8. Six Cardinal Rules of Financial Innovation

Ever since the seismic jolts that shook world markets in 2008, a full-throated debate has raged about whether financial innovation got us into this mess in the first place. Critics have been all too eager to break out the torches and pitchforks.

But it’s our contention that dreaming up intentionally opaque financial instruments for the sole purpose of speculating or deceiving has nothing whatsoever to do with real innovation. The genuine article is all about increasing transparency, measuring and reducing risk, and finding new ways to direct capital to where it’s vitally needed. At this perilous moment in history—burdened with a deep recession and facing unprecedented challenges in health, housing, the environment, business, and global development—we need more financial innovation, not less. Even staunch critics of financial innovation are forced to recognize that we need “good” innovations to deliver financial services to the poor, fund medical solutions, and achieve other social objectives.¹ We need to find a better way to evaluate and introduce new financial products so that we can separate the wheat from the chaff.

The ultimate test for financial innovations is their ability to function successfully in capital markets, attracting investment that is sustainable. If either the investor or the promoter of the investment knows that he will not be accountable and will not bear the costs of failure, the whole basis of the underlying social and financial contract dissolves.

Debate continues about the government’s role in reining in financial excesses, but it is important to proceed here with caution. Measures that undermine incentives to innovate or create moral hazard could have dramatic unintended consequences that ultimately harm the resiliency of financial markets and the real economy. Financial innovation—in the true sense of the term—is needed to help us move beyond the crisis by taming volatility, unlocking frozen credit markets, and enabling better corporate decision making.

If recent events have taught us anything, it is that we need new and better tools for confronting asset bubbles and mitigating risks in real estate markets (which are the source of most financial crises).² During the giddy days of the bubble, investors discarded historical pricing data, happy to ride the wave of easy money. Even though it was apparent that returns were unsustainable, a kind of optimistic tunnel vision took hold. Going by expectations alone (as indicated by narrowing interest rate spreads among various assets before the crisis), it appears that investors assumed very high rates of return everywhere for the foreseeable future. In this environment, consumers and financial institutions alike became dangerously overleveraged—and both seemed oblivious to the risks buried in the complex products on their balance sheets.

It turns out that the “irrational exuberance” and market failures that preceded the tech bubble of 2000 never really dissipated. They were simply transferred to real estate assets, where they assumed an even more toxic form. Clearly, we have to find a better way to prevent the recurrence of boom-and-bust cycles.

Blame for the crisis was wrongly placed at the feet of financial innovation, which soon became everyone’s favorite punching bag. But the excesses were fueled by artificially low interest rates and the easy availability of credit. In this hyperliquid environment, the introduction of convoluted, opaque financial products that created incentives to default through nonrecourse contracts and negative amortization mortgages was like adding a flame to dry tinder.

Though the crisis originated in the United States, countries with little or no financial innovation (such as Ireland, Spain, and Greece) also experienced asset bubbles and real estate–driven financial crises.³ It is spurious to suggest that financial innovation was the chief culprit.

Real financial innovation requires going back to the basics of valuation and risk assessment, tasks that were neglected in the heady days prior to 2007. When all the arrows were pointing up, few people asked the hard questions: What about the lack of transparency in the $1 trillion market for collateralized debt obligations? Was it possible for financial firms to extend their leverage ratios from 5:1 to 30:1 over just five years without consequences? What cash flows and corporate strategies supported that leverage? Were any asset valuations—on homes, securities, or commodities—based in reality? At the end of the day, who paid and who benefited from the massive socialization of credit risks by the government?

Newly gun-shy after the crisis, many officials and pundits have suggested curbing the entire field of financial innovation. But this stance ignores the reality that monetary policy and government actions that encourage moral hazard lie at the root of the story. Financial innovation is a process of trial and error—and you don’t advance science by blowing up laboratories. We are facing unresolved questions on how to price and manage risk, and we can waste no time in finding the answers. The resiliency and vitality of the financial sector—plus its future ability to generate growth and solve social problems—depends on our ability to develop better applications.

Financial innovators always look ahead. But as the old saying goes, those who cannot learn from history are doomed to repeat it. Before we can finance the future, we have to understand and correct the excesses of the past.

Lesson 1: Complexity Is Not Innovation

At some point in the last decade, new securities became so complex that even the CEOs of investment houses couldn’t understand them. But intricate and innovative aren’t synonyms, and they never were.

Financial innovations don’t have to be laboriously contrived and complicated Rube Goldberg contraptions (see Figure 8.1). Yes, some valuable financial technologies involve daunting equations and specialized jargon, but the level of complexity alone doesn’t qualify something as a breakthrough. Even the best of financial models will fail with bad or unexamined data. Sometimes the best solutions are elegant in their simplicity. Many of the byzantine financial products that failed in the recent crisis obscured rather than disclosed data, concentrated rather than distributed risks, raised rather than reduced costs of capital, and created rather than resolved capital gaps. In that sense, many of these products pushed back financial innovation rather than advancing it.

Figure 8.1. Dodging bill collectors

Used with permission by Rube Goldberg. Rube Goldberg is the ® and © of Rube Goldberg, Inc.

Product differentiation is not, in itself, an innovation in any field. It’s a marketing strategy. A me-too drug that simply mimics an existing drug offers no therapeutic advance. Another sugar-coated breakfast cereal created to capture additional shelf space in the supermarket offers no new nutritional value. A credit card, mobile calling plan, or insurance policy that includes more hidden fees fails to solve the problems of standardization and transparency required of a real financial innovation, and leaves the underlying product unchanged. Hiding charges and risks is not innovative—it’s just opaque. The ultimate objective of real innovation is not to trick or cheat consumers or investors in any market.

Financial markets and innovations create benefits for businesses, households, and governments when they provide value by overcoming, rather than creating, information asymmetries. By obscuring information about risk and failing to examine data fundamental to credit analysis, which is key to any investment decision, the products that proved toxic in the most recent crisis distorted the whole purpose of financial innovation.

Lesson 2: Leverage Is Not Credit

Ever since Modigliani and Miller first got us thinking about capital structure in creative ways, we’ve known that nothing inherent in leverage creates value. Credit is a vital tool for enabling healthy growth, but when monetary policy is too loose, market participants at every level have a temptation to use excessive amounts of borrowed money in pursuit of greater profits. When investors are highly leveraged, it takes only a small decline in the value of underlying assets to leave them underwater.

The dangers of misaligned incentives (such as mortgage brokers passing along all the risks involved in making questionable loans, or rating agencies accepting fees from the issuers of securities they were rating) became magnified during an era of freewheeling credit and easy money. Homeowners who put no money down—and there were many at the height of the housing boom—were likewise given increased incentives to default.

The same story played out with Fannie Mae and Freddie Mac, which were encouraged to expand and buy various complex securitizations, thereby creating a “too big to fail” problem for both the government and the private financial institutions that held their obligations.⁴ Ultimately, this pyramiding of risk suggests that some government actions might have transformed the problem into institutions that are now “too big to save.” Too many financial institutions were caught with too little capital to support their growing leverage ratios. The issue was compounded among those firms that used short-term borrowing to fund their assets. Unfortunately, when the house of cards collapsed, we careened abruptly from an era of easy credit to an era of frozen credit.

The ability to excessively leverage caused market players to skip vital steps: the fundamental analysis of financial statements, financial products, management, and market conditions. No matter how sophisticated a new financial product may be, its ultimate value rests on data-driven, back-to-basics scrutiny. Restoring the fundamentals of due diligence and prudence will be key to ensuring that credit can once again flow appropriately.

Lesson 3: Transparency Enables Innovation

Financial innovation works best when it incorporates the accurate, fundamental data necessary to assess risks. This holds true whether the issue is evaluating the risk associated with a bond or credit-scoring a mortgage applicant. Consumers, businesses, investors, and the overall economy all benefit from adequate disclosure and transparent information. Better credit data enables broader capital access.

The need to get solid information and carefully evaluate risk was tossed aside during the bubble years. Borrowers signed on the bottom line whether or not they understood the fine print on the complex mortgages they were taking out. Investors speculating with borrowed money relied too heavily on rubber-stamp ratings from agencies rather than doing their own homework on credit quality. The risks of overly complex securities (the CDO-squared and the CDO-cubed spring to mind) were underestimated by rating agencies and investment banks alike. The opacity of special-purpose vehicles and the shadowy market for credit default swaps enabled the situation to metastasize.

Problems mushroom in the dark; but, as Supreme Court Justice Louis Brandeis once said, “Sunlight is the best disinfectant.” Real innovation quantifies and mitigates risk rather than obscures it. This tenet will need to guide our reshaping of the market’s oversight and enforcement structures, as well as future financial products.

Lesson 4: Capital Structure Matters

Designing the right capital structure to allow a firm’s expansion or fund an ambitious infrastructure project is equal parts art and science. The optimal capital structure may take different forms at different times to account for industry dynamics, the state of the economy, government regulations, or growing demand. The ratio of debt to equity that works in one business cycle may be dangerous in the next—as we’ve seen with companies that found themselves with too much debt when the recent liquidity freeze descended. The means and methods to manage capital structure flexibly enable managers to deleverage when needed. Finding that sweet spot is especially important for start-ups and growth-oriented firms, as well as traditional industries seeking to reinvent themselves for the future.

Finance is a continuum, and a successful financial innovator must select just the right combination of technologies and securities when designing a firm or project’s capital structure. The art of improvisation, which has grown so sophisticated in corporate finance, will enable the development of instruments with new applications in fields such as environmental finance and economic development.

Lesson 5: Democratizing Access to Capital Spurs Growth

The largest firms in America held an iron grip on employment, profits, and market share during the first seven decades of the twentieth century. This concentration of power created oligopolies in many industries, stifling competition. But the wave of financial innovation that emerged from the credit crunch and market collapses of 1974 incorporated many of the practices and principles outlined in this book. By opening new channels of capital to entrepreneurs, it paved the way for new businesses, technologies, and industries to thrive. A high-tech, knowledge-based economy was the ultimate result.

Broadening access to capital has this kind of transformative effect. When start-ups gained the financing they needed to grow and challenge the existing monopolies, the competition and innovation that followed made the U.S. economy more vibrant and diversified. American democracy became stronger when lenders ceased to marginalize minorities and redline urban centers. Participation in the global economy is beginning to erase poverty in the developing world.

Markets are healthier when there are fewer barriers to entry, greater economic participation, and increased competition that generates further product and process innovations. But to get a level playing field in product markets, you sometimes need financial bulldozers—and capital market solutions provide them.

The ultimate test of financial innovation is its ability to drive growth. Making credit, financial services, and physical and social infrastructure accessible to wider segments of society around the globe can power that growth and generate broad-based prosperity.

Lesson 6: Financial Innovation Can Be a Force for Positive Social Change

Financial innovation isn’t just an exercise in rearranging numbers on a balance sheet or income statement. It’s about creating tangible, real-world impact. This book has chronicled dozens of instances in which financial innovation has paved the way for progress—and laid out a series of urgent challenges that are still to be met.

Business and corporate finance has always been a fertile laboratory for financial innovators. Here in the United States, we have seen capital market solutions finance a young nation’s expansion across a vast continent. Trailblazers opened commercial banking and investment products to the middle class, while venture capitalists bankrolled the ambitions and ideas of entrepreneurs. Today small businesses are struggling and jobs are evaporating. We urgently need to bridge the capital gap and find new ways to get credit and equity investments flowing to the entrepreneurial companies that generate most of America’s jobs.

Where homeownership was once exclusively for the wealthy, innovations changed the face of the housing market. The advent of the 30-year self-amortizing mortgage made it possible for millions of middle- and working-class families to realize their dreams of owning a home. While a number of products have recently failed with serious consequences, we cannot afford to cease innovating altogether in this field. We need fresh solutions that will stabilize the housing market and attract private capital back into the system. Innovators will have to find new ways to more responsibly promote homeownership and address the shortage of affordable housing.

Environmental finance has seen a major burst of momentum in recent decades. State revolving funds have been used to finance clean drinking water systems and preserve wetlands. The cap-and-trade market for sulfur dioxide emissions permits has virtually eliminated the problem of acid rain. Debt-for-nature swaps have preserved some of the planet’s most endangered landscapes and species, while individual transferable quotas have restored depleted fisheries. Despite this remarkable progress, the biggest challenges of all still lie ahead: implementing a market-based solution for curbing carbon emissions and financing a new green economy.

Development finance was once left to government officials and NGOs, but today there is a growing awareness that foreign aid alone is not enough to permanently eradicate poverty. We need to direct private capital to stimulate growth in emerging markets. Microfinance has found creative ways to help the poorest of the poor start small businesses to support their families, while mobile banking via cellphone is beginning to bring financial services to millions who were once excluded from the global economy. Impact investors are forging new models that combine elements of venture capital and aid. World Bank Green Bonds are financing the introduction of clean technology and sustainability projects in low-income nations. The next great task is financing the “missing middle”—the small and medium-size businesses that are too big for microcredit but too small to be served by commercial banks in the developing world. This sector has an enormous capacity to generate jobs, and with adequate capital, it could unleash the kind of broad-based and sustainable growth that lifts large populations out of poverty.

In medicine, financial innovation can smooth the translation of basic research into cures. Because development and clinical trials can be a long, risky process, financing solutions are urgently needed to make sure that breakthrough ideas don’t wither and die in the lab. New structures such as PIPEs, royalty-based models, contract research organization (CRO)–linked financings, and public-sector risk-sharing facilities have been devised to try to bridge this capital gap. In global health, public–private partnerships are providing new funding for once-neglected diseases of the developing world. Advance purchase agreements and donor bonds are making it possible to pursue new cures for diseases of poverty.

Despite the recent crisis, finance remains a powerful catalyst for expanding opportunity. By analyzing economic, social, environmental, and public policy challenges through the lens of finance, and then deploying the right tools in a responsible way, we can conquer problems that were once considered insurmountable.

Endnotes

¹ Simon Johnson and James Kwak, “Finance: Before the Next Meltdown,” Democracy: A Journal of Ideas, no. 13 (2009): 23–24.

² Richard J. Herring and Susan Wachter, “Real Estate Booms and Banking Busts: An International Perspective,” Wharton School Center for Financial Institutions, working paper no. 99-27 (July 1999).

³ Rudiger Ahrend, Boris Courned, and Robert Price, “Monetary Policy, Market Excesses and Financial Turmoil,” OECD Economic Department working papers, no. 597 (March 2008).

⁴ John B. Taylor, “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong,” NBER working paper no. 14631 (January 2009).