Financial Innovation, Continued

My post on the quality of discussions of financial innovation generated a much larger response than I was anticipating (some pro, some less-than-pro). Now people apparently expect me to follow through on my promise to write a follow-up post on financial innovation. I guess I've boxed myself in, so here goes.

First, let me just say that I don't consider myself a "defender of financial innovation." In fact, at the retail level, I'm actually firmly anti-financial innovation, and I'm all for the Consumer Financial Protection Agency. My contention is simply that discussions of institutional-level financial innovation over the past year have taken place at an extremely superficial level, and have been premised on a number of basic misconceptions. The point of my last past was to point out two of those misconceptions, not to make a broad defense of financial innovation. (The point was definitely not to "get CDOs off the hook," as I specifically criticized CDO attachment points.)

In his 2002 post-mortem on the internet bubble, Michael Lewis has a great passage on the psychology of booms vs. busts, which I think is particularly appropriate right now:

The markets, having tasted skepticism, are beginning to overdose. The bust likes to think of itself as a radical departure from the boom, but it has in common with it one big thing: a mob mentality. When the markets were rising and everyone was getting rich, it was rare to hear a word against the system—or the people making lots of money from it. Now that the markets are falling and everyone is feeling poor, or, at any rate, less rich, it is rare to hear a word on behalf of either the system or the rich. The same herd instinct that fueled the boom fuels the bust. And the bust has created market distortions as bizarre—and maybe more harmful—as anything associated with the boom.

I think the general anti-finance backlash, fueled by this herd instinct, has driven much of the debate over financial innovation. It's definitely made commentators more willing to make broad, sweeping (and wrong) claims about financial innovation. But anyway, on to the substance.

Poorly defined terms are one reason that discussions of financial innovation have suffered so much. What constitutes a "financial innovation"? What are we considering acceptable goals/uses for new financial products? What about a product that's created to take advantage of a change in the tax code or regulatory capital rules? (Are financial institutions supposed to not respond to incentives in the tax code or the regulatory capital rules?) Are financial innovations that are theoretically sound but have been misused in practice still considered beneficial, or are we only judging financial innovations based on the way they've been used in practice?

I'm willing to define "financial innovation" as a new financial product that enjoys widespread use, and that was not created solely to realize tax or accounting benefits. That ignores the small-scale, one-off style of financial innovation, where an individual transaction is structured in a unique way in order to suit the particular particular parties in the transaction. These transactions often create new kinds of financial products, and the only reason they're considered "customizations" rather than "financial innovations" is that they're never adopted by the wider market.

It's also important to determine when it's fair to say that a financial innovation "caused" a certain problem. Did securitization "cause" the housing bubble? Clearly not, since securitization worked fine for 20+ years before the housing bubble. A more interesting question is: If a regulation allows a financial innovation to be used in a way that turns out to be harmful, is that the fault of the financial innovation or the regulation? For example, in a Planet Money podcast on financial innovation, Mike Konczal of Rortybomb, after saying that credit default swaps were also a great innovation, says:

CDSs were also a terrible innovation, because they allowed a lot of investment firms to skirt regulatory regimes. Basel II had certain requirements about how much debt you could take on, and the CDS was almost engineered to be able to sneak around that regulation.

This is actually not accurate, and in a way that's important to how you view CDS as a financial innovation. CDS do not allow banks to "sneak around" or "skirt" Basel II. Basel II explicitly recognizes CDS as an eligible "credit risk mitigant" that banks can use to reduce the amount of capital they're required to hold—and thus increase their leverage (see paragraphs 191–200 of Basel II). The majority (~$350bn) of AIG's CDS book consisted of these so-called "regulatory capital relief" trades, most of which involved European banks buying CDS protection from AIG.

But is this the fault of CDS, or is it the fault of Basel II? I'd argue that it was mostly the fault of Basel II, because CDS were developed primarily for nonregulatory reasons—it took the Basel Accords (both I and II) to make CDS the leverage-encouraging instruments they became. Basel II would have encouraged excessive leverage whether CDS had been invented or not, because banks could also have used total return swaps—which predate CDS—to reduce their regulatory capital under Basel II.

So while it's fair to say that using CDS for regulatory capital relief encouraged excessive leverage, it's not fair to lay the blame for this at the CDS market's door. I'm curious to see if Mike Konczal has another argument for why CDS were a bad innovation, or if this was the only one.

Finally, I want to push back against an argument that I've seen several times, and that Felix Salmon happened to make in the Planet Money podcast. After listing several of financial innovation's alleged sins over the past 20 years, Salmon attempts to deny any benefits by arguing:

[E]fficiency didn't really improve, as is evidenced by the enormous profits that the financial sector made. If they were getting more efficient, you would expect them to be making less money; in fact, they made more.

This is wrong on multiple levels. On a theoretical level, Salmon is confusing the industrial efficiency of the financial services sector with the informational efficiency of asset markets. Industrial efficiency is concerned with whether the services provided by financial institutions are priced at their marginal cost. Informational efficiency is concerned with whether asset prices fully reflect available information (which is what people commonly mean when they discuss financial market efficiency). While industrial and informational efficiency are obviously related, they are by no means the same thing, and the "enormous profits" in the financial sector say very little about the informational efficiency of asset markets.

Salmon's argument also presumes, wrongly, that the financial sector has earned consistently high profits for the same activities. The hugely profitable activities in finance are different practically every year. Traders and salesmen in that year's new, "hot" market pull down seven-figure bonuses, but then every other bank on the Street piles into that market, pushing down margins to more normal levels, and two years later traders in that market are applying for jobs on the muni bond desk. In the early '80s it was mortgage trading desks, then it was LBOs and junk bonds, then it was interest rate swaps, then it was anything calling itself a "hedge fund," then it was internet IPOs, etc., etc. The fact that new, different groups within the financial sector made outsized profits each year doesn't show, or really even suggest, that informational efficiency in the asset markets has failed to improve.

Okay, in the next post (which I've already written) I'll discuss some of the specific financial innovations I highlighted last time. This post is getting way too long though, so I'm splitting it into two posts.