The 2007-09 financial crisis and the lackluster performance of the global economy since, has led to ‘great criticism’ of innovation in the domain of finance. After all, dicey financial products and opaque mortgage-backed securities did play a dubious role in the run-up to the global crisis.
However, given incomplete markets, financial innovation can bring about better management of risk, tax avoidance, etc. Besides, the very process of financial development has been marked by waves of innovation that go back a long way. A recent Wharton working paper is on the trends in financial innovation.
The paper mentions upfront that financial innovation ‘does have a dark side’, and such practices can sometimes be undertaken to obfuscate, create complexity and take the purchaser for a ride. But it adds that many financial innovations have had ‘significant positive effect’ as well.
The role of venture capital in establishing marquee corporates is mentioned; also, there is much evidence to suggest that private equity-managed entities are more efficiently run than publicly-listed ones. There have been other similar innovation in finance that have proven to be hugely beneficial in fields as varied as the environment and global health, adds the study. To avoid financial maladies, we clearly need proactive policy and prudential oversight.
However, when it comes to the very process of financial reform, of the sequences and shapes of the development path to be followed, the literature and empirical evidence is rather thin, aver the mavens. Now, financial development can be seen as systemic reform to reduce and circumvent the ‘frictions’ that hamper contracting and access to finance. Yet, few papers have attempted to analyse these frictions systematically, notes a recent World Bank study.
The fact remains that almost half the population here does not have bank accounts, and there are financial rigidities in place such as high cash reserve for the banking system and other statutory requirements that generally repress returns. Hence the need for financial reform.
The Wharton paper cites instances of superficial innovation that did not provide any ‘redeeming service’ to investors. For example, in the US, a major investment bank did have as many as 64 issues of a structured equity product termed ‘stock participation accreting redemption quarterly pay securities’, during 2001-05. And the return on these risky securities was less than the risk-free rate.
The game plan appears to have been to structure ‘complexity to exploit uninformed investors’. The point is that while financial innovation is often beneficial, this is by no means always the case even in the most financially-developed economies. The point also made is that financial crisis does not necessarily presuppose innovation. It notes that in the pan-Asian crises of 1997, financial novelty is not underlined as a cause.
The paper elaborates that in the US, the repackaging of housing-mortgage receivables into high-yield securities hit 85% of such debt only as late as the mid-2000s. It adds that while many people have criticised the securitisation of subprime mortgages – loans to those with poor repayment records, even at the peak of the innovation binge – subprime loans amounted to only around 20% of all mortgages.
However, the fact of the matter is that more than half the massive amounts of mortgage-backed securities issued had the highest credit rating. In contrast, only about 1% of normal, single-name corporate bonds enjoy triple-A or the safest credit rating.
As is now well known, the non-recourse nature of housing loans in the US – lenders have no recourse on borrowers other than the underlying property – meant perverse incentive to default on mortgage payments, even for prime borrowers, once house prices there collapsed.
And rising defaults meant unprecedented amounts of ‘toxic’, wholly non-performing securities. It led to the crisis. The innovation of large-scale repackaging of mortgage receivables into tradable debt paper did end in fiasco. But the venture capital industry, with its structure of limited partnerships, has backed many successful companies, especially in the hi-tech sector.
The paper goes on to cite a 2009 study of companies in the US, Europe and Asia that found that corporate control via private equity funds leads to better management practices. However, the rate of income growth cannot keep accelerating as the level of income rises, ‘a clear dynamic impossibility’. Which suggests that the impact of finance on growth should necessarily level off at some point. So, the financial sector cannot have a rising, disproportionate share of income, as it did in the US prior to the crisis.