Magazine | October 3, 2011, Issue

Innovations and Limitations

Where financial innovation went wrong, and how to set it right

Innovation propels economies forward. It is why most Americans live long lives in relative comfort instead of toiling on a subsistence farm. Innovation usually refers to the creation of a new product or a new method of production. But it comes at a price; it is, by nature, unpredictable. When a new good comes to market, there is typically uncertainty regarding its true value. This may initially cause economic instability and dislocation.

But if the benefits of innovation are worth the cost, is financial innovation different from innovation in other fields? Lately, a popular perception has emerged that innovation coming from Silicon Valley is good and innovation from Wall Street is bad. But this view fails to appreciate how interconnected financial innovation is with innovations in other fields, and it ignores the fact that some inventions, even in finance, are better than others.

When financial innovation is successful, it channels capital to its most productive uses. A firm gets the capital it needs at a fair price. This is achieved in finance by identifying, pricing, and managing risk. Risk is a function of uncertainty; it may mean you do not know how much an asset you buy today will be worth tomorrow. It also involves liquidity; assets you can sell easily at any time provide more certainty and are more desirable. Financial innovation should come up with new ways for investors who desire less risk to hedge it, and for investors who want more risk to take it on. In exchange for taking on more risk, investors are rewarded with larger expected returns.

As the market for new financial products develops, the trade-offs become clearer. That compels more investors to participate in financial markets. With more capital available, prices become lower and assets more liquid. That makes it easier and cheaper to start or expand a business and for governments to raise money for wars, infrastructure, or social programs.

Some recent financial innovations did not achieve these goals — quite the opposite. But the success of any innovation depends on three things. The first is how good the product is to begin with. Some financial products are poorly conceived or designed. Next is the appropriate use of the product: Is the product meant for a particular market or type of risk? And finally, the value of an innovation hinges on the competence of the person implementing it. Many of the products associated with the financial crisis failed on all these fronts. Some were created with the intent of obfuscating risk rather than making it more transparent. Other failed products were good ideas in theory but were misused and fed data that assumed housing prices would never fall.

But this does not mean that all recent financial innovation failed or that financial innovation poses such a grave danger that it must be stopped. Rather, the solution is better regulation. Like any other innovation, some new and poorly understood financial products have the potential to cause harm. But saying we don’t need new financial products and should go back to the methods of the 1960s is as absurd as saying we’ve cured enough disease and don’t need new medicine.

While financial innovation’s history goes back thousands of years, the post-war era is notable in several ways that changed finance. The first change was technological. Computing power made it possible to solve complex mathematical problems in an instant. The second was the emergence of finance as an academic discipline. Ideas that came from academia fed the financial industry. These factors spawned new ways to identify and hedge risk so that innovation became more about supplying capital to new, small firms and individuals than about supplying it to old, large firms and governments. The pace of innovation that occurred in finance amounts to a revolution in the field. But in the wake of the financial crisis, the question has been raised: Was it good for you? Clearly it was good for people in the financial industry. Many became very wealthy while wages for most Americans in other industries stagnated.

#page#This is remarkable, because this is the very period in which finance became more democratic. It became much easier and cheaper for individuals and small businesses to get capital. Corporate finance — raising funds through equity (in which the investor buys a piece of a company) or issuing debt (through which an investor lends money to a company and is promised a series of payments) — had existed for centuries, but new ideas and technology meant it became much more important in this period. This made it much cheaper and easier for firms of all sizes to get capital to fund their growth. According to Thomas Philippon of New York University’s Stern School of Business, starting in the 1970s, investment opportunities shifted from large, older firms that used their own cash to young, smaller firms that raised money by issuing debt or equity. He believes this explains most of the growth in the finance industry from the post-war period up until 2000.

Nonetheless, if democratization of finance was good for America, you’d expect it to help more than a handful of talented entrepreneurs. But rising income inequality does not mean America did not benefit from financial innovation. The root of growing income inequality in America goes much deeper than financial innovations; it has more to do with disparities in education. Also, while income stagnated, increased globalization and entrepreneurship provided a broader range of goods to American households at cheaper prices. This was made possible by financial innovations that made trade and international finance less risky and entrepreneurship cheaper.

Innovation is usually associated with rich, sophisticated investors. But a notable aspect of recent financial innovation is how much more accessible financial markets became. Investing in American and foreign companies became easier and safer for the average person because of the availability of mutual and index funds. Before, few people owned stock, and if they did, they usually had shares in five or fewer companies.

Robert Litan of the Brookings Institution and the Kauffman Foundation recently assessed the value of many post-war financial innovations. He argues that many — credit cards, money-market funds, mutual funds, and credit scoring — have been beneficial for the American economy, and not just for people who work in finance. These innovations were instrumental in expanding the average American’s access to credit and capital markets. He also found that private equity and venture-capital markets were extremely important to the growth of the technology sector. Even though many useful financial innovations were not complex products that relied on rocket science, Litan notes, most financial derivatives, such as options, forward contracts, swaps, and even credit-default swaps, have been beneficial to the American economy by making capital cheaper and the market more liquid.

Financial derivatives are the most controversial aspect of financial innovation, because they are less comprehensible to the average person than a straightforward stock or bond. The market for derivatives took off in the early 1970s, when Fischer Black, Myron Scholes, and Robert Merton created and solved the Black-Scholes formula, which is a tractable way to price options. Soon after, Texas Instruments developed a calculator that used this formula to calculate that price in seconds. Derivatives had been traded for centuries before this, but they were priced using arbitrary strategies that differed from investor to investor. The ability to derive a common price made it possible for a vibrant and liquid market of derivatives to evolve. This not only made international trade and investment easier, because investors could hedge currency and foreign-asset risk, it also changed the nature of corporate finance. The derivatives market provided a new set of tools for firms to raise the capital they needed to be globally competitive.

Some have criticized derivatives models for relying on assumptions that are too simple and do not adequately account for very bad outcomes. But since the 1970s, models like Black-Scholes have proven to be quite flexible and robust under a range of different assumptions. Using these models requires knowing how to apply them and what assumptions to make. Using any financial model when investing is like going on a car trip with a road atlas. The map gives you a sense of where you are going and how your destination relates to other major landmarks. But your skill as a driver is still necessary to avoid accidents and unpredictable hazards, or to travel on a new road if your atlas is out of date. The existence of the road atlas means more people are on the road and not driving around aimlessly in circles. But it does not guarantee a perfectly safe journey.

#page#Economists such as Amar Bhide argue that finance should go back to simple, local, bank-to-person lending, and that complex derivatives mainly cause harm to the economy. But it’s important to remember that while derivatives have the potential to be misused, they also often make markets safer and more transparent by pricing risk and allowing investors to hedge it. Securitization, the process by which an individual’s debt (such as a mortgage or student loan) is bundled together with other people’s debt and sold in pieces, is one example of this. Josh Lerner and Peter Tufano, both of Harvard Business School, recently conducted a study to assess what America would have been like without post-war financial innovation. They found that the American economy benefited from simpler forms of securitization, increasing access to homeownership, especially among minorities. Up until 2006, securitization reduced bank foreclosures, because it made home lending less risky.

Whether securitization in all its forms made markets less risky is a harder question to answer. Taken to the extreme, securitization contributed to the housing bubble and caused the financial crisis. Securitization is supposed to spread small, manageable amounts of risk across many investors, making the economy safer. It didn’t work out that way. What went wrong? It was a combination of misguided regulatory policy, incompetence, and greed.

Borrowing money and then investing it can be very profitable, but it is also very risky. That is why regulation exists dictating the amount of liquid assets a bank must hold to cover potential losses. This is known as a capital requirement, and the level of the requirement depends on how risky the bank’s asset portfolio is. Less risk means a less onerous requirement. Large banks used securitization to lower their capital requirements to take on more risk. They did this by taking securitized housing assets and refashioning them into tranches of different risk levels. The least risky tranche received a AAA rating, meaning it was considered very low-risk but still offered a high return. Such a high-return and low-risk assessment depended on the assumption that national house prices would never fall. Banks were supposed to sell these products to investors, spreading the risk around to a safe level, but many banks kept these assets. According to Viral Acharya and Philipp Schnabl of the Stern School of Business, 50 percent of AAA asset-backed securities remained in the banking system. Keeping the AAA mortgage assets meant banks did not have to hold as much capital to comply with regulations. Through more engineering, some of these assets could even be held off balance sheet, which lowered the capital requirement further still. So when housing prices fell, and no one wanted to buy housing assets, many large banks had insufficient capital to cover their losses.

According to Franklin Allen and Glenn Yago’s new book, Financing the Future, much of the abuse and negligence involving mortgage products was not true innovation. Often it involved complicated products with the sole intention of creating risk and avoiding regulation rather than identifying and hedging existing risk. They stress that financial innovation is supposed to make risk more transparent, not obfuscate it. What happened in the market for mortgage assets is a prime example of something that resembles innovation at its worst. But rather than vilify all financial innovation, we should focus on the lessons we can learn.

It is very difficult to know in advance which products will benefit society and which ones have the potential to blow up the economy. Simple securitization had a noble goal — to increase home ownership — but it was impossible to foresee in the early days how things might go wrong. Regulation can help, but too much regulation can also be self-defeating. In fact, when regulation is too strict, it encourages regulatory arbitrage, innovation for the sole purpose of skirting the rules and creating opacity.

Litan asks whether finance should be regulated the same way drugs are by the FDA: Should new products be required to demonstrate their value and safety before they’re made available? The alternative is what we do now, letting the market decide which innovations are useful, with the government stepping in only if there is a clear danger.

#page#In order to foster an environment where good and socially useful innovations are discovered, regulation must take the wait-and-see approach. Some of the best innovations were created to service a particular client need. Financial products that are not born from market demand — complex innovations for the sake of complexity — are often just marketing ploys that create opacity and provide little value. Regulation under the presumption of guilt would make the process of demand-driven innovation prohibitively slow. It takes years for the FDA to approve a drug. A similar timeline would undermine the competitiveness of financial firms, because clients can go elsewhere. As perilous as it may be, the only lab where new financial products can be tested is the market.

Lerner and Tufano explain that new financial products are adopted in stages. The early creators and buyers are often the most sophisticated and competent. Then, as the product is adopted by others, more naïve investors participate. They take the fact of a product’s popularity as a substitute for adequate diligence. This tends to be the stage at which things go wrong. Transparency and accountability help get around this problem, and these must be the principles of successful regulation.

As the global economy continues to evolve, new needs will emerge, requiring more innovation. It is impossible to predict what all these needs will be, but I can already see a few.

One is how to deal with retirement. A notable feature of our time is that people live longer and retire earlier. This leaves people with the complex financial task of funding their retirement. Up until the 1980s, employers took on this responsibility with defined-benefit pension plans. The existence of large pension funds changed wealth- and risk-management. In the last 30 years, the burden has been shifted to individuals, and their investment needs differ from those of a large institution. Everyone now must figure out how much he needs to save and how he should invest for a comfortable retirement. New financial products have the capacity to help us with these decisions (full disclosure: I am working on developing such a product).

Another area is the environment. Pollution, for example, occurs in part because individuals often do not pay for the negative externalities they impose on others. Innovation can be used to create a sophisticated market that forces people to pay for their impact on the environment. There is also a need to provide capital for the development of new, sustainable forms of energy. They will require a large, up-front, fixed investment but may not be profitable for many years.

The scope for future innovation, in any field, depends on a paradox. On one hand, innovation becomes more difficult over time, because the most obvious, simple discoveries — the wheel, double-entry bookkeeping — already have been made. At the same time, innovators today have it easier, because they stand on the shoulders of giants and have a tremendous base of knowledge at their disposal. If we are to remain competitive, future financial innovation must continue to evolve in response to our changing economic environment. That may or may not mean more complexity of the sort we saw in housing finance: Often the best innovations are simple and do not require any mathematical complexity at all, and even the most complex products must hold up to basic common sense. It is the responsibility of the innovators and regulators to ensure that they do.

– Allison Schrager is a New York–based economist and writer. She has worked at the Bank of England and the International Monetary Fund.

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