Financial Innovation and Monetary Policy

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Financial innovation and monetary policy

As financial innovation is a continuous process, it is difficult, in practice, to grasp all of its contours; and even moredifficult to predict its consequences. Therefore, financial innovation adds an element of uncertainty to the economicenvironment in which central banks operate.

If financial innovation improves the efficiency of the financial system, then it should also have a considerable effect on

the functioning of the economy in general. For example, insofar as financial innovation improves the availability offunds for business activities that might not have otherwise taken place, it is likely to have a positive impact on longer-term economic growth prospects. This is at least one reason why central bankers need to be aware of financialinnovation trends.

The development of innovative means of payments reduces transaction costs, thereby facilitating trading and theexchange of goods and services, which in the end should lead to a better allocation of resources. In the long term,this should be favourable for economic growth. The important thing and this is another way in which financialinnovation promotes growth and perhaps even dampens the business cycle is the proliferation of new financialproducts that help to make markets more complete. This is, for instance, the case of the development of financialtechnology such as derivatives and securitisation, which, by enabling risks to be unbundled and repackaged, hasgreatly expanded the range of tradable risks. As a result, markets have become deeper and more liquid, and priceshave become more competitive.

Another reason why central banks have to closely follow developments in financial innovation is that somedevelopments may change the way in which the economy reacts to monetary policy, or may affect the informationcontent of the indicators that central banks regularly monitor and that serve as a basis for taking policy decisions. Inthis respect, the monetary policy strategy of the ECB is well suited to deal with the challenges posed by financialinnovation. The ECB's strategy, which includes the analysis of various monetary and non-monetary indicators,constitutes a "full-information" framework, which allows information derived from different sources and using differentapproaches to be cross-checked. This eclectic and diversified approach, incorporating a broad range of data andanalysis, tries to take into account the influence of financial innovation on the economy in order to better understandthe risks to price stability in the euro area.

Let me elaborate on this by focusing on the particular cases of financial innovation in means of payment, ininvestment products and in financing choices.

Financial innovation in means of payment

Turning first to financial innovation in means of payment, developments in payment media and systems have startedto create close substitutes for banknotes, thus affecting a core part of central banking. This is, for example, the casewith the generalisation of the use of debit and credit cards, which facilitate the use of electronic means of payment,thereby speeding up the velocity of narrow money and substituting for the use of physical cash. More importantly,payment cards have also enabled the issuance of electronic money (e-money), which directly rivals physical cash insmall-value payments.

E-money can be defined as an electronic store of monetary value on a technical device that may be widely used formaking payments to undertakings other than the issuer, without necessarily involving bank accounts in thetransaction but acting as a prepaid bearer instrument. The ECB has studied the issue of e-money in depth. The mainmotivation for this was concern that e-money developments might endanger the function of money as a unit ofaccount for economic transactions. For this reason, a "redeemability" requirement for electronic money has been laiddown in European Union legislation. This ensures that the unit of account function of money is preserved, as holdersof e-money can always exchange it into banknotes at par. In addition, the reserve base of the ECB's reserve

requirements can be extended to issuers of electronic money so as to treat it in a similar way to short-term bankdeposits. The reserve requirements also safeguard the effectiveness of monetary policy. Indeed, as long as someform of ultimate recourse to central banks remains, the ability of central banks to influence money market interestrates will be maintained.

E-money may also have an effect on the information content of monetary variables. However, the ECB collects dataand compiles statistics on electronic money and can, therefore, monitor the evolution of this phenomenonappropriately. Overall, with these measures in place, the ECB does not expect its ability to maintain price stability tobe endangered by the development of electronic money.

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In any case, e-money schemes have thus far had problems in achieving a critical mass in Europe and their spreadhas been slowing. There are currently 25 different card-based schemes in Europe, which are mostly operated byfinancial institutions. At the end of December 2002, the total stock of electronic money in circulation amounted to

240 million. The use of software-based e-money (network money) also remains negligible. Most software-based e-money initiatives in recent years closed down before they were able to operate on a wider scale. All in all, electronicmoney still represents a very small fraction of total money: it corresponds to only 0.1% of banknotes and coins incirculation. Therefore, the practical relevance of electronic money for economic analysis remains very limited at the

moment.

Looking a long way ahead, there may be additional issues related to the widespread issue of e-cash by private non-banks.

The plans of some national authorities to issue e-cash with legal tender status are rather unique. The ECB followswith interest the development of such plans. I would like to mention here some issues arising from a central bankissuing e-money that depend on the relationship between privately and publicly provided e-money. One option is thata central bank could hold a monopoly on the issuance of electronic money, forcing private issuers to procure legaltender from the central bank. Alternatively, the official e-money is introduced alongside its private counterparts. Underthis option the central bank would have an advantage over other issuers because central bank e-cash wouldpresumably be more trusted and would eventually become the dominant form.

Furthermore, if a central bank wants to play a leadership role in the local development of electronic money, it should

look at the experiences of others, some not far from here. At the ECB we look at them with interest. Some countries,for instance, have chosen to play a co-ordinating role in the industry-led standardisation process, while others havedefined standards for private initiatives. In the common pool of experience I mentioned earlier, the euro area can offerthe case of Finland whose central bank contributed directly to establishing the infrastructure for the new paymentinstruments in its country in the early 1990s.

The usefulness of having a common pool of experience leads me to an additional but rather different point. Thisrelates to the leapfrogging opportunities offered by e-finance. In some countries whose financial systems have limitedservices and less-developed financial infrastructure, the use of electronic cash and multipurpose cards offer savingsand payment services to customers who could not be reached via more traditional forms of finance. In some cases,e-finance allows financial services to be delivered in such countries from offshore, providing the additional benefits ofinternational technology and oversight, but creating, at the same time, additional repercussions on the effectivenessof local monetary policy operations.

Financial innovation in investment products

As far as the introduction of new instruments for financial investment purposes is concerned, the emergence of newfinancial products may lead economic agents to substitute money with other types of assets, potentially affecting theinformation content of those assets and the demand for money. This is straightforward when the new instruments areclose to instruments with monetary character included in broader monetary aggregates. However, the effect offinancial innovation on monetary aggregates does not necessarily concern only close substitutes for money. Indeed,standard finance theory prescribes that economic agents should hold diversified portfolios including assets with avaried spectrum of risk-return combinations and, partly related to this, of varying degrees of liquidity. Therefore, theimpact of financial innovation on monetary aggregates can also come about, for example, through the emergence ofnew instruments which, although illiquid and risky, offer a sufficiently high return to motivate economic agents tosubstitute part of their holdings in monetary assets for these alternative instruments. Potentially, this can havedestabilising effects on money demand. The ECB's monetary policy strategy is designed in such a way that monetarypolicy decisions can take account of the consequences of financial innovation. The ECB does not react in amechanistic way to monetary aggregates, but instead carefully analyses monetary developments and their

information content for price stability. In addition, by cross-checking the information from monetary developments withthat of a wide range of non-monetary economic variables, monetary policy is made robust to possible effects offinancial innovation on money demand.

Financial innovation in financing choices

Another channel through which financial innovation may affect monetary policy is the developments on the financingside, which may have important consequences for the monetary transmission mechanism. Traditionally, the euroarea economy has been dominated by bank lending, in contrast to other economies such as the United States, wheresecurities markets play a much larger role in channelling savings towards investment. In recent years, we have seen

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Home>News & Events>2009 Speeches

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Speech

Chairman Ben S. Bernanke

At the Federal Reserve System's Sixth Biennial Community Affairs Research Conference, Washington,

D.C.

April 17, 2009

Financial Innovation and Consumer Protection

The concept of financial innovation, it seems, has fallen on hard times. Subprime mortgage loans, credit defaultswaps, structured investment vehicles, and other more-recently developed financial products have becomeemblematic of our present financial crisis. Indeed, innovation, once held up as the solution, is now more oftenthan not perceived as the problem. I think that perception goes too far, and innovation, at its best, has beenand will continue to be a tool for making our financial system more efficient and more inclusive. But, as we haveseen only too clearly during the past two years, innovation that is inappropriately implemented can be positivelyharmful. In short, it would be unwise to try to stop financial innovation, but we must be more alert to its risksand the need to manage those risks properly.

My remarks today will focus on the consumer protection issues raised by financial innovation. First, though, Iwant to say how pleased I am to join you for the sixth biennial Federal Reserve System Community Affairs

Research Conference. We all want to see our communities grow and thrive, especially those that have beentraditionally underserved. But the people in this room know as well as anyone that, when it comes to consumerprotection and community development, good intentions are not enough. Hard-won knowledge, as exemplifiedby the empirical work presented here during the past two days, is required. I applaud your diligent and tough-minded research in analyzing what works and what doesn't. Only with such knowledge can efforts to spreadprosperity more widely become increasingly effective.

Sources of Financial InnovationWhere does financial innovation come from? In the United States in recent decades, three particularlyimportant sources of innovation have been financial deregulation, public policies toward credit markets, andbroader technological change. I'll talk briefly about each of these sources.

The process of financial deregulation began in earnest in the 1970s, a period when stringent regulations limitedcompetition and the range of product offerings in the markets for consumer credit. For example, Regulation Q,which capped interest rates on deposits, hampered the ability of depository institutions to attract funding andthus to extend credit. Restrictions on branching were a particularly significant constraint, as they limited the sizeof the market that individual depository institutions could service and thus their scope to reduce costs througheconomies of scale.

1The lifting of these regulations, especially branching restrictions, allowed the development

of national banking networks. With national networks, the fixed costs of product innovation could be spreadover larger markets, making the development and marketing of new products more profitable.

Many public policy decisions have affected the evolution of financial products and lending practices. Oneparticularly important example was the Community Reinvestment Act of 1977 (CRA), which induced lenders to

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find ways to extend credit and provide services in low- and moderate-income neighborhoods. Anotherimportant set of policies was the government's support for the development of secondary mortgage markets,particularly through the government-sponsored enterprises, Fannie Mae and Freddie Mac. Secondarymortgage markets were rudimentary and thin in the 1970s; indeed, the Federal Reserve's Flow of Fundsaccounts do not even record private securitization activity until the early 1980s. As secondary mortgagemarkets--an important innovation in themselves--grew, they gave lenders both greater access to funding andbetter ability to diversify, providing further impetus to expansion into new markets and new products.

On the technological front, advances in information technology made possible the low-cost collection,processing, and dissemination of household and business financial data, functions that were once highlylocalized and, by today's standards, inefficiently managed.

2 As credit reporting advanced, models for credit

scoring gradually emerged, allowing for ever-faster evaluation of creditworthiness, identification of prospectiveborrowers, and management of existing accounts.

All these developments had their positive aspects, including for people in low- and moderate-incomecommunities. Prior to the introduction of the CRA, as you know, many of these communities had limited accessto mortgages and other forms of consumer credit. Subsequent innovations in financial products and services,processes, and technology helped at least some underserved consumers more fully enter the financialmainstream, save money, invest, and build wealth, and homeownership rates rose significantly.

Yet with hindsight, we can see that something went wrong in recent years, as evidenced by the currently highrates of mortgage delinquency and foreclosure, especially in minority and lower-income neighborhoods.Indeed, we have come almost full circle, with credit availability increasingly restricted for low- and moderate-income borrowers. And the damage from this turn in the credit cycle--in terms of lost wealth, lost homes, andblemished credit histories--is likely to be long-lasting. One would be forgiven for concluding that the assumedbenefits of financial innovation are not all they were cracked up to be.

A number of factors explain the recent credit boom and bust, including problems stemming from financialinnovation. From a consumer protection point of view, a particular concern has been the sharp increase in thecomplexity of the financial products offered to consumers, complexity which has been a side effect ofinnovation but which also has in many cases been associated with reduced transparency and clarity in theproducts being offered. I will illustrate the issue in the context of some familiar forms of consumer credit: creditcards, mortgages, and overdraft protection.

Credit Cards, Mortgages, and Overdrafts: Some Instructive ExamplesThe credit card is an example of financial innovation driven by technological advance, including improvementsin communications, data management, and credit scoring. When the first general-purpose credit card wasissued in 1952, it represented a way to make small loans more quickly and at a lower cost than the closed-endinstallment loans offered by retailers and finance companies at the time. Moreover, this form of credit doubledas a means of payment. Card issuers benefited by spreading fixed costs over multiple advances of credit, overlarger customer bases, across geographic areas, and among many merchants.

3 From the consumer's

perspective, credit cards provided convenience, facilitated recordkeeping, and offered security from loss (bytheft, for example).

4Their use gradually expanded among American families, rising to 43 percent in 1983 and

to 70 percent by 2007. Among lower-income families, usage increased from 11 percent in 1983 to 37 percent in2007.

5

Mortgage markets saw similar product innovations. For example, in the early 1990s, automated underwriting

systems helped open new opportunities for underserved consumers to obtain traditional forms of mortgagecredit. This innovation was followed by an expansion of lending to borrowers perceived to have high credit risk,which became known as the subprime market. Lenders developed new techniques for using credit informationto determine underwriting standards, set interest rates, and manage their risks. As I have already mentioned,the ongoing growth and development of the secondary mortgage market reinforced the effect of theseinnovations, giving mortgage lenders greater access to the capital markets, lowering transaction costs, andspreading risk more broadly. Subprime lending rose dramatically from 5 percent of total mortgage originationsin 1994 to about 20 percent in 2005 and 2006.

6

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Innovation thus laid the groundwork for the expansion of credit card and mortgage lending that has taken placeover the past 15 years or so, as well as some other forms of credit like auto loans. However, while innovationoften brought consumers improved access to credit, it also brought increased complexity and an array ofchoices that consumers have often found difficult to evaluate properly.

Take the case of credit cards. In the early days, a card may have allowed the user to make purchases or obtaincash advances, with a single, unchanging annual percentage rate, or APR, applied to each feature. Card feeswere typically limited to an annual fee, a charge for cash advances, and perhaps fees for making a latepayment or exceeding the credit limit. In contrast, today's more-complex products offer balance transfers andtreat different classes of purchases and cash advances as different features, each with its own APR. Inaddition, interest rates adjust much more frequently than they once did, and the array of fees charged forvarious features, requirements, or services has grown.

More-complex plans may benefit some consumers; for example, pricing that varies according to consumers'credit risk and preferences for certain services may improve access to credit and allow for more-customizedproducts. Growing complexity, however, has increased the probability that even the most diligent consumerswill not understand or notice key terms that affect a plan's cost in important ways. When complexity reachesthe point of reducing transparency, it impedes competition and leads consumers to make poor choices. And, insome cases, complexity simply serves to disguise practices that are unfair and deceptive.

Mortgage products have likewise become much more complex. Moreover, in recent years, the increasedcomplexity has sometimes interacted with weakened incentives for good underwriting, to the detriment of theborrower. The practice of securitization, notwithstanding its benefits, appears to have been one source of thedecline in underwriting standards during the recent episode. Depending on the terms of the sale, originatorswho sold mortgage loans passed much of the risk--including the risks of poor underwriting--on to investors.Compensation structures for originators also caused problems in some cases. For example, some incentiveschemes linked originator revenue to particular loan features and to volume rather than to the quality of theloan. Complexity made the problem worse, as the wide array of specialized products made consumer choicesmore difficult. For example, some originators offered what were once niche products--such as interest-onlymortgages or no-documentation loans--to a wider group of consumers. And, we have learned, loan featuresmatter. Some studies of mortgage lending outcomes, after controlling for borrower characteristics, have foundelevated levels of default associated with certain loan features, including adjustable rates and prepaymentpenalties, as well as with certain origination channels, including broker originations.

7Although these results are

not conclusive, they suggest that complexity may diminish consumers' ability to identify products appropriate to

their circumstances.

The vulnerabilities created by misaligned incentives and product complexity in the mortgage market werelargely disguised so long as home prices continued to appreciate, allowing troubled borrowers to refinance orsell their properties. Once housing prices began to flatten and then decline, however, the problems becameapparent. Mortgage delinquencies and foreclosure starts for subprime mortgages increased dramaticallybeginning in 2006 and spread to near-prime (alt-A) loans soon thereafter. By the fourth quarter of 2008, thepercentages of loans 60 days past due, 90 days or more past due, and in foreclosure were at record highs.

8

Credit cards and mortgages are not the only product classes for which innovation has been associated withincreased complexity and reduced transparency. I will cite one more example: overdraft protection.

Historically, financial institutions used their discretion to determine whether to pay checks that would overdraw

a consumer's account. In recent years, institutions automated that process with predetermined thresholds.

Although institutions usually charged the same amount when they paid an overdraft as when they returned thecheck unpaid, many consumers appreciated this service because it saved them from additional merchant feesand the embarrassment of a bounced check. However, technological innovations allowed institutions to extendthe service, often without consumers' understanding or approval, to non-check transactions such as ATMwithdrawals and debit card transactions. As a result, consumers who used their debit cards at point-of-saleterminals to make retail purchases, for instance, could inadvertently incur hundreds of dollars in overdraft feesfor small purchases. In response to this problem, the Board last December proposed regulatory changes that

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would give consumers a meaningful choice regarding the payment of these kinds of overdraft fees, and weexpect to issue a final rule later this year.

Protecting Consumers in an Era of Innovation and ComplexityIn light of this experience, how should policymakers ensure that consumers are protected without stiflinginnovation that improves product choice and expands access to sustainable credit? The first line of defenseundoubtedly is a well-informed consumer. The Federal Reserve System has a long-standing commitment topromoting financial literacy, and we devote considerable resources to helping consumers educate themselvesabout their financial options.

9Consumers who know what questions to ask are considerably better able to find

the financial products and services that are right for them.

The capacity of any consumer, including the best informed, to make good choices among financial products isenhanced by clear and well-organized disclosures. The Board has a number of responsibilities and authoritieswith respect to consumer disclosures, responsibilities we take very seriously. In the past year or so, the Boardhas developed extensive new disclosures for a variety of financial products, most notably credit cards, and weare currently in the midst of a major overhaul of mortgage disclosures.

In designing new disclosures, we have increased our use of consumer testing. The process of exploring howconsumers process information and come to understand--or sometimes misunderstand--important features offinancial products has proven eye-opening. We have used what we learned from consumer testing to make our

required disclosures better. For example, our recently released rules on credit card disclosures require certainkey terms to be included in a conspicuous table provided at account opening; we took this route because ourfield testing indicated that consumers were often already familiar with and able to interpret such tables onapplications and solicitations, but that they were unlikely to read densely written account agreements.

We have also learned from consumer testing, however, that not even the best disclosures are alwaysadequate. According to our testing, some aspects of increasingly complex products simply cannot beadequately understood or evaluated by most consumers, no matter how clear the disclosure. In those cases,direct regulation, including the prohibition of certain practices, may be the only way to provide appropriateprotections. An example that came up in our recent rulemaking was the allocation of payments by credit cardissuers. As creditors began offering different interest rates for purchases, cash advances, and balancetransfers, they were also able to increase their revenues through their policies for allocating consumerpayments. For example, a consumer might be charged 12 percent on purchases but 20 percent for cashadvances. Under the old rules, if the consumer made a payment greater than the minimum required payment,

most creditors would apply the payment to the purchase balance, the portion with the lower rate, thusextending the period that the consumer would be paying the higher rate. Under these circumstances, theconsumer is effectively prevented from paying off the cash advance balance unless the purchase balance isfirst paid in full.

In an attempt to help consumers understand this practice and its implications, the Federal Reserve Board twicedesigned model disclosures that were intended to inform consumers about payment allocation. But extensivetesting indicated that, when asked to review and interpret our best attempts at clear disclosures, manyconsumers did not demonstrate an understanding of payment allocation practices sufficient to make informeddecisions. In light of the apparent inadequacy of disclosures alone in this case, and because the methods ofpayment allocation used by creditors were clearly structured to produce the maximum cost to the consumer,last year we put rules in place that will limit the discretion of creditors to allocate consumers' payments madeabove the minimum amount required. We banned so-called double-cycle billing--in which a bank calculates

interest based not only on the current balance, but also on the prior month's balance--on similar grounds; wefound from testing that the complexity of this billing method served only to reduce transparency to theconsumer without producing any reasonable benefit. These actions were part of the most comprehensivechange to credit card regulations ever adopted by the Board.

Similar issues have arisen in the mortgage arena. Many of the poor underwriting practices in the subprimemarket were also potentially unfair and deceptive to consumers. For example, the failure to include an escrowaccount for homeowners' insurance and property taxes in many cases led borrowers to underestimate thecosts of homeownership. In this case, allowing greater optionality--which we usually think of as a benefit--hadthe adverse effects of increasing complexity and reducing transparency. Restricting this practice was one of the

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new protections in the residential mortgage market that the Board established in a comprehensive set of rulesreleased in July. Banning or limiting certain underwriting practices, which the new rules do for the entiremortgage market, also helps to address the incentive problems I discussed earlier. For institutions that wesupervise, these incentive issues can also be addressed by requiring that lenders set up compensation plansfor originators that induce behavior consistent with safety and soundness.

Where does all this leave us? It seems clear that the difficulty of managing financial innovation in the periodleading up to the crisis was underestimated, and not just in the case of consumer lending. For example,complexity and lack of transparency have been a problem for certain innovative products aimed at investors,such as some structured credit products.

ConclusionI don't think anyone wants to go back to the 1970s. Financial innovation has improved access to credit,reduced costs, and increased choice. We should not attempt to impose restrictions on credit providers soonerous that they prevent the development of new products and services in the future.

That said, the recent experience has shown some ways in which financial innovation can misfire. Regulationshould not prevent innovation, rather it should ensure that innovations are sufficiently transparent andunderstandable to allow consumer choice to drive good market outcomes. We should be wary of complexitywhose principal effect is to make the product or service more difficult to understand by its intended audience.

Other questions about proposed innovations should be raised: For instance, how will the innovative product orpractice perform under stressed financial conditions? What effects will the innovation have on the ability andwillingness of the lender to make loans that are well underwritten and serve the needs of the borrower? Thesequestions about innovation are relevant for safety-and-soundness supervision as well as for consumerprotection.

In sum, the challenge faced by regulators is to strike the right balance: to strive for the highest standards ofconsumer protection without eliminating the beneficial effects of responsible innovation on consumer choiceand access to credit. Our goal should be a financial system in which innovation leads to higher levels ofeconomic welfare for people and communities at all income levels.

Footnotes

1. For a listing of these rules, see Dean F. Amel and Daniel G. Keane (1986), "State Laws AffectingCommercial Bank Branching, Multibank Holding Company Expansion and Interstate Banking," Issues in BankRegulation, vol. 10, no. 2 (Autumn), pp.30-40. Research indicates that non-interest expenses, wages, and loanlosses all declined following the lifting of branching restrictions leading to lower loan prices. Also, the lifting ofgeographic restrictions lead to larger and more diversified banking institutions. See Randall S. Kroszner andPhilip E. Strahan (forthcoming), "Regulation and Deregulation of the U.S. Banking Industry: Causes,Consequences, and Implications for the Future," in Nancy Rose, ed., Economics of Regulation, NBERConference Volume.Return to text

2. Board of Governors of the Federal Reserve System (2007),Report to the Congress on Credit Scoring and ItsEffects on the Availability and Affordability of Credit, (Washington: Board of Governors, August).Return to text

3. Dagobert L. Brito and Peter R. Hartley (1995), "Consumer Rationality and Credit Cards," Journal ofPolitical Economy, vol. 103 (April), pp. 400-33.Return to text

4. Board of Governors of the Federal Reserve (2006),Report to the Congress on Practices of the ConsumerCredit Industry in Soliciting and Extending Credit and their Effects on Consumer Debt and Insolvency(Washington: Board of Governors, June).Return to text

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5. See note 4, Report to the Congress on Practices of the Consumer Credit Industry, table 6; and Board ofGovernors of the Federal Reserve System (2007),2007 Survey of Consumer Finances, Board of Governors.Return to text

6. See Chris Mayer and Karen Pence (2008), "Subprime Mortgages: What, Where, and to Whom?" Financeand Economics Discussion Series 2008-29 (Washington: Board of Governors of the Federal Reserve System,June); and Inside Mortgage Finance (2007), The 2007 Mortgage Market Statistical Annual vol. 1; The PrimaryMarket(Bethesda, Md.: Inside Mortgage Finance Publications).Return to text

7. Lei Ding, Roberto Quercia, Wei Li, and Janneke Ratcliffe (2008), "Risky Borrowers or Risky Mortgages:Disaggregating Effects Using Propensity Score Models," Working Paper (Chapel Hill, N.C.: UNC Center forCommunity Capital). See also Elizabeth Laderman and Carolina Reid (2009), "CRA Lending During theSubprime Meltdown (470 KB PDF)," in Revisiting the CRA: Perspectives on the Future of the CommunityReinvestment Act, pp. 115-33 (San Francisco: Federal Reserve Bank of San Francisco, February). Otherstudies do not find evidence of consistent harm from stemming from certain practices or products. See, forexample, Morgan J. Rose (2008), "Predatory Lending Practices and Subprime Foreclosures: DistinguishingImpacts by Loan Category," Journal of Economics and Business, vol. 60 (January-February), pp. 13-32; andChristopher L. Foote, Kristopher Gerardi, Lorenz Goette, and Paul S. Willen (2008), "Just the Facts: An InitialAnalysis of Subprime's Role in the Housing Crisis," Journal of Housing Economics, vol. 17 (December), pp.291-305.Return to text

8. Mortgage Bankers Association (2009), National Delinquency Survey, MBA, March.Return to text

9. See, for instance, materials on theConsumer Informationportion of the Federal Reserve's website.Returnto text

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2009 Speeches

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Paper to be presented at the International Schumpeter Society Conference 2010 onINNOVATION, ORGANISATION, SUSTAINABILITY AND CRISESAalborg, June 21-24, 2010

Financial Innovation and the Financial CrisisJim StewartTrinity College Dublin

[email protected]: 374

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ISS SCHUMPETER Conference 2010Innovation, Organisation, Sustainability and CrisesAalborg University, Denmark, 21-24 June 2010

Financial Innovation and the Financial CrisisJim StewartSchool of Business, Trinity College, DublinEmail: [email protected]

Financial Innovation and the Financial CrisisThe message of Schumpeter for our times is that market-oriented economicdevelopment requires two analytically distinct sets of entrepreneurs; the innovatorsin product and process and the innovators in finance. Hyman Minsky (1990)Innovation plays a key role in economic development, through the development of newproducts, new processes and in increasing productivity. The focus of this paper is oninnovation in the financial sector. Some have argued that financial innovation has a keyrole as a source of economic growth. The financial crisis has also drawn attention to the

role of financial innovation in introducing instability and deep recession.This paper in particular examines one financial innovation - referred to as the shadowbanking system, the essential feature of which is that it was either unregulated or subjectto light touch regulation.1. The contribution of MinskyThe dominant paradigm in dealing with the current financial crisis is to reduceGovernment expenditures. This is the proposed solution to the Greek crisis is anexample (see the IMF conditionality programme available at http://www.mnec.gr.).Portugal Spain, and other countries have also announced programmes to reducegovernment expenditures including wage cuts. Commentators often cite Ireland(Barkham, 2010) as a role model in dealing with the financial and economic crisis.

Yet in the week these announcements were made and following the recent intervention inGreece, stock markets fell. Commentators writing in the financial press generally supportthese policies, but at the same time report fears that retrenchment in European countriesmay result in a double dip recession (Oakley, 2010).Some economists for example, Stiglitz, Krugman, argue that the policy prescriptionsfrom Keynes are the most appropriate response to the current crisis. But as argued byMinsky Keynesian arguments neglect the role of finance in causing cycles.Minsky argues that Keynesian economics as largely implemented does not take sufficientaccount of finance, because the role of finance was implicit rather than explicit in theGeneral Theory. Minsky argues that .. implicit in the analysis in the General theory is theview that a capitalist economy is fundamentally flawed because the financial systemnecessary for capitalist vitality and vigor. ..contains the potential for runaway

expansion, powered by an investment boom. (Minsky 1975, pp. 11-12). Minsky states:-..in a boom the ingenuity of bankers is directed at turning every possible sourceof temporarily idle cash into a source of financing for either real operations orfinancial position making. (Minsky, 1975, p. 143).3

This expansion is ended because accumulated financial changes render thefinancial system fragile so that not unusual changes can trigger serious financialdifficulties. (Minsky, 1975, p. 12).

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Minsky argues that booms and busts are an inherent feature of every economiy wherefinancial innovation is driven by market forces. (Minsky, 1009, p. 60).The General Theory had much to say about uncertainty. Skidelsky (2009, p. 84) statesuncertainty pervades Keyness picture of economic life. A situation of certainty is often assumed in financial and economic analysis, as in the standard Fisher-Hirschleiferanalysis of investment decision making (Stewart, 2000). If a framework based onprobabilities is developed this is almost always done in the context of assuming eventsfollow a normal distribution. Keynes however assumes the view of the future is subjectto sudden and violent changes (Minsky p. 67). Uncertainty leads to volatility ininvestment even though production relations are stable (Minsky p. 68), and quotes thefamous statement by Keynes that When the capital development of a coun try becomes aby-product of the activities of a casino, the job is likely to be ill-done (Minsky p. 90).Minsky argues policies pursued by governments have led to a fragile financial system,and the real economy behaves in quite a different way with a fragile financial system. Itis much more prone to cycles. The fragility of the financial system is related to theextent to which units are dependent upon refinancing their positions in long assets insmoothly functioning short-term financial markets (Minsky, 1975, p. 163).

Minsky argues the problem is that Keynes never explicitly developed a theory of theboom and the crisis and he never articulated a model or an explanation of how theliability structure of firms, banks, and other financial institutions evolve. It is notsufficient to advocate Keynesian type policies, or indeed other policies without analysingthe role of finance in the current crisis.3. The Key Role of Financial InnovationIn his Nobel lecture Merton (1997, p. 108) identifies innovation as a central forcedriving the financial system towards greater economic efficiency. Merton in this lectureemphasised financial innovation resulting from academic research in finance via thedevelopment of options and derivatives. Merton argues that contracting technology hasincreased risk sharing, lowered transaction costs and reduced information and agencycosts (Merton, 1997, p. 88). The development of derivative securities has allowed very

diverse financial systems to become much more integrated and helped create the globaleconomy (Merton, 1997, p. 89). Apart from the development of markets devotedexclusively to trading options and derivatives, the development of these new products hashad an impact on new firm formation, for example firms specifically dedicated to tradingstrategies using these new instruments. More fundamentally trading in derivativesmarkets has become an integral part of the operation of financial institutions such as4

banks because a derivative when purchased with the underlying asset may be equivalentto an insurance policy, which prevents the value of the asset combined with the optionfalling below the exercise price of the option. Merton does not discuss with the issue thatderivatives also allow speculation where there is no economic interest in the underlying

asset.Financial innovation has resulted in the securitisation of mortgage loans, collateraliseddebt obligations, and credit default swaps to name but a few.Some have argued that financial innovation, in particular financial innovation associatedwith risk management has been a major source of growth in particular for the USeconomy (Bernstein, 1996). Baily et al (2008), have argued that financial innovationsuch as securitisation has been an extremely positive innovation for credit markets .In contrast Minsky argues that booms associated with financial innovation will inevitablylead to a subsequent collapse. Minsky states Economies with financial innovations that

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are driven by market prospects are structurally conducive to booms and busts.. (Minsky,1990, p 60).It is not surprising that Minsky has become one of the most quoted economists in recenteconomic policy debate (Kay, 2010). Hence a number of issues arise as follows: (1)What determines financial innovation and (2) is it necessarily the case that financialinnovation is followed by collapse? This paper considers the causes of the current crisisin terms of financial innovation and in particular the emergence of the shadow bankingsystem with particular reference to the Irish Financial Services Centre in Dublin.The Causes of Financial innovation: Merton versus MillerMiller argues frequent and unanticipated change in regulatory and tax codes have beenthe main forces for financial innovation. This argument is supported by others forexample, Calomiris (2002, p. 312-313) argues that costly regulations gives incentivesfor new financial products, services and intermediaries.In contrast Merton (1990b) argues that the forces driving innovation are:- (1) Demand tocomplete the markets; (2) lowering transaction costs (3) reduction in agency costs due toasymmetric information or incomplete monitoring. Merton and Bodie in their textbookstate :-

"Generally, financial innovations are not planned by any central authority but arisefrom the individual actions of entrepreneurs and firms" (Merton and Bodie ,Finance, Prentice-Hall, 1998, p. 33).Some Examples of Financial Innovation followed by CollapseThe successful innovation by Drexel Burnham Lambert in the junk bond market in theUS led to a large increase in the number of junk bond issues (from $1.3 billion in 1981 to5

$32.4 billion in 1986) and very large profits. The innovation was to provide anunderwriting service and a market for junk bonds, enabling a much wider spread ofinvestors to purchase junk bonds (Milgrom and Roberts, 1992, pp. 485-489). Thesubsequent collapse led to the bankruptcy of Drexel Burnham Lambert, the jailing ofseveral of the key players (Boesky, Milkin, Drexel), and partly explained the problems

with the Savings and Loan Associations3 .Long Term Capital Management was probably the best known managed fund specialisingin arbitraging between different markets and is an example of a firm whose strategy wasbased on academic research in finance. The key innovation by LTCM and similarfinancial firms was to develop trading strategies which involved identifying andseparating the option component of a financial instrument. In 1995 and 1996 LTCMearned net returns for investors of 40%, and a return to LTCM of 63% and 57%respectively (Dunbar, p. 170). In 1997 LTCM had total equity of $4.72 billion, assets of$129 billion, liabilities of $124.5 billion, and a derivatives position of $1.25 trillion(Dunbar, 2002, p. 191). However by September 2008 LTCM losses amounted to $4.6billion and the New York Federal Reserve Board organised a capital injection by other

financial institutions and the eventual liquidation of LTCM. The fund was liquidated in2000.The development and collapse in the value of debt based on subprime mortgages and inthe value of various forms of financial instruments (ABS, CDO, SIVs) and subsequentlosses at banks and other financial institutions has resulted in the most widespreadfinancial crisis since the great depression. One early estimate by the IMF was that losseson loans and securities would amount to $1400 billion for banks, (Financial Times13/11/08). This estimate was raised to 2200 billion in January 2009, 2400 million inApril 2009 and remained unchanged in September 2009 (IMF Global Financial Stability

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created by recent financial innovation were administered in low tax financial centres/taxhavens, resulting in an unregulated financial system. The conjunction of new financialproducts organised by financial firms located in low tax financial centres led to thedevelopment of a shadow banking system. The emergence of the shadow bankingsystem is central to the current crisis.7

5. Emergence of the Shadow Banking SystemIn the crisis involving Northern Rock, the Financial Times argued that the greatestregulatory concern is:-.. .. ..the supervision of so-called conduits, off-balance sheet vehicles whichborrow money, finance loans, and generally behave just like banks. Most of thisactivity is regulatory arbitrageit exits to avoid the restrictions placed on banksand supervisors appear to have ignored it. If there is to be reform then this is theplace to start. (Financial Times, Leader, The Right Response to Northern Rock,October 1, 2007).The ECB in an analysis of the effects of the crisis on bank funding, states that onenoteworthy feature was the large increase in banks off-balance sheet financing prior to

the crisis, and continues that many banks had financial vehicles that were not includedin their balance sheets, but which made investment decisions for which their parentcompanies were liable (ECB, p. 10). The Turner Report also notes the growth of theunregulated shadow banking system (Turner Report, p. 21; see also Roubini, 2008;Martin Wolf, 2008). Goodman (2010) comments that the shadow banking system cameto specialize in innovations that created the illusion that risk was being responsiblymanged; in crucial cases they actually intensified the dangers.The shadow banking system consists of non-bank financial institutions that borrowshort term and lend long term , such as securitised investment vehicles (SIVs), hedgefunds, conduits, money market funds, etc. These financial institutions are subject to riskand uncertainty. One source of risk arises from liquidity, but in contrast to banks, nonbankfinancial firms do not have access to central bank lending facilities, but rather relied

on interbank lending for liquidity and as a source of funding. There were exceptions as inthe case of Long Term Capital Management. Once this market collapsed those financialfirms dependent on the inter-bank market as a source of funds either found that the costof funds increased dramatically or were unable to raise funds at any price. Some bankswere so dependent on the interbank market that even though they could access CentralBank lending, they were either nationalised (Northern Rock), or part nationalised (RoyalBank of Scotland) or in the case of US banks received considerable amounts of state aidin the form loans and cash in exchange for assets. In particular as noted earlier, liquiditydifficulties with subsidiaries in the IFSC led to liquidity and threats of insolvency withinthe group as a whole in the case of four German banks with subsidiaries in the IFSC .A further source of risk is poor or non-existent regulation. This is because of the location

of shadow banking type activities in off shore financial centres one of whose mainadvantages was light touch regulation and in recognised tax havens such as the CaymanIslands. This source of risk typically only becomes apparent in a crisis. As a consequencewhen markets became aware of the risk associated with these firms, liquidity is reduced,increasing risk further.8

The existence of hedge and other funds, often controlled by a firm located in a low taxregime/tax haven (Bender, 2010) is a key feature of the shadow banking system. Thesefunds may be organised as a special purpose vehicle, thus disguising the true ownership

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and liability in the event of default. These off balance sheet vehicles also featured in thedot.com crisis involving the collapse of Enron and other firms. Their advantage is thatcapital adequacy ratios are disguised meaning that the group as a whole has adequatecapital ratios and hence is less risky. Their location in a tax haven reduces tax, butperhaps more important, is also associated with light touch regulation.6. The Irish Financial Services Centre (IFSC) in IrelandFinancial centres such as the Irish Financial Services Centre (IFSC) formed a major partof the shadow banking sector. Developing and maintaining a financial centre in Dublin isa major part of current Irish Government Policy. The annual Finance Act often amends orintroduces new legislation to enhance the attractions of financial firms located in Ireland.For example the most recent Finance Act (2010) makes it easier to move the location forfunds to move from locations such as the Cayman Islands to Dublin (Grene, 2009). Stateagencies including the Industrial Development Authority (IDA)(http://www.idaireland.com/home/) and the Central Bank are required by law to supportthe IFSC. The Central Bank and Financial Services Act (2003) required the CentralBank is to promote the development within the State of the financial services industry1.This requirement is now being removed. The IFSC along with Luxembourg are the two

main centres for administering hedge and other funds in Europe. In 2008 the IFSCapproximately 8000 funds were located in the IFSC, with 1560 billion of assets(Johnson, 2008).These funds are also often quoted on the Irish Stock Exchange in order to comply withregulatory requirements. The Irish Stock Exchange states:-The Irish Stock Exchange is recognised worldwide as a leading centre for listinginvestment funds. With over 4,400 funds and sub-funds listed, the ISEs combinationof effective and prudent regulation, flexibility of approach and efficient and timelyprocessing of listing applications has proved attractive and cost effective. The ISEcontinues to provide a dynamic listing framework to meet market demands andtrends2.The Irish stock exchange (as well as the Luxembourg exchange) are recognised as major

world centres for listed international bonds. In 2007, at the start of the financial crisis,the Luxembourg stock exchange accounted for 46% of international bonds, followed bythe Irish Stock Exchange with 26%. In contrast the New York Stock Exchange had ashare of just over 4.1% (Source: PricewaterhouseCoopers, 2008, p. 2). In 2009 there were70,287 listed international bonds quoted on five stock markets (Luxembourg StockExchange, 2010). The five stock markets include NYSE Euronext, London StockExchange and Deutsche Borse. In the year 2009 the Luxembourg Stock Exchangeaccounted for 43 % of all issues and the Irish Stock Exchange a further 25%. In9

comparison the next largest in terms of listed bonds, accounted for 18%. This represents aslight fall in market share since 2007.

The Irish Stock Exchange states that seeking a quotation for a fund has benefits in termsof source country investors because there may be restrictions in investing in unlistedsecurities or securities that are not listed on a recognised, regulated stock exchange3.Hence a quotation on the Irish Stock Exchange enables a fund to market to theseinstitutional investors. The Irish Stock Exchange also states that the Exchange hasstandards of regulation to stockbrokers and listed companies which are acknowledged tobe among the highest in Europe4, and as a result the Irish Stock Exchange is recognisedas an appropriate regulator from the market authorities in many jurisdictions includingJapan and the United States.

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In spite of these stated high regulation standards many of the funds that have collapsed invalue because of liquidity difficulties, are listed on the Irish Stock Exchange. Thecollapse of the subprime market in turn led to large losses at subsidiaries of three Germanlandesbanks (Sachsen Bank, IKB, and WestLB) located in the IFSC. The largest andpotentially most serious losses occurred at Depfa Bank, an Irish registered bank locatedin the IFSC which became a subsidiary of Hypo Bank in 2007. Losses at these banksrequired large amounts of State aid from the German Government. This issue isdiscussed later in this paper.Hedge funds quoted in Dublin are often managed in London but domiciled in a taxhaven/low tax regime. As a result of the financial crisis there was an estimated outflowfrom hedge funds of $400 billion in 2008 (Financial Times, 21/1/09). This outflow led toa restructuring and closure of hedge funds. Of three funds announcing a closure on oneday (Mackintosh, 2009), all were managed in London, quoted in Dublin but domiciled ina tax haven. For example, one of the funds (Lansdowne Partners) had seven fundsconsisting of 148 sub funds quoted in Dublin and all but one, were domiciled in theCayman Islands. A second firm (Rab Capital) had seven funds and 23 subfunds quotedin Dublin, 19 were domiciled in the Cayman Islands, three in the Isle of Man, and one in

the British Virgin Islands, and the third firm (New Star) had three main funds and eightsubfunds quoted in Dublin, and all were domiciled in Bermuda.The IFSC dominates financial flows for the Irish economy. Table (1) shows total foreigninvestment in Ireland for the period 2003-2008. The table shows that foreign directinvestment reached a peak in 2003 and has since fallen. In contrast total foreigninvestment in the IFSC has continued to rise until 2007 and fell in 2008 reflecting thefinancial crisis. In 2008 IFSC investment was over 13 times the size of foreign directinvestment and approximately 11 times the size of GNP.10

Table (1)The growth of the IFSC in Dublin: Total foreign Investment in Ireland ( billion)(1) This number may understate IFSC type activities, as these are no longer required to locate at the IFSC

see Stewart (2008) for a further discussion.Source: CSO (2009) and (2008), International Investment Position, Table 1 and 3.

Competition between financial centres is considerable and this in turn has led to reducedregulation. Historically hedge funds were often domiciled in the Cayman Islands,Bermuda of the British Virgin Islands, but more recently European jurisdictions such asChannel Islands, Ireland and Luxembourg have been streamlining regulation amongstother factors to attract funds. One effect of this is that in Ireland if the relevant documentsare provided to the regulator by 3 p.m. and fund will be authorised the next day (Steward,2008)6. In 2008, Luxembourg introduced a new law, so that as long as the fund managernotifies the regulator within a month of launch, the fund can enjoy pre-authorisationapproval. Steward comments that unlike the Irish regulator, the regulator in Luxembourgdoes not scrutinise promoters.

An important issue is where responsibility for regulation rests. The role of tax havens andlocations with light touch regulation however has not been subject to any criticism orsuggestions for reform in the current banking crisis. For example an editorial in theFinancial Times laid the blame on the difficulties faced by German banks exclusivelywith the structure of the German banking industry and State owned banks (BankingBother, 3/9/07). The Irish Financial Regulator has been quoted as saying that the Irishregulator had no responsibility for entities whose main business is raising and investingin funds based on subprime lending.7 Part of this issue is a conflict between financial

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firms who might like to locate activities which incur lowest cost (least regulated) andlowest tax, and the requirements of the location of investors/liabilities of these firms whoare concerned with conduct of business type regulation for example, greater protection ofinvestors and regulation that will prevent systemic risk to the financial systems in theparent country. Part of this conflict is demonstrated by the debate on regulating the fundmanagement industry within the EU. The industry would like to locate outsourcedactivities in any jurisdiction. This position was supported by regulators in Germany,France and the UK (F.T. January 14 2008). In contrast Luxembourg and Ireland opposedthis position and wish to maintain the current system where there are restrictions onoutsourcing. Thus Luxembourg and Ireland as centres of the fund management industryhave a considerable number of employees involved in administration of funds. Howeveran issue that has arisen in relation to the current arrangement is whether these funds even2003 2004 2005 2006 2007 2008Direct 176.435 152.446 138.626 118.824 138.362 120.954Portfolio 542.200 720.952 1025.902 1223.683 1329.908 1183.690Other 389.807 443.796 556.906 678.293 838.713 995.659Total 950.469 1108.442 1721.428 2020.800 2306.983 2300.303Represented

by IFSC1813.336 975.357 1300.223 1566.668 1727.005 1645.53511

though they may have an administrative presence are adequately supervised and if in factthey have key decision making functions.The recent Madoff and Stanford cases also illustrate some of the regulatory and otherissues involved with financial firms located in tax havens8.7. The IFSC and Securitised Investment VehiclesA front page article in the Financial Times (Sakoui, 2008) cites a plan to restructure anSIV called Cheyne Capital after 10 monthes of negotiations, but without referring to thefact that Cheyne capital and its funds are quoted on the Irish Stock Exchange. The samearticle refers to further restructuring at four more SIVS (Golden Key, Mainsail,

Whistlejacket and Rhinebridge). Again all funds were quoted on the Irish StockExchange. The implications of a quotation is that the funds were regulated by the IrishFinancial Regulator, were subject to the rules of the Irish Stock exchange, and if managedby an incorporated entity in Ireland, this entity would be subject to Irish company law,and accounting regulations, yet the location of funds and the market where they werequoted receives very little (if any) attention.There are numerous connections between funds involved in the subprime crisis and theIFSC. There are over 4000 investment funds and many more subfunds, quoted on theIrish Stock Exchange. Many of these funds assets consisted of subprime loans. In orderto be quoted on the Dublin Stock Exchange they must be sponsored by a local stockbroking firm (Mostly Davy and Goodbody Stockbrokers) documents must be lodged withthe regulator, and in the case of an entity incorporated in Ireland, Company Registration

Office. In return fees are paid to the Irish Stock Exchange and to the sponsoring broker.Regulators in the resident country of potential investors may require securities to be listedon a recognised stock exchange. These investment funds may in turn be owned by alegal entity (the so called conduits), managed by a firm based in the IFSC, as in the caseof Rhinebridge and IKB or in the case of the conduit Ormond Quay, managed bySachsen Bank (Ireland) which was in turn a wholly owned subsidiary of Sachsen Bank.Banks and investment funds were not the only entities involved in sub-prime loans at theIFSC. A Treasury management firm operating at the IFSC, Dublin (GMAC-RFC) which

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is a wholly owned subsidiary of the Residential Financing Corporation of the US and inturn owned by General Motors, was extensively involved in mortgage lending in the US.The web site of this firm states:-GMAC-RFC, one of the largest private mortgage conduits in the United States, hasled the mortgage industry for over two decades. A pioneer in the field of mortgagesecuritization, we continue to build on our track record of success. Our relationshipslastand the mortgage lenders that we partner with grow and prosper along withus (Source:- https://www.gmacresidentialfunding.com/lenders/).In total over 40 funds quoted on the Irish Stock Exchange have been the subject of mediareports indicating financial difficulties9.12

8. Bear Stearns and the IFSCThe collapse of Bear Stearns and its subsequent takeover by JP Morgan in March 2008,was one of the early indicators of the severity of the current crisis. The first publicindication of problems at Bear Stearns emerged when a Bear Stearns hedge fundannounced considerable losses (Business Week June 12, 2007), and a second fundannounced a smaller loss (Bear Stearns High-Grade Structured Credit Strategies).

Lenders attempted to reclaim loans (Bajaj and Cresswell, 2007). On June 22nd BearStearns pledged $3.2 billion in loans (Cresswell and Bajaj, 2007), but this wasinsufficient to prevent further withdrawals. redemptions were suspended and both fundsfiled for bankruptcy approximately six weeks after the first announcement of losses. Bothfunds were incorporated in the Cayman Islands where they were liquidated (BloombergAugust 7 2007). While key executives at both funds faced prosecution in the US(Thomas, New York Times, 20/6/08), they were acquitted in November 2009 (Kouweand Slater, 2009). One puzzling aspect is that the reported reason why Bear Stearnsattempted to rescue these funds was because of reputational risk rather than a contractual obligation (Baily, et al. p. 52). This failed intervention is likely to have been akey component of the