Financial Innovation & Risk
- Financial innovation can be of three types: institutional, product and process innovation. Institutional innovation refers to changes in systems and institutions (e.g., reforms in legal and supervisory frameworks). Process innovation includes improvements in business processes (e.g., new accounting software). And probably the most popular type of innovation--product innovation--is represented by new products like collateralized debt obligations (CDOs) or credit default swaps (CDSs).
- Financial innovation has always been with us, at least since the first money prototypes were invented. However, financial innovation as we know it today, has really taken off only since the Reagan-Thatcher pro-business policies of the 1980s.The Internet and Technological Revolution of the subsequent decade delivered great new capacities to the financial industry, raising electronic trading to a new level, introducing new software to every aspect of the industry, and spreading the popularity of new financial products like mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs).
- Mortgage-backed securities (MBSs), collateralized debt obligations (CDOs) and credit default swaps (CDSs) were the most popular product innovations of the recent past.
When a bank issues a mortgage to a person, and does not want to keep it on its books, it can sell it to other investors in the form of an MBS. If there are investors who want to get the higher or lower returns that a normal MBS would provide, they can buy a CDO--a derivative on the MBS. A CDO allows investors to get the risk-return ratio they want. For example, if they want higher returns, they can opt for lower-level CDO tranches--i.e., they will be the first ones to suffer losses if the underlying mortgages are not repaid.
A CDS allows investors to separate default from credit risk in corporate or government securities. Thus, when a company or a government defaults, investors will still get their money from the CDS issuer. - As the subprime mortgage market soured in the U.S. in 2008, many investors who bought into MBSs and CDOs suffered losses. As it was not clear who ended up having most toxic tranches (those that would be the first to bear losses on the underlying mortgages), banks started shying away from lending to each other. This was one of the primary factors that caused financial and economic crisis of 2008 and 2009
In the end, the collapse of a number of prominent banks like Lehman Brothers caused a panic in the CDS market. The sell-off was so big that many CDS issuers started having severe problems, as they would now need to pay out for the bonds they insured against default. Problems with the CDSs were one of the main reasons why AIG, a famous American insurer, had to be bailed out by the U.S. government. - Financial innovation has faced great criticism in many circles because of the systemic risk it poses. Paul Volcker, widely respected former chairman of the Fed, observed that the recent financial innovations were largely beneficial for society as a whole, and that the biggest recent innovation was not MBSs, CDOs or the CDSs, but the humble automatic teller machine (ATM).