Bruised but Not Out: A Bullish View on the Future of Financial Innovation

The Great Recession has given a black eye to the tools of financial innovation. Collateralized debt obligations, synthetic derivatives and other once-arcane investment vehicles are now the poster boys of what went wrong — toxic players in the boom-and-doom scenario of the housing implosion and market rout. But these highly opaque and complex instruments are not representative of real financial innovation, which stresses transparency and responsible management of risk, argues Wharton finance professor Franklin Allen in his new book, Financing the Future: Market-Based Innovations for Growth, co-written with Glenn Yago, executive director of financial research at the Milken Institute. Financial innovation, properly used, has been the engine of growth through the centuries, Allen says, and is especially needed now to get the world economy on track again.

Allen met recently with Knowledge@Wharton to discuss his book. An edited transcript of the conversation follows.

Knowledge@Wharton: Financial innovation seems to have developed something of a bad reputation because it is equated so much with the high-risk products that caused such turmoil in the financial markets. Do you think this reputation is deserved?

Franklin Allen: It is partly deserved, but not fully deserved — it got too much of the blame. If you look at countries where there was much less financial innovation, like Spain, for example, you get the same kinds of problems. It certainly didn’t help to have the subprime mortgages and all the innovations in that sector, but the crisis would still have happened, as it happened in Spain. The basic problem was the housing price bubble. When a bubble bursts, it causes problems.

Knowledge@Wharton: Your book has a chapter outlining the history of financial innovations. Could you take us through some of the major milestones?

Allen: There are many milestones going back thousands of years — we focus on a number of them. We start with the founding of the American republic and Alexander Hamilton’s debt-for-debt swap in which he refinanced the government debt and put it on a much sounder footing, helping the U.S. greatly at the beginning of its life. Through the 19th century, we saw the financing of the railroads. That effort helped to develop the markets because we had to do things in new ways to raise the huge capital that was needed. Then in the 20th century, we saw the development of banking for the masses. The San Francisco earthquake was followed by the famous expansion of what was originally the Bank of Italy, which eventually became the Bank of America. Many people who had previously not had loans or access to finance were allowed in.

Knowledge@Wharton: Innovators are usually trying to solve one or more specific problems. How does this work in the world of financial innovation?

Allen: The basic question is, how do people get their money back? This is the big difficulty — so we need innovations to allow that to happen better. A good example would be the development of venture capital, which started after World War II but didn’t take off in a significant way until the late 1970s and early 1980s. What people discovered was that you needed limited partnerships to provide the kinds of incentives for the people who were screening the projects to do a good job. And you also had to provide the right incentives to the managers. It was a whole set of things that came together, which suddenly allowed the financing of small start-ups in high technology. This, of course, has transformed our economy.

Knowledge@Wharton: When you consider innovations in the sphere of business finance would you agree that sometimes they seem to come at the cost of transparency? How can this problem be addressed?

Allen: In many cases, financial innovation is a wonderful thing, as we just pointed out with venture capital. But there is also a dark side to financial innovation: if you make things complicated enough, people don’t understand what is going on and it becomes possible to trick them. Much of the innovation that has occurred in recent years has been of that nature. That is unfortunate because it gives innovation as a whole a bad name. It happens in many different spheres — in both personal finance and in business finance. We need to avoid this level of complication because it does cause problems.

Knowledge@Wharton: An example might help explain this. Let’s take the situation in Greece, where the national debt was going up but this was not apparent to many people because some of the transactions that increased the debt were disguised as currency transactions.

Allen: Yes — this is a very old story, which goes back to the Middle Ages. The Church had restrictions on paying interest — usury, as it is called. There were a number of ways that people got around this. One way was to build a discount into foreign exchange transactions, which effectively meant that interest was being paid. That is, of course, what happened when Goldman Sachs arranged such transactions for Greece. There was a swap component, but because of the way that the transactions were priced there was also a credit component. Effectively, then, Greece was borrowing billions of dollars and that was hidden unless you looked very carefully at the prices of the underlying transactions. It is not clear that the people in Brussels knew exactly what was going on and understood that credit was part of the picture. Some people claim they did understand this, but it is not so clear.

Knowledge@Wharton: How can these transactions be made more transparent? Or is complexity necessarily going to be built into the way financial innovation occurs?

Allen: Often, it is not necessary. But with some of these swaps and other transactions it is inevitable that they are somewhat complicated and you need a level of sophistication to understand them. Certainly, governments should be able to understand these things. The problem is in retail markets. People should always be wary and if they don’t understand exactly what is going on they should not participate in the transaction.

Knowledge@Wharton: That exactly is what seems to have happened to a lot of people in the field of housing finance. You have a chapter in the book about this. Could you explain how some innovations led to the subprime crisis?

Allen: A lot of the innovations there were well-intentioned: People wanted to enable people of lower means to own their own houses because there are many advantages to doing that. What they did was to design these new products, which for a long time did help people who otherwise would not have been able to buy a house. But unfortunately, these products relied very heavily on prices going up. As the boom, the bubble, grew in the early part of the decade, these aspects got more and more exploited. It went too far. So when the bubble burst, it caused these huge problems. If we hadn’t had the bubble, if housing prices had just kept going up at reasonable rates of 2% or 3%, like the rate of inflation, we would not have seen these problems. That’s because the sellers of these new products would not have exploited these reset options and all the other things that were used then in an abusive way. It would have worked as it worked for a number of years.

Knowledge@Wharton: Turning from housing to the environment, do you think financial innovation can be used to make the planet more eco-friendly?

Allen: The environment is one area in which financial innovation has already made a great contribution and it will contribute much more in the future. One example is the state revolving funds under which the federal government puts up money that is matched by state and local governments. This program allows various reclamation projects, water projects and other environmental projects to be financed in a sustainable way. There are many other examples. For instance, in the book we describe how New Zealand was able to renew its fishery resources using tradable permits to fish.

Knowledge@Wharton: What kind of special challenges does financing health care cause? How can financial innovation tackle some of those challenges?

Allen: This is one of the areas where there has been a lot of progress, but much more needs to be done. One of the biggest problems is coming up with cures for diseases that affect poorer countries but not richer ones. With richer countries, it is relatively easy to get financing because the payoffs are going to be large if you discover a new cure, a new vaccine or a new drug. But in the case of many diseases, most of the people affected have very little income and few resources. To grapple with this problem, we need a combination of the private sector and donations made through the big foundations, like the Bill and Melinda Gates Foundation. Financial innovation has a big role to play to combine those different sources of funds in ways that will foster the development of new cures and vaccines.

Knowledge@Wharton: In addition to improving health care, can financial innovation be used broadly to promote economic growth in the developing world?

Allen: Financial innovation can make a huge contribution in this area going forward, but as yet it hasn’t done as much as we would like. There are obviously examples where it has done a lot, like microfinance, which has received a lot of attention. But there is so much more to do.

Knowledge@Wharton: Near the end of your book, you present six rules of financial innovation. Could you walk us through these rules — and describe some of the consequences of ignoring them?

Allen: We have talked about some of them already.

Lesson one: Complexity is not innovation. Sometimes complexity is necessary, but often it is there to trick people.

Lesson two: Leverage is not credit. We have to be very wary of leverage. One of the big problems in the financial crisis was that there was so much leverage. This is a very old lesson. If you want to make a lot of money, leverage is one way to do it. But the problem is that the people who are lending to you often end up losing a lot, too, when things go bad. And in this particular case, and in many other crises, it is the government that ends up losing as well.

Lesson three: Transparency enables innovation. If you can be transparent, that is very helpful and people will be much more willing to accept the innovation.

Lesson four: Capital structure matters. This is very important. So if we go back to the example of venture capital, it is extremely important to come up with the right set of financing instruments and the right incentives for all sides of the transaction.

Lesson five: Democratizing access to capital spurs growth. If you read our historical chapter at the beginning of the book, one of the lessons is that it is very important for many people to have access to finance. Not just to consumer finance — so they can buy houses and cars and so on — but also to business finance, to gain access to funding so that they can grow the economy. This accessibility has been particularly important in the United States for spurring growth over the years.

Lesson six: Financial innovation can be a force for positive social change. This rule gets to some of the things that we talked about in terms of health care, the environment, and broad economic development.

Knowledge@Wharton: One last question: When you look to the future, do you see any areas that are ripe for financial innovation? What are the new and emerging frontiers for would-be financial innovators?

Allen: The most promising ones are in the developing world and helping the people there become richer and reach Western levels of income. Consider China’s experience. In just 30 years, China has gone from being a very poor country to raising hundreds of millions of its people out of abject poverty. Hopefully, in the next 20 to 30 years the same thing will happen to the rest of the population. They will all be able to have reasonable middle-class lives. Financial innovation has played an important role in this shift. If you look at the growth of small businesses, new ways of financing have been developed that stress networks and relationships. If you look at India, you see the same kind of thing.

What we still need to do is develop these kinds of mechanisms in other places, like Africa, where at the moment there is very much a financial development gap. We need to fill that gap — and that’s the next big challenge for financial innovation.

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Bruised but Not Out: A Bullish View on the Future of Financial Innovation. Knowledge@Wharton (2010, May 19). Retrieved from https://knowledge.wharton.upenn.edu/article/bruised-but-not-out-a-bullish-view-on-the-future-of-financial-innovation/

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