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8/8/2019 Financial InnovTION Nnd Risk Management
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Financial Innovation
(a survey study)
Author: Peter Tufano
Sylvan C. Coleman
professor at HBS
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Outlines
This paper provide a survey which covers
a wide range of fields:
±G
eneral equilibrium analysis ± Legal and policy
± Industrial organization
± Clinical studies of individual innovations
± Empirical studies of innovations process
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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 theseinnovations
± New means of protecting the intellectualproperty
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Agenda
Definition of Innovation
History of Innovation
Functions of financial innovations Tufano¶s Taxonomy
Identities and Returns to innovators
The Impact of innovations to socialwelfare
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
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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
new means of distributing securities,«
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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
process.
1836 new security codes from 1980 to 2001
(financial database, done by Tufano)
± a normal pattern: when a security is created, later it
may be modified slightly by competitors.
Refer to Page 6,7
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Taxonomy of financial innovations
Merton, 1992
1. 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
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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)
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6 functions of financial
innovations1. To complete the incomplete markets
2. To address agency concerns and info.
asymmetries3. To minimize transaction cost
4. Response to taxes or regulations
5. Response to globalization and risk6. Stimulated by technological shocks
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1. to complete the incomplete markets
(1/2)
Duffie and Rahi (1995) ±
± Review the relationship between market
incompleteness and innovations
± They suggest that hedging function of
innovations exists.
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1. to complete the incomplete markets
(2/2)
± Black (1986) Exchange-traded contracts
Viability (trading volume) vs. completeness
(correlation 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 multipleclasses claims generating values from differentinvestor preferences and needs
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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 andMagliolo(1995): R&D financing vehicles reduce
interest conflicts
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2. To address agency concerns and
information asymmetries (2/2)
Ross(1989)
± Agency problem borrowing cost increases
± Agency considerations interact with marketingcosts to produce innovations
Dewing(1919, 1934)
± 19 century, using innovations to squeezeinformation from firms
± e.g. assemble stock (pg13), covenant term(pg14), income bond (pg14)
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3. To minimize transaction, search, or
marketing cost
Merton(1989) ± Equity swap is efficient to
multinational investors
McConnell and Schwartz(1992) ± Merrill Lynch¶s LYONs no cost for
rolling over their notes
Ross(1989), Madan and
Soubra(1991) ± Techs reduce cost. e.g. ATM, smartcard, ACH, e-401k
± Web e.g. Instinet, Open-IPO, Ebay(pg15)
± Reduced cost stimulates innovations Refer to Page 14~16
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4. response to taxes or regulations
Miller(1986): ³The 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 taxes
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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 payment contracts
Masson and Stratton(1938)
± Risk from inflation (1830 - 1930) currency choice
bonds
Cleverland(1920)
± legal tender = {gold, silver, currency} Refer to Page 20,21
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6. Stimulated by technological shocks
(1/2)
A ³supply-side´ explanation for the timing
of innovations.
e.g. folioFN
,O
penIPO
White(2000): technological view of
financial innovations
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6. Stimulated by technological shocks
(2/2)
Tech of pricing mechanism
± B&SMerton hedging contracts
Techs of information and internet support...
± Risk management systems
± On line retirement planning
± Real option
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A case study: no ³one´
explanation works
Innovations in 1970s
± ³Market´ 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.
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Tufano¶s Cases
Innovations in 1990s
± ETFs, TIPs, SPDRs, HOLDERs
± Above are ³index funds´ but provide moreattractions
Reducing transaction cost
Tax-deductible (or tax timing advantage)
Innovations in 2000s ± folioFN: Web based Personal funds
Small denomination
Tax-timing advantageRefer to Page 24~26
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Identities and Returns to innovators
± Ross(1988)
Investment banks max profit by bundling securities
± Boot and Thakor(1997)-pg27
Lower innovations in a ³universal banking system´
Greater competition leads to increased innovation
± Silber(1983) - pg28
Constrained (small, weak) firms would be morelikely to innovate because they benefit more from
innovations
This can not be observed in empirical studies
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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
O
ther benefits ± Profit from enhanced reputation by innovation
± Increasing the quality of staffs (personal
involvement, career progression«)
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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, smallinstitution has smaller feasible region for
innovative products to span.
innovation
SizeMathhhew,1994
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Identities and Returns to innovators
Innovations of diffusion (adoption)
± Which organizations adopt innovations and
how 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
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Identities and Returns to innovators
Although innovations usually bring benefits
to issuers (Geanuracos and Millar, 1991),
investors may endured slightly increasingbenefit while bearing much higher risk
(Tufano, 1996)
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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
warrants
± Jarrow and O¶Hara (1989), Primes andScores
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The Impact of innovations to
social welfare
Positive opinions
± Merton (1992)
± Shilling (1989)
± Sirmans andBenjamin(1990)
± Jameson, Dewan and
Sirmans (1992)
Negative opinions
± Terence (1995)
± Peter (2000)
± Innovations increasevolatility
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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)
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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 ³business process´ which is hard topatent
opportunity ± 1998, Signature Financial sued State Street Bank on
Federal Circuit Court
± Will patenting encourage or discourage innovations?
Refer to Page 36