Financial Innovation Peter Tufano* Revised:June 16,2002 Peter Tufano Sylvan C.Coleman Professor of Financial Management Harvard Business School Soldiers Field Boston,Massachusetts 02163 ptufano@hbs.edu Abstract:This essay surveys the literature on financial innovation from a wide variety of disciplines:financial economics,history,law,and industrial organization.I define financial innovation,discuss problems with creating taxonomies of financial innovation, and outline the explanations given for the extensive amount of financial innovation we observe both today and in history.I also review work that studies the identity of innovators,the process of diffusion of innovation,the private benefits of innovation and the social welfare implications of innovation. This paper is to appear as a chapter in The Handbook of the Economics of Finance (North Holland),edited by George Constantinides,Milt Harris and Rene Stulz.I would like to thank Rene Stulz,Josh Lerner and Belen Villalonga for their very helpful comments,and Scott Sinawi for his able research assistance.This work was funded by the Division of Research of the Harvard Business School
1 Financial Innovation Peter Tufano* Revised: June 16, 2002 Peter Tufano Sylvan C. Coleman Professor of Financial Management Harvard Business School Soldiers Field Boston, Massachusetts 02163 ptufano@hbs.edu Abstract: This essay surveys the literature on financial innovation from a wide variety of disciplines: financial economics, history, law, and industrial organization. I define financial innovation, discuss problems with creating taxonomies of financial innovation, and outline the explanations given for the extensive amount of financial innovation we observe both today and in history. I also review work that studies the identity of innovators, the process of diffusion of innovation, the private benefits of innovation and the social welfare implications of innovation. * This paper is to appear as a chapter in The Handbook of the Economics of Finance (North Holland), edited by George Constantinides, Milt Harris and René Stulz. I would like to thank René Stulz, Josh Lerner and Belen Villalonga for their very helpful comments, and Scott Sinawi for his able research assistance. This work was funded by the Division of Research of the Harvard Business School
1.Introduction In Merton Miller's (1986)view on financial innovation,the period from the mid- 1960s to mid-1980s was a unique one in American financial history.Looking backward, he rhetorically asked,"Can any twenty-year period in recorded history have witnessed even a tenth as much(financial innovation)?"Looking forward,he asked the question, "Financial innovation:Is the great wave subsiding?"Answering"No"to the first question and"Yes"to the second,he concluded that the period was an extraordinary one in the history of financial innovation.However,with 20-20 hindsight,we can disagree with his assessment and answer the two questions somewhat differently History shows that financial innovation has been a critical and persistent part of the economic landscape over the past few centuries In the years since Miller's 1986 piece,financial markets have continued to produce a multitude of new products, including many new forms of derivatives,alternative risk transfer products,exchange traded funds,and variants of tax-deductible equity.A longer view suggests that financial innovation-like innovation elsewhere in business-is an ongoing process whereby private parties experiment to try to differentiate their products and services,responding to both sudden and gradual changes in the economy.Surely,innovation ebbs and flows with some periods exhibiting bursts of activity and others witnessing a slackening or even backlash.However,when seen from a distance,the Schumpeterian process of I For example,there have been numerous periods throughout the past centuries in which innovation flourished,failures took place,and public and regulatory sentiment led to temporary anti-innovation feelings.See Chancellor(1999).More recently,the failure of Enron has probably slowed the innovation of new forms of special purpose entities and off-balance sheet financing,although this chilling effect is unlikely to be permanent. 2
2 1. Introduction In Merton Miller’s (1986) view on financial innovation, the period from the mid- 1960s to mid-1980s was a unique one in American financial history. Looking backward, he rhetorically asked, “Can any twenty-year period in recorded history have witnessed even a tenth as much (financial innovation)?” Looking forward, he asked the question, “Financial innovation: Is the great wave subsiding?” Answering “No” to the first question and “Yes” to the second, he concluded that the period was an extraordinary one in the history of financial innovation. However, with 20-20 hindsight, we can disagree with his assessment and answer the two questions somewhat differently. History shows that financial innovation has been a critical and persistent part of the economic landscape over the past few centuries In the years since Miller’s 1986 piece, financial markets have continued to produce a multitude of new products, including many new forms of derivatives, alternative risk transfer products, exchange traded funds, and variants of tax-deductible equity. A longer view suggests that financial innovation—like innovation elsewhere in business—is an ongoing process whereby private parties experiment to try to differentiate their products and services, responding to both sudden and gradual changes in the economy. Surely, innovation ebbs and flows with some periods exhibiting bursts of activity and others witnessing a slackening or even backlash.1 However, when seen from a distance, the Schumpeterian process of 1 For example, there have been numerous periods throughout the past centuries in which innovation flourished, failures took place, and public and regulatory sentiment led to temporary anti-innovation feelings. See Chancellor (1999). More recently, the failure of Enron has probably slowed the innovation of new forms of special purpose entities and off-balance sheet financing, although this chilling effect is unlikely to be permanent
innovation-in this instance,financial innovation-is a regular ongoing part of a profit- maximizing economy. In this review piece,I summarize the existing research on financial innovation and highlight the many areas where our knowledge is still very incomplete.The existing work,while fairly modest in scope relative to others topics covered in this volume,is spread over a wide range of fields:general equilibrium analyses of the role for financial innovation;thought pieces proposing the reasons for innovation;legal and policy analyses of tax rules,regulation and innovation;studies of financial innovation in the industrial organization literature;clinical studies of individual innovations:and a handful of empirical studies of the process of innovation.2 A number of comprehensive books on the subject have been written,including Allen and Gale's(1994)comprehensive overview,and entire issues of journals have been devoted to the topic (e.g.,Journal of Economic Theory (1995,Volume 65.))The topic of financial innovation has been addressed by a number of AFA presidents,including Merton,Miller,Ross and Van Horne,some in their Presidential Addresses.My goals in this short overview are to cover the breadth of the existing literature briefly,rather than treat one sub-area in detail,and to highlight open issues that researchers may find suitable for future work. This piece is divided into five sections.The first defines financial innovation and discusses the difficulty of creating a taxonomy of financial innovations.The second section discusses the explanations advanced for financial innovation.The third section discusses the identity of innovators.The fourth section discusses the implications of 2 In addition,there are a variety of a large number of articles in the financial press as well as popular business books addressing the topic of financial innovation,typically from the perspective of how businesses can capitalize on them.For examples of popular book-length discussions of financial innovation,see Geanuracos and Millar(1991),Walmsley (1988)and Crawford and Sen(1996). 3
3 innovation—in this instance, financial innovation—is a regular ongoing part of a profitmaximizing economy. In this review piece, I summarize the existing research on financial innovation and highlight the many areas where our knowledge is still very incomplete. The existing work, while fairly modest in scope relative to others topics covered in this volume, is spread over a wide range of fields: general equilibrium analyses of the role for financial innovation; thought pieces proposing the reasons for innovation; legal and policy analyses of tax rules, regulation and innovation; studies of financial innovation in the industrial organization literature; clinical studies of individual innovations: and a handful of empirical studies of the process of innovation.2 A number of comprehensive books on the subject have been written, including Allen and Gale’s (1994) comprehensive overview, and entire issues of journals have been devoted to the topic (e.g., Journal of Economic Theory (1995, Volume 65.)) The topic of financial innovation has been addressed by a number of AFA presidents, including Merton, Miller, Ross and Van Horne, some in their Presidential Addresses. My goals in this short overview are to cover the breadth of the existing literature briefly, rather than treat one sub-area in detail, and to highlight open issues that researchers may find suitable for future work. This piece is divided into five sections. The first defines financial innovation and discusses the difficulty of creating a taxonomy of financial innovations. The second section discusses the explanations advanced for financial innovation. The third section discusses the identity of innovators. The fourth section discusses the implications of 2 In addition, there are a variety of a large number of articles in the financial press as well as popular business books addressing the topic of financial innovation, typically from the perspective of how businesses can capitalize on them. For examples of popular book-length discussions of financial innovation, see Geanuracos and Millar (1991), Walmsley (1988) and Crawford and Sen (1996)
financial innovation on private and social wealth.The final section concludes with a brief discussion of new means of protecting the intellectual property of innovators and a review of the open issues in this field. 2.What is financial innovation? Much of the theoretical and empirical work in financial economics considers a highly stylized world in which there are few types of securities(debt and equity,perhaps) and maybe a handful of simple financial institutions(banks or exchanges.)However,in reality there is a vast range of different financial products,many different types of financial institutions and a variety of processes that these institutions employ to do business.The literature on financial innovation attempts to catalog some of this variety, describe the reasons why we observe an ever-increasing diversity of practice,and assess the private and social implications of this activity. "Innovate"is defined in Webster's Collegiate Dictionary as "to introduce as or as ifnew,"3 with the root of the word deriving from the Latin word"novus"or new. Economists use the word "innovation"in an expansive fashion to describe shocks to the economy (e.g.,"monetary policy innovations")as well as the responses to these shocks (e.g.,Eurodeposits).Broadly speaking,financial innovation is the act of creating and then popularizing new financial instruments as well as new financial technologies, institutions and markets.The "innovations"are sometimes divided into product or process innovation,with product innovations exemplified by new derivative contracts, new corporate securities or new forms of pooled investment products,and process improvements typified by new means of distributing securities,processing transactions
4 financial innovation on private and social wealth. The final section concludes with a brief discussion of new means of protecting the intellectual property of innovators and a review of the open issues in this field. 2. What is financial innovation? Much of the theoretical and empirical work in financial economics considers a highly stylized world in which there are few types of securities (debt and equity, perhaps) and maybe a handful of simple financial institutions (banks or exchanges.) However, in reality there is a vast range of different financial products, many different types of financial institutions and a variety of processes that these institutions employ to do business. The literature on financial innovation attempts to catalog some of this variety, describe the reasons why we observe an ever-increasing diversity of practice, and assess the private and social implications of this activity. “Innovate” is defined in Webster’s Collegiate Dictionary as “to introduce as or as if new,”3 with the root of the word deriving from the Latin word “novus” or new. Economists use the word “innovation” in an expansive fashion to describe shocks to the economy (e.g., “monetary policy innovations”) as well as the responses to these shocks (e.g., Eurodeposits). Broadly speaking, financial innovation is the act of creating and then popularizing new financial instruments as well as new financial technologies, institutions and markets. The “innovations” are sometimes divided into product or process innovation, with product innovations exemplified by new derivative contracts, new corporate securities or new forms of pooled investment products, and process improvements typified by new means of distributing securities, processing transactions
or pricing transactions.In practice,even this innocuous differentiation is not clear,as process and product innovation is often linked.The processes by which one creates a new index linked to college costs or invests to produce returns that replicate this index are hard to separate from a new indexed investment product that tries to help parents save to pay for their children's education. Innovation includes the acts of invention(the ongoing research and development function)and diffusion(or adoption)of new products,services or ideas.+Invention is probably an overly generous term,in that most innovations are evolutionary adaptations of prior products.The lexicographer's addition of the phrase"as if'to the definition of innovation reflects one difficulty in any study of this phenomenon-almost nothing is completely "new"and the degree of newness or novelty is inherently subjective.'(Patent examiners charged with judging the novelty of inventions face this challenge routinely.) One sub-branch of the literature on financial innovation has created lists or taxonomies of innovations.Given the breadth of possible innovations,this work tends to specialize in particular areas,such as securities innovations.For example,Finnerty (1988,1992,2001)has created a list of over 60 securities innovations,organized by broad type of instrument(debt,preferred stock,convertible securities,and common equities)and by the function served (reallocating risk,increasing liquidity,reducing agency costs,reducing transactions costs,reducing taxes or circumventing regulatory constraints.)One investment bank published a guide to innovative international debt securities in the mid-1980s.This 64-page booklet did not describe individual innovations, 3 Webster's Ninth New Collegiate Dictionary (1988). 4 See Rogers(1983)for a discussion of the adoption of innovations. 5
5 or pricing transactions. In practice, even this innocuous differentiation is not clear, as process and product innovation is often linked. The processes by which one creates a new index linked to college costs or invests to produce returns that replicate this index are hard to separate from a new indexed investment product that tries to help parents save to pay for their children’s education. Innovation includes the acts of invention (the ongoing research and development function) and diffusion (or adoption) of new products, services or ideas.4 Invention is probably an overly generous term, in that most innovations are evolutionary adaptations of prior products. The lexicographer’s addition of the phrase “as if” to the definition of innovation reflects one difficulty in any study of this phenomenon—almost nothing is completely “new” and the degree of newness or novelty is inherently subjective.5 (Patent examiners charged with judging the novelty of inventions face this challenge routinely.) One sub-branch of the literature on financial innovation has created lists or taxonomies of innovations. Given the breadth of possible innovations, this work tends to specialize in particular areas, such as securities innovations. For example, Finnerty (1988, 1992, 2001) has created a list of over 60 securities innovations, organized by broad type of instrument (debt, preferred stock, convertible securities, and common equities) and by the function served (reallocating risk, increasing liquidity, reducing agency costs, reducing transactions costs, reducing taxes or circumventing regulatory constraints.) One investment bank published a guide to innovative international debt securities in the mid-1980s. This 64-page booklet did not describe individual innovations, 3 Webster’s Ninth New Collegiate Dictionary (1988). 4 See Rogers (1983) for a discussion of the adoption of innovations