Financial Innovation (a survey study) Author: Peter Tufano Sylvan C. Coleman professor at HBS.
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Transcript of Financial Innovation (a survey study) Author: Peter Tufano Sylvan C. Coleman professor at HBS.
Outlines
• This paper provide a survey which covers a wide range of fields:– General equilibrium analysis– Legal and policy– Industrial organization– Clinical studies of individual innovations– Empirical studies of innovations process
Refer to Page 3
Outlines
• Discussions: – Taxonomy of financial innovations:
classification by functionalities is probably the best way
– Reasons for financial innovations– Identity of innovators– Private and social implications of these
innovations– New means of protecting the intellectual
property
Refer to Page 3
Agenda
• Definition of Innovation
• History of Innovation
• Functions of financial innovations
• Tufano’s Taxonomy
• Identities and Returns to innovators
• The Impact of innovations to social welfare
• Future Studies
• To complete the incomplete markets
• To address agency concerns and info. asymmetries
• To minimize transaction cost• Response to taxes or regulations• Response to globalization and risk• Stimulated by technological shocks
Definition of Innovation
• Example of innovations: Derivatives, risk transfer products, ETFs, tax-deductible equity
• Innovate: to introduce as or as if new• Innovation= Invention (R&D)
+ diffusion (adoption)• Classification by the targets of innovations
– Products, e.g. derivatives, structured notes– Process, e.g. pricing mechanism or platform, setting n
ew means of distributing securities,…
Refer to Page 4,5
History of Innovation
• 1694 innovative product: Million Adventure (bond plus a lottery ticket, Allen and Gale, 1994)
• 258 innovative securities on 17 pages (Graham and Dodd ,1934)– financial innovation is an on going evolutionary proces
s.
• 1836 new security codes from 1980 to 2001 (financial database, done by Tufano)– a normal pattern: when a security is created, later it m
ay be modified slightly by competitors.
Refer to Page 6,7
Taxonomy of financial innovations
• Merton, 19921. Moving funds across times
and space
2. Pooling of funds
3. Managing risk
4. Extracting information to support decision making (VIX index)
5. Addressing moral hazard and info. asymmetry
6. Facilitating sale and purchase of goods
• Finnerty, 19921. Reallocating risk
2. Reducing agency cost
3. Increasing liquidity
• BIS, 19861. Transferring risk
2. Enhancing liquidity
3. Supporting credit
Refer to Page 9,10
Taxonomy of financial innovations
• The drawbacks of these taxonomy– Even a simple innovation is likely to address
multiple functions ≡ these functional dimensions lack discriminating ability
– E.g. using Merton’s scheme, an asset securitization invokes 3 functions: pooling the promise + reducing risk + increasing liquidity (moving funds)
Refer to Page 10
6 functions of financial innovations
1. To complete the incomplete markets
2. To address agency concerns and info. asymmetries
3. To minimize transaction cost
4. Response to taxes or regulations
5. Response to globalization and risk
6. Stimulated by technological shocks
1. to complete the incomplete markets (1/2)
• Duffie and Rahi (1995) – – Review the relationship between market inco
mpleteness and innovations– They suggest that hedging function of innovati
ons exists.
Refer to Page 10
1. to complete the incomplete markets (2/2)
– Black (1986)• Exchange-traded contracts• Viability (trading volume) vs. completeness (correlati
on with some risks)
– Grinblatt and Longstaff (2000)• STRIPS (zero-coupon bonds)• Primary Incentive is to complete the market
– Allen and Gale(1988)• In a short sale restricted market• It may be optimal for firms to provide multiple classes
claims generating values from different investor preferences and needs
Refer to Page 11
2. To address agency concerns and information asymmetries (1/2)
• Design contract from the principal-agent theory– Harris and Raviv(1989)– Allen and Gale(1994) (book)
• Theoretical proposition on more derivative beyond stocks and bonds– Haugen and Senbett (1981): embedded options– Lerner and Tufano (1993) and Berger and Magliolo(1
995): R&D financing vehicles reduce interest conflicts
Refer to Page 12
2. To address agency concerns and information asymmetries (2/2)
• Ross(1989)– Agency problem →borrowing cost increases– Agency considerations interact with marketing
costs to produce innovations
• Dewing(1919, 1934)– 19 century, using innovations to squeeze
information from firms– e.g. assemble stock (pg13), covenant term
(pg14), income bond (pg14)
Refer to Page 13,14
3. To minimize transaction, search, or marketing cost
• Merton(1989)– Equity swap is efficient to multinational in
vestors
• McConnell and Schwartz(1992)– Merrill Lynch’s LYONs no cost for rolling o
ver their notes
• Ross(1989), Madan and Soubra(1991)– Techs reduce cost. e.g. ATM, smart card,
ACH, e-401k– Web e.g. Instinet, Open-IPO, Ebay (pg15)– Reduced cost stimulates innovations
Refer to Page 14~16
4. response to taxes or regulations
• Miller(1986): “The major impulses to successful innovations over the past 20 years have come, I am saddened to have to say, from regulation and taxes.” – e.g. zero coupon bonds or Eurodollar
Eurobonds → not to trigger immediate capital gains
• Tufano(1997b),Santngelo andTufano(1997)Equity-linked structures → delay paying capital
gain taxesRefer to Page 16,17
5. response to globalization and risk
• Globalization →exchange rate, interest rate, political risk →Interamerican Development Bank →innovations embed currency convertibility
• Mason, Merton, Perold and Tufano(1995)– Risk from deregulation of gas → volumetric production pa
yment contracts
• Masson and Stratton(1938)– Risk from inflation (1830 - 1930) → currency choice bond
s
• Cleverland(1920)– legal tender = {gold, silver, currency}
Refer to Page 20,21
6. Stimulated by technological shocks (1/2)
• A “supply-side” explanation for the timing of innovations.
• e.g. folioFN, OpenIPO
• White(2000): technological view of financial innovations
Refer to Page 15,22
6. Stimulated by technological shocks (2/2)
• Tech of pricing mechanism– B&S,Merton → hedging contracts
• Techs of information and internet support...– Risk management systems– On line retirement planning– Real option
Refer to Page 15,22
A case study: no “one” explanation works
• Innovations in 1970s– “Market” funds (i.e. index fund, e.g. Equally-
weighted S&P 500 fund, Value-weighted fund)– Complete market + reduce traction cost+
stimulated by tech ←no single one explanation can explain the development of index fund.
Refer to Page 23
Tufano’s Cases
• Innovations in 1990s– ETFs, TIPs, SPDRs, HOLDERs– Above are “index funds” but provide more attracti
ons • Reducing transaction cost• Tax-deductible (or tax timing advantage)
• Innovations in 2000s– folioFN: Web based Personal funds
• Small denomination• Tax-timing advantage
Refer to Page 24~26
Identities and Returns to innovators
– Ross(1988) • Investment banks max profit by bundling securities
– Boot and Thakor(1997)-pg27• Lower innovations in a “universal banking system”• Greater competition leads to increased innovation
– Silber(1983) - pg28• Constrained (small, weak) firms would be more
likely to innovate because they benefit more from innovations
• This can not be observed in empirical studies
Refer to Page 27,28
Identities and Returns to innovators
– Tufano(1989)• Underwriting spreads of the 1st innovator were not
higher
– Carrow(1999)• As rivals increase, the spreads decrease• Underwriting spreads of the 1st should be higher
• Other benefits– Profit from enhanced reputation by innovation– Increasing the quality of staffs (personal
involvement, career progression…)Refer to Page 27
Identities and Returns to innovators
• Empirical Thesis– Tufano(1989)
• Larger investment banks → more innovations
– Matthews(1994)(book)• Self-reinforcing cycle
– Small institution has higher willing (larger gradient for its utilization). However, small institution has smaller feasible region for innovative products to span.
innovationinnovation
Size↑ Size↑
Mathhhew,1994
Refer to Page 29
Identities and Returns to innovators
• Innovations of diffusion (adoption)– Which organizations adopt innovations and ho
w quickly they do so?– Hannan and McDowell (1987), ATM– Saloner and Shepherd (1995), ATM– Akhavein, Frame and White(2001), Credit scoring– Lerner (2002), patterns– Molyneux and Shamroukh(1996), Obay (2000), off-balance– Molyneux and Shamroukh(1999), junk bond
• Larger firms have innovated more rapidly
Refer to Page 30
Identities and Returns to innovators
• Although innovations usually bring benefits to issuers (Geanuracos and Millar, 1991),
• investors may endured slightly increasing benefit while bearing much higher risk (Tufano, 1996)
Refer to Page 30,31
Identities and Returns to innovators
• wealth impact of innovations: some Innovations were used to take advantages of investors: – Nanda (1996), poison put in CB – Rogalski and Seward (1991), currency warran
ts– Jarrow and O’Hara (1989), Primes and Score
s
Refer to Page 31
The Impact of innovations to social welfare
• Positive opinions– Merton (1992)– Shilling (1989)– Sirmans and Benjamin
(1990)– Jameson, Dewan and
Sirmans (1992)
• Negative opinions– Terence (1995)– Peter (2000)– Innovations increase
volatility
Refer to Page 32,33
We cannot directly measure whole social welfare, thus…
• Innovations in mortgage loan lead to lower mortgage rate charged to borrowers
• Innovation leads to complexity that in turn leads to bad business decisions and social costs (e.g. misuse of derivatives)
• Specific innovations contribute to high market volatility
• The completeness of the market may make all agents worse off! See Elul (1995)
Refer to Page 34
How to protect intellectual property?
• Keep secrecy– Product secrecy is impossible to hold– Process secrecy is possible
• Patent– However, US Pattern office’s point of view :
• Financial innovation is “business process” which is hard to patent
• opportunity– 1998, Signature Financial sued State Street Bank on
Federal Circuit Court– Will patenting encourage or discourage innovations?
Refer to Page 36