resources of an individual or an entity or country.³
Transferring resources across time and boundaries; that is, how investors save for the future or how corporations invest globally.⁴
Risk-sharing and risk reduction. This function is all too apparent for those of us who are deeply involved in the risk-transfer mechanisms of derivative instruments.⁵
Providing pricing and valuation signals to investors. This function provides the transparency investors need to make informed decisions about changing investments or making additional corporate investments.⁶
Seeking ways to reduce market frictions or costs through the reduction of asymmetric information conflicts among those who transact in markets.⁷ This function may well be the most important to both entities and individuals.

The key to profitable provision of services is to provide one or more of these six financial functions at less cost or greater economic benefit than current institutional arrangements allow. Although the services that clients demand from providers might not be producible for a cost that they would be willing to cover, advances in both information technology and our economic understanding reduce these costs.

Current arrangements are fluid, giving way to new arrangements as competitors discover more efficient mechanisms to provide financial services to clients. For example, the technological advances during the last ten years have completely changed the economics of establishing exchange-trading mechanisms.

SOME FAILURE IS INHERENT

Economic theory suggests that all innovation, including financial innovation, must lead to some failures. And because successful innovations are hard to predict, the infrastructure necessary to support innovation needs to lag innovations, increasing the probability that controls will be insufficient to prevent breakdowns in governance mechanisms. Failures, however, do not lead to the conclusion that re-regulation will succeed in stemming future failures, or that financial entities will not learn on their own to provide governance mechanisms to prevent failures similar to the ones witnessed recently.

Because failures occur in bunches, legislatures will find it difficult to ascertain why they happen in any particular economic or financial crisis or whether they will feature at all in a subsequent crisis. The markets are interconnected in nonlinear and computationally difficult ways. The information set is too rich to arrive at definitive conclusions. For example, many pundits argue that subprime mortgages caused the 2008 crisis. Others claim that credit default swaps and other derivatives were the cause. Still others place the blame on monetary policy.

Financial innovation was certainly at fault. Many tax rules and regulations are implemented globally, and innovators respond and work around the rules to suit their own interests. However, the number of tools available to bend the rules has exploded, and regulators and governance mechanisms have been slow to keep up. Financial modelers have used information technology to design new financial instruments and to obfuscate the economics underlying them.

Models and modelers have also been blamed for the crisis. In part, that is correct. By definition, a model is an incomplete description of reality. Faulty assumptions lead to models with a greater chance of error. Modelers who use existing models and ignore their underlying assumptions do so with predictable consequences. And model appliers need data or predictions to calibrate them.⁸ To provide services, a financial entity must develop models to price and evaluate whether they are profitable for the risk undertaken. Governance mechanisms, however, must control scale. For that, common sense, control mechanisms, and incentives are primary. Without measurement, senior management cannot control financial innovation. Incentives without monitoring will be insufficient to prevent large failures.⁹

RISK MANAGEMENT IS KEY

In response to failures, risk management and risk managers should be given higher status in financial entities. The board of directors must understand risk management and take responsibility for the risk decisions made by senior management.

The global accounting system is archaic and does not correctly account for risk and for economic valuation. For example, if Goldman Sachs enters into a financial derivative contract and books a profit of $200 million, shouldn’t the other party to the contract book an immediate $200 million loss? This must be a zero-sum game; if accounted for correctly, it would stop the growth of many contracts that are used to circumvent regulations. If an advisor were to suggest that California issue taxable bonds and buy a broad index of common stocks with the proceeds, voters would reject this proposal. On the other hand, if California promised state employees a pension benefit indexed to wages, which are indexed to bond returns, and invested the foregone wages in a broad portfolio of common stocks, this practice would be accepted (indeed, it is accepted) without question. The same holds true for corporate pension plans. Although the economics of the two are exactly the same, the pension promise and funding (or lack thereof) are not recorded as corresponding liabilities and assets (nor are other derivatives) on financial statements.

In another example, how is it possible for a money market mutual fund to promise its investors that they will always receive their money back when the underlying fund invests in risky securities? The accounting system should not allow banks to hold risky, illiquid, nontraded assets—or to book income on the higher return they earn each period on these illiquid assets—without recording an appropriate reserve for the possible costs of forced liquidation prior to maturity. To present a complete picture of economic health, contingencies need to be taken into account. The accounting system in place today is, to say the least, not transparent. Financial innovators fashion contracts that feed on these inconsistencies. A revised accounting system should correctly account for all assets and liabilities (direct or contingent) and provide measures of risk.

MANAGING RISK IN THE SAVINGS MARKET

During the last fifteen years, we have witnessed the disaggregation and deregulation of financial services in the United States, especially at the retail level. The government no longer guarantees financial performance. Where Social Security and the defined-benefit pension plan once assured households that others had taken care of their retirement program, including its risk, there has been a major shift away from government-provided retirement income (other than for low-income earners) as well as away from corporate plans to defined-contribution pension plans. The amount a household has available for retirement depends on the performance of these plans. The household bears the responsibility and risk for the allocation of the funds. Individuals are asked to make decisions on risk that they did not have to make in the past and may not be trained to make now. We have moved financial functions down to the level of the individual.

Disintermediation and deregulation are also occurring in Europe and Asia, but with a lag. Government deficits in Europe and Japan suggest that societies can no longer afford to pay their past unfunded-pension promises. Corporations, fearful that retirement and health care burdens will be passed along to them, are moving away from wage replacement to defined contribution programs. Thus, European and Japanese savers will soon be in the same position faced by U.S. savers.

But this deregulation provides an opportunity for innovation to the benefit of savers. The next generation of successful financial institutions will recognize this vacuum. Investors and savers need help. The population of baby boomers, currently aged forty to sixty, will be retiring in the next five to fifteen years. At that time, they will want income products.

The Friedman and the Modigliani life-cycle models imply that after a moderate bequest motive, we should spend our last remaining dollar the day we die. Empirical evidence, however, rejects this model. Individuals die with too much unspent wealth. Many must over-save (and as a result, pay too much in taxes) because they feel exposed to external events that they have not hedged. Holding equity (reserves) competes with hedging. But for savers, reserves might not be as efficient as direct hedging. Obviously, clients want to hedge their larger financial exposures, such as dying too soon and thereby leaving loved ones unprotected, living too long, or living in bad health. They also want to provide for the purchase of large assets, such as a home or second home, for the education or the homes of children or grandchildren, and for protection against personal liabilities.

Although technically sophisticated to develop, computing, communication, and financial technologies are currently available to provide help for individuals. Some products will be packaged and developed by organizations such as banks, in conjunction with insurance companies, and distributed in their own name. The products most likely will incorporate these dynamic elements without the client having to learn how to manage each one or to bear tax and other adjustment costs. The bank will offer products created to suit client needs; it will hedge out the risks of making the products available by using underlying funds, insurance products, and other financial instruments.¹⁰

Exchanges that provide efficient risk transference and risk-sharing services will play an increasing role. These providers will need to find other investors or entities (such as hedge funds) to offset their own risks, which will increase the growth of hedging devices such as derivatives. Moreover, dynamic products that adjust to changing market circumstances to hedge risks will themselves be traded on organized exchanges. Although in the near term it will be too costly to provide a unique solution to every client, the Internet offers a way to assist clients to make choices efficiently. Standardized solutions can be developed and augmented to suit client needs.

MANAGING RISK IN CORPORATIONS AND GOVERNMENTS

Hedging as a form of financial innovation will continue to grow as an integral component of corporate strategy. In addition, corporations will separate the products that clients want from the risks of producing them.¹¹

Again, hedging competes with equity capital. As information technology and financial technology have reduced the cost of hedging, entities are turning to hedging and reducing more expensive equity capital. Equity capital is an all-purpose risk cushion. It hedges not only the idiosyncratic risks necessary to earn money in a business, but also the generalized risks undertaken as a necessary consequence of running the business. Generalized risks, such as adverse changes in interest rates, commodity prices, or exchange rates, are uncompensated risks with zero present value.¹² The market is well developed to hedge these risks.

It is not possible, however, to hedge idiosyncratic risks. Corporations must concentrate in idiosyncratic risks to make money. These risks have positive present value. With hedging, the firm can undertake larger positions in positive present value risks without increasing equity capital. At the appropriate margin, the cost of hedging might be less than the cost of additional equity capital. The recent financial crisis, however, has taught us that adjusting hedges in a crisis might be very expensive.

Emerging governments as well as governments in smaller countries face the same predicament. They are akin to a small, nontraded firm. Their citizens must concentrate their activities to be efficient. They cannot replicate the world economy within their own borders, nor can they provide sufficient assurances to outsiders to garner a low-liquidity premium. Hedging what they cannot produce internally may allow countries to reduce risks and enable them to concentrate in efficient activities at lower costs than by holding currency reserves or by diversifying into many activities. The extent to which a country issues hedging securities depends on the cost.¹³

INNOVATION AND SPECULATIVE BEHAVIOR

Innovation provides tools for speculators to bet against one another in the market. With efficient markets, most of these bets are zero-sum: one party gains at the expense of another. And with any zero-sum game, we tire of playing after a while. If it is not a money-maker, we desert it. Most speculation in the markets is not zero-sum, in that speculators are paid by hedgers to carry risks or bring out-of-line markets back into equilibrium. Without the function of the speculator, markets would not work. Every speculator needs a valuation anchor to intermediate supply-and-demand imbalances caused by liquidity and risk-transfer needs. Hedgers know that they are paying speculators for services rendered. Speculators compress time for prices to return to equilibrium and make the markets more efficient. They step into the shoes of the ultimate buyer of securities by carrying inventory or providing inventory to the markets.

Innovations such as derivatives, short selling, credit default swaps, options, swaps, futures, computers, and models have added to the speculators’ tool kit. Hedge funds and the proprietary departments of financial entities make money as speculators. These new tools speed up the intermediation process and tend to reduce the money-making ability of any entity to the benefit of hedgers. The speculators are always first to be blamed when prices that need to adjust do so quickly and cause immediate loss to counterparts in the transactions. Some believe that speculators benefit by working in unison to force down asset prices, buying back in at the bottom and profiting from the uninformed. If this practice is occurring—and there are laws that penalize collusive behavior—it must be rare indeed. For speculators must have strong beliefs that an asset is overvalued to “attack” it. Otherwise, competing speculators will game against them and, as a result, they waste time employing their capital in the wrong activity. Speculators make markets work and mitigate larger frictions that would exist without them. At times of shock, when speculators stop intermediating until they ascertain liquidity and valuation components, the effects on market prices are dramatic. Markets function chaotically until they return.

RISK AND LIQUIDITY

Financial institutions are the natural providers of risk transfer and liquidity services. They earn returns by providing liquidity to markets. In the Black-Scholes framework, a put option prices the value of liquidity. It prices liquidity of a specific form. If an intermediary issues an illiquid contract and buys a put option on that contract, the value of the put increases as the price of the asset falls; and as the asset continues to fall, the put value increases dollar for dollar with a fall in asset value. It is a self-liquidating contract. Although the put contract or various nonlinear option contracts price liquidity, financial institutions have insufficient information to define the “liquidity contracts” or payoffs that they need to hedge their risks at times of crisis or shock. The inability to aggregate the hedging demands of all entities in the market in order to define the needed liquidity options made the recent crisis more extreme.

The Bank for International Settlements encouraged banks to use portfolio theory to measure risks. Portfolio theory, otherwise known as “value-atrisk,” measures risks when there is no aggregation problem and no liquidity shock. Value-at-risk does not work when it is needed. In a crisis, the lack of speculative interest and the need to reduce risk changes the correlation structure. Financial entities that lose money need to reduce leverage. To do so, they raise more equity and sell assets. If many entities need to do so simultaneously, their risk reduction requires that asset prices fall and liquidity prices increase.

The financial system is innovative. Banks and other financial entities will learn from this crisis. They will increase capital and they will charge more for providing liquidity services. Moreover, they will use their information systems to build methods to monitor and control risks.

NEVER LET A FINANCIAL CRISIS GO TO WASTE

We need to gauge the extent to which financial innovation was the cause of the 2007–2008 financial crisis. Although there have been many financial crises in the past, this one was extreme by any measure. To learn from it, however, is no easy matter. Myriad scholars and pundits have multiple explanations of what and who were at fault. With so many explanations and so little data, it will be extremely difficult to parse out the connection between financial innovation and crises. Given this problem, many will come to a conclusion that might be without merit. Andrew Lo, a professor of finance at MIT, has proposed the establishment of a Financial Inquiry Board, patterned after the Federal Aviation Authority that studies airplane crashes.

As discussed above, innovation must lead infrastructure to support successful innovation. In recent years, innovations such as pooled mortgage products and credit default swaps expanded dramatically—in many cases, without adequate internal controls and risk management. Senior management’s primary responsibility is to measure the risk of each activity its business engages in and to judge whether the returns are worth that risk. If innovation leads to growth that outstrips these controls, then it is management’s responsibility to make sure that infrastructure catches up. Although innovation has rewards, costs might rise exponentially if innovation is unbridled. Detailed study of why these innovations caused failures might lead future managers to provide more efficient risk management and control systems.

Experience broadens theory and theory focuses attention. Needed regulations should follow after this learning. Antifraud rules are in place. Without study, it is unclear whether and how subprime mortgage holders and/or financial entities were duped. To me, it appeared that many were duping the mortgage providers. If true, rules should be in place to protect the buyers of mortgages, pension funds, or foreign banks. But we need more time to dig deeply into understanding why they bought these products and why they held tranches on their own balance sheets.

To help control innovations, regulations might penalize the failure to act. Some financial instruments and contracts that have existed for centuries might have caused financial crises in recent years because the growth of both economic knowledge (for example, derivatives) and information technology exposed their weaknesses. For example, the limited liability corporation allows investors to invest capital in an enterprise without the possibility of clawback in the event of bankruptcy. Moreover, debt contracts allow corporations to borrow additional capital from another class of investors who might have been restricted to invest in less risky securities (for example, insurance companies). Bankruptcy laws allow firms near or at insolvency to declare bankruptcy and to be unwound or reorganized, preserving capital for the priority claimants of the firm and, if possible, any residual claimants. Generally, this is a costly and time-consuming activity.

In addition, bankruptcy might introduce spillover effects between financial entities and into the general economy. If human capital and the value of teams are major assets of the banks, losing this talent makes reorganizing the financial entity extremely expensive.¹⁴ To reduce these deadweight costs, governments and central banks have stepped in to bail out the firm’s claimants— debt-holders mainly and stockholders to a limited extent—as an alternative to bankruptcy.

Because liquidity prices are mean reverting, the primary value of these bailouts is the belief that liquidity, not valuation, is the cause of a bank’s difficulties during a financial crisis. Providing temporary support to financial or other institutions gives the market time to resupply liquidity once speculators return to buy undervalued instruments after they have regained confidence in their underlying valuations. The bankruptcy mechanism is too draconian and permanent to solve a temporary liquidity problem. That is why mark-to-market accounting comes under heavy attack at times of liquidity crises. This accounting forces liquidation or triggers debt covenants that were not meant to handle liquidity shocks. Mark-to-market accounting is excellent at times other than a liquidity crisis, for correct valuations help senior management make better investment decisions. We need to suspend mark-to-market accounting during a crisis. But to identify whether liquidity and/or a valuation is causing a crisis is not easy.

If crises are generally liquidity crises, debt contracts can be restructured to provide time for markets to provide liquidity again. New contracts would supplement or replace bailouts as alternative mechanisms. For example, debt could be converted into equity on a systemic event. Without having to reduce risk, bank management would have more time to assess when and whether prices will revert as the liquidity crisis ebbs. As a result, the bank would continue without taxpayer support. Debt-holders will have incentives to monitor bank activities. And, in a crisis, if values are permanently affected—in that prices do not mean revert to a great extent as liquidity returns—the debt- and equity-holders suffer loss.

This alternative might be superior to breaking up “too big to fail” entities. It might also be superior to mechanisms to unwind a bank’s so-called living will on a government takeover. We must be careful to measure the net economic benefits of various alternatives. Anger and retribution may not be costly, but there should be a better way. Setting examples may not work as expected. Preserving the value of the banking franchise under new ownership may be a better alternative.

THE CHALLENGE OF FUTURE INNOVATION

Future innovations will follow in the steps of previous innovations. Failures lead to changes. Some failures are permanent.¹⁵ Some failures lead to better and more efficient provision of financial services. Although the costs to provide services for individuals, corporations, and governments might increase as a result of the failures, the new learning enhances benefits.¹⁶ These benefits, coupled with correctly specified financial modeling, can reduce the deadweight costs of financial shocks.¹⁷

I liken markets to men walking dogs. The dog walkers control the dogs on leashes and keep them along a set path. From time to time, the dogs break the leash and scatter. The men must retrieve the dogs. When done, they set off on a new path and continue their walk. While retrieving the dogs, the walkers’ actions appear chaotic. In this analogy, dog walkers are the speculators and the dogs are investors with particular needs or behavioral tendencies. The leashes are the provision of liquidity. Generally, bank trading desks anticipate investor demands—in other words, they follow the trends—while proprietary trading desks attempt to understand investor demands and react by taking opposite positions—in other words, they bring markets back to equilibrium values.¹⁸

Shocks and crisis create change. With disorder comes order. We learn from crises. Although financial employment has grown dramatically since 1980 as a percentage of total compensation in the economy, the number of risk managers or modelers with sufficient economic and econometric training has far from kept pace. More talent is needed to measure, monitor, and control risks. More talent is needed to manage horizontally diverse firms. Clients trust financial entities to provide products and services that solve their problems. Senior management bears responsibility for establishing controls to preserve this trust. The challenge of financial innovation, then, is to create products and provide services that address the functions of finance without abusing client trust. Financial innovations are crucial to address the changing desires of a global society. To harness the power of financial innovation—while controlling its inherent risks, conflicts of interest, and adverse incentives—is the challenge.

ENDNOTES

1. Robert C. Merton, “A Functional Perspective of Financial Intermediation,” Financial Management 24 (Summer 1995).

2. Consider, for example, the recent use of cell phones by farmers in rural villages in India to reduce transportation costs. The farmers communicate with their banks to borrow money on crops and sell them forward, and as a result, they bypass the local money-supplier monopolies.

3. Communication technology lowers information and monitoring costs, allowing for direct foreign investments and globalization on a scale many times greater than would have been possible without our modern communication infrastructure. The failure of the original vision of the Internet led to building the “pipes” for global communications to flourish. Most Chinese and Indians communicate through cell phones, not over land lines. At times, innovations lead to unintended consequences.

4. The main retirement savings vehicles provided by governments have been “social security” systems. Recently, countries such as Chile and Sweden have offered citizens the ability to save for retirement by allocating their own savings to invest in global financial instruments such as stocks and bonds. This practice has enhanced wealth and welfare for citizens of these countries. Moreover, countries with unanticipated accumulations of wealth, such as Denmark, are saving for future generations.

5. Although recent difficulties in financial markets have been severe, they might have been even more concentrated and severe without the ability that entities had to transfer and hedge risks. In fact, the difficulties might have been accentuated because entities such as UBS, Merrill Lynch, Fannie Mae, and Bear Stearns retained, rather than transferred, risks.

6. In an efficient market, market prices amalgamate the information of a diverse set of investors. They provide signals for when to invest and when investors should change their holdings. As I discuss below, information technology has led to financial innovations that have benefited investors around the world.

7. Economist Kenneth Arrow has classified these information costs as those relating to either “hidden information” (sometimes labeled the “negotiation problem” or the “winner’s curse”) or “hidden action” (sometimes referred to as the “principal-agent problem”). See Kenneth I. Arrow, “The Role of Securities in the Optimal Allocation of Risk Bearing,” Review of Economic Studies 31 (April 1964).

8. Agencies such as Moody’s and Standard & Poor’s gave many financial structures their highest rating. Many of these structures defaulted during the crisis. This was an extremely low probability outcome. Why did it happen? It could have happened by chance, or the underlying models could have been at fault, or the calibration of the models could have been made in error. For example, the rating agencies used only recent data in their simulations to determine whether housing prices might decline; they assumed that, in general, homeowners defaulted on home mortgages idiosyncratically, and they did not take account of the fact that Goldman Sachs might reverse engineer its methods and reduce the quality of inputs just to pass the test and achieve the highest rating.

9. Merrill Lynch was an also-ran in the mortgage packaging business. Within three years it shot up to be among the top three in the business. Common sense would suggest that that outcome would be impossible unless Merrill was underpricing its products, and if not, that management did not measure the risks or monitor the consequences of the growth in risk concentration. Similarly, AIG Financial Products had a gigantic position in credit default swaps booked as insurance contracts. Insurance companies rely on the law of large numbers to protect them. When the debts of many companies fall in value, in unison, their losses grow exponentially. Models or modelers, along with the applications of existing models, failed dramatically. But governance and common sense failed as well.

10. Financial entities are more efficient at assuming basis risk than individuals. They diversify across many clients and products. They have shareholders. They are more efficient at transferring risk in the market.

11. When technology company Dell sells a computer, it knows the cost of each component and the cost of producing a specific component for future delivery. It quotes a firm price to a client and produces the machine for an anticipated profit after the order is placed. It takes “basis risk”: the risk that its quote will be too low because prices change prior to its securing the components or labor to produce the requisite machine. Similarly, through hedging, financial service companies can quote a firm price on a financial product to a client prior to producing (hedging the risks by buying the components). The clients are better off. Information technology makes this possible. Clients state what they want, with the financial service provider specifying the price and then producing the product to hedge its own requirements to do so. For example, mortgage companies are paid a fee to service mortgages. They lose these fees if mortgages are paid off sooner as a result of a decline in interest rates. To hedge these risks, investment banks sell these companies synthetic mortgage contracts that provide a compensating payoff if mortgages are prepaid sooner than expected. They quote a price on these contracts and then enter the market to produce these contracts by combinations of mortgages, swaps, and options. They produce the computer, so to speak.