Why does financial innovation occur?
Economic theory has much to say about what types of securities should exist, and why some
may not exist (why some markets should be "incomplete") but little to say about why new
types of securities should come into existence.
One interpretation of the Modigliani-Miller theorem is that taxes and regulation are the only
reasons for investors to care what kinds of securities firms issue, whether debt, equity, or
something else. The theorem states that the structure of a firm's liabilities should have no
bearing on its net worth (absent taxes, etc.). The securities may trade at different prices
depending on their composition, but they must ultimately add up to the same value.
Furthermore, there should be little demand for specific types of securities. The capital asset
pricing model, first developed by Markowitz, suggests that investors should fully diversify
and their portfolios should be a mixture of the "market" and a risk-free investment. Investors
with different risk/return goals can use leverage to increase the ratio of the market return to
the risk-free return in their portfolios. However, Richard Roll argued that this model was
incorrect, because investors cannot invest in the entire market. This implies there should be
demand for instruments that open up new types of investment opportunities (since this gets
investors closer to being able to buy the entire market), but not for instruments that merely
repackage existing risks (since investors already have as much exposure to those risks in their
portfolio).
If the world existed as the Arrow-Debreu model posits, then there would be no need for
financial innovation. The Arrow-Debreu model assumes that investors are able to purchase
securities that pay off if and only if a certain state of the world occurs. Investors can then
combine these securities to create portfolios that have whatever payoff they desire. The
fundamental theorem of finance states that the price of assembling such a portfolio will be
equal to its expected value under the appropriate risk-neutral measure.
[edit] Academic literature
Tufano (2003) and Duffie and Rahi (1995) provide useful reviews of the literature.
The extensive literature on principal-agent problems, adverse selection, and information
asymmetry points to why investors might prefer some types of securities, such as debt, over
others like equity. Myers and Majluf (1984) develop an adverse selection model of equity
issuance, in which firms (which are trying to maximize profits for existing shareholders)
issue equity only if they are desperate. This was an early article in the pecking order
literature, which states that firms prefer to finance investments out of retained earnings first,
then debt, and finally equity, because investors are reluctant to trust any firm that needs to
issue equity.
Duffie and Rahi also devote a considerable section to examining the utility and efficiency
implications of financial innovation. This is also the topic of many of the papers in the special
edition of the Journal of Economic Theory in which theirs is the lead article. The usefulness
of spanning the market appears to be limited (or, equivalently, the disutility of incomplete
markets is not great).
Allen and Gale (1988) is one of the first papers to endogenize security issuance contingent on
financial regulation—specifically, bans on short sales. In these circumstances, they find that
the traditional split of cash flows between debt and equity is not optimal, and that state-
contingent securities are preferred. Ross (1989) develops a model in which new financial
products must overcome marketing and distribution costs. Persons and Warther (1997)
studied booms and busts associated with financial innovation.
The fixed costs of creating liquid markets for new financial instruments appears to be
considerable. Black and Scholes (1974) describe some of the difficulties they encountered
when trying to market the forerunners to modern index funds. These included regulatory
problems, marketing costs, taxes, and fixed costs of management, personnel, and trading.
Shiller (2008) describes some of the frustrations involved with creating a market for house
price futures.
[edit] Historical examples of financial innovation
[edit] Examples of spanning the market
Some types of financial instrument became prominent after macroeconomic conditions forced
investors to be more aware of the need to hedge certain types of risk.
The development of interest rate swaps in the early 1980s after interest rates
skyrocketed.
The development of credit default swaps in the early 2000s after the recession
beginning in 2001 led to the highest corporate-bond default rate in 2002 since the
Great Depression.
[edit] Examples of mathematical innovation
The market in options exploded after the development of the Black–Scholes model in
1973.
The development of the CDO was heavily influenced by the popularization of the
copula technique (Li 2000).
Futures, options, and many other types of derivatives have been around for centuries: the
Japanese rice futures market started trading around 1730. However, recent decades have seen
an explosion use of derivatives and mathematically-complicated securitization techniques.
MacKenzie (2006) argues from a sociological point of view that mathematical formulas
actually change the way that economic agents use and price assets. Economists, rather than
acting as a camera taking an objective picture of the way the world works, actively change
behavior by providing formulas that let dispersed agents agree on prices for new assets.
[edit] Examples of innovation to avoid taxes and regulation
Miller (1986) places great emphasis on the role of taxes and government regulation in
stimulating financial innovation. Modigliani and Miller (1958) explicitly considered taxes as
a reason to prefer one type of security over another, despite that corporations and investors
should be indifferent to capital structure in a fractionless world.
The development of checking accounts at U.S. banks was in order to avoid punitive taxes on
state bank notes that were part of the National Banking Act.
Some investors use total return swaps to convert dividends into capital gains, which are taxed
at a lower rate.[1]
Many times, regulators have explicitly discouraged or outlawed trading in certain types of
financial securities. In the United States, gambling is mostly illegal, and it can be difficult to
tell whether financial contracts are illegal gambling instruments or legitimate tools for
investment and risk-sharing. The Commodity Futures Trading Commission is in charge of
making this determination. The difficulty that the Chicago Board of Trade faced in
attempting to trade futures on stocks and stock indexes is described in Melamed (1996).
In the United States, Regulation Q drove several types of financial innovation to get around
its interest rate ceilings, including eurodollars and NOW accounts.
[edit] The role of technology in financial innovation
Some types of financial innovation are driven by improvements in computer and
telecommunication technology. For example, Paul Volcker suggested that for most people,
the creation of the ATM was a greater financial innovation than asset-backed securitization.[2]
Other types of financial innovation affecting the payments system include credit and debit
cards and online payment systems like PayPal.
These types of innovations are notable because they reduce transaction costs. Households
need to keep lower cash balances -- if the economy exhibits cash-in-advance constraints then
these kinds of financial innovations can contribute to greater efficiency. Alvarez and Lippi
(2009), using data on Italian households' use of debit cards, find that ownership of an ATM
card results in benefits worth €17 annually.
These types of innovations may also have an impact on monetary policy by reducing real
household balances. Especially with the increased popularity of online banking, households
are able to keep greater percentages of their wealth in non-cash instruments. In a special
edition of 'International Finance' devoted to the interaction of electronic commerce and
central banking, Goodhart (2000) and Woodford (2000) express confidence in the ability of a
central bank to maintain its policy goals by affecting the short-term interest rate even if
electronic money has eliminated the demand for central bank liabilities, while Friedman
(2000) is less sanguine.
