What Is Financial Innovation?

Robert Merton, the Nobel Prize-winning financial economist, suggests that “the primary function of a financial system is to facilitate the allocation and deploy­ment of economic resources, both spatially and across time, in an uncertain en­vironment.

There are two perspectives in the economic literature on the overall contri­bution of financial innovation to modern economies (Frame and White, 2010; Silber, 1983). One emphasizes the centrality of finance in an economa and its im­portance for economic growth (R. Levine, 1997). Since finance is a facilitator of virtualla all production activita and much consumption activita, improvements in the financial sector are thought to have direct positive effects throughout an economa. In the case of the innovations surrounding mortgage securitization, scholars have noted that connecting capital markets to mortgage markets made the allocation of capital across the economa more efficient. This works two ways. First, instead of depending on just savers for money to loan homeowners, access to the national capital market means that more investment can flow into hous­ing. Second, it also means that the overall efficienca of the capital markets is enhanced, as the relative returns to mortgage investment versus all other forms of investment should now reflect real rates of returns across all kinds of assets on a risk-adjusted basis.

But the financial crisis of 2008 has also caused some economists to search for evidence that financial innovation might produce instability in the overall func­tioning of financial markets (Lerner, 2006). Because financial innovations, like any innovation, can have negative as well as positive consequences on the econ­omy and society more generally, at the very least one has to look at their overall net effects (Frame and White, 2010). From a sociological perspective, the critics of financial innovation are operating at a different level of analysis than those who look only at individual financial innovations. Their arguments focus not on whether a given product or process is useful for participants in an exchange but instead on how such innovations might have unintended consequences when aggregated across transactions or sets of actors.

For example, Lerner and Tufano (2011) show that failure can be especially costly for widely diffused innovations such as mortgage securities where the per­ception of the underlying value of those assets can change quickly with new in­formation. Thakor (2012) and Gennaioli et al. (2010) have produced theoretical models that show that the diffusion of new kinds of loans or securities can be the source of bank runs or financial panics. This is because there is little structure in place to prevent the rapid spread of new information about the stability of such innovations and its sudden effects on asset prices. Beck et al. (2014) show empirically how financial innovation is associated with higher but more volatile economic growth and with greater bank fragility in a dataset indexing the expe­riences with financial innovation across many countries.

Herman Minsky (2008), a heterodox economist, proposed that financial in­novation almost always leads to financial instability through an endogenous pro­cess centered on how financial institutions behave. Minsky's argument is that fi­nancial innovation begins as a way to create a stable financial regime by engaging in producing products that allow market actors to hedge risk.

While there are aspects of what happened in 2008 that fit these theories, they do not entirely explain what happened here. Minsky's argument centers on how the internal dynamics of finance drive financial innovation more than exogenous shocks. But Minsky's argument does not explain all financial crises. For example, it does a poor job of explaining the collapse of the savings and loan industry. As I have already shown, it was the exogenous financial shock of persistently high interest rates that destabilized the business model of the savings and loan banks, not an era of speculation in mortgages. While deregulation did subsequently produce an era of speculation for the savings and loan banks, it ended not be­cause monetary authorities pulled the plug on easy credit but because banks had taken on many risky projects that simply failed or, in many cases, because the owners and managers engaged in the looting of the assets of their firms.

In the case of the 2008 meltdown, while financial institutions were certainly more vulnerable because of having high leverage, there were market conditions that pushed financial institutions to find new sources of mortgages and keep selling mortgage-based securities. In Chapter 5, I will show how the dynamics of the mortgage securitization industry pushed them to search for new sourc­es of mortgages in order to keep their securitization machines going because they were seeking to continue make money off of originating, securitizing, and buying and selling asset-backed security collateralized debt obligations (ABS- CDOs).

Even as the savings and loan banks and smaller commercial banks failed in the 1980s, the financial sector grew dramatically, and capital markets expanded and benefited from the transformation of mortgage finance. The provision of financial products to consumers expanded dramatically in the 1980s and 1990s. This transformation caused a tighter linkage between the national (and interna­tional) capital markets and all of the biggest and most important banks in the US economy. Investment banks, commercial banks, the remaining large savings and loan banks, and newly emergent mortgage banks all used financial innovation to take advantage of the huge market for mortgages as a pipeline to create new products at all stages in that pipeline and earn massive profits. This larger, more diversified financial sector absorbed more and more capital and drove a massive housing price bubble from 2003 to 2006. Because of its large size and involve­ment in so much of the American economy, its downturn produced dramatic effects not just in finance but across the economy.