Banking and finance

The quest for financial innovation has seen the introduction of the now-indispensable ATM, but also gave birth to synthetic debt instruments which a few years later were associated with the global financial crisis, says Patrick Jenkins

If any self-respecting investment bankers had been asked six years ago to name the greatest financial innovation of recent times, they would probably not have hesitated to name the collateralised debt obligation – a clever structure based on thousands of chopped-up mortgages and mortgage-backed securities.

The demand for the high, supposedly safe, investment returns that came with CDOs allowed them to grow stratospherically in the decade up to 2007.

Today, even the bankers who made their millions in that business are coy about letting the discredited three-letter acronym pass their lips. The popularity of CDOs in turn fuelled growth in the underlying loans, many of them ultimately concentrated in high-risk subprime mortgages to poor Americans who were soon struggling to keep up repayments. As anyone with even a passing interest in finance will know, this was how the seeds of the financial crisis were sown. Simple securitisation, repackaging loans into new bonds, is edging back into fashion as fund managers seek investments that will generate a little income amid stubbornly low interest rates. But the CDO – and the more abstruse derivatives it generated – is certainly not high on many people’s best-inventions list any more.

There is even some recognition among investment bankers that Paul Volcker, the US policymaker and former Federal Reserve governor, might have had a point when he talked about the simple cash machine, or ATM. “The most important financial innovation that I have seen the past 20 years is the automatic teller machine,” he said at the height of the financial crisis in 2009. “That really helps people and prevents visits to the bank and it is a real convenience. How many other innovations can you tell me of that have been as important to the individual as the ATM?”

With investment banking so unfashionable these days, other retail innovations are also popular contenders for the greatest inventions awards. Online banking via a smartphone, for example, is now taken for granted by millions. But it is particularly powerful in emerging markets, creating a virtual infrastructure for a fast, efficient spread of credit and broader financial services. That is especially true in Africa, where technology has allowed banks and their customers to leapfrog the expensive and time-consuming process of building up vast branch networks to support growth.

For many, the best big-picture innovation of the last millennium was the creation of the capital market. Fourteenth-century Venice and 16th-century Belgium can both lay claim to the concept. But whatever the roots, there could scarcely be a more apposite touchstone, especially in Europe, as the region struggles to escape the eurozone financial crisis and rebuild economic growth.

The region’s politicians and central bankers alike are desperate to move the financing of the European economy into line with that of the US, where about three-quarters of company funding comes not from banks but from capital markets, rather than the meagre quarter that Europe can boast. The crisis taught European leaders a powerful lesson about the vulnerability of an economy that relies on bank finance when banks are themselves so vulnerable to failure.

It is far from clear that this shift will happen, whatever the political will. Who knows? Perhaps quantitative easing, the Basel III rulebook on bank capital and the European Central Bank’s longer-term refinancing operation – all innovative responses to the crisis – will one day be recognised as the best financial inventions of recent years.