Macro Policy
The implications of financial innovation

The process of financial innovation has gathered momentum in recent years. The pace of innovation has increased dramatically in the last decade. The number of traded financial futures contracts, for example, has increased from a handful to nearly one hundred. The variety of contracts on offer has also increased: even the British Government now issues gilts apparently tailored to a range of specialized clienteles. The changing structure of financial markets has significant implications for the economies in which it is occurring. Some financial innovations appear to have raised the degree of capital mobility and the level of interdependence in the world economy. At the same time, some channels through which economic policy operates have become less effective, while the potency of other policy instruments has increased.

The Centre held a workshop on July 3, to discuss the consequences of financial innovation. The workshop was organized by Research Fellow David Begg (Bank of England and CEPR) and Associate Programme Director Stephen Schaefer (London Business School and CEPR), and formed part of the joint CEPR/Brookings project on Macroeconomic Interactions and Policy Design in Interdependent Economies. Participants were drawn both from central banks and from the academic world.

In the opening paper of the workshop, Ian Cooper (London Business School) drew attention to a common theme of innovation: the creation of new market instruments. In his paper, 'Financial Markets: New Market Instruments', Cooper analysed why the pace of change in financial markets had increased in recent years. Cooper classified the new financial instruments into three groups: 'forwards and futures', such as swaps and traded futures; 'securitized loans', which included certificates of deposit and Eurobonds; and 'options', such as traded options and 'cap' agreements.

The development of the forwards and futures markets had attracted considerable attention, Cooper also noted a general trend to 'securitization', whereby traded instruments such as bonds and certificates of deposit are substituted for direct borrowing from financial institutions. There had also been a tendency to include within traditional securities complex provisions that have the characteristics of options. Convertible bonds and capped floating rate notes were examples of this trend. A capped floating rate note, for example, can be considered as an agreement to borrow at a floating rate plus an agreement by the lender to pay to the borrower the difference between the floating interest rate and the level specified in the cap agreement whenever the floating rate exceeds the cap level. This agreement has all the characteristics of a 'call' option and, indeed, is priced and sold on that basis.

What might have led to the heightened importance of futures, forwards and securitized loans? Cooper argued that two of the most common explanations of innovation were not entirely convincing. One is that innovation is opportunistic and caused by arbitrary tax rules and regulation. The other is that innovation has introduced instruments that create new and useful opportunities to spread risks. Cooper noted that, in the case of 'swaps', innovation was initially a response to regulatory anomalies. The conventional explanations of innovation would have been equally applicable twenty years ago, however. The risk-sharing gains from offering equity index futures were potentially as great in 1956 as they are today, Cooper argued. These explanations cannot account for the most striking feature of innovation: its recent explosive growth.

The single most important change which had stimulated innovation was, in Cooper's view, the improvement in technology. It had not been possible to run highly liquid and competitive global markets in the absence of fast and efficient computer and telecommunica- tions systems. Technology, Cooper argued, explained the pace of recent innovation in financial instruments. It also explained the proliferation of complex securities, and the substitution of trading arrangements that generate liquidity for institutional arrangements aimed at coping with a lack of liquidity. Greater sophistication, competition or regulators' attitudes were the effects rather than causes of innovation. Regulation had been loosened in response to the destruction of the status quo, leading to greater competition, and those institutions most affected had been forced to introduce more sophisticated instruments and techniques.

Cooper argued that the financial futures market, for example, did not create contracts with new risk-sharing functions but simply lowered transactions costs. Innovation has been motivated largely by the changed technological capability for conducting particular transactions whose economic functions are not fundamentally new. Such innovations create 'transactionally efficient' vehicles for trading risks that are already traded in other ways, though the new instruments produce more liquidity and lower prices.

The growth of options, however, had other causes in addition to improved technological efficiency. They also provided a means of trading in a particular economic variable, namely asset price volatility, and indeed options market traders describe their deals as 'buying or selling volatility'. Such options performed a new economic function and their development could be regarded as bringing about a more 'complete' range of markets.

Cooper noted one implication of innovation of particular interest to regulators. The development of traded instruments has meant that it is now possible to calculate the market value of a bank which holds entirely traded assets. In this situation, the bank's net equity is clearly visible, and banks holding non- performing risky assets would be forced to recognize the reduction in the market value of their equity and could divest the assets if necessary. Forced and rapid realization of such losses would avoid the disruptive effects of large losses that have already occurred but have not yet been recognized by the accounting system. This type of regulation was not feasible until recently, because many assets and liabilities were not traded and so did not have readily observed prices. Innovation allows regulators to move away from face-to-face informal agreements to impersonal systems based upon market prices.

Bruce Greenwald (Bell Laboratories) presented the second paper of the workshop, entitled 'Information, Finance Constraints and Business Fluctuations', and written jointly with Joseph Stiglitz (Princeton University). Greenwald described a model of macroeconomic fluctuations based upon informational imperfections such as adverse selection and moral hazard. These informational imperfections may prevent agents from entering into agreements to share risks. As a result, individuals attempt to manage risks without depending on external markets, and they are likely to do this in two ways that have significant macroeconomic consequences.

First, they can usually reduce risks by reacting to unexpected 'shocks' through adjustments to their level of economic activity. In the process, they may transmit these 'shocks' to other agents. Second, accumulated 'net' asset balances, particularly liquid asset balances, can act as 'buffer stocks' to absorb risks and allow adjustments to other economic variables to be postponed. Fluctuations in 'net' asset balances, which are likely to be persistent, can lead to persistent fluctuations in the level of economic activity. In Greenwald's model, both these mechanisms are at work and they produce persistent macroeconomic cycles whose characteristics resembled those of observed business cycles.

The distinctive feature of Greenwald's model was a finance constraint which affected not the quantity of funds available, as in much of the literature on credit rationing, but the form in which funds may be raised. In particular, there are limits on the amount of equity capital that firms can attract. This constraint on equity financing exists as a result of 'adverse selection'. A firm's management is likely to have better knowledge of their firm's prospects than investors at large. Hence if the managers are willing to sell stock at existing market prices then potential purchasers will tend to be wary of buying it. Under these circumstances, firms may only be able to sell equity at the cost of a significant drop in its market price. This is consistent with firms' infrequent reliance on public equity issues and with the significant declines in the value of company stocks after an equity issue announcement.

The equity constraint has important consequences in Greenwald and Stiglitz's model. In the absence of futures markets for goods, every decision to produce is risky: each firm risks its current working capital, hoping to sell its output in the next period at a price sufficient to yield an adequate return on this capital. In the event of an unanticipated price decline, a firm's equity capital will be depleted. Adverse selection and the equity constraint mean that firms cannot share this risk with investors. Firms will therefore produce less, with multiplier effects on other firms.

Greenwald used this model to explain certain features of observed cyclical behaviour. In the trough of a recession, banks often claim that they have an excess supply of loans. This suggests that credit rationing does not occur. Instead, firms appear to ration themselves by not seeking loans at the terms on which banks make them available. This is because, in Greenwald and Stiglitz's analysis, a firm's equity capital determines simultaneously the decision to borrow and the decision to produce, and the level of equity would be relatively low in a recessionary climate. If firms did borrow, they would face the risk of having their credit line reduced or even cut off in the future. The possibility of a future credit constraint will, therefore, serve to reduce their current demand for credit and their current levels of production. Greenwald suggested that such risks would be less, and economic stability greater, in countries such as Japan and Germany where banks and industrial companies had forged close relationships, so that lenders were better informed of borrowers' financial positions. This type of relationship could, however, in certain circumstances accentuate the adverse selection problem. If banks know the risks facing potential borrowers, the fact that a firm resorts to equity finance may indicate to outside investors that its prospects have been badly rated by the bank.

Another widely observed characteristic of business cycles is the disproportionate severity of fluctuations in the investment goods sectors, such as business fixed investment and construction, residential construction and consumer durables. In principle, investment projects should be less subject to cyclical variations than shorter-term undertakings: Greenwald's model could be extended to account for this puzzling phenomenon.

The final paper of the morning session was 'Innovation in Financial Markets and Macroeconomic Policy: Some Issues', by David Currie (Queen Mary College, London, and CEPR). Currie discussed ways in which the effects of financial innovation could be incorporated into large macroeconomic models, and outlined some of its policy implications. Greater competition between banks had led to a proliferation of interest-bearing deposit accounts. The rates paid on these accounts now move in line with other market interest rates; as a consequence there is less variation in the opportunity cost of holding such money, since this cost depends on the gap between deposit rates and other interest rates. The demand for money is therefore less sensitive to the general level of interest rates. Macro models reflect this by a steeper LM curve, but this had by no means captured all the effects of innovation, Currie argued: it had also undermined the stability of the demand for money, on which the LM curve was based. Portfolio allocation models had also exhibited some tendency towards instability in the face of financial change, and the treatment by econometric models of capital flows in a world of increased capital mobility was less than satisfactory.
Currie argued that innovation had resulted in a change in the magnitude and timing of the impact of financial variables on the real economy. In the case of the exchange rate, for example, improved hedging techniques in the foreign exchange markets may have diminished the impact of exchange rate volatility on company behaviour. This was consistent with the apparent decline in the elasticities of real trade flows with respect to exchange rate movements.

Currie noted that financial innovation had a number of important implications for policy-making. First, the effectiveness of some traditional policy instruments, for example capital controls, was being eroded. Capital controls may have been one reason why the EMS had survived, but the system may not be sustainable in the face of the rapid evolution of financial markets. Second, some new instruments had been created in response to fiscal differences among countries. Thus there may be a need for greater harmonization of fiscal practices in countries closely linked by capital flows. Third, the increased use of the ECU in financial markets suggests that a major new type of international money is developing alongside other European currencies. Fourth, Currie suggested that governments should attempt to foster new instruments, such as bonds whose value was linked to the price of commodities: this would be useful for the less developed countries. Innovation may also change the incentives affecting international policy cooperation, Currie concluded.

The afternoon session was introduced by Lionel Price (Bank of England), who had been a contributor to 'Recent Innovations in International Banking', published by the Bank for International Settlements. This publication had discussed the problem of 'an excess supply' of banks, whose competitive advantage had fallen as information on the credit status of their customers had become more freely available. Problems with lending, notably to developing countries, had also reduced the credit standing of many major international banks relative to that of their prime customers and of some non-bank intermediaries. Banks had been forced to offer a wider range of financial services, but inevitably not every firm could be successful in every field it entered. Despite the over-supply of banks, there was as yet no generally accepted procedure by which to reduce their number. A shortage of bank capital had also arisen, and many recent financial market innovations had been introduced as attempts to overcome this shortage. Some of these innovations may well have been underpriced due to the strength of competition, as banks strove to maintain market share. In addition, the complexity of many innovations has made it difficult to price them appropriately.

Price drew attention to a number of other issues, many of which were subsequently discussed by the workshop participants. What is the appropriate role of banks? Do innovations expand the total supply of credit or merely substitute for other financial instruments? Are accounting procedures, particularly with respect to off-balance-sheet items, lagging behind market practices? Has efficiency in the provision of financial services increased as products have been 'unbundled' and as their components have been produced more cheaply individually than in aggregate?

There followed a wide-ranging discussion based on a number of themes. What were the causes of innovation? What was its impact on domestic economies and on international economic relationships? Did innovation only affect the slope of the LM curve, or did more efficient financial markets also have wider real economic consequences by allowing firms to undertake projects that would not otherwise have been viable? And how did it affect the conduct of economic policy?

The macroeconomic impact of innovation, it was argued, was determined ultimately by the causes of the innovation itself: an improved understanding of innovation at the microeconomic level was necessary for greater comprehension of its macroeconomic implications. If innovation was attributable largely to falling transactions costs resulting from the use of more sophisticated technology, it could be regarded as bringing about a more complete set of markets. By reducing uncertainty and spreading risk more widely, this would lead to an increase in economic welfare, though Gilles Oudiz (Compagnie Bancaire, Paris, and CEPR) suggested that difficulties might be encountered as risk- taking shifted from banks to speculators.

If innovation was instead a market response to inappropriate government policies, however, it may only serve to offset the adverse effects of these policies. If regulatory regimes or fiscal incentives created by governments were the major causes of innovation, the benefits from innovation might prove illusory. Charles Goodhart (LSE) noted that the imposition of more onerous capital requirements following the LDC debt crisis had precipitated a widening of banks' margins. This weakening of their competitive position has led to a transfer of financial activity to institutions less affected, and to banks seeking to evade these capital requirements through increased off-balance- sheet activity. Lionel Price suggested that the Glass-Steagall act in the United States, designed to separate commercial and investment banking, had stimulated innovative activity in London.

David Begg (Bank of England and CEPR) argued that the impact of innovation on real economic developments may be of only second- order importance, but that this was clearly not the case for financial variables themselves. Innovation may have reduced the information conveyed by measurements of the quantities of financial instruments. Gerry Holtham (Brookings Institution) argued that the means by which policy affected economic developments was changing. Innovation and the creation of new and relatively unregulated markets meant that credit allocation was taking place through the market price, not through credit rationing. Charles Goodhart suggested that the sensitivity of expenditure to interest rates may be changing as a result of the increased importance of variable rate lending. Macro policy, he suggested, may now have its greatest impact not on the housing sector, as in the past, but on manufacturing, because of the greater impact of policy on the exchange rate. This might increase protectionist pressure at times when the monetary stance was restrictive. Commenting further on the international implications of innovation, Helmut Mayer (Bank for International Settlements) suggested that if improved facilities for hedging meant that larger exchange rate movements were needed to produce a given economic out-turn, this would punish excessively those who were unable to hedge fully against risk. David Currie contended that a system which allowed all risks in international financial markets to be hedged might replicate some features of international cooperation. Drawing the session to a close, David Begg concluded that financial innovation was currently an exciting and fruitful area of applied microeconomic research. The conclusions of that research would be of great significance for macroeconomic modelling. The initial work had been suggestive, and macroeconomists would await further, and more concrete, results with interest.