User:Afelton/Financial Innovation

There are several interpretations of the phrase financial innovation. In general, it refers to the creating and marketing of new types of securities.

Why does financial innovation occur?
Economic theory has much to say about what types of securities should exist, and why some may not exist (why some markets should be "incomplete") but little to say about why new types of securities should come into existence.

One interpretation of the Modigliani-Miller theorem is that taxes and regulation are the only reasons for investors to care what kinds of securities firms issue, whether debt, equity, or something else. The theorem states that the structure of a firm's liabilities should have no bearing on its net worth (absent taxes, etc.). The securities may trade at different prices depending on their composition, but they must ultimately add up to the same value.

Furthermore, there should be little demand for specific types of securities. The capital asset pricing model, first developed by Markowitz, suggests that investors should fully diversify and their portfolios should be a mixture of the "market" and a risk-free investment. Investors with different risk/return goals can use leverage to increase the ratio of the market return to the risk-free return in their portfolios. However, Richard Roll argued that this model was incorrect, because investors cannot invest in the entire market. This implies there should be demand for instruments that open up new types of investment opportunities (since this gets investors closer to being able to buy the entire market), but not for instruments that merely repackage existing risks (since investors already have as much exposure to those risks in their portfolio).

If the world existed as the Arrow-Debreu model posits, then there would be no need for financial innovation. The Arrow-Debreu model assumes that investors are able to purchase securities that pay off if and only if a certain state of the world occurs. Investors can then combine these securities to create portfolios that have whatever payoff they desire. The fundamental theorem of finance states that the price of assembling such a portfolio will be equal to its expected value under the appropriate risk-neutral measure.

Academic literature
Tufano (2003) and Duffie and Rahi (1995) provide useful reviews of the literature.

The extensive literature on principal-agent problems, adverse selection, and information asymmetry points to why investors might prefer some types of securities, such as debt, over others like equity. Myers and Majluf (1984) develop an adverse selection model of equity issuance, in which firms (which are trying to maximize profits for existing shareholders) issue equity only if they are desperate. This was an early article in the pecking order literature, which states that firms prefer to finance investments out of retained earnings first, then debt, and finally equity, because investors are reluctant to trust any firm that needs to issue equity.

Duffie and Rahi also devote a considerable section to examining the utility and efficiency implications of financial innovation. This is also the topic of many of the papers in the special edition of the Journal of Economic Theory in which theirs is the lead article. The usefulness of spanning the market appears to be limited (or, equivalently, the disutility of incomplete markets is not great).

Allen and Gale (1988) is one of the first papers to endogenize security issuance contingent on financial regulation—specifically, bans on short sales. In these circumstances, they find that the traditional split of cash flows between debt and equity is not optimal, and that state-contingent securities are preferred. Ross (1989) develops a model in which new financial products must overcome marketing and distribution costs. Persons and Warther (1997) studied booms and busts associated with financial innovation.

The fixed costs of creating liquid markets for new financial instruments appears to be considerable. Black and Scholes (1974) describe some of the difficulties they encountered when trying to market the forerunners to modern index funds. These included regulatory problems, marketing costs, taxes, and fixed costs of management, personnel, and trading. Shiller (2008) describes some of the frustrations involved with creating a market for house price futures.

Examples of spanning the market
Some types of financial instrument became prominent after macroeconomic conditions forced investors to be more aware of the need to hedge certain types of risk.
 * The development of interest rate swaps in the early 1980s after interest rates skyrocketed.
 * The development of credit default swaps in the early 2000s after the recession beginning in 2001 led to the highest corporate-bond default rate in 2002 since the Great Depression.

Examples of mathematical innovation
Futures, options, and many other types of derivatives have been around for centuries: the [|Japanese rice futures market] started trading around 1730. However, recent decades have seen an explosion use of derivatives and mathematically-complicated securitization techniques. MacKenzie (2006) argues from a sociological point of view that mathematical formulas actually change the way that economic agents use and price assets. Economists, rather than acting as a camera taking an objective picture of the way the world works, actively change behavior by providing formulas that let dispersed agents agree on prices for new assets.
 * The market in options exploded after the development of the Black–Scholes model in 1973.
 * The development of the CDO was heavily influenced by the popularization of the copula technique (Li 2000).

Examples of innovation to avoid taxes and regulation
Miller (1986) places great emphasis on the role of taxes and government regulation in stimulating financial innovation. Modigliani and Miller (1958) explicitly considered taxes as a reason to prefer one type of security over another, despite that corporations and investors should be indifferent to capital structure in a fractionless world.

The development of checking accounts at U.S. banks was in order to avoid punitive taxes on state bank notes that were part of the National Banking Act.

Some investors use total return swaps to convert dividends into capital gains, which are taxed at a lower rate.

Many times, regulators have explicitly discouraged or outlawed trading in certain types of financial securities. In the United States, gambling is mostly illegal, and it can be difficult to tell whether financial contracts are illegal gambling instruments or legitimate tools for investment and risk-sharing. The Commodity Futures Trading Commission is in charge of making this determination. The difficulty that the Chicago Board of Trade faced in attempting to trade futures on stocks and stock indexes is described in Melamed (1996).

In the United States, Regulation Q drove several types of financial innovation to get around its interest rate ceilings, including eurodollars and NOW accounts.

The role of technology in financial innovation
Some types of financial innovation are driven by improvements in computer and telecommunication technology. For example, Paul Volcker suggested that for most people, the creation of the ATM was a greater financial innovation than asset-backed securitization. Other types of financial innovation affecting the payments system include credit and debit cards and online payment systems like PayPal.

These types of innovations are notable because they reduce transaction costs. Households need to keep lower cash balances -- if the economy exhibits cash-in-advance constraints then these kinds of financial innovations can contribute to greater efficiency. Alvarez and Lippi (2009), using data on Italian households' use of debit cards, find that ownership of an ATM card results in benefits worth €17 annually.

These types of innovations may also have an impact on monetary policy by reducing real household balances. Especially with the increased popularity of online banking, households are able to keep greater percentages of their wealth in non-cash instruments. In a special edition of 'International Finance' devoted to the interaction of electronic commerce and central banking, Goodhart (2000) and Woodford (2000) express confidence in the ability of a central bank to maintain its policy goals by affecting the short-term interest rate even if electronic money has eliminated the demand for central bank liabilities, while Friedman (2000) is less sanguine.