While most authors acknowledge that innovation has both positive and negative impacts on society, their conclusion regarding the net impact of financial innovation reflects a diversity of opinions. Merton (1992) stakes out one side of the argument: ’Financial innovation is viewed as the “engine” driving the financial system towards its goal of im-proving the performance of what economists call the “real economy.’ He cites the U.S.
national mortgage market, the development of international markets for financial deriva-tives and the growth of the mutual fund and investment industries as examples where innovation has produced enormous social welfare gains. Others take the opposite view-point to make the argument that innovation’s benefits are less clear: Time and again, business has seized upon a new idea—junk bonds, LBOs41, derivatives— only to push it far past its sensible application to a seemingly inevitable disaster.
How do we research the question of the net social benefits of innovation? One ap-proach attempts to measure the size of the gains for specific innovations, say the in-novations in mortgage markets in the form of securitization. While some find positive evidence, other researchers often from the legal and policy literature find contrary evi-dence by discussing the costs due to tax evasion, reduced tax revenues, loss of confievi-dence in government and social costs of inequality or inequity. Other arguments against welfare gains are complexity that in turn leads to bad business decisions and social costs or that specific innovations contribute to high levels of market volatility and possibly to market crashes.
Do derivatives have a positive or negative influence on social welfare? Tuffano (2002) states: ’Despite the best intentions of the authors, their studies cannot measure social welfare directly, nor can they benchmark the observed outcomes against those never ob-served. Furthermore, in light of the innovation spiral (where successful innovations beget others) and the evolutionary process (where many innovations fail), it is exceedingly dif-ficult to identify the boundaries of a particular innovation, if one wanted to measure its
41A leveraged buyout (LBO) occurs when an investor acquires a controlling interest in a company’s equity and where a significant percentage of the purchase price is financed through borrowing, i.e.
leverage.
costs. It is a hopeless task to measure the ex post impacts innovations. Ex ante views often focus on very specific and narrow aspects of innovation to permit a meaningful dis-cussion.’ The existing theoretical models are too stylized and to narrow to allow for general welfare considerations. Duffie and Rahi (1995), summarize a wide range of the literature: At this early stage, while there are several results providing conditions for the existence of equilibrium with innovation, the available theory has relatively few norma-tive or predicnorma-tive results. From a spanning point of view, we can guess that there are incentives to set up markets for securities for which there are no close substitutes, and which may be used to hedge substantive risks. This summary still holds true today. The complexity of the question contrasts with the strengths of the available analytical tools.
If we setup a general economic model yet the specification of the individual preferences is a complicated task if one wishes to capture the time-varying opportunity set with and without innovation and possible feedback effects of decision not related to the innova-tion part and vice versa. The complexity further increases if one aggregates individual preferences and tries to derive properties of the general equilibrium. Reality shows that such a model could only be treated numerically. One might ask, whether the traditional microeconomic approach is in principle well suited to answer such questions or whether not a different approach is needed. A lot of the heated debate about the dark side of financial innovation reflects the shortcomings of traditional analytic tools where moral, ethics and emotions replace formal thinking.
Given the difficulty to value financial innovation for society, one could propose that there is value if an innovation becomes successful and that one puts the efforts in the identification of potential dark sides of innovations.
There is more than evidence that financial innovations is sometimes undertaken to create complexity and exploit the purchaser - CDO Squared are an example. Some emails from investment bankers which became public show that some bankers indeed follow such a client hostile strategy. Paul Volcker said in December 2009 that the biggest innovation in the industry over the past 20 years had been the cash machine. He went on to attack the rise of complex products such as credit default swaps (CDS). I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth
— one shred of evidence, said Mr Volcker. Many others made a similar point. Krugman (2007) argues
(T)he innovations of recent years—the alphabet soup of C.D.O.’s and S.I.V.’s, R.M.B.S.
and A.B.C.P.—were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead—aside from making their creators a lot of money, which they didn’t have to repay when it all went bust—was to spread confusion, luring investors into taking on more risk than they realized.
Henderson and Pearson (2011) provide evidence for a particular type of structured
equity product.42 They show that these were overpriced and did not provide any redeem-ing service to investors. They document 64 issues of SPARQS by Morgan Stanley from June 2001 to the end of 2005 and show that the return on these risky securities was less than the risk free rate. They are able to show that these securities have no advantageous hedging properties, liquidity features or tax advantages that can explain this low return.
During the three and a half years they study Morgan Stanley issued about USD 2.2 billion of these securities. Their payoffs were tied to the stock price of major listed companies.
They are typically callable after six months and have a maximum maturity of slightly over a year Henderson and Pearson demonstrate that they have a price premium when they are issued of 8 percent compared to an equivalent dynamic trading strategy with exactly the same payoffs. Given the short maturity and interest rates at the time this means their payoff was less than the risk free rate. Since they are positively correlated with major stock indices they do not have any advantageous hedging properties. They are taxed as prepaid terminable forward contracts. If anything this gives them a tax dis-advantage rather than dis-advantage. Moreover, they are not particularly liquid. Henderson and Pearson argue investors would have been better off investing in banks’ certificates of deposit. Structured equity products became very popular not only in the U.S. but also in Asia and Europe.
Bergstresser (2008) documents that at the peak structured products reached a total outstanding of Euro 4.4 trillion. He considers a much larger sample than Henderson and Pearson consisting of 314,000 individual notes including issues in Asia, and Europe as well as the US. His results are similar. Prior to 2005, these products were overpriced similarly to those considered by Henderson and Pearson, particularly those issued by Goldman Sachs and Unicredit. However, subsequently this overpricing was considerably reduced. There seem to be many occasions where structured equity products were signif-icantly overpriced in order to extract money from investors who did not fully understand the alternatives to what they were buying.
I do not intend to comment on the adequacy of the used methods neither I want to look for a needle in a haystack. When I compare the issuance margin - the 8 percent difference between the fair price and the issuance price - Henderson and Pearson (2011) provide about the 1y products SPARQS with the issuance margin of the business of a large Swiss bank in the last 3 years across all products, then I conclude:
• Innovation has a culturalcomponent.
• The life cycleof innovation insight applies.
These claims follow from the issuance margin in all structured products of a Swiss bank which ranges in the last three years between 1.15 and 1.32 percent. The value of the issue amount ranged between 2.5 and 3 Billion CHF. All types of structured products were considered except vanilla option (warrants, knock-out warrants). The difference
42They are known as Stock Participation Accreting Redemption Quarterly Pay Securities (SPARQS)
between the pricing of the Swiss bank and the U.S. Investment bank shows that two differences interfere. First, during the period where SPARQS were issued this type of product was not a mass type product from the supply side - only few issuers could and indeed offered the products. In such an early stage of a product life cycle margins are higher as we already discussed. Second, the incentives, total compensation for bankers and the way how the bank considers the point of sales are different for people working for a large investment bank compared to bankers working in smaller, more retailed focus institution. These differences make have a cultural component. This triggers different answers to the question ’Which costs do we charge?’.
The vast range of different financial products, types of financial institutions and ser-vices raise the motivation to search for a categorization. But all attempts to catalog innovation face some shortcomings. One might ask what the value of such a categoriza-tion is and for whom? It is doubtful whether people who innovate need a categorizacategoriza-tion scheme.
Innovation can mean for example 1. Products (swaps, options, ...),
2. New corporate securities (tier 1 bonds, hybrid capital, ....),
3. Processes (outsourcing industry production, using new transaction processes, ...), 4. Governance (salary system, point of sales, ...).
Although these types of innovations seem independent from each other they often are not. Innovation often affects several types. Truly novel innovations occur very few. In-dependent of the originality of an innovation, it has two parts. An act of invention is followed by a diffusion of new products, services etc. The attempt to categorize innova-tions tends to be either uninformative (firms use names to differentiate similar products), not consistent if legal or regulatory definitions are used since innovations often spans be-tween the defined objects (structured products are a debt-like product but they possess characteristics of equity and other assets classes), not manageable if products features are used for categorization (e.g., maturity, redemption provisions, etc.). Academics prefer to characterize products by their function they serve, see the BIS approach. Merton’s (1992) functional decomposition identifies six functions delivered by financial systems:
(1) moving funds across time and space; (2) the pooling of funds; (3) managing risk;
(4) extracting information to support decision-making; (5) addressing moral hazard and asymmetric information problems; and (6) facilitating the sale of purchase of goods and services through a payment system. There is much overlap in these descriptions. To setup a Collateralized-Debt-Obligation (CDO) one pools funds, manages risks, and moves funds across time. The BIS scheme identifies the functions performed by innovation, focusing on the transfer of risks (both price and credit), the enhancement of liquidity, and the generation of funds to support enterprizes (through credit and equity.). No commonly
accepted and unique taxonomy of functions has been adopted. If functions represent timeless demands put upon financial systems, then why do we observe innovation? Some authors adopt a static framework, where no attempt is made to explain the timing of the innovation. Other authors adopt a dynamic framework, where innovations reflect responses to changes in the environment, and the timing of the innovation mirrors this change.