Financial Innovations: Unlocking Value
Tuesday, April 25, 2006 / 2:10 pm - 3:25 pm
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Moderator
Glenn Yago, Director, Capital Studies, Milken Institute

Speakers
Richard Kauffman, Chairman, Global Financing Group, Goldman, Sachs & Co.
Michael Milken, Chairman, Milken Institute; Chairman, FasterCures / The Center for Accelerating Medical Solutions
Lewis Ranieri, Founder, Hyperion Private Equity Funds; Chairman, CEO and President, Ranieri & Co. Inc.
Myron Scholes, Nobel Laureate, Economic Sciences, 1997; Chairman, Oak Hill Platinum Partners; Frank E. Buck Professor of Finance Emeritus, Stanford University Graduate School of Business

The vast majority of the wealth creation in history has come over the past 200 years. These improvements have resulted, said moderator Glenn Yago of the Milken Institute, from technological innovations and financial innovations that have allowed for more efficient deployment of capital, and they have given nations, companies and individuals the ability to manage risk. With these thoughts in mind, a distinguished panel of financial innovators shared their ideas regarding the financial innovations that would unlock more value and generate further growth in the global economy.

Myron Scholes, a Nobel laureate known for his work in valuing options, began the panel by noting that many financial innovations result from major economic shocks. This idea drew widespread agreement from the panelists, who noted that one recent shock, Hurricane Katrina, has demonstrated the need for many new types of financial products.

One area of development, said Lewis Ranieri, is for private insurance for catastrophic events like hurricanes. As private insurers debated whether hurricane or flood insurance should cover Katrina's damages, and government agencies responded slowly, many small and medium-sized businesses collapsed because they did not receive the bridge financing required to survive. Financial innovations like the securitization of tax credits for low-income housing development could further improve the pace of the rebuilding effort, noted Yago.

Another source of financial innovation is regulatory change. Richard Kauffman of Goldman, Sachs & Co. shared that the first Basel Accord, which provided a regulatory framework for bank reserves, had the unanticipated consequence of widespread securitization. The second Basel Accord, if passed, would allow banks to allocate capital according to internal risk models rather than external rules, and has the promise of spurring further innovations to mitigate risk and manage a portfolio of assets. Building on these comments, Ranieri noted that the second Basel Accord has been stalled for nine years because of concerns over the widespread innovation and change it may unleash.

Many of the most celebrated financial innovations have been in the area of risk management and hedging, and corporate activities to manage financial risk were a source of much discussion. Panelist Michael Milken shared his concern that many industrial operating companies, like General Motors, have largely become financial companies with their vast financing activities and pension plans.

"We need to move industrial operating companies back to operating companies," Milken said, by unloading their financial businesses to companies better suited to managing the risks of these portfolios. One important innovation to improve the management of pension plans and other financial portfolios, noted Kauffman, is a liability management industry. Asset managers are evaluated according to equity market performance, but pension and other liabilities may not be tied to the same indicators as the assets that support them. In the discussion of corporate risk management and hedging activities, the panelists also expressed concern that the market may not be rewarding companies for hedging their risks, even though such actions may increase the return on invested capital. Kauffman noted that hedge funds, which focus on the return on invested capital, may be changing this market dynamic and rewarding risk-reduction activities. As Scholes and others responded positively to the question of corporate hedging activities, Milken cautioned that hedging activities were not worthwhile unless corporate managers were qualified to understand and evaluate their risks.

Myron Scholes also noted that financial innovation would be supported and encouraged by a better corporate accounting system. The current GAAP accounting system, he said, "makes no economic sense" because it does not reflect the innovations that have taken place. Pension plans and hedging activities are not accounted for on corporate balance sheets. By keeping these off the balance sheets, their perceived importance is diminished. Such an antiquated system, says Milken, encourages rash decisions by managers with little understanding of their risk.

From new accounting systems to new insurance products, the financial innovations session was filled with exciting ideas. These new ideas have the potential to unlock and create value, just as option markets, high-yield debt and the securitization of mortgages created value and generated economic growth over the past 30 years.