Should all financial innovation be curbed?

BBC business editor Robert Peston on financial innovation and fragility

I was struck by a name, Shleifer, that kept popping up in Adair Turner's recent lecture on whether reform of the financial system had been radical enough (see my post, Turner's 'radical' changes at the banks) and in the response to Lord Turner made by Paul Tucker, deputy governor of the Bank of England.

By the way, it was resonant that Turner and Tucker were sparring in the same Cambridge room, since they are the heavyweight contenders to succeed Mervyn King as Governor of the Bank of England.

But that's a proper punch up for another day, since on this occasion they were agreed on the importance of a recent academic paper by the Harvard economist Andrei Shleifer - in collaboration with Nicola Gennaioli and Robert Vishny - entitled Financial Innovation and Financial Fragility.

As much as these things ever set the pulse racing (unless you are a saddo like me). It is a gripping piece of work - because it purports to offer a mathematical proof that much financial innovation is socially and economically harmful, by definition as it were, turning on its head the prevailing orthodoxy of the previous 30 years that markets are rational and efficient.

So the significance of its equations are not to be understated. You could say that the authors employ the methodology lauded for years by Alan Greenspan, when he was the most powerful central banker the world has ever seen, the pontiff of liberal capitalism, to demonstrate that Greenspan's faith in the universal, eternal benefits of free markets and financial innovation was false.

Schleifer et all start from the premise - which no liberal ideologue would dispute - that most financial innovation is based on the desire to create investments that deliver reliable, above average cash returns to investors.

In that lost world of four years ago where there was limited issuance of the supposedly safest investments - or loans to the strongest and richest states, bonds issued by the likes of the US, UK and Germany (don't smirk) - there was a powerful motive to repackage and reconstruct other kinds of loans so that they would mimic those ostensibly low-risk government bonds.

So far, so orthodox.

As you know, in recent years, the most conspicuous and deadly example of what became known as the search for yield was the explosive growth of structured or tranched products, of AAA-rated bonds - collateralised debt obligations - manufactured out of low quality or subprime loans to US homebuyers.

These CDOs seemed to offer the safety of US Treasuries or UK gilt-edged stock - they had the same AAA rating - but with a much higher yield.

Now, this combination of putative security and superior returns can be seen in many other innovative products of recent years that subsequently went wrong, from split capital trusts in the UK to the collateralised mortgage obligations of 20 years ago in the US.

There was also an element of the same psychology at work in the creation of enormous money market funds in the US - which in reality represented a significant market risk for investors but where those investors in practice believed their savings could never fall below 100 cents in the dollar (they were convinced the buck would never be broken).

For Shleifer and his colleagues, there is no coincidence that investors in CDOs, CMOs, money market funds, split capital trusts and so on failed to appreciate the scale of the risks they were running.

One of their important insights is that all investors - professional, wholesale investors as much as retail ones - are prone to what they call "local thinking".

To put it another way, investors will tend to ignore low probability risks - even when those risks relate to potentially devastating events.

And the longer those low-probability risks fail to materialise, the more investors will behave as though those risks don't exist at all.

That local thinking or myopia is now - in hindsight - conspicuous in the way that investors bought trillions of dollars of bonds created out of US subprime loans.

If investors thought about the risks at all, they took comfort from the performance of the US housing market in their lifetimes, during which default rates among borrowers were consistently low and where there had only been regional house price slumps, never a national one.

The consequence was that investors behaved - invested their precious cash - as if a national decline in house prices could not ever happen and as if there could never be an epidemic of defaults.

What flowed from this combination of local thinking by investors and from the understandable desire of investment bankers to create and sell fee-earning new products was that vastly more money was invested in CDOs made out of subprime - and by extension vastly more money was lent to homebuyers who never stood the remotest chance of repaying their debts - than was remotely healthy, either for the investors or for the wider economy.

It is of course the damage to all of us, not to individual investors who should know better, that matters.

And an important element of that damage to the rest of us isn't just that when the supposedly safe investments go bad, losses are generated for some important institutions - banks for example - that find it difficult to absorb the losses. What also happens is that investors become gripped by blind panic when they finally recognise they've been prone to local thinking, that they failed to appreciate the real risks they were running.

When investors learn the bitter truth, they instinctively exaggerate how bad it really is. They dump the bad investments - the CDOs for example - in a herdlike way that's as irrational as the silly optimism they manifested when buying the investments in the first place.

The price of the investments collapses, to fire-sale prices. And those unable to shift the investments - including, during the real-life example of 2007-8, banks which play a vital economic role - face bankruptcy.

The powerful conclusion of Schleifer's financial modelling is that there was nothing anomalous or exceptional in the great crash of 2008 that was triggered (if not caused) by the subprime, CDO boom.

They purport to have delivered mathematical proof that the existence of local thinking will inevitably lead to credit booms that seriously undermine economic stability. Which implies that if we want to avoid those destabilising bubbles, curbs have to be imposed on bankers' freedom to create whatever financial products meet perceived market demand.

Particularly important in this conclusion is the implication that we can't expect the financial economy to be made sufficiently safe if all we do is continue down the mainstream route currently being taken by international regulators of controlling leverage, or limiting how much banks and other financial institutions can borrow and lend relative to their capital resources.

For Schleifer, the recent global drive by regulators to force banks to hold more loss-absorbing capital relative to assets - to increase their capital ratios - will lessen the magnitude of boom-bust shocks.

But those boom-bust shocks will remain severe, they imply, unless restraints are imposed on investment banks' creative tendencies.

That said, there is nothing particularly radical about this conclusion as applied to the creation of retail products. It is taken for granted by regulators and governments that the likes of you and me need protecting from our own ignorance and folly when investing.

However the conclusion that the Financial Services Authority - or rather its successor bodies under George Osborne's reconstruction of the British regulatory system - should routinely ban or limit the use of products designed by the likes of Goldman Sachs and Barclays Capital, for consumption by financial institutions, well that will be deeply troubling for the City.

However that is indeed where the thinking of Lord Turner, chairman of the FSA and the most influential regulator in the UK, is heading.

He said as much in his recent Clare College lecture and I expect him to elaborate on all this in the coming days.

The natural home for a new culture of busybody interference in the innovative activities of investment banks - as and when that innovation may have potentially serious consequences for the economy - will be the soon-to-be-created Financial Policy Committee.

If I were running Barcap, Goldman Sachs or Deutsche Bank, I might be more than a teeny bit anxious about the imminent advent of the FPC.

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.

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