Financial Innovation: A Counterfactual Agenda

The document begins by establishing that financial innovations act similarly to 'general purpose technologies,' impacting the entire economic system. These innovations offer returns to innovators while influencing households (investment, consumption choices, reduced funding costs) and firms (increased capital access at lower costs). Michalopoulos, Laeven, and Levine's (2010) model is cited, highlighting that economic growth is fueled not just by profit-maximizing entrepreneurs commercializing new technologies but also by financial entrepreneurs who develop innovative funding and screening methods. The complexities of real-world financial institutions and their business processes are emphasized, acknowledging the intricate nature of analyzing financial innovation.

Financial innovation is defined as the creation and popularization of new financial instruments, technologies, institutions, and markets. The text differentiates between product innovations (e.g., new derivatives, securities) and process innovations (e.g., new transaction methods), although it notes the frequent overlap. The process encompasses both invention and diffusion, often involving evolutionary adaptations of existing products. Lerner's (2006) study, using Wall Street Journal articles, reveals that smaller, less profitable firms are disproportionately innovative, a finding consistent with Silber's (1975, 1983) work. The study also finds a higher innovation rate in older, less leveraged firms situated in regions with robust financial innovation activity. Data limitations—focused on US firms and a specific time frame (1990-2002)—are acknowledged.

The document explores the unique aspects of financial innovation compared to other forms of new product development. Canonical accounts (Ross, 1976; Allen and Gale, 1994) suggest that investor demand for specific cash flows drives financial innovation, with intermediaries creating securities to meet this demand, generating profits and increasing social welfare. This contrasts with product innovations in other sectors, using examples such as Apple's tablet or Tropicana's fortified orange juice. The quantifiable nature of innovation benefits, as established by Trajtenberg (1990), is discussed, along with methodologies for estimating social welfare impacts and addressing the potential for rent-seeking behavior (Dasgupta and Stiglitz, 1980).

Assessing the social impact of financial innovation is complex due to widespread externalities. Positive externalities include venture capitalists providing funding and expertise, and credit cards improving purchasing convenience. Early adopters' decisions often impact others; for instance, the expansion of mutual funds led to lower fees. Negative externalities, often termed 'systemic risk,' are also significant. Alan Greenspan's (1995) quote is cited, illustrating the difficulty in defining and measuring systemic risk. The adoption process, following an S-curve pattern (Rogers, 1962), is highlighted, noting that systemic implications typically arise only after widespread adoption. The challenges in assessing financial products after widespread adoption are discussed, focusing on litigation by later adopters who claim unawareness of product flaws (Lerner, 2010; Alexander, 1991).

The analysis emphasizes challenges in empirical work on financial innovation. Studying single innovations in isolation is insufficient due to the 'innovation spiral,' where innovations influence future ones. Empirical studies, particularly randomized control trials, primarily focus on early adopters, neglecting the experiences and adaptations of later adopters, which might better reveal social welfare implications. The long diffusion times of financial innovations necessitate extended timeframes or historical approaches. The 'regulatory dialectic' (Kane, 1977), a back-and-forth between innovators exploiting regulatory gaps and regulators responding with new rules, adds another layer of complexity. Defining 'systemically important' innovations is also discussed, utilizing top-down economic data to identify widely adopted innovations (e.g., money market funds, mutual funds, retirement plans). Limitations of econometric methods and the benefits of complementary approaches like counterfactual analysis are acknowledged.

The document advocates for using counterfactual analysis, a method involving constructing hypothetical scenarios ('what if?') to assess the impact of innovations. This approach, although debated (Carr, 1987; Ferguson, 1997, 1999; Cowan and Foray, 2002; Sylvan and Majeski, 1998; Bunzl, 2004; Tetlock and Lebow, 2001), is viewed as a valuable complement to existing research methods. Robert Fogel's (1964) work on railways is used as an example, demonstrating how counterfactual analysis can challenge established assumptions. Criticisms of Fogel's work (Nerlove, 1966; McClelland, 1968; David, 1969) are acknowledged, particularly concerning complementarities, path dependence, and the challenge of partial equilibrium approaches. The document argues that counterfactual analysis is particularly useful when innovations are deeply intertwined with the economy, prompting further research and discussion beyond simplistic views of financial innovation.

The section introduces venture capital, highlighting American Research and Development (ARD) as a pioneering example. Established in 1946 by Ralph Flanders, then head of the Federal Reserve Bank of Boston, ARD aimed to address potential post-war economic lethargy by systematically financing new businesses. The firm's strategy involved a focus on both private and social returns, emphasizing its goal of increasing the standard of living for Americans. The challenges of venture capital are explored: the difficulty in assessing the viability of new companies and the potential for opportunistic behavior by entrepreneurs after receiving funding. These factors historically deterred investors, leading to higher required rates of return. ARD's innovative approach to mitigating these risks by intensely scrutinizing companies before providing funds is described, along with the methods used to monitor and control firms after investment, such as convertible securities, staged investments, and board oversight. This approach, including management incentivization and certification of entrepreneurs, became a model for subsequent venture capital firms.

The text examines the impact of venture capital on innovation and industry growth. The cyclical nature of venture capital fundraising and investment is discussed, noting periods of high returns driven by factors such as the market for initial public offerings and technological innovations (particularly in information technology). The document notes that the impact of venture capital investment is significant in highly innovative industries like software, biotechnology, computer services, and semiconductors, where venture-backed firms constitute a large portion of industry value. However, the impact is comparatively less pronounced in industries with more mature companies. Studies investigating the relationship between venture capital and product market strategies are referenced. These studies, using survey data, suggest that venture capital funding is associated with faster product launches, especially for firms pursuing 'innovator' strategies. The importance of venture capital as a significant milestone in company lifecycles is highlighted, indicating a potential link between venture capital and traditional product innovation.

The section delves into the challenges of determining the causal relationship between venture capital and innovation. The difficulty in distinguishing correlation from causation is highlighted, emphasizing that the observed link between increased venture funding and innovation doesn't necessarily imply that one caused the other. Researchers attempt to address these causality concerns by examining historical discontinuities, such as the 1970s policy changes in the Employee Retirement Income Security Act (ERISA) that allowed pension funds to invest in venture capital. This significant increase in venture capital funding provides a basis for assessing its impact, as it's unlikely to be directly related to the number of entrepreneurial opportunities. Studies focusing on patenting activity as a proxy for innovation are discussed, alongside the concern that venture capital funding might incentivize patent applications even for less significant innovations. A further study by Mollica and Zingales (2007) employs regional patterns and instrumental variables (size of state pension funds) to examine the relationship between venture capital investments and innovation at a local level.

The section addresses the growing prominence of private equity and the anxieties surrounding its impact on various markets globally (China, Germany, South Korea, UK, and the US). While leveraged buyouts of the 1980s were studied extensively, those analyses had limitations: a focus on a small number of transactions involving US publicly traded firms, and a failure to account for the substantial growth and evolution of the industry since then. The section introduces a study by Lerner, Sorenson, and Stromberg (2008) examining the long-run investment strategies of private equity-backed firms. This study is motivated by the debate over whether private equity fosters longer-term investment horizons or encourages short-term profit maximization through actions like special dividends to equity investors. The impact of private equity on employment and productivity is another key area of focus, highlighting the conflicting claims of job losses versus job creation. Existing studies on employment impacts are noted for their limitations, including reliance on incomplete survey data, inability to control for comparable firms, and difficulty in disentangling venture capital-backed firms from other private equity investments.

The document provides historical context by analyzing the financing of entrepreneurial ventures in Cleveland at the turn of the 20th century (Lamoreaux, Levenstein, and Sokoloff, 2007). This period is presented as analogous to Silicon Valley's later success, highlighting the reliance on personal networks (friends, family, mentors) for financing and support. These networks provided services akin to modern venture capitalists—capital, certification to partners, and protection from exploitation. The text also considers alternative financing models to private equity, mentioning angel investors who predate formal venture funds, and highlighting the activities of wealthy families (Phippes, Rockefellers, Vanderbilts, and Whitneys) in the late 19th and early 20th centuries who invested in and advised businesses. A comparison of angel-backed and venture-backed firms is presented, indicating roughly equal performance in smaller deals but superior performance for venture-backed firms in larger transactions, possibly due to capital constraints. The difficulties encountered by the European Union in its efforts to encourage new firm financing through undercapitalized funds are also noted.

The section examines a counterargument to criticisms of private equity, focusing on the high debt levels associated with private equity transactions. This high debt level, as argued by Jensen (1989), forces firms to react swiftly and decisively to negative economic shocks, improving their ability to withstand recessions. This argument implies that even private equity-backed firms that eventually encounter financial distress might be in better operational shape than their peers, facilitating more efficient restructuring and reducing economic deadweight costs. Andrade and Kaplan's (1998) study of financially distressed leveraged buyouts in the 1980s is cited, suggesting that even those most severely impacted added some economic value. The ongoing debate surrounding the relationship between private equity's cyclical nature and its overall economic effect is acknowledged, with the lasting impact of private equity practices remaining an open question.

This section begins by outlining the history of the US mutual fund industry, noting key milestones. The early 1970s saw the introduction of municipal bond funds by Kemper and Fidelity, expanding available asset classes. Institutional index funds emerged around the same time, offering investors stock index returns. A major retail innovation followed in 1976 with Jack Bogle's Vanguard First Index Investment Trust, bringing indexing to retail investors via a low-cost model. The document highlights the ongoing debate regarding the systemic importance of mutual funds, particularly money market mutual funds, and the potential for increased regulation beyond the SEC's purview. Mutual funds are characterized as one of the most successful financial innovations of the 20th century, based on their growth rates, adoption, capital intermediation, and influence on household balance sheets. The concept of the 'innovation spiral' is discussed, showcasing how the original mutual fund structure has given rise to various innovations (index funds, ETFs, sector funds, money market funds).

The section addresses the challenge of evaluating the social welfare consequences of mutual funds. Unlike venture capital and private equity, where impacts on employment, business formation, and innovation are readily documented, macro-level social welfare analyses of the mutual fund industry are less common. The document suggests that mutual funds' impact stems from benefits to investors (low-cost diversified portfolios) and capital markets (information processing, capital pools). The analysis focuses on the costs and benefits for investors. The introduction of money market funds is noted for its potential effect on household risk tolerance (increased holdings in low-risk assets). The complexities of calculating incremental fees are discussed, comparing mutual fund expenses and turnover to a pre-fund benchmark portfolio (bank deposits, direct security holdings). The document posits that a direct-held portfolio would likely lead to less diversification and higher transaction costs for retail investors.

This section utilizes counterfactual analysis to explore the potential outcomes if mutual funds hadn't existed. The first counterfactual scenario is a pre-fund status quo dominated by banking and direct security holdings, with closed-end funds remaining minor players (Fink, 2008). This scenario envisions poorly diversified, rarely rebalanced portfolios, relying on bank trust departments, brokers, and periodicals for advice. The absence of index funds and ETFs is noted, along with the uncertain existence of low-cost brokerage. The cost of direct investing—including financial advisor fees—is emphasized as a crucial factor missing from some analyses (French, 2008). The underperformance of broker-sold mutual funds compared to direct-sold funds (Bergstresser, Chalmers, and Tufano, 2009) is also cited. A second, more speculative, counterfactual suggests that an alternative functional substitute for mutual funds might have emerged, offering low-cost pooling, investment management, small lot sizes, and liquidity. The example of folioFN, enabling the direct purchase of fractional shares of stocks and mutual funds, is used to illustrate this possibility. Closed-end funds are compared to open-end funds, highlighting differences in asset management, economies of scale, and distribution expenses.

The section traces the evolution of securitization, starting with its origins as a method of pooling assets and selling claims against them. Early securitization involved a single class of investors sharing proportionally in risks and returns, including prepayment risk. A major innovation was the development of tranched structures, exemplified by the Collateralized Mortgage Obligation (CMO) issued by Freddie Mac in 1983. CMOs introduced a multi-class security where predetermined rules allocated cash flows and managed prepayment risk among investors. This allocation addressed the inherent disadvantage of prepayment risk (borrowers prepaying when advantageous to them) by offering higher returns to investors accepting greater prepayment risk. The Tax Reform Act of 1986, enabling the Real Estate Mortgage Investment Conduit (REMIC) tax vehicle, significantly accelerated the expansion of CMO issuance and securitization more broadly. The development of increasingly complex structures, including CDO-squareds and synthetic securitizations, further expanded the securitization landscape.

This section explores the challenges and contradictory findings in research on securitization's impact. Analyzing the effects on bank stability is complicated by the difficulty in establishing clear causal links. The use of counterfactual analysis, even with limitations, is considered. One example is the study by Sarkisyan et al. (2010), which implicitly assumes the continued existence of securitization by other institutions while focusing on its effect on bank performance. Another study by Jiangli and Pritsker (2008), using an instrumental variables approach, concludes that securitization reduced bank insolvency risk. However, the document acknowledges the numerous conflicting results from empirical analyses that use various measures of bank stability (Z-scores, systemic risk), culminating in a reference to a recent survey (Michalak and Uhde, 2010) which demonstrates a negative relationship between securitization and bank financial soundness. The inconsistent findings emphasize the complexity in assessing securitization's overall effects.