Summary:“Financial innovations aren’t easy,” stated Milken Institute Chairman Michael Milken, but persistence in designing, patenting, and securitizing these instruments could offer substantial benefits to society by increasing the number of risks that can be insured against. Financial innovations help realize gains in two key areas: first, by lowering costs and volatility; and second, by finding new solutions to meet the changing needs of the world. Great opportunities lie ahead in the evolution of financial instruments because the process of evolution has only just begun.
Milken identified investment in education and human capital as a huge and important opportunity for future financial innovations. Current financing looks at the balance sheet and requires an understanding of credit, but Milken argues that this leads to “financing the past – not the future.” He said balance sheets are “wrong” because they don’t account for largest and most important asset: human capital. Milken wants to see new financing for learning and human capital to provide encouragement for further education. Simply issuing credit cards to college students is not enough.
New financial innovations can also be used to solve environmental problems. Richard Sandor, CEO of the Chicago Climate Exchange, said, “We need to find market-based incentives to take care of the world.”
Carbon trading permits are an example of financial instruments that have been shown to work. Anybody who reduces carbon emissions could sell the unused permit to someone else. As long as the marginal cost of reduction is less than the permit price, emissions reductions serve as a potential source of profits. This case proves that financial innovations can solve environmental programs such as carbon emissions at lower cost than command-and-control environmental policies. To make these marketable permits effective, transaction costs must be kept low and property rights must be clearly defined. Thus, the success of any new exchange hinges largely on the security of patents for the exchange’s underlying financial instruments.
Financial innovations can alleviate social problems such as housing and insurance costs, but also face challenges. Derivatives and other new financial instruments have historically enabled sub-prime borrowers to gain access to the mortgage market so that they can afford homes. Yet current policies are making it difficult to lend to people with high credit risk because the new legislation, which effectively declares sub-prime borrowers a bad credit risk.
Lewis Ranieri, Chairman of Hyperion Partners, worried that re-regulation of innovative financial instruments will make it make it uneconomical for banks do business with the poor. Consumers with better credit will get better price on credit, and those with worse credit will get higher prices as a result of this re-regulation. Therefore, government subsidies for housing will go to those who need it least and as the re-regulation “alienates” those people who the regulations were initially supposed to protect. These sub-prime borrowers make up a huge portion of the market, so Lewis called for lenders and policies to look beyond risk and profit to include social concerns. Risk aversion should not be used as an excuse to shut sub-prime borrowers entirely out of the housing market because such inequality would be bad for society. It does not make sense to subsidize credit for the people who need it least and restrict it for those who need it most.
When financial innovations threaten companies that rely on the existing financial order, or perhaps the financial system itself, the ensuing regulation can potentially hinder the development of these new financial innovations. One case is the criticism of derivatives. Sandor argued that this criticism of derivatives has been undue: they have been effective tool in allocating risk cost-effectively to help make the most recent recession mild and brief. Yet insurance companies feel threatened by derivatives because they can allocate risk more cost-effectively. Perhaps, Warren Buffet’s stake in one of the largest insurance companies explains why he called derivatives “time bombs.”
Ranieri disagreed claiming that highly engineered financial instruments are the “nuclear waste” of the financial industry. He pointed out that many of these financial innovations are extremely new to the market and have not yet been tested under periods of serious cyclical distress. The economy will have to wait and see whether the current visible benefits of these instruments outweigh the potential future costs.
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