Financial Innovation, Regulation and Crises in History

Harold James

• Publisher: Routledge
• Year: 2015
• ISBN:
  9781317317647
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

With contributions from world-renowned figures such as Niall Ferguson and Adair Turner, this volume investigates how financial institutions and markets have undergone or reacted to past pressures, and the regulatory responses that emerged as a result.

1 Financial Innovation, Regulation and Crises: A Historical View

Piet Clement

Harold James

Herman Van der Wee

DOI: 10.4324/9781315653969-1

In public opinion, as in much of the academic literature, the financial crisis that started in 2007–8 has been blamed on financial innovations gone awry.¹ In a nutshell, the by-now conventional account runs like this: spurred on by a cheap-money environment, the financial boom in the years prior to the crisis generated an over-issue of new and complex financial products, such as credit default swaps (CDS), off-balance-sheet derivatives and, infamously, subprime mortgages packaged in mortgage-backed securities and collateralized debt obligations (CDO).² The main problem of this type of financial innovation has been that the underlying risks of these novel products were often incorrectly priced or not transparent to the ultimate creditor. This fundamental misalignment infected the global financial system on an unprecedented scale, and eventually proved lethal once the boom ended and vulnerabilities became apparent. The generalized loss of confidence and the collective run for safety (de-leveraging in the jargon; i.e. financial institutions’ attempt to get rid of high-risk, toxic assets and to improve capital/asset ratios) have sparked a global financial crisis, which in terms of its severity and longevity has been the worst since the Great Depression.

It is no surprise that the current crisis has led to renewed interest in the work of the American economist Hyman Minsky (1919–96). Minsky argued that booms associated with financial innovation can easily lead to speculative euphoria, increased financial fragility and eventual collapse (the financial instability hypothesis).³ One of the key problems is that financial innovations not only help to spread risks – thereby increasing the economy’s overall capacity to bear risks – but often enough also have the potential, partly due to their complexity, to obscure the real, underlying risks.⁴ That happens, for instance, when risk diversification is achieved by shifting risks to naive investors, who face insurmountable information asymmetries. In the recent crisis, such risk transfer proved to be the shell game of credit markets. A short con, quick and easy to pull off. Financial innovation did not decrease risk but increased risk significantly in complex ways’.⁵

New financial products that claim to spread risks more evenly are easily perceived as safe. Rating agencies play an important role in this process: although these new products are untested in times of market stress, they nevertheless receive a clean bill of health in the form of a triple-A rating. The underlying risks are still present, but are largely ignored.⁶ Moreover, while risks with a normal distribution can be mathematically modelled and thus factored in in the pricing of financial products, uncertainty, due to the use of systematic errors, cannot. In a boom market, this potential weakness of new financial products is further compounded by their over-issue and financial institutions’ over-leveraging. Because they are supposedly risk-free and at the same time promise high returns, there is a high demand for and excessive issuance of such new products.⁷ Over-issuing finally contributes to a loss of confidence and a collapse. The end result is often that the economic and social value the initial innovation may have had is wiped out altogether. Some even go so far as to argue that many of the recent financial innovations had little or no economic or social value to begin with, but were mainly driven by an insatiable market appetite or, worse, merely aimed ‘to give banks new instruments to allow them to profit at the expense of unsophisticated individuals and households’.⁸ Indeed, Paul Volcker once famously remarked that the only socially valuable financial innovation of recent decades has been the automatic teller machine.

In short, the current crisis has cast financial innovation in a bad light. However, this should not mean that it is necessarily or always a bad or dangerous thing. In fact, financial innovation per se is not inherently bad or good. It is the use that is made of it that matters. As Michael Haliassos puts it: ‘financial products have something in common with building materials. One can use a brick to build a house or to smash a window’.⁹ In economic literature, financial innovation is most commonly seen as a positive force. There are plenty of examples in which financial innovation has played the positive role it is supposed to play.

First, much of the financial innovation over the past centuries has helped to expand access to credit for households and firms (and government), by tapping into new sources of funding.

Secondly, many financial innovations have indeed been aimed at improving the spread of underlying risks – market risks, credit risks, liquidity risks – and have been successful in doing so. They have thereby enhanced the capacity of the financial system and of the economy as a whole to take on more risk without necessarily jeopardizing overall stability. A good example of an institutional innovation that has achieved precisely that, is the introduction of limited liability in the nineteenth century.¹⁰ A good example of a successful financial product innovation would be exchange-traded forward contracts (futures), which first appeared in Japan in the 1730s (Dōjima Rice Exchange, Osaka) and which became fashionable in the sector of commodity trading as of the late nineteenth century.

Third, financial innovations have tended to increase returns earned by the intermediaries who market them, and thus have often had a positive impact on the overall profitability of the financial sector. Indeed, in the decades preceding the 2007–8 crisis, banks increased their returns considerably thanks to the development of a structured credit market (credit derivatives, structured investment vehicles, collateralized debt obligations), which allowed them to move capital intensive assets off balance sheet through the direct pairing of non-bank liquidity providers (fixed income investors) with corporate and sovereign borrowers.¹¹ It should be immediately added that precisely because of these higher returns the incentive or justification for pushing such innovations and high-risk activities ever further proved irresistible, often enough beyond what was sustainable over the longer term.

For all these reasons, and notwithstanding repeated excesses, a strong case can be made that, on balance, financial innovation has been a positive force for economic growth, wealth creation and development globally. Joseph Schum-peter has argued that many of the technological and commercial innovations of the nineteenth and twentieth centuries would not have been possible without financial innovations such as the joint-stock company and limited liability.¹²

Given the apparent Jekyll and Hyde quality of financial innovation, the key question seems to be: how can we ensure that financial innovation remains a force for the good and prevent it from going awry? Proper risk management and regulation may seem the most logical answers. Risk management – be it in the form of collateral, hedging, hidden reserves or the sophisticated types of risk modelling currently in vogue – is at least as old as the financial system itself. Regulation too has a long history, for instance in the form of religious interdictions on usury. If unregulated financial innovations are an important cause of financial crises, it would appear reasonable to aim for tighter, or at least more effective, regulation. However, due to the very nature of innovation, regulation will practically always be behind the curve – that is to say, it will try to regulate to avoid a repetition of what already went wrong rather than to prevent things that still may go wrong.¹³ There is a race between financial innovators and regulators that the regulators will always lose, ‘but it matters how much they lose by’.¹⁴Tighter supervision and new regulations typically aim to address the deficiencies – perceived or real – of loose or outdated regulation. But regulatory reform may also hold the risk of over-regulation – particularly when it is undertaken under the impression of a severe crisis. Over-regulation tends to stifle innovation and therefore might have negative welfare-effects. In short, the difficulty is to strike the right balance. It should be clear that there are no easy fixes in this area.

A financial crisis and the almost inevitable regulatory responses to it, have longer-term effects when they shape the future path of financial development. New risk management strategies, adopted to contain a crisis situation, may in turn prompt financial innovations in the quest to achieve a better spread and reduction of risks. Regulation may block undesirable developments and undo earlier innovations, and thereby elicit new ones and open up new trajectories.

Finally, the long and winding road of financial development is marked out not only by innovation, crisis and regulation, but also by the financial policies – monetary, fiscal, institutional – pursued by central banks and governments. The result of these interlocking, and often conflicting, events, influences and interests is that the financial system does not develop linearly, but rather along a tortuous, often unpredictable, path, with many ups and downs and characterized by sometimes violent pendulum swings between financial repression and financial liberalization.

This volume explores a few stretches of this road, highlighting many of the key issues in the dynamic relationship between financial innovations, crises, risk management and regulation. When or under what conditions are financial product innovations most likely to occur? And, equally important, what makes them stick? (Chapter 2) How and when do institutional innovations arise and what is their longer-term effect? Do they give rise to alternative models in financial development that tend to lead to a better (or worse?) risk mitigation? (Chapters 3 and 5) Under what circumstances can financial innovations become a threat to financial stability? Does history suggest that there is an almost inevitable sequence from financial innovation to ‘irrational exuberance’ (to borrow Alan Greenspans famous phrase) to crisis? Or does one rather have to look to misguided policies and failing oversight to explain why financial crises occur over and over again? (Chapter 6) Finally, once a financial crisis has broken, what strategies have been adopted in the past to deal with it – at company, national and international level? How have companies managed the fall-out of severe financial crises? (Chapter 4) How have national and international authorities reacted, and what has been the longer-term impact of their actions on regulation and, eventually, on further innovation? (Chapters 5, 6 and 7) Most chapters look at historical episodes of financial innovation and crisis, but there is also a conscious attempt, particularly in the final section of this book (Chapters 8 and 9), to reflect, from a historical perspective, on the current crisis.

In Chapter 2, Lodewijk Petram deals with a financial innovation that has had a durable institutional impact. Petram traces the origins of the secondary shares market to the Dutch Republic in the early seventeenth century. Secondary trading in shares of the Dutch East India Company (VOC) developed in a full-fledged financial market that allowed investors to actively manage their portfolio and thereby to diversify risks. The consistent enforcement of the related contracts through the courts was decisive in making this innovation stick. This created a larger measure of legal certainty, which reduced risk and transaction costs and consequently persuaded more investors to become active in this new market. Drawing on extensive research in the original court records, Petram demonstrates how the Court of Holland effectively built the worlds first securities law. This legal framework also included regulatory aspects, for instance through the prohibition of short-selling in 1610. What is interesting to see is that the gradual clarification of this legal framework also influenced private enforcement mechanisms on the secondary and sub-markets. Such mechanisms typically included some form of self-regulation, for instance through peer pressure or through trading clubs submitting voluntarily to adjudication in case of disputes. In short, the successful emergence of a secondary market for VOC shares and the legal framework that was created around it resulted in a relatively stable system of shares trading that enabled the VOC to meet its high capital requirements and thrive. As such it became a model to be copied.

Joke Mooij (Chapter 3) offers another story of successful financial innovation in the Netherlands, but in a very different time period and context. The creation of a network of co-operative agricultural banks in the Netherlands during the early twentieth century not only facilitated access to credit and financial services for small-scale farmers, but also made the individual, small-scale banking institutions themselves more resilient in the face of adverse conditions. This was, Mooij argues, largely because of an idiosyncratic business model, characterized by an intimate knowledge of the customer base and a built-in, high degree of mutual solidarity, whereby the network took responsibility for the individual members whenever they got into trouble. In exchange for this solidarity, a relatively high degree of centralization, strong internal safeguards and an embryonic form of prudential supervision were accepted by the participating banks from early on. These factors allowed the co-operative agricultural banking sector in the Netherlands to get through the Great Depression without any significant bankruptcies and with its market share largely intact. However, such an outcome was not a given: in Belgium, where the co-operative banking sector operated on a similar model, its evolution during the 1920s and 1930s was, by contrast, disastrous, before making a remarkable come-back after the Second World War.¹⁵In other words, institutional robustness is no absolute guarantee, and particular circumstances, short-term business decisions and investment practices matter a lot. Nevertheless, the Dutch case, as analysed by Mooij, provides a good example of an institutional innovation that has been successful in reducing risk.

Institutional innovation may have been helpful in mitigating risks in times of crisis in the case of the Dutch co-operative banks, but Tobias Straumann highlights other, less orthodox, strategies of risk management (Chapter 4). Straumann is puzzled by the fact that Swiss Re, one of the world’s leading reinsurance companies, got through the Great Depression of the 1930s seemingly unscathed. Did Swiss Re owe this outcome to a far-sighted management taking timely action to counteract the fall-out from the crisis? Or was it thanks to the implementation of a timely strategic re-orientation of the company’s business model? Based on a thorough analysis of the unpublished records of Swiss Re, Straumann comes to a very different conclusion. The truth of the matter is that Swiss Re managed to weather the storm only thanks to the high amount of hidden reserves accumulated over the preceding decades. In that way, the company was able to report a positive result and to maintain a solid market reputation in spite of the underlying financial results being catastrophic. In other words, during the 1930s, hidden reserves allowed Swiss Re to absorb a major macroeconomic shock. This was not possible during the 2008–9 financial crisis: the primacy of shareholder value and the necessity to create full transparency over the accounts had long since done away with hidden reserves. As a result, Swiss Re took the full brunt of the crisis and suffered accordingly. In that sense, Straumann offers a cautionary tale on how the markets react to the revealed positions of financial firms – even, or particularly, when these prove to be incomplete or unreliable – and, more generally, on how the financial sector interacts with the real economy.

A severe financial crisis, such as the Great Depression or the current crisis, always produces a political and regulatory backlash, particularly when the crisis can be and is widely blamed on financial innovations – be it at the product or institutional level – having gone wrong. However, the regulatory responses are far from unambiguous. In Chapter 5, Federico Barbiellini Amidei and Claire Giordano illustrate this point vividly by comparing the re-design of the banking industry in the US and in Italy in the wake of the 1930s crisis. They convincingly refute the received wisdom that the US Banking Acts of 1933–5 and the Italian Banking Act of 1936 responded in a broadly similar fashion by splitting commercial from investment banking. In fact, both sets of legislation differed substantially in that they sought to address very different problems (‘evils’). While the US legislator was mainly concerned with the risks posed by commercial banks’ direct and active role in the stock exchange market, the Italian legislator primarily sought to address the problems caused by the long-term debt and equity stakes in industrial firms held by Italian commercial banks. This is a classic story of political economy and (attempted) regulatory capture. At the same time, it demonstrates that while regulatory responses to crises tend to cut off a particular path of future development, t...