Lord Turner, the Chairman of the Financial Services Authority, took this question as one of the themes of his lecture this week on “Securitisation, shadow banking and the value of financial innovation”:
“Ahead of the crisis, there was high confidence that financial innovation in general, and in particular its application to the wholesale markets had delivered important benefits. Central to the perceived value were the related concepts of market completion, market efficiency and liquidity. In addition it was often asserted that the financial innovations of securitisation had beneficially enabled additional credit creation, and thus directly stimulated growth.
The market completion argument involved two underlying propositions.
• First that greater market liquidity made possible by a securitised credit system, and by the development of related derivatives such as credit default swaps, had brought the wisdom of the market to bear in the pricing of credit risk, enhancing price discovery.
• Second, that the techniques of pooling and tranching, combined with complex multi-step distribution chains, had enabled the packaging and then the placing of combinations of risk, return and liquidity, which more precisely met the preferences of investors and their risk-bearing capacity. As a result, it was argued that both market efficiency and financial stability would be enhanced.
These propositions were believed almost axiomatically – a specific expression in the financial markets of the general Arrow-Debreu proposition that complete markets will tend to generate allocative efficiency and welfare benefits…
…Alongside these theoretical arguments, however, a more empirically straightforward argument for securitisation was also often advanced – that it enabled more credit creation, by enabling economies in the use of scarce bank capital; that it enabled, for instance, the extension of mortgage credit on a scale that would otherwise have been constrained…
These assumptions were profoundly shocked by the financial crisis: and in its aftermath, every aspect of the pre-crisis conventional wisdom has been challenged.
• The financial system has clearly not been more stable – it was made highly unstable.
• Much of the credit expansion seems in retrospect to have driven harmful misallocation of resources.
• And the general proposition that financial innovation creates value by completing markets has been rejected. Paul Volcker has commented that he cannot think of a useful financial innovation since the ATM; Paul Krugman that it is hard to think of any big recent financial breakthroughs which have aided society. And Joseph Stiglitz has argued that in the run up to the crisis most financial innovation ‘was not directed at enhancing the ability of the financial sector to perform its social functions’.”
Leading Lord Turner to observe:
“…while there clearly can be beneficial financial innovation, there are fundamental reasons why innovation and finance tends to be less likely to produce beneficial social impact and more likely to produce rent extraction, than innovation in other sectors…within finance, our greatest concern should be focused on innovations which relate to the credit and money creation process, because it is there that financial innovation can produce not just zero social value but large negative externalities.
Which post-war major financial innovations have been beneficial?
“• The development from the 1940s onwards, of venture capital financing techniques, which enabled dispersed wealth holdings (held for instance in pension funds) to fund entrepreneurial new venture investment.
• And the development of mutual funds, which enabled savers with modest holdings of wealth to invest indirectly in diversified securities portfolios, rather than being either confined to bank deposits or to undiversified securities portfolios, or to face excessive transaction costs.”
Increasing financial intensity is not limitlessly beneficial – in particular, shadow banking, securitisation and high-frequency trading:
“The great economic transformation of the last 250 years was accompanied by financial innovations – joint stock banks, stock markets, corporate bonds – and it is impossible to imagine the complex exchange economy without a complex financial intermediation system. Richer countries tend to have somewhat larger financial sectors as a percent of GDP, and in some countries further financial deepening would almost certainly be beneficial – India needs to extend basic banking services more effectively to rural areas. But we cannot assume by axiom that increasing financial intensity is limitlessly beneficial simply because it must be ‘completing more markets’ or ‘making markets more efficient’. Beyond some point the benefits must be subject to declining marginal returns and the dangers of offsetting distributive and externality effects probably increase.
• In the arena of securitisation and shadow banking, the purported benefits of market completion were the increased availability to investors of their precise desired combinations of risk, return and liquidity. Even if this had been delivered without increased risk, this beneficial impact must surely have been subject to declining marginal returns [Exhibit 28]. But in fact the very complexity involved in pursuit of this market completion, and the related increase in financial system interconnectedness, increased the dangers of underestimated risks and thus the dangers of financial instability. As a result the net impact of increasing attempted market completion may be a function subject first to declining and then eventually to negative marginal returns.
• And it is possible (though here the hypothesis is even more speculative) that the same logic may apply to increased market liquidity. There are strong reasons for believing that reasonably liquid markets, which enable investors to buy and sell securities (or foreign exchange or commodities) in reasonably large quantities, rapidly, at low bid-offer spreads, are of social value. But the benefits of ever further liquidity, market efficiency and price discovery, must be subject to declining marginal returns. It is therefore not clear that high frequency trading, based on computer algorithms, can possibly deliver significant positive social value – price discovery at the nano-second interval cannot possibly give a significant allocative efficiency benefit over price discovery on a second-by-second basis. And there must be at least some danger that the increased role of algorithmic trading, without which high frequency trading is impossible, could contribute to increased volatility or mispricing. At the limit, an equity market in which 100% of trading was driven by algorithms of an arbitrage or momentum (rather than fundamental value) nature would become a self-referential random number generator. Increased liquidity of markets – normally treated as an iconic variable which we should always seek to maximise – may also logically be subject to first rising and then falling social returns.”
Debt and credit creation has to be controlled…
“What can we say about the optimal balance of debt versus equity instruments in the economy? In attempting to assess the impact of ‘securitisation’ I stressed that we could not conclude that it had been beneficial simply because it had helped ‘create more credit’, that we needed to ask whether and how far the new credit created had had a beneficial effect. The balance between debt and equity instruments in an economy is a centrally important issue: more debt gives more apparent certainty, which both savers and borrowers may value: but more debt makes the system potentially more fragile. We used to assume that the free market chosen level of debt within the economy was axiomatically optimal: in the wake of the crisis we can no longer do so.”
…as Minsky said:
“So what follows for policy? Well Hyman Minsky was, wisely, cautious of believing that any regulator could precisely offset the instability which the operation of private incentives, innovation and changing risk appetite would unleash.
‘In a world of business men and financial intermediaries who aggressively seek profit, innovators will always outpace regulators: the authorities cannot prevent changes in the structure of portfolios from occurring. What they can do is to keep the asset-equity ratio of banks within bounds by setting equity absorption ratios for various types of assets. If the authorities constrain banks and are aware of the activities of fringe banks and other financial institutions, they are in a better position to extenuate the disruptive expansionary tendencies of our economies.’
The vital policy implications of the story of shadow bank financial innovation are indeed that we should seek to constrain the instability potentially created by credit and money creation processes, by credit and asset price cycles. That implies:
• Much higher bank capital and liquidity requirements than we had in place before the crisis – the Basel III reforms. These constrain banks’ ‘asset-equity’ ratios at the institutional level.
• Appropriate constraints on shadow bank credit and money equivalent creation – for instance through ‘asset-equity’ controls at the contract level – minimum initial haircuts. These will be considered by the Financial Stability Board this year.
• The development of macroprudential countercyclical levers which can lean against the strength of the credit and asset price cycle. The UK’s interim Financial Policy Committee has recently recommended to Parliament that it should have the power to vary across the cycle both total bank capital requirements and the riskweights applied to specific types of asset (such as real estate). It has also flagged that regulating margins on secured financing contracts might be desirable in future, within the context of internationally agreed approaches.”
See also: What is shadow banking?