In Defense of Financial Innovation

At a 2013 conference held by The Economist in New York, business and policy leaders debated whether talented university graduates should join Google or Goldman Sachs. Vivek Wadhwa, a serial entrepreneur, spoke up for Google. “Would you rather have your children engineering the financial system [and] creating more problems for us, or having a chance of saving the world?” he asked. He had a much easier time pitching his case than Robert Shiller, the Nobel Prize–winning economist who advocated for Goldman Sachs by arguing that every human activity, even saving the world, had to be financed. No use; in the end, the audience voted heavily in favor of Mountain View and against Wall Street.


Such bias reflects the profound shift in public attitudes toward Wall Street that followed the 2008 financial crisis. In the decade before the meltdown, bankers were lionized. Policymakers applauded the efficiency of financial markets, and widespread praise for financial innovation drowned out any criticism. But when the crisis hit, the pendulum swung too far in the opposite direction. The new consensus now portrays bankers as villains whose irresponsible practices and shady techniques unleashed disaster. This view holds that only a small part of the financial industry actually benefits society—the one that doles out loans to individuals and businesses. The rest constitutes dangerous, unnecessary gambling, and so financial ingenuity of all kinds is highly suspect. 


Such anger is well founded; finance certainly did a bad job of applying itself to big problems in the run-up to the crisis, and the popular myth of the industry’s invincibility contributed to this failure. Eliminating this misperception was entirely for the best. But demonizing finance is also a mistake, and restricting the sector to its most familiar elements would do nothing to mend its flaws. Worse, such a course could wreak damage outside the banking industry, because financial ingenuity reaches far beyond Wall Street. Innovative financiers are currently helping solve an array of socioeconomic problems—including those related to the strength of social safety nets, the poor’s ability to save, and the capacity of the elderly to support themselves—that weigh heavily on governments around the world. Instead of fearing such innovation, policymakers and the public should welcome it, with prudent oversight.


REALITY CHECK


For critics of Wall Street, the financial crisis served as a warning against experimentation. Financial innovation, they argue, has approached a point of diminishing returns. If only finance could turn back the clock, all would be well. Gone would be toxic practices such as securitization, the banks’ way of bundling mortgages, credit-card loans, and other financial assets into bonds that they resell to investors—a technique seen as having triggered the crisis. The out-of-control financial wizardry that generated skyrocketing amounts of consumer debt would come to an end. And stock exchanges would stop serving as the playthings of algorithms.


Some skeptics go so far as to argue that “banking should be boring”—a slogan adopted by Elizabeth Warren, the senior Democratic senator from Massachusetts, who has demanded tighter restrictions on finance. In 2013, Warren launched a campaign to separate U.S. banks into two distinct groups. The first would include the comfortingly familiar retail businesses that accept deposits and provide mortgages. The second would contain investment firms that raise money and manage risks through obscure capital-market practices, and they would be barred from taking insured deposits to fund themselves. Although the bill that Warren introduced has stalled on Capitol Hill, it counts plenty of sympathizers. 


Going one step further, a few prominent observers have suggested that financial creativity has reached the limits of its utility. They point to a host of seemingly out-of-control pre-crisis financial forces, from the blinding speed of high-frequency traders to the exploding volume of credit default swaps, a type of insurance policy written against borrowers going bust. In 2009, for example, Paul Volcker, the former Federal Reserve chair, said that no financial innovation of the pre-crisis period was as useful as the simple automatic teller machine. Similarly, the economist Paul Krugman admitted in a 2009 New York Times column that he had trouble thinking of a single recent financial breakthrough that had aided society. Rather, he wrote, “overpaid bankers taking big risks with other people’s money brought the world economy to its knees.”


To be fair, the motives behind many new financial products are far from pure, and greater scrutiny would help stave off crises in the future. But widespread criticism of particular Wall Street innovations has had the effect of unfairly smearing the reputation of finance as a whole, and it has given rise to proposed solutions that could do more harm than good. Calling a halt to financial inventiveness—freezing finance in place; no bright ideas allowed—would not solve the problems associated with the industry. In fact, the greatest dangers to economic stability often lurk in the most familiar parts of the financial system. 


After all, retail and commercial banks accounted for some of the most massive write-downs recorded during the crisis. The biggest bank failure in U.S. history was that of Washington Mutual, which collapsed in 2008 with $307 billion in assets and a pile of rotting mortgages on its books. The largest quarterly loss for a bank was suffered in 2008 by Wachovia, which was brought down by bad loans. And the product that caused the most damage during the financial crisis was mortgages, the most familiar instrument of all. The amount of mortgage debt in the United States had roughly doubled between 2001 and 2007, to $10.5 trillion. Real estate was by far the biggest asset held by U.S. households, reaching $22.7 trillion in value in 2006, when house prices were at their peak. The United States was not alone in this vulnerability; wide holdings of residential and commercial property were the common denominator across the countries most affected by the crisis, including Ireland, Spain, and the United Kingdom. 


Part of the reason is that property has inherently destabilizing characteristics. This asset thrives on debt: in many housing markets, buyers routinely take out loans worth more than 90 percent of the property’s value. Virtually the entire worldwide rise in the ratio of private-sector debt to GDP in the past four decades has been caused by rising levels of mortgage lending. Yet banks tend to see this type of secured lending as safe, even though it could involve decisions made solely on the basis of collateral offered by the borrower (say, a house) rather than the borrower’s creditworthiness. 


Indeed, the great irony of the property bubble was that many banks and investors had thought that concentrating on housing was a prudent bet. Although the financial sector has since been criticized for recklessness, it was its pursuit of safe returns that brought trouble. An insightful study by the economists Nicola Gennaioli, Andrei Shleifer, and Robert Vishny revealed that much financial-sector creativity—from the invention of money-market funds to the pre-crisis surge in mortgage-backed securities—is rooted in a search for safety as well as profit. The reason investors sought out mortgage-backed securities was that these instruments offered slightly higher returns than more traditional assets (such as U.S. Treasury bonds) while also appearing to be low risk. This pattern holds across a wide range of other financial products; the siren song of safety is a recurring theme in finance.


The property market thus offers a lesson for the financial industry more broadly: studying the ways in which people and companies manage money and risk—and harnessing these behaviors for more constructive ends—could help address the dangers that still lurk in plain sight. Rather than being a warning against innovation, the crisis was a clarion call for creative thinking of a different kind. Indeed, when it comes to property, finance is already demonstrating how using new techniques could forestall future shocks.


Some entrepreneurs, for example, are exploring ways to temper the adverse effects that fluctuations in housing prices carry for both borrowers and lenders. A housing downturn can reduce the price of a property to less than the value of the mortgage holder’s outstanding loan, triggering a loan default that hurts both the buyer and the bank. One answer is to offer borrowers no interest on their mortgages in return for allowing the lenders to share in the gains or losses from movements in house prices. If prices fall, owners are more protected; if they rise, lenders reap some of the rewards. As for the adverse effects that market downturns can have on lenders, one firm, London-based Castle Trust, has found a clever solution: tying its funding to the national house price index in a way that makes assets and liabilities on its balance sheet rise and fall in unison. The Castle Trust model is a radical break from the norm—but one that is entirely welcome.


THE IDEAS MACHINE


Even the most ardent critics of Wall Street do not dispute the value of financial innovation over the long sweep of human history. The invention of money, the use of derivative contracts, and the creation of stock exchanges all represent smart responses to real-world problems. These advances helped foster trade, create companies, and build infrastructure. The modern world needed finance to come into being.


But this world is still evolving, and the demand for financial creativity is as strong today as ever. Fortunately, despite all the recent criticism, the financial sector has been evolving as well. Today, this industry is home to not only big banks skimming fat fees but also visionary innovators that are rethinking the ways in which money, livelihoods, and technology relate to one another.


To take just one example, many countries, including the United States, face unprecedented pressure to trim their budgets by cutting public spending. As a result, social programs—say, rehabilitating prisoners and training the unemployed—can fall by the wayside. Even where such initiatives do continue, they often end up wasting taxpayers’ money, because they either fail to tie spending to desired outcomes or focus on the wrong outcomes altogether. Many job-training programs, for example, focus on the number of people they enroll and graduate rather than the number of participants who subsequently find jobs. Flaws of this kind are common across state-funded initiatives. According to the Brookings Institution, out of ten rigorous evaluations of social programs run by the U.S. federal government in 1990–2010, nine found that the programs either produced weak positive results or had no impact at all.


Finance has stepped in with answers to both the funding problem and the shortfalls of planning and monitoring. One innovative tool, known as a social-impact bond, channels private investment to programs that track measurable social benefits. For instance, a social-impact bond focused on rehabilitating prisoners might monitor the number of new convictions of former inmates one year after they were released from prison. Fewer repeat convictions means less spending by the government, which can then use the cash it saves to pay back investors. The first initiative of this kind was introduced in 2010 by the city of Peterborough in the United Kingdom, and that program has already reduced reoffending rates vis-à-vis the national control group. Other countries, including the United States, have introduced similar programs of their own. New York City launched a social-impact bond in 2012 focused on adolescents incarcerated at Rikers Island; the program counts Goldman Sachs as an investor. And Massachusetts has announced two social-impact bonds, one of which will fund a seven-year effort to reduce prisoner recidivism with a budget of $27 million.


The reason finance has a shot at solving problems of such complexity is its ability to align the incentives of diverse market participants—in this case, governments that commission services, social organizations that provide them, and investors that supply capital. Governments are attracted to social-impact bonds because they require payouts only when the programs they fund achieve results. Social organizations come on board because these initiatives involve private investment with longer time frames than federal contracts usually offer. And investors benefit from detailed data on how well the programs are performing. Social-impact bonds will never be the only answer to the shrinking state. But they are an extremely promising avenue to explore. 


THE NEXT FRONTIER


Governments are not alone in facing an enormous financial squeeze; individuals must grapple with similar challenges. Today, ordinary people in developed economies expect to live longer than any generation did before them, yet they generally do not save nearly enough for retirement. Too many of these people put far too little money aside as protection against unexpected shocks. And a large share have trouble accessing credit, especially if they find themselves on the periphery of the economic system.


Finance has been providing ingenious answers to these kinds of problems by drawing on the insights of behavioral economics. Recent years have given rise to the birth of a subfield known as behavioral finance, which studies the different prompts and nudges that help people achieve more financially efficient outcomes. This field already counts one remarkable achievement: getting more Americans to save for retirement by enrolling them in 401(k) pension plans automatically. People have a tendency to dither, so requiring them to opt out of a scheme, rather than make the effort to opt in, draws in scores of new customers. U.S. companies that have introduced auto-enrollment mechanisms have reported sharp rises—of as much as 60 percent—in average 401(k) participation rates.


A more recent application of behavioral economics has allowed society’s least creditworthy people to build up their savings accounts. Millions of people in developed economies lack any sort of financial cushion. A 2012 survey by the Financial Industry Regulatory Authority asked Americans whether they’d be able to come up with $2,000 if an unforeseen need arose; almost 40 percent said no or probably not. Nearly two-thirds did not have three months’ worth of emergency funds on which they could draw if they fell ill or became unemployed. And whereas the housing boom had once disguised these problems—as long as prices kept climbing, people in distress could refinance or sell their homes—today, average Americans have no choice but to save more.


When money is tight, of course, saving is difficult. To make matters worse, new regulations discourage mainstream banks from reaching low-income households by capping the credit-card penalties and overdraft fees that banks can levy. Once again, innovative financial players have moved in to fill the gap. Some, such as the Massachusetts-based Doorways to Dreams (D2D) Fund, have managed to motivate savers via a simple trick: offering prizes for putting money aside. After all, humans love lotteries, and the prospect of winning awards instantly makes saving seem more attractive.


In 2009, the D2D Fund launched a prize-linked savings program in Michigan (one of the few places that permits private lotteries) called Save to Win. For each $25 in deposits, savers earn raffle tickets that give them a chance to win quarterly prizes of as much as $5,000, as well as smaller monthly rewards. Nebraska, North Carolina, and Washington State have since introduced versions of the program, and D2D hopes to eventually tap into state lottery systems directly in order to reach more people. Meanwhile, in Michigan, its strategy has helped customers set up more than 50,000 accounts and put away over $94 million in new savings—a small amount by the financial industry’s standards but a significant achievement for scores of low-income families. 


It’s not just the poor who have trouble accessing credit. At all levels, potential borrowers get turned away by banks; other people get deterred by high interest rates on bank-offered loans. One solution involves peer-to-peer lending, which allows suppliers and consumers of credit to connect directly rather than rely on a bank to intermediate. Leading the charge is a San Francisco–based firm named Lending Club, which was launched in 2007; many others are following its example. 


Lending Club invites borrowers to make a pitch for loans and then allows lenders to choose those individuals they would like to fund. Both parties get a better deal than they would at an established bank. Peer-to-peer lending does not carry the heavy costs of the legacy information technology systems and branch networks that weigh down established banks, so it can offer borrowers lower interest rates than a bank can provide. The average rate that Lending Club borrowers paid on loans in 2013, for example, was 14 percent—well below typical credit-card rates. Allowing for a default rate of four percent and Lending Club’s service fees, the returns to investors were nine to ten percent—not bad given how low interest rates have been.


Peer-to-peer platforms are designed to address some of the flaws of mainstream finance. A firm such as Lending Club is inherently more resilient than a bank because it does not run a balance sheet on which it incurs debts in order to fund lending of its own. If there are defaults on a bank’s loan book, its creditors still expect to be paid back. But when a customer defaults on a Lending Club loan, the investors absorb the costs. Moreover, Lending Club locks up lenders’ money for the duration of the loan. After investors fund a three-year consumer loan, for example, they can’t demand the money back one month later in the way that bank depositors can. The borrower, therefore, will not face a sudden call for cash and the scramble to raise money that it entails. 


Admittedly, the numbers involved in this new sector remain tiny. Lending Club had facilitated loans totaling more than $7 billion by the end of 2014—an amount that pales in comparison to the outstanding credit-card debt of roughly $700 billion in the United States that same year. Nevertheless, peer-to-peer lending is gaining wide credibility. Lending Club was valued at $5.4 billion when it went public in 2014, and institutional investors now account for more than two-thirds of its loan volume. Some insurers and sovereign wealth funds have made allocations of as much as $100 million. 


The success of these new lending platforms, of course, does not mean that mainstream banks are about to disappear. Banks may be slower to innovate, but they can mobilize an awful lot of money and operate across borders. They also offer their customers many unique advantages, such as the ability to access savings instantly, that make them hard to dislodge. 


But banks have good reason to worry. For one thing, regulators are pushing them to reduce their leverage—their ratios of debt to equity, a rough proxy for financial fragility—which means that banks must find other ways to increase returns to their investors. To do so, they could try cutting expenses, but it is hard to imagine that they could ever run leaner ships than the innovators competing with them. Banks could also increase the cost of credit, but that measure would simply create more opportunities for the likes of Lending Club to exploit. 


In the end, the two groups will probably drift closer. Financial innovators will gradually eat away at the banks’ activities, and the banks will slowly evolve to become more efficient. Some peer-to-peer platforms are already collaborating with mainstream lenders; others will end up being bought by them. 


BANKING ON CREATIVITY

Anyone who defends the financial industry must recognize its inherent failings. There is a destructive logic to the way that the seething brains of finance innovate, experiment, and standardize. Even a banking sector populated by saints would tend toward excess, and modern finance is rather short of halos. The words that finance immediately conjures up—“bonuses,” “recklessness,” “greed,” “bastards,” “greedy bastards”—are all part of the industry’s narrative. 


The banking industry has certainly not lost its destructive tendencies in the wake of the crisis. Beyond a certain scale and beyond a certain point in their evolution, good ideas have a tendency to run wild. But suppressing financial innovation is the wrong answer to the problems facing Western societies. Instead, regulators and financiers must strike a careful balance between watchfulness for the risks that can cause economic damage and tolerance for creativity that can yield real benefits.


Two warning signs, in particular, ought to cause alarm among regulators. The first is rapid growth. When a financial technology or product truly takes off, the surrounding infrastructure often fails to keep pace. This pattern manifests itself in many different ways, from the ability of high-speed traders to outrun the stock exchanges on which they operate to the opacity of the credit default swap market in the run-up to the financial crisis. During periods of quick growth, the front offices of financial firms often sell at a breakneck pace, while the back offices struggle to cope and the rapid flow of money relies on jerry-built plumbing. Regulators must be wary of market overheating of this sort and seek to ensure that the infrastructure of finance keeps pace with its innovators.


The second pitfall is the assumption of safety. Policymakers should remember that the false comfort of the familiar helped precipitate the crisis in the first place. In the United States, home buyers and lenders fell for the faulty notion that property prices couldn’t crash nationwide and that AAA credit ratings represented a gold-plated promise of creditworthiness. Such misconceptions are hard to uproot; after all, the Western financial system remains heavily skewed in favor of providing supposedly safe mortgages to affluent households. Introducing higher capital requirements even for those assets that appear to be low risk could be one answer. 


For all the problem-solving power of finance, growth and greed can distort any good idea. But when the next financial crisis hits, its triggers will likely come from an established market, such as property, in which mainstream investors and profit-maximizing institutions have once again gotten carried away. The true innovators of finance will not be the ones to blame. They are the reason the world should look at finance with a clear eye.