Financial Innovation Peter Tufano* Revised:June 16,2002 Peter Tufano Sylvan C.Coleman Professor of Financial Management Harvard Business School Soldiers Field Boston,Massachusetts 02163 ptufano@hbs.edu Abstract:This essay surveys the literature on financial innovation from a wide variety of disciplines:financial economics,history,law,and industrial organization.I define financial innovation,discuss problems with creating taxonomies of financial innovation, and outline the explanations given for the extensive amount of financial innovation we observe both today and in history.I also review work that studies the identity of innovators,the process of diffusion of innovation,the private benefits of innovation and the social welfare implications of innovation. This paper is to appear as a chapter in The Handbook of the Economics of Finance (North Holland),edited by George Constantinides,Milt Harris and Rene Stulz.I would like to thank Rene Stulz,Josh Lerner and Belen Villalonga for their very helpful comments,and Scott Sinawi for his able research assistance.This work was funded by the Division of Research of the Harvard Business School
1 Financial Innovation Peter Tufano* Revised: June 16, 2002 Peter Tufano Sylvan C. Coleman Professor of Financial Management Harvard Business School Soldiers Field Boston, Massachusetts 02163 ptufano@hbs.edu Abstract: This essay surveys the literature on financial innovation from a wide variety of disciplines: financial economics, history, law, and industrial organization. I define financial innovation, discuss problems with creating taxonomies of financial innovation, and outline the explanations given for the extensive amount of financial innovation we observe both today and in history. I also review work that studies the identity of innovators, the process of diffusion of innovation, the private benefits of innovation and the social welfare implications of innovation. * This paper is to appear as a chapter in The Handbook of the Economics of Finance (North Holland), edited by George Constantinides, Milt Harris and René Stulz. I would like to thank René Stulz, Josh Lerner and Belen Villalonga for their very helpful comments, and Scott Sinawi for his able research assistance. This work was funded by the Division of Research of the Harvard Business School
1.Introduction In Merton Miller's (1986)view on financial innovation,the period from the mid- 1960s to mid-1980s was a unique one in American financial history.Looking backward, he rhetorically asked,"Can any twenty-year period in recorded history have witnessed even a tenth as much(financial innovation)?"Looking forward,he asked the question, "Financial innovation:Is the great wave subsiding?"Answering"No"to the first question and"Yes"to the second,he concluded that the period was an extraordinary one in the history of financial innovation.However,with 20-20 hindsight,we can disagree with his assessment and answer the two questions somewhat differently History shows that financial innovation has been a critical and persistent part of the economic landscape over the past few centuries In the years since Miller's 1986 piece,financial markets have continued to produce a multitude of new products, including many new forms of derivatives,alternative risk transfer products,exchange traded funds,and variants of tax-deductible equity.A longer view suggests that financial innovation-like innovation elsewhere in business-is an ongoing process whereby private parties experiment to try to differentiate their products and services,responding to both sudden and gradual changes in the economy.Surely,innovation ebbs and flows with some periods exhibiting bursts of activity and others witnessing a slackening or even backlash.However,when seen from a distance,the Schumpeterian process of I For example,there have been numerous periods throughout the past centuries in which innovation flourished,failures took place,and public and regulatory sentiment led to temporary anti-innovation feelings.See Chancellor(1999).More recently,the failure of Enron has probably slowed the innovation of new forms of special purpose entities and off-balance sheet financing,although this chilling effect is unlikely to be permanent. 2
2 1. Introduction In Merton Miller’s (1986) view on financial innovation, the period from the mid- 1960s to mid-1980s was a unique one in American financial history. Looking backward, he rhetorically asked, “Can any twenty-year period in recorded history have witnessed even a tenth as much (financial innovation)?” Looking forward, he asked the question, “Financial innovation: Is the great wave subsiding?” Answering “No” to the first question and “Yes” to the second, he concluded that the period was an extraordinary one in the history of financial innovation. However, with 20-20 hindsight, we can disagree with his assessment and answer the two questions somewhat differently. History shows that financial innovation has been a critical and persistent part of the economic landscape over the past few centuries In the years since Miller’s 1986 piece, financial markets have continued to produce a multitude of new products, including many new forms of derivatives, alternative risk transfer products, exchange traded funds, and variants of tax-deductible equity. A longer view suggests that financial innovation—like innovation elsewhere in business—is an ongoing process whereby private parties experiment to try to differentiate their products and services, responding to both sudden and gradual changes in the economy. Surely, innovation ebbs and flows with some periods exhibiting bursts of activity and others witnessing a slackening or even backlash.1 However, when seen from a distance, the Schumpeterian process of 1 For example, there have been numerous periods throughout the past centuries in which innovation flourished, failures took place, and public and regulatory sentiment led to temporary anti-innovation feelings. See Chancellor (1999). More recently, the failure of Enron has probably slowed the innovation of new forms of special purpose entities and off-balance sheet financing, although this chilling effect is unlikely to be permanent
innovation-in this instance,financial innovation-is a regular ongoing part of a profit- maximizing economy. In this review piece,I summarize the existing research on financial innovation and highlight the many areas where our knowledge is still very incomplete.The existing work,while fairly modest in scope relative to others topics covered in this volume,is spread over a wide range of fields:general equilibrium analyses of the role for financial innovation;thought pieces proposing the reasons for innovation;legal and policy analyses of tax rules,regulation and innovation;studies of financial innovation in the industrial organization literature;clinical studies of individual innovations:and a handful of empirical studies of the process of innovation.2 A number of comprehensive books on the subject have been written,including Allen and Gale's(1994)comprehensive overview,and entire issues of journals have been devoted to the topic (e.g.,Journal of Economic Theory (1995,Volume 65.))The topic of financial innovation has been addressed by a number of AFA presidents,including Merton,Miller,Ross and Van Horne,some in their Presidential Addresses.My goals in this short overview are to cover the breadth of the existing literature briefly,rather than treat one sub-area in detail,and to highlight open issues that researchers may find suitable for future work. This piece is divided into five sections.The first defines financial innovation and discusses the difficulty of creating a taxonomy of financial innovations.The second section discusses the explanations advanced for financial innovation.The third section discusses the identity of innovators.The fourth section discusses the implications of 2 In addition,there are a variety of a large number of articles in the financial press as well as popular business books addressing the topic of financial innovation,typically from the perspective of how businesses can capitalize on them.For examples of popular book-length discussions of financial innovation,see Geanuracos and Millar(1991),Walmsley (1988)and Crawford and Sen(1996). 3
3 innovation—in this instance, financial innovation—is a regular ongoing part of a profitmaximizing economy. In this review piece, I summarize the existing research on financial innovation and highlight the many areas where our knowledge is still very incomplete. The existing work, while fairly modest in scope relative to others topics covered in this volume, is spread over a wide range of fields: general equilibrium analyses of the role for financial innovation; thought pieces proposing the reasons for innovation; legal and policy analyses of tax rules, regulation and innovation; studies of financial innovation in the industrial organization literature; clinical studies of individual innovations: and a handful of empirical studies of the process of innovation.2 A number of comprehensive books on the subject have been written, including Allen and Gale’s (1994) comprehensive overview, and entire issues of journals have been devoted to the topic (e.g., Journal of Economic Theory (1995, Volume 65.)) The topic of financial innovation has been addressed by a number of AFA presidents, including Merton, Miller, Ross and Van Horne, some in their Presidential Addresses. My goals in this short overview are to cover the breadth of the existing literature briefly, rather than treat one sub-area in detail, and to highlight open issues that researchers may find suitable for future work. This piece is divided into five sections. The first defines financial innovation and discusses the difficulty of creating a taxonomy of financial innovations. The second section discusses the explanations advanced for financial innovation. The third section discusses the identity of innovators. The fourth section discusses the implications of 2 In addition, there are a variety of a large number of articles in the financial press as well as popular business books addressing the topic of financial innovation, typically from the perspective of how businesses can capitalize on them. For examples of popular book-length discussions of financial innovation, see Geanuracos and Millar (1991), Walmsley (1988) and Crawford and Sen (1996)
financial innovation on private and social wealth.The final section concludes with a brief discussion of new means of protecting the intellectual property of innovators and a review of the open issues in this field. 2.What is financial innovation? Much of the theoretical and empirical work in financial economics considers a highly stylized world in which there are few types of securities(debt and equity,perhaps) and maybe a handful of simple financial institutions(banks or exchanges.)However,in reality there is a vast range of different financial products,many different types of financial institutions and a variety of processes that these institutions employ to do business.The literature on financial innovation attempts to catalog some of this variety, describe the reasons why we observe an ever-increasing diversity of practice,and assess the private and social implications of this activity. "Innovate"is defined in Webster's Collegiate Dictionary as "to introduce as or as ifnew,"3 with the root of the word deriving from the Latin word"novus"or new. Economists use the word "innovation"in an expansive fashion to describe shocks to the economy (e.g.,"monetary policy innovations")as well as the responses to these shocks (e.g.,Eurodeposits).Broadly speaking,financial innovation is the act of creating and then popularizing new financial instruments as well as new financial technologies, institutions and markets.The "innovations"are sometimes divided into product or process innovation,with product innovations exemplified by new derivative contracts, new corporate securities or new forms of pooled investment products,and process improvements typified by new means of distributing securities,processing transactions
4 financial innovation on private and social wealth. The final section concludes with a brief discussion of new means of protecting the intellectual property of innovators and a review of the open issues in this field. 2. What is financial innovation? Much of the theoretical and empirical work in financial economics considers a highly stylized world in which there are few types of securities (debt and equity, perhaps) and maybe a handful of simple financial institutions (banks or exchanges.) However, in reality there is a vast range of different financial products, many different types of financial institutions and a variety of processes that these institutions employ to do business. The literature on financial innovation attempts to catalog some of this variety, describe the reasons why we observe an ever-increasing diversity of practice, and assess the private and social implications of this activity. “Innovate” is defined in Webster’s Collegiate Dictionary as “to introduce as or as if new,”3 with the root of the word deriving from the Latin word “novus” or new. Economists use the word “innovation” in an expansive fashion to describe shocks to the economy (e.g., “monetary policy innovations”) as well as the responses to these shocks (e.g., Eurodeposits). Broadly speaking, financial innovation is the act of creating and then popularizing new financial instruments as well as new financial technologies, institutions and markets. The “innovations” are sometimes divided into product or process innovation, with product innovations exemplified by new derivative contracts, new corporate securities or new forms of pooled investment products, and process improvements typified by new means of distributing securities, processing transactions
or pricing transactions.In practice,even this innocuous differentiation is not clear,as process and product innovation is often linked.The processes by which one creates a new index linked to college costs or invests to produce returns that replicate this index are hard to separate from a new indexed investment product that tries to help parents save to pay for their children's education. Innovation includes the acts of invention(the ongoing research and development function)and diffusion(or adoption)of new products,services or ideas.+Invention is probably an overly generous term,in that most innovations are evolutionary adaptations of prior products.The lexicographer's addition of the phrase"as if'to the definition of innovation reflects one difficulty in any study of this phenomenon-almost nothing is completely "new"and the degree of newness or novelty is inherently subjective.'(Patent examiners charged with judging the novelty of inventions face this challenge routinely.) One sub-branch of the literature on financial innovation has created lists or taxonomies of innovations.Given the breadth of possible innovations,this work tends to specialize in particular areas,such as securities innovations.For example,Finnerty (1988,1992,2001)has created a list of over 60 securities innovations,organized by broad type of instrument(debt,preferred stock,convertible securities,and common equities)and by the function served (reallocating risk,increasing liquidity,reducing agency costs,reducing transactions costs,reducing taxes or circumventing regulatory constraints.)One investment bank published a guide to innovative international debt securities in the mid-1980s.This 64-page booklet did not describe individual innovations, 3 Webster's Ninth New Collegiate Dictionary (1988). 4 See Rogers(1983)for a discussion of the adoption of innovations. 5
5 or pricing transactions. In practice, even this innocuous differentiation is not clear, as process and product innovation is often linked. The processes by which one creates a new index linked to college costs or invests to produce returns that replicate this index are hard to separate from a new indexed investment product that tries to help parents save to pay for their children’s education. Innovation includes the acts of invention (the ongoing research and development function) and diffusion (or adoption) of new products, services or ideas.4 Invention is probably an overly generous term, in that most innovations are evolutionary adaptations of prior products. The lexicographer’s addition of the phrase “as if” to the definition of innovation reflects one difficulty in any study of this phenomenon—almost nothing is completely “new” and the degree of newness or novelty is inherently subjective.5 (Patent examiners charged with judging the novelty of inventions face this challenge routinely.) One sub-branch of the literature on financial innovation has created lists or taxonomies of innovations. Given the breadth of possible innovations, this work tends to specialize in particular areas, such as securities innovations. For example, Finnerty (1988, 1992, 2001) has created a list of over 60 securities innovations, organized by broad type of instrument (debt, preferred stock, convertible securities, and common equities) and by the function served (reallocating risk, increasing liquidity, reducing agency costs, reducing transactions costs, reducing taxes or circumventing regulatory constraints.) One investment bank published a guide to innovative international debt securities in the mid-1980s. This 64-page booklet did not describe individual innovations, 3 Webster’s Ninth New Collegiate Dictionary (1988). 4 See Rogers (1983) for a discussion of the adoption of innovations
but rather categorized the characteristics of the innovative securities along five dimensions(coupon,life,redemption proceeds,issue price and warrants.) Neither innovation nor the impulse to categorize it are new activities:The 1934 edition of the investing classic,Benjamin Graham and David Dodd's Security Analysis included an appendix entitled "A Partial List of Securities which Deviate from the Normal Patterns,"which they introduced in this way: In assembling the material presented herewith it has not been our purpose to present a complete list of all types of securities which vary from the customary contractual arrangements between the issuing corporation and the holder.Such a list would extend the size of this volume beyond reasonable limits.We have, however,attempted to give a reasonably complete example of deviations from the standard patterns. In the following 17 pages,they described 258 securities.Put in modern language,their list included pay-in-kind bonds,step-up bonds,putable bonds,bonds with stock dividends,zero coupon bonds,inflation-indexed bonds,a variety of exotic convertible and exchangeable bonds,23 different types of warrants,voting bonds,non-voting shares, and a host of other instruments.Graham and Dodd's list is not an anomaly.A small literature on the history of financial innovation demonstrates that the creation of new financial products and processes has been an ongoing part of economies for at least the past four centuries,if not longer.?While many of these old innovations sound quite new even today,some have become extinct.For example,the "Million Adventure,"described by Allen and Gale (1994,p.13)raised one million pounds in 1694.The structure of this "lottery loan"innovation was a 16 year bond paying 10%with an added bonus-a lottery 5 Scholars in Industrial Organization sometimes differentiate between"drastic"and"incremental" innovations.Drastic innovations bring costs to a level below the corresponding monopoly price.See Tirole(1988,chapter 10). Other useful lists were drawn up by Tufano(1989,1995),Matthews (1994)and Silber(1975). 7For extended discussions,see Silber(1975),Allen and Gale(194,Chapter 2)and Tufano(1995,1997). 6
6 but rather categorized the characteristics of the innovative securities along five dimensions (coupon, life, redemption proceeds, issue price and warrants.)6 Neither innovation nor the impulse to categorize it are new activities: The 1934 edition of the investing classic, Benjamin Graham and David Dodd's Security Analysis included an appendix entitled "A Partial List of Securities which Deviate from the Normal Patterns," which they introduced in this way: In assembling the material presented herewith it has not been our purpose to present a complete list of all types of securities which vary from the customary contractual arrangements between the issuing corporation and the holder. Such a list would extend the size of this volume beyond reasonable limits. We have, however, attempted to give a reasonably complete example of deviations from the standard patterns. In the following 17 pages, they described 258 securities. Put in modern language, their list included pay-in-kind bonds, step-up bonds, putable bonds, bonds with stock dividends, zero coupon bonds, inflation-indexed bonds, a variety of exotic convertible and exchangeable bonds, 23 different types of warrants, voting bonds, non-voting shares, and a host of other instruments. Graham and Dodd’s list is not an anomaly. A small literature on the history of financial innovation demonstrates that the creation of new financial products and processes has been an ongoing part of economies for at least the past four centuries, if not longer.7 While many of these old innovations sound quite new even today, some have become extinct. For example, the “Million Adventure,” described by Allen and Gale (1994, p. 13) raised one million pounds in 1694. The structure of this “lottery loan” innovation was a 16 year bond paying 10% with an added bonus—a lottery 5 Scholars in Industrial Organization sometimes differentiate between “drastic” and “incremental” innovations. Drastic innovations bring costs to a level below the corresponding monopoly price. See Tirole (1988, chapter 10). 6 Other useful lists were drawn up by Tufano (1989, 1995), Matthews (1994) and Silber (1975). 7 For extended discussions, see Silber (1975), Allen and Gale (1994, Chapter 2) and Tufano (1995, 1997)
ticket which gave the holder a chance to share in an additional f40,000 per year for each of the next 16 years. In preparing this chapter,I asked my research assistant to compile a complete list of security innovations so that I could update an estimate from the mid-80s that showed that 20%of all new security issues used an"innovative"structure.One place to begin this exercise was Thompson Financial Securities Data(former SDC),a data vendor that tracks new public offerings of securities.He provided me with a list of 1,836 unique security codes"used from the early 1980s through early 2001,each purporting to be a different type of security.Some of the securities listed were nearly-identical products offered by banks trying to differentiate their wares from those of their competitors. Others represented evolutionary improvements on earlier products.Perhaps a few were truly novel.Nevertheless,the length of the list represents a"normal"pattern of financial innovation,where a security is created,but then modified (and improved)slightly by each successive bank that offers it to its clients. Even this list-if combed to eliminate false innovation-would severely underestimate the amount of financial innovation,as it only includes corporate securities. It excludes the tremendous innovation in exchange-traded derivatives,over-the-counter derivative contracts'(such as the credit derivatives,equity swaps,weather derivatives and exotic over-the-counter options),new insurance contracts(such as alternative risk transfer contracts or contingent equity contracts),and new investment management products(such as folioFN or exchange traded funds.) s The original estimate comes form Tufano(1989) Duffie and Rahi (1995)cite the Wall Street Journal (June 14,1994),p.C1 as stating there are over 1200 different types of derivative securities in use,although these journalistic calculations are somewhat suspect
7 ticket which gave the holder a chance to share in an additional £40,000 per year for each of the next 16 years. In preparing this chapter, I asked my research assistant to compile a complete list of security innovations so that I could update an estimate from the mid-80s that showed that 20% of all new security issues used an “innovative” structure.8 One place to begin this exercise was Thompson Financial Securities Data (former SDC), a data vendor that tracks new public offerings of securities. He provided me with a list of 1,836 unique “security codes” used from the early 1980s through early 2001, each purporting to be a different type of security. Some of the securities listed were nearly-identical products offered by banks trying to differentiate their wares from those of their competitors. Others represented evolutionary improvements on earlier products. Perhaps a few were truly novel. Nevertheless, the length of the list represents a “normal” pattern of financial innovation, where a security is created, but then modified (and improved) slightly by each successive bank that offers it to its clients. Even this list—if combed to eliminate false innovation—would severely underestimate the amount of financial innovation, as it only includes corporate securities. It excludes the tremendous innovation in exchange-traded derivatives, over-the-counter derivative contracts9 (such as the credit derivatives, equity swaps, weather derivatives and exotic over-the-counter options), new insurance contracts (such as alternative risk transfer contracts or contingent equity contracts), and new investment management products (such as folioFN or exchange traded funds.) 8 The original estimate comes form Tufano (1989). 9 Duffie and Rahi (1995) cite the Wall Street Journal (June 14, 1994), p. C1 as stating there are over 1200 different types of derivative securities in use, although these journalistic calculations are somewhat suspect
The many different"lists"of financial innovations-even just security innovations-demonstrate the difficulty in categorizing new products.Lists organized by product name(like SDC's categorization)tend to be uninformative,because firms use names to differentiate similar products.Lists by"traditional labels"(e.g.,legal or regulatory definitions of debt or equity,etc.)tend to be problematic,as innovations often intentionally span across different traditional labels.Lists organized by product feature (e.g.,maturity,redemption provisions,etc.)provide a great deal of information and highlight the component parts of each innovation,but do so at creating a classification system that has so many dimensions as to be unmanageable. The alternative chosen by most academics writing about innovation has been to adopt a functional approach to classifying products.Rather than group products by their names or features,authors categorize them by the functions they serve.Finnerty's taxonomy mentioned above does this,as does The Bank for International Settlements (BIS,1986).The BIS discusses the problems with creating taxonomies and concludes that the best scheme is a functional one.While there seems to be some agreement that the best categorization scheme is a functional one,it is less clear how to identify the particular functions. 3.Why do financial innovations arise?What function do they serve? If the world were free of all "imperfections"-such as taxes,regulation, information asymmetries,transaction costs,and moral hazard-and if markets were complete in the sense that existing securities spanned all states of nature,we could arrive 8
8 The many different “lists” of financial innovations—even just security innovations—demonstrate the difficulty in categorizing new products. Lists organized by product name (like SDC’s categorization) tend to be uninformative, because firms use names to differentiate similar products. Lists by “traditional labels” (e.g., legal or regulatory definitions of debt or equity, etc.) tend to be problematic, as innovations often intentionally span across different traditional labels. Lists organized by product feature (e.g., maturity, redemption provisions, etc.) provide a great deal of information and highlight the component parts of each innovation, but do so at creating a classification system that has so many dimensions as to be unmanageable. The alternative chosen by most academics writing about innovation has been to adopt a functional approach to classifying products.10 Rather than group products by their names or features, authors categorize them by the functions they serve. Finnerty’s taxonomy mentioned above does this, as does The Bank for International Settlements (BIS, 1986). The BIS discusses the problems with creating taxonomies and concludes that the best scheme is a functional one. While there seems to be some agreement that the best categorization scheme is a functional one, it is less clear how to identify the particular functions. 3. Why do financial innovations arise? What function do they serve? If the world were free of all “imperfections”—such as taxes, regulation, information asymmetries, transaction costs, and moral hazard—and if markets were complete in the sense that existing securities spanned all states of nature, we could arrive
at an M&M-like corollary regarding financial innovation.Financial innovations would benefit neither private parties nor society and would simply be neutral mutations Against this backdrop,a sizeable body of literature attempts to understand how various"imperfections"(and changes in these imperfections)stimulate financial innovation.These imperfections prevent participants in the economy from efficiently obtaining the functions they need from the financial system.Generally,authors establish how financial innovations are optimal responses to various basic problem or opportunities,such as incomplete markets that prevent risk shifting or asymmetric information.Some of these analyses are"institution-free"in that they do not explicitly consider the role of innovators in the process,while other institutionally-grounded explanations study the parts played by financial institutions using innovation to compete What functions do innovations help us perform?Merton's(1992)functional decomposition identifies six functions delivered by financial systems:(1)moving funds across time and space;(2)the pooling of funds;(3)managing risk;(4)extracting information to support decision-making;(5)addressing moral hazard and asymmetric information problems;and(6)facilitating the sale of purchase of goods and services through a payment system.Different writers use slightly different lists of functions,but there is much overlap in these descriptions.For example,Finnerty (1992)identifies a set of functions,two of which correspond closely to Merton's functions(reallocating risk and reducing agency costs),and a third("increasing liquidity")which is an amalgam of 1 While various authors have proposed functional classification schemes,the broader notion of using "function"as the critical unit in understanding financial systems has been advanced strongly by Merton (1992),and is developed in Crane et al.(1995). While the notion of neutral mutations has been long recognized in evolution,Miller(1977)used the term to describe a variety of financial decisions and financial innovations.While this term is normally used as a derogatory one,Miller is careful to note that the existence of seemingly neutral mutations can"permit the 9
9 at an M&M-like corollary regarding financial innovation. Financial innovations would benefit neither private parties nor society and would simply be neutral mutations.11 Against this backdrop, a sizeable body of literature attempts to understand how various “imperfections” (and changes in these imperfections) stimulate financial innovation. These imperfections prevent participants in the economy from efficiently obtaining the functions they need from the financial system. Generally, authors establish how financial innovations are optimal responses to various basic problem or opportunities, such as incomplete markets that prevent risk shifting or asymmetric information. Some of these analyses are “institution-free” in that they do not explicitly consider the role of innovators in the process, while other institutionally-grounded explanations study the parts played by financial institutions using innovation to compete. What functions do innovations help us perform? Merton’s (1992) functional decomposition identifies six functions delivered by financial systems: (1) moving funds across time and space; (2) the pooling of funds; (3) managing risk; (4) extracting information to support decision-making; (5) addressing moral hazard and asymmetric information problems; and (6) facilitating the sale of purchase of goods and services through a payment system. Different writers use slightly different lists of functions, but there is much overlap in these descriptions. For example, Finnerty (1992) identifies a set of functions, two of which correspond closely to Merton’s functions (reallocating risk and reducing agency costs), and a third (“increasing liquidity”) which is an amalgam of 10 While various authors have proposed functional classification schemes, the broader notion of using “function” as the critical unit in understanding financial systems has been advanced strongly by Merton (1992), and is developed in Crane et al. (1995). 11 While the notion of neutral mutations has been long recognized in evolution, Miller (1977) used the term to describe a variety of financial decisions and financial innovations. While this term is normally used as a derogatory one, Miller is careful to note that the existence of seemingly neutral mutations can “permit the
Merton's movement of funds and pooling functions.The BIS(1986)has a slightly different scheme to identify the functions performed by innovation,focusing on the transfer of risks(both price and credit),the enhancement of liquidity,and the generation of funds to support enterprises (through credit and equity.)Each author strives to describe the functions in a parsimonious fashion,but it is probably fair to say that no commonly accepted and unique taxonomy of functions has been adopted.Even if it were to exist,no functional scheme could avoid the complication that a single innovation is likely to address multiple functions.For example,using Merton's functional scheme, asset securitization invokes at least three functions:it pools various future promises, modifies risk profiles through diversification,and moves funds across time and space. If functions represent timeless demands put upon financial systems,then why do we observe innovation?Some authors adopt a static framework,where no attempt is made to explain the timing of the innovation.Other authors adopt a dynamic framework, where innovations reflect responses to changes in the environment,and the timing of the innovation mirrors this change.My discussion below summarizes most of the key arguments,and uses a combination of recent and historical examples to illustrate the points.12 (1)Innovation exists to complete inherently incomplete markets.In an incomplete market,not all states of nature can be spanned,and as a result,parties are not able to move funds freely across time and space,nor to manage risk.Duffie and Rahi (1995), in their introduction to a special issue of the Journal of Economic Theory on financial market innovation and security design,review the literature on market incompleteness adaptation to new conditions to take place more quickly or surely"in response to real changes in the economy. 10
10 Merton’s movement of funds and pooling functions. The BIS (1986) has a slightly different scheme to identify the functions performed by innovation, focusing on the transfer of risks (both price and credit), the enhancement of liquidity, and the generation of funds to support enterprises (through credit and equity.) Each author strives to describe the functions in a parsimonious fashion, but it is probably fair to say that no commonly accepted and unique taxonomy of functions has been adopted. Even if it were to exist, no functional scheme could avoid the complication that a single innovation is likely to address multiple functions. For example, using Merton’s functional scheme, asset securitization invokes at least three functions: it pools various future promises, modifies risk profiles through diversification, and moves funds across time and space. If functions represent timeless demands put upon financial systems, then why do we observe innovation? Some authors adopt a static framework, where no attempt is made to explain the timing of the innovation. Other authors adopt a dynamic framework, where innovations reflect responses to changes in the environment, and the timing of the innovation mirrors this change. My discussion below summarizes most of the key arguments, and uses a combination of recent and historical examples to illustrate the points.12 (1) Innovation exists to complete inherently incomplete markets. In an incomplete market, not all states of nature can be spanned, and as a result, parties are not able to move funds freely across time and space, nor to manage risk. Duffie and Rahi (1995), in their introduction to a special issue of the Journal of Economic Theory on financial market innovation and security design, review the literature on market incompleteness adaptation to new conditions to take place more quickly or surely” in response to real changes in the economy
