Financial Innovation and Financial Fragility

Financial Innovation and Financial FragilityAuthor(s): Michael CarterSource: Journal of Economic Issues, Vol. 23, No. 3 (Sep., 1989), pp. 779-793Published by: Association for Evolutionary EconomicsStable URL: http://www.jstor.org/stable/4226172 .

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J JOURNAL OF ECONOMIC ISSUES Vol. XXIII No. 3 September 1989

Financial Innovation and Financial Fragility

Michael Carter

The extent of structural change and product innovation in financial markets during the past twenty years has been striking. Regulatory and technological barriers inhibiting banking competition across state and national boundaries and between different types of financial intermediaries have tumbled, while new financial instruments and usages have proliferated. Moreover the pace of innovation has accelerated since 1980. Innovations of the 1970s such as currency futures, mortgage- backed securities and floating rate notes have gained much wider market acceptance in the last decade. Entirely new markets in financial options, currency and interest-rate swaps, zero coupon bonds and junk bonds have emerged since 1980 and already play a major role in portfolio management and in government and corporate finance.'

Hyman Minsky alludes to this rapid institutional change in his recent treatise on financial instability, Stabilizing an Unstable Economy and notes the absence of any coherent analysis of its effects on the stability of the financial structure. "In recent years we have seen many institutional changes in banking and finance. These changes have been per- mitted even though the authorities have no theory enabling them to determine whether the changes taking place in financial practises tend to increase or decrease the overall stability of the financial system."2 Minsky himself has no doubt that the overall impact of financial inno-

The author is Assistant Professor of Economics, University of Lowell, Lowell, Massa- chusetts.

779



780 Michael Carter

vation is to promote greater fragility in the financial structure. "The introduction of additional layering in finance together with the inven- tion of new instruments designed to make credit available by tapping pools of liquidity is evidence, beyond that revealed by the financial data itself, of the increased fragility of the system."3

This bold and, ultimately, insightful statement flows quite naturally from Minsky's analysis of the endogenous movement towards speculative and Ponzi financing arrangements during business cycle upturns. However, his examples of financial innovations that led to fragile markets that collapsed and required Federal Reserve lender-of-last-resort intervention both date from the early 1970s, (the panic in the commercial paper market following the default of Penn-Central in 1970 and the failure of many Real Estate Investment Trusts in 1974).4 In later arti- cles there are elliptic references to more recent developments: "Take- overs are a technique by which indebtedness adjusts to the erosion of felt risk."'5 Yet Minsky does not supply any comprehensive analysis of the more recent financial innovations. Many of these more recent innovations such as financial futures and options facilitate hedging of interest rate risk, while others such as the development of Eurobond and currency swaps markets or various off-balance sheet commercial bank financing techniques would seem to increase the elasticity of finance even in the presence of reserve restraint by the monetary authorities. Since crucial elements in Minsky's theory of endogenous financial instability depend on the deleterious effects of sharply rising interest rates in the later stages of investment booms, recent financial innovation might at first blush seem to reduce systemic instability.

In the remainder of this article we will extend Minsky's work on financial instability through a review of the major institutional innovations in financial instruments and processes of the last decade. We con- clude that these innovations inevitably lead to the evolution of more fragile financial structures even though they afford individual financing units a wider range of financing options, enhanced liquidity of assets, and insulation from interest rate risk. Indeed, it is precisely the ability of individual financing units to use recent financial innovations to increase liquidity and diversity in their portfolios that-paticularly in the context of heightened competition among financial intermediaries- collectively encourages the absorption over time of a higher proportion of risky assets into portfolios. Similarly, it is precisely the ability of individual financing units to insulate themselves from scattered defaults and to circumvent attempts at credit restriction by the Federal Reserve, that in the end generates a volume of speculative finance and a degree



Financial Innovation and Financial Fragility 781

of credit restriction that threatens wholesale defaults, debt deflation and financial panic.

We first briefly review Minsky's theory of endogenous financial instability. We then consider the rationales for financial innovation com- monly cited by othodox financial theorists and relate these to Minsky's discussion of financial innovation. The orthodox view suggests that much financial innovation either helps firms reduce the exposure of their portfolios to unforeseen interest and exchange rate changes or helps them avoid taxes and regulatory restraints on their behavior. While the consequences for the stability of the financial system as a whole are seldom considered, the presumption is that problems of financial instability if not obviated are at least mitigated by financial innovation. Finally, we outline an alternative view of financial innovation that emphasizes its roots in technological change and its effects in intensifying competition among financial intermediaries. This vision of the process suggests that none of the circumstances cited by Minsky as critical in generating a fragile financial system are removed by changes in financial instruments and usages. Instead, pressures towards the evolution of more fragile financial structures are only enhanced. Fi- nancial innovation disguises the growth of financial fragility and aids in the localization and containment of financial disturbances but in the end this only encourages an ever-greater tilt towards speculative financing based on unrealistic expectations of future income flows and asset prices.

Minsky on Financial Instability

Minsky's theory of endogenous financial instability has been sum- marized elsewhere in recent years, but it will be convenient to retrace that ground here, pausing to elucidate those elements of the theory most pertinent to our subsequent analysis.6 Minsky asserts that economic expansions generate a self-reinforcing feedback loop in which higher levels of investment generate higher levels of profitability, which generate higher expected profits and, thus, higher market prices for capital assets. But these developments in turn increase both lender and borrower confidence and stimulate yet more investment. Investment must be financed, and during the course of the boom Minsky argues that an increasing proportion of financing will be short term as firms grow more confident of their ability to roll over debt as necessary for refinancing and seek to take advantage of the typically lower yields on short-term debt instruments. That is, an increasing proportion of



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finance is either what Minsky refers to as "speculative" or "Ponzi" finance. In speculative financing, firms face debt service payments in some near-term periods that exceed their expected income flows in those periods. In Ponzi financing, income flows are not sufficient even to cover interest on outstanding debt so that refinancing necessarily en- tails an increase in indebtedness. The proliferation of speculative and Ponzi financing arrangements generates a fragile financial structure in which any sharp rise in interest rates will generate present value rever- sals, impairing the ability of firms to refinance investment projects in process and their willingness to undertake new investment. Invest- ment, profits and confidence all fall as defaults rise. In a worst case sce- nario, with no lender of last resort intervention to increase liquidity and restore faith in the ability of financial institutions to honor com- mitments, bank runs and panic sales of assets bring on full-blown debt deflation.

Notice that the volatility in this boom-bust cycle depends critically on the assumption that for quite some time during the upswing lenders (and borrowers too) systematically underestimate the increase in risk as borrowers' leverage rises and as near-term debt payments balloon in relation to near-term expected income flows. Minsky writes:

Since we live in a world of uncertainty and current views about the future affect capital asset prices, the governor mechanism by way of financing terms is often dominated by positive, disequilibrating feedbacks. An increase in the demand prices for capital assets relative to the supply prices of investment output increases investment, which increases not only profits but also the ... amount of financing avilable from banks and financial markets at any set of terms, and businessmen's willingness to invest.7

If lenders smoothly raised their lending rates to compensate for increased risk because of higher corporate leverage and lower balance sheet liquidity, and if borrowers smoothly raised the risk premia they added on to borrowing rates when discounting expected flows from highly leveraged investments, then the growth of investment and speculative credit arrangements would be slowed. Abrupt tightening of credit with consequent sharp increases in interest rates would be less likely. Central banking authorities would not be faced with explosive money or credit growth and hence would have no need for precipitate credit tightening. Financial intermediaries would have no reason to re- vise their risk premia suddenly upward and drastically tighten credit on their own.

We take special note of Minsky's assumption that in the presence of uncertainty, "positive disequilibrating feedbacks" (rather than "ra-




tional expectations") dominate investment and lending decisions because many of the changes in financial structures and many of the associated innovations in financial instruments of the last decade increase both the pressures on and the opportunities for banks to assume risk in financing decisions, thereby exacerbating tendencies towards disequilibrating feedback. This is the major point insufficiently appre- ciated in conventional analysis of recent financial innovation, to a summary of which we now turn.

Conventional Interpretations of Financial Innovation

Standard interpretations of the financial innovation of the 1980s emphasize its roots in the desire to evade taxes and regulations that limited the responsiveness of banks to the high and volatile interest rates emerging in the 1 970s. For example, Merton Miller writes, "The major impulses to successful financial innovation over the past twenty years have come, I am saddened to have to say, from regulations and taxes."8 Taxes and regulations have always been with us, so the timing of the innovative surge is explained by the increased volatility of exchange rates and interest rates in the 1970s. These developments increased the demand for hedging services and make existing restrictions on domestic bank asset and liability management more cumbrous. The authors of a recent IMF paper note:

Developments in macroeconomic policies and in the world economic environment during the 1970s and early 1980s have strongly influenced the structure of financial markets. In particular, high and variable rates of in- flation and sharply fluctuating interest rates contributed to the development of floating rate instruments.9

Similarly Julian Walmsley observes:

Risk transferring innovations are new instruments or techniques that allow investors or traders to transfer the price or credit risks in financial positions .... They include interest-rate and foreign-exchange futures and options, currency and interest rate swaps, and a host of other futures and options contracts enabling the hedging of various price risks. Probably the two biggest factors in developing these markets were the breakdown of fixed exchange rates, and the emergence of floating currencies in the mid- 1 970s, coupled with the adoption by the Federal Reserve of its New Economic Policy in October 1979, which led to unprecedented instability of interest rates.'0

Several accounts note in passing that advances in computer technologies were a necessary prerequisite to pricing some of the more com-



784 Michael Carter

plex new financial instruments and to implementation of complicated cross-border arbitrage strategies that integrate financial markets around the world."I Likewise, increasing competition among financial intermediaries because of deregulation and integration of world financial markets is cited as a spur to innovation of new instruments and financing practices. For example, the surge in off-balance sheet financing is attributed to attempts by banks to maintain return on equity in the face of competitive pressures on interest rate spreads and regulatory pressures for higher capital/asset ratios.'2

The wider implications of these latter points have not been developed in standard interpretations of financial innovation, although authors with experience in financial institutions have noted that recent developments increase the difficulty of assessing credit risks both in individual institutions and in financial markets as a whole. Julian Walmsley, who has experience as a trader himself, writes: "In the past risk was limited by cutting down positions. Now, the positions are held but hedged with derivative instruments .., large basis risk positions can build up unnoticed."'3 The authors of a recent IMF study on developments in international capital markets fear that:

New instruments are affecting credit appraisal by complicating the analysis of balance sheets. Insofar as an institution's position in swaps and financial futures is not disclosed, it may be very difficult to gauge accu- rately the degree of risk to which the institution is actually exposed ... Moreover, as risks are unbundled and repackaged, the adequacy of risk management systems-and the division of credit assessment between different parties-may be a source of difficulty.'4

Despite these insights, even these authors ultimately embrace the view that recent financial innovation is first and foremost a response to inefficiencies or gaps in the financial intermediation process. As such it has necessarily strengthened financial intermediation processes and rendered them more efficient. Investors now have a wider choice of instruments to accomodate their preferences for risk or duration of lending while borrowers have access to more funding sources. Oppor- tunities to structure loans so that the timing or currency of anticipated income flows matches that of interest and principal repayments have been increased by the evolution of interest and currency swaps. Alter- natively, firms may now hedge exposure to interest rate risk and currency risk through financial options and futures markets. Moreover, previously illiquid assets such as mortgages and automobile receivables have been packaged into securities traded in secondary markets, thus




allowing for shifting and diversification of formerly concentrated credit risks. In short, the standard view is that:

On balance, however, the innovations have been almost certainly bene- ficial for the system as a whole. The different types of risks involved in the various instruments have been unbundled. This should increase the efficiency of the financial system, since each element of a deal can be provided-and the associated risk taken-by the financial entity which can do so most efficiently. The increase in the number of separate risks should not, in itself, increase the total risk for the system as a whole."5

This benign view of recent financial innovation suggests that Min- sky's fears of increasing systemic financial fragility are misplaced. Never before have financial markets provided lenders and borrowers alike so many opportunities to hedge their portfolios against sudden increases in interest rates. Never before have lenders had more opportunities to insulate their portfolios from bankruptcies in individual firms, industries, or geographic regions through diversification and securitization of their loans. Given the assumption that the "total risk for the system as a whole" is not increased, and given an implicit belief that competition among financial institutions will weed out the impru- dent or incompetent, the conclusion seems inescapable that increased opportunities for prudential risk management will result in greater re- silience of the financial structure and greater stability of asset values vis-a-vis unforeseen exogenous shocks.

This benign view of recent financial innovation is also a benighted view. What is missing is sufficient appreciation of the role that developments in data base and information transfer technologies have played in exposing financial institutions to new sources of competition both in raising and in using funds.

Technological Change and Financial Innovation

Increased volatility of interest rates and exchange rates is but one aspect of the worldwide integration of capital markets that these technological developments have precipitated. A second aspect is the obso- lescence of regulations at the level of individual nations restricting the scope and form of competitive behavior among financial institutions. As profit margins in their traditional protected, regulated markets evap- orated, financial institutions have been driven to develop new services and markets, spurring in the process the wave of financial innovation we have witnessed. But they have also been driven in the same process



786 Michael Carter

to assume more risk and to generate an increasingly fragile financial structure. Some of the recent financing innovations enable institutions to hide this risk from regulators, others enable them to delude themselves (and their creditors) about the amount of risk embedded in their portfolios.

The last decade has been marked by a vast increase in financial capital flows across international boundaries. The increases have been most pronounced in short-term debt instruments and in instruments actively traded in secondary markets. The most fundamental cause of this up- surge in international capital flows has been technological development. The key developments have been electronic wire price quote services and wire transfer technologies to provide investors with timely information on price movements and ready access to their funds around the world. Absent these technological advances, illiquidity and the information advantages of local over foreign capital effectively de- ter foreign investment based on international interest rate differentials or short-term capital gains prospects.

However, once the technological prerequisites of global capital market integration are in place, nations that restrict access to their financial markets or unduly regulate the behavior of financial intermediaries within their borders lose market share in financial services to nations with fewer restrictions. For example, financial intermediaries whose ability to structure liabilities and create assets is limited only by market faith in their solvency and not by federally mandated capital adequacy ratios are able to operate with higher leverage. This permits them to offer lower interest rate spreads and provide depositors and borrowers alike more services without sacrificing return on equity. Nations that attempt to restrict particular forms of capital inflow or outflow not only handicap their own financial institutions but in the end find themselves outmaneuvered by financial innovation among money center banks anyway. The futility of policy making authorities' attempts to track- let alone restrict-international capital flows in an environment where technological barriers to capital mobility are rapidly tumbling is illustrated by the dramatic growth in the "statistical discrepancy" category of the U.S. balance-of-payments accounts. Pressures to deregulate inevitably build in such a context and most strongly from within the sphere of large domestic financial institutions themselves, which are the institutions most directly in competition with foreign financial institutions. For example, the drive to repeal restrictions on the under- writing activities of commercial banks is being led by the largest money center banks. Their argument is that, "They are now engaging in these




activities overseas without major mishaps. Moreover, they have argued that U.S. law places them at a disadvantage in competing against foreign banks that can underwrite securities in this country."'6

Minsky is correct to note that the Fed has allowed financial innovation and deregulation without any theory about its overall effects on the stability of the financial system. However, technological development and the exigencies of international competition for market share in financial services left the Fed with no real choice. Given the technological preconditions for globally integrated capital markets, any significant restrictions on the behavior of financial intermediaries must be synchronized across nations. Although there are signs of growing international awareness of this issue, such as the signing of an agreement in the summer of 1988 by all nations with money center banks to phase in a common set of capital requirements, international regulatory policy coordination remains in its infancy.

In short, the integration of capital markets on a world scale is a product of the revolution in data base technologies and is irreversible. Regulations at the level of individual nations that restrict competition among financial intermediaries no longer function to protect the market position of entrenched financial institutions. The erosion of traditional bases of profitability in heretofore protected markets is the fundamental reality underlying the drive to innovate around existing regulations, to develop new financial products, and to exploit heretofore overlooked loopholes and unevenness in tax treatment of different types of income flows.

Financial Innovation and Increased Risk Acceptance

Our emphasis in the preceding paragraphs on the increase in competitive pressures on the "supply" side of financial services markets as the initiating source of recent financial innovations, suggests that those same pressures tilt the calculus of decision-makers in many financial institutions towards absorption of greater risks in their portfolios in the pursuit of higher profits. Futures and options markets may be as readily used for highly leveraged speculation as for hedging. The "unbundling" of risks made possible through financial innovations such as loan securitization, off-balance sheet financing and swap agreements may facilitate acceptance of greatest risk not by the financial entity able to do so "most efficiently," but by financial entities most desperate to increase rate of return or with access to federally insured funds. An example of this last is the use of commercial bank standby letters of credit



788 Michael Carter

to "enhance" the negotiability and market price of debt instruments issued by nonbanks. The commercial bank in effect assumes the risk of default on the issuer's debt offering and receives a fee for this service. Its recorded assets, and, hence, its required capital, do not increase. Yet the bank's letter of credit has market value in large part because of the privileged access to loan markets conferred on it by federal deposit insurance protection. The capital adequacy requirements are part of the regulatory mechanism designed to prevent excessive risk taking with insured funds, yet their intent is circumvented here. Interest rate swaps between corporations with differential access to fixed rate bond markets arranged and guaranteed by commercial banks are a similar example of risk transfer to deposit insurance agencies.

The phenomenon of increased risk-taking by already desperate financial institutions is well illustrated by the deterioration in the qual- ity of loan portfolios in the savings and loan industry. The thrift industry initially encountered serious difficulties during the run up in interest rates in the late 1 970s and early 1 980s. After regulations restricting cap- italization requirements and diversification of asset portfolios out of long-term mortgages were dropped in 1982, many S&Ls used their new freedoms to invest in highly speculative ventures in an attempt to return to financial health. Despite all the financial innovations developed to allow hedging of interest rate risk and reduction of default risk through securitization of assets, losses mounted at thrifts because their target rate of return was too high to allow them to pay the price of hedging their portfolios adequately. Although most attention has focused on thrift failures in Texas where fraud was endemic, as of the start of 1989, despite sustained economic growth for six years in the economy, 400 thrifts from California to New York currently operate with capital (including overvalued "goodwill") of less than 3 percent of assets. Col- lectively these 400 institutions have a tangible net worth of -.2 billion dollars! 17

Apart from increasing competitive pressures on financial institutions the computerization of debt and securities markets has encouraged greater risk-taking by creating the illusion that diversification of asset holdings, combined with liquidity of individual instruments protects investment portfolios from sharp declines in value because of defaults by individual firms. Even in institutions that constrain managers of investment funds to use futures, options, and swaps markets only for the conservative ends of hedging interest rate or exchange rate risk, increasing default risk on individual assets for the sake of higher return on investment is tolerated. This belief in the efficacy of diversification and




liquidity as substitutes for analysis of default risk of individual assets is reflected most dramatically in the spectacular growth of asset securitization and of the high-yield bond market.

Asset securitization refers to the packaging of formerly illiquid assets such as mortgages and automobile finance receivables into securities that are tradeable on secondary markets. A pool of mortgages col- lateralizes the stream of payments promised by a set of securities that are structured into "tranches" that vary by duration and fixity of the payment schedule. This development facilitates the sale of loans by lending institutions that collect fees for originating and servicing the loan while freeing up capital for new lending activity.

There have been no major defaults yet in these markets. Indeed, the securities offered typically receive vary high AAA or AA credit ratings based either on Federal Home Loan Mortgage Corporation (FHLMC) or letter-of-credit guarantees of payment. On the other hand there have been no economic downturns since the development of these markets to prompt widespread defaults on the underlying mortgages col- lateralizing the market. From a structural point of view, the economic incentive for a thorough credit analysis of each and every loan by the originating institution is clearly diluted by the knowledge that that institution will only have the loan on its books for a few weeks or months. And once a loan has been packaged along with hundreds or thousands of other loans into a security such as a Real Estate Mortgage Investment Conduit (REMIC), or Collateralized Mortgage Obligation (CMO), or a certificate of Automobile Receivables (CAR), its individual character- istics, including default risk, become completely opaque. The purchaser of the security is relying entirely on guarantees by federal agencies and on the pooling of risks to maintain the flow of revenue from the securities purchased. Although in times of normal prosperity the default risk on any mortgage loan underlying a REMIC may be assumed inde- pendent of that on any other loan underlying the security, in a major recession, such an assumption would clearly be unwarranted, particu- larly if competition in the previous business cycle upswing among ag- gressive banks and S&Ls had led to systematic shading of the normal standards of prudential lending.

The cavalier attitude towards default risk that has arisen out of the combination of increased competition among financial intermediaries coupled with faith in asset liquidity and diversification is nowhere bet- ter nor more alarmingly demonstrated than in the growth of the "high yield" or, more colorfully and aptly named, "junk" bond market. This designation is applied to securities rated below investment grade by at



790 Michael Carter

least one of the major ratings agencies. While there have always been companies that have fallen on hard times and had their previously issued debt downgraded, what distinguishes the last five years is the explosive growth in debt initially issued with below investment grade rating. As late as 1982 junk bond issues accounted for less than 5 percent of all new corporate debt issues, but by 1987 the volume of new junk bonds issued had increased to fourteen times 1982 levels and accounted for 23.2 percent of all corporate debt issued. Moreover, there has been a trend towards progressively more speculative issues even within this high-yield segment of the market. In 1984, 26.4 percent of these new high-yield issues received a rating of"Ba" (ust below investment grade). By 1987 only 7.6 percent of new high yield issues merited the "Ba" rating.'8

The spectacular growth in this market has been fueled most visibly by corporate financing requirements for leveraged buyouts of outstanding corporate stock. Following such a buyout, whether by the existing or an outside management group, the corporation faces debt service charges that are large relative either to expected operating income or cash flow. Indeed, sales of some corporate assets at favorable prices are typically required to meet some of the debt obligations in- curred in the buyout process. This high leveraged situation is the reason for the speculative rating on the debt issue. Another less visible segment of the high-yield market supplies operating capital to firms too young or inadequately capitalized to merit an investment grade rating from the major ratings agencies.

Although there have already been several major defaults in this market, these have been sufficiently few and the yield differential between junk bonds and either corporate or Treasury bonds sufficiently high, that well diversified portfolios of junk would have earned higher returns than portfolios of corporate or treasury securities. 19 The historical record is highly misleading here. The market has grown up entirely in the favorable environment of a sustained business cycle expansion with rising corporate profits and asset values. Moreover, much of the debt has been structured with balloon payments that have not yet come due. Despite these favorable conditions, increasing numbers of leveraged buyout firms are considered likely default candidates as evidenced by the rise in yields on their debt to the 18-22 percent range.20 Given the already low levels of cash flow relative to debt service payments in this sector, even an initially mild recession would force a wholesale sell-off of assets and create the conditions for a classic debt-deflation. Reces- sions destroy the independence of default risks among highly leveraged




firms. Despite this danger some major U.S. banks have devoted as much as 40 percent of their domestic business lending to financing leveraged buyouts.2"

The increased willingness of financial institutions to extend loans in the face of already unprecedented levels of corporate indebtedness is reflected not just in the growth of the high-yield market, but in data comparing net interest payments and short-term corporate liabilities to corporate profits and cash flow. At the end of the last business cycle expansion, the ratio of short-term corporate liabilities to corporate profits was 3.7 in 1979 and 4.9 in 1981. (Moreoever, this was at a time when real interest rates were low and nominal interest rates were widely expected to fall. Hence, the incentives for corporations to use short- term debt financing were great.) Between 1985 and 1987, short-term liabilities averaged over seven times corporate profits.22 Similarly, corporate net interest payments rose from 24.2 percent of cash flow in the late 1970s (and that was up from 8.6 percent in 1959) to 31.5 percent of cash flow by the first quarter of 1988.23

Conclusion

The above data illustrate the rise in financial fragility during the 1 980s in Minsky's sense of the term. Debt service obligations of nonfinancial corporations have risen much more rapidly than incomes during the current expansion. Even moderate diminutions in corporate cash flow threaten massive defaults or panic sales of assets and atten- dant debt deflation. Our review of recent innovations in financial markets suggests that the recent wave of innovations is an integral part of a wider dynamic of capital market restructuring spawned by fundamental technological changes in the storage, transfer, and manipulation of financial market data. The qualitative increases in capabilities in these areas have exposed financial institutions to sources of competition never before envisioned and touched off a scramble to innovate around formerly protective legislation and to develop new markets and more finely differentiated financial products to replace lost profits. Although many of these innovations allow financial and nonfinancial corporations to hedge or diversify away from financial risks, they also allow greater scope for risk taking. The use-at least by a substantial subset of financial institutions-of recent financial innovations to increase the amount of risk they assume in pursuit of higher returns is imminent in the intensified competitive struggle unleashed by the new technologies that have enabled development of those innovations.



792 Michael Carter

The most significant of recent financial innovations in altering risk- taking behavior and attitudes are: development of financial futures and options markets, increased reliance on off-balance sheet financing, securitization of assets and-development of high-yield bond markets. The former two of these developments facilitate institutional disguise of the amount of risk embedded in portfolios and complicate analysis of credit risk by potential lenders or regulatory authorities. The latter two developments epitomize and encourage the belief by portfolio managers that liquidity and diversification can permit absorption of assets with greater credit risks into portfolios without substantial increases in the overall riskiness embedded in the portfolio. While this view has merit as long as disturbances to the expansion of profitability and asset values are small and localized, any widespread decline in profitability exposes portfolios to higher default rates and more rapid decline in asset values than if these assets had never been absorbed. In the aggregate, liquidity is an illusion. The increased speed in transferring data and selling assets, which the computer revolution has made possible, only increases the speed of collapse of asset values when selling pressure be- comes generalized. In the meantime, the success of portfolio managers and institutions who have absorbed high-risk assets into their portfolios in sustaining above average returns despite occasional localized defaults, encourages emulation and greater speculative excesses. The self-reinforcing feedbacks identified and analyzed by Minsky through which financial fragility builds operate even more strongly as a result of recent financial innovations than in the past.

Notes

1. Julian Walmseley, The New Financial Instruments, (New York: John Wi- ley & Sons, 1988), pp. 4-6.

2. Hyman Minsky, Stabilizing an Unstable Economy, (New Haven: Yale University Press, 1986), p. 45.

3. Ibid., p. 87. 4. Ibid., pp. 57-64. 5. Hyman Minsky, "Evolution of Financial Institutions," Journal of Eco-

nomic Issues 20 (June 1986): 345-54, at p. 350. 6. A concise summary of the Minsky model with references to related litera-

ture is found in: Marc Jarsulic, "Financial Instability and Income Distribution," Journal of Economic Issues 22 (June 1988): 545-52.

7. Minsky, Stabilizing an Unstable Economy, p. 228. 8. Merton Miller, "Financial Innovation: The Last Twenty Years and the

Next," Journal of Financial and Quantitative Analysis, 21 (December 1986): 460-71, at p. 460.




9. M. Watson, D. Mathieson, R. Kincaid, E. Katler, "Intemnational Capital Markets: Developments and Prospects," (International Monetary Fund, Occasional Paper No. 43, February 1986): p. 8.

10. Walmseley, New Financial Instruments, p. 7. 11. Ibid., p. 10. 12. Watson et al., "International Capital Markets," p. 8. 13. Walmseley, New Financial Instruments, p. 14. 14. Watson et al., "International Capital Markets," p. 10. 15. Ibid., p. 15. 16. Robert Guenther, "Four Banks Ask Fed for Broad Powers," Wall Street

Journal, 28 September 1988, p. A3. 17. Paulette Thomas, "Reforming Savings and Loan Industry," Wall Street

Journal, 30 January 1989, p. A16. 18. Barrie Wigmore, "Speculation and the Crash of 1987," (Goldman Sachs &

Co., unpublished manuscript, December 1988, Table 3). 19. Jane Tripp Howe. Junk Bonds: Analysis & Portfblio Strategies, (Chicago:

Probus Publishers, 1988), pp. 34-38. 20. Randall Smith, George Anders, "Leveraged Buy-outs that Appear Shaky

Are on the Increase," Wall Street Journal, 5 December 1988, p. Al. 21. Georgette Jasen, "Banks May Suffer from LBO Loans S&P Report Says,"

Wall Street Journal, 5 December 1988, p. Cl. 22. Board of Governors of the Federal Reserve System. Flow of Funds Ac-

counts: Quarterly Series, 4th Quarter 1987, 1988, pp. 10-11. 23. Henry Myers, "Goverment's Role May Soon Grow Again," Wall Street

Journal, 12 December 1988, p. Al.



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Financial Innovation and Financial Fragility

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