Financial innovation and monetary policy

As financial innovation is a continuous process, it is difficult, in practice, to grasp all of its contours; and even more difficult to predict its consequences. Therefore, financial innovation adds an element of uncertainty to the economic environment in which central banks operate. If financial innovation improves the efficiency of the financial system, then it should also have a considerable effect on the functioning of the economy in general. For example, insofar as financial innovation improves the availability of funds for business activities that might not have otherwise taken place, it is likely to have a positive impact on longerterm economic growth prospects. This is at least one reason why central bankers need to be aware of financial innovation trends. The development of innovative means of payments reduces transaction costs, thereby facilitating trading and the exchange of goods and services, which in the end should lead to a better allocation of resources. In the long term, this should be favourable for economic growth. The important thing and this is another way in which financial innovation promotes growth and perhaps even dampens the business cycle is the proliferation of new financial products that help to make markets more complete. This is, for instance, the case of the development of financial technology such as derivatives and securitisation, which, by enabling risks to be unbundled and repackaged, has greatly expanded the range of tradable risks. As a result, markets have become deeper and more liquid, and prices have become more competitive. Another reason why central banks have to closely follow developments in financial innovation is that some developments may change the way in which the economy reacts to monetary policy, or may affect the information content of the indicators that central banks regularly monitor and that serve as a basis for taking policy decisions. In this respect, the monetary policy strategy of the ECB is well suited to deal with the challenges posed by financial innovation. The ECB's strategy, which includes the analysis of various monetary and non-monetary indicators, constitutes a "full-information" framework, which allows information derived from different sources and using different approaches to be cross-checked. This eclectic and diversified approach, incorporating a broad range of data and analysis, tries to take into account the influence of financial innovation on the economy in order to better understand the risks to price stability in the euro area. Let me elaborate on this by focusing on the particular cases of financial innovation in means of payment, in investment products and in financing choices.

Financial innovation in means of payment

Turning first to financial innovation in means of payment, developments in payment media and systems have started to create close substitutes for banknotes, thus affecting a core part of central banking. This is, for example, the case with the generalisation of the use of debit and credit cards, which facilitate the use of electronic means of payment, thereby speeding up the velocity of narrow money and substituting for the use of physical cash. More importantly, payment cards have also enabled the issuance of electronic money (e-money), which directly rivals physical cash in small-value payments. E-money can be defined as an electronic store of monetary value on a technical device that may be widely used for making payments to undertakings other than the issuer, without necessarily involving bank accounts in the transaction but acting as a prepaid bearer instrument. The ECB has studied the issue of e-money in depth. The main motivation for this was concern that e-money developments might endanger the function of money as a unit of account for economic transactions. For this reason, a "redeemability" requirement for electronic money has been laid down in European Union legislation. This ensures that the unit of account function of money is preserved, as holders of e-money can always exchange it into banknotes at par. In addition, the reserve base of the ECB's reserve requirements can be extended to issuers of electronic money so as to treat it in a similar way to short-term bank deposits. The reserve requirements also safeguard the effectiveness of monetary policy. Indeed, as long as some form of ultimate recourse to central banks remains, the ability of central banks to influence money market interest rates will be maintained. E-money may also have an effect on the information content of monetary variables. However, the ECB collects data and compiles statistics on electronic money and can, therefore, monitor the evolution of this phenomenon appropriately. Overall, with these measures in place, the ECB does not expect its ability to maintain price stability to be endangered by the development of electronic money.

In any case, e-money schemes have thus far had problems in achieving a critical mass in Europe and their spread has been slowing. There are currently 25 different card-based schemes in Europe, which are mostly operated by financial institutions. At the end of December 2002, the total stock of electronic money in circulation amounted to 240 million. The use of software-based e-money (network money) also remains negligible. Most software-based emoney initiatives in recent years closed down before they were able to operate on a wider scale. All in all, electronic money still represents a very small fraction of total money: it corresponds to only 0.1% of banknotes and coins in circulation. Therefore, the practical relevance of electronic money for economic analysis remains very limited at the moment. Looking a long way ahead, there may be additional issues related to the widespread issue of e-cash by private nonbanks. The plans of some national authorities to issue e-cash with legal tender status are rather unique. The ECB follows with interest the development of such plans. I would like to mention here some issues arising from a central bank issuing e-money that depend on the relationship between privately and publicly provided e-money. One option is that a central bank could hold a monopoly on the issuance of electronic money, forcing private issuers to procure legal tender from the central bank. Alternatively, the official e-money is introduced alongside its private counterparts. Under this option the central bank would have an advantage over other issuers because central bank e-cash would presumably be more trusted and would eventually become the dominant form. Furthermore, if a central bank wants to play a leadership role in the local development of electronic money, it should look at the experiences of others, some not far from here. At the ECB we look at them with interest. Some countries, for instance, have chosen to play a co-ordinating role in the industry-led standardisation process, while others have defined standards for private initiatives. In the common pool of experience I mentioned earlier, the euro area can offer the case of Finland whose central bank contributed directly to establishing the infrastructure for the new payment instruments in its country in the early 1990s. The usefulness of having a common pool of experience leads me to an additional but rather different point. This relates to the leapfrogging opportunities offered by e-finance. In some countries whose financial systems have limited services and less-developed financial infrastructure, the use of electronic cash and multipurpose cards offer savings and payment services to customers who could not be reached via more traditional forms of finance. In some cases, e-finance allows financial services to be delivered in such countries from offshore, providing the additional benefits of international technology and oversight, but creating, at the same time, additional repercussions on the effectiveness of local monetary policy operations.

Financial innovation in investment products

As far as the introduction of new instruments for financial investment purposes is concerned, the emergence of new financial products may lead economic agents to substitute money with other types of assets, potentially affecting the information content of those assets and the demand for money. This is straightforward when the new instruments are close to instruments with monetary character included in broader monetary aggregates. However, the effect of financial innovation on monetary aggregates does not necessarily concern only close substitutes for money. Indeed, standard finance theory prescribes that economic agents should hold diversified portfolios including assets with a varied spectrum of risk-return combinations and, partly related to this, of varying degrees of liquidity. Therefore, the impact of financial innovation on monetary aggregates can also come about, for example, through the emergence of new instruments which, although illiquid and risky, offer a sufficiently high return to motivate economic agents to substitute part of their holdings in monetary assets for these alternative instruments. Potentially, this can have destabilising effects on money demand. The ECB's monetary policy strategy is designed in such a way that monetary policy decisions can take account of the consequences of financial innovation. The ECB does not react in a mechanistic way to monetary aggregates, but instead carefully analyses monetary developments and their information content for price stability. In addition, by cross-checking the information from monetary developments with that of a wide range of non-monetary economic variables, monetary policy is made robust to possible effects of financial innovation on money demand.

Financial innovation in financing choices

Another channel through which financial innovation may affect monetary policy is the developments on the financing side, which may have important consequences for the monetary transmission mechanism. Traditionally, the euro area economy has been dominated by bank lending, in contrast to other economies such as the United States, where securities markets play a much larger role in channelling savings towards investment. In recent years, we have seen

a move towards more finance being raised in the form of securities issuance in the euro area. In particular, the corporate bond market grew substantially, presenting corporations with a viable choice as to where they obtain their funding. While the slowdown in economic activity in the euro area last year obviously had a negative influence on this development, corporate bond issuance continued nevertheless to grow at a relatively robust pace. One explanation, among others, for this development is the role played by e-finance in securities markets especially on the retail side, where online trading has quickly taken large market shares. On average, almost one-quarter of brokerage services are now provided online in the euro area; whereas the figure in the United States is about 50%. But in some emerging countries, the figure is even higher. The rapid acceptance of e-finance in securities markets reflects the technology-driven nature of these markets and the ease with which consumers can switch between brokers. The spread of e-broking in retail markets has markedly reduced transaction costs, which has been a factor in encouraging more small investors to invest directly in the markets. In the euro area, the development of the private bond market implies that there has been an increase in the options available to borrowers. At the same time, changes in the financial structure towards more securitisation are likely to increase the importance of wealth effects of monetary policy, as households and non-financial corporations will probably hold a larger share of their wealth in the form of financial market instruments, such as corporate bonds or equity. An increase in new forms of finance or new products leading to disintermediation could also have a significant impact on the way that monetary policy influences the cost of financing. For example, securitisation can affect the way in which monetary policy influences bank lending behaviour and might potentially reduce the role of bank lending in the monetary transmission mechanism. Securitisation also leads to more market-based finance and, given that markets sometimes react more quickly to changes in monetary policy than banks, this could even strengthen the efficiency of monetary policy. Therefore, the question raised by financial innovation appears not to be a loss of effectiveness of monetary policy, but rather the impact that it may have on the transmission mechanism of monetary policy. This again calls for close monitoring of the transmission mechanism by central banks. However, for the time being, the possibility of financial innovation affecting the monetary transmission mechanism in the euro area looks quite remote. Even if there is evidence suggesting that securitisation is growing in popularity in the euro area, the European market is still not highly developed.

Conclusion
All in all, financial innovation can help to increase the efficiency of the financial system, which facilitates the operation of monetary policy, but at the same time complicates the environment in which monetary policy operates. To deal with this complexity, central banks need to respond by monitoring the financial landscape, by following developments closely and by trying to predict the consequences of innovations that, at first, may appear very marginal. The ECB's monetary policy strategy is well designed to deal with these challenges. Although it gives a prominent role to money, it also takes into account possible influences of financial innovation on monetary aggregates. Furthermore, through its examination of non-monetary indicators, including both real and financial variables, the information from monetary aggregates can be cross-checked, which makes monetary policy more robust and less dependent on single indicators that may become distorted by financial innovation.

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Home > News & Events > 2009 Speeches

Print

Speech
Chairman Ben S. Bernanke
At the Federal Reserve System's Sixth Biennial Community Affairs Research Conference, Washington, D.C.

April 17, 2009

Financial Innovation and Consumer Protection

The concept of financial innovation, it seems, has fallen on hard times. Subprime mortgage loans, credit default swaps, structured investment vehicles, and other more-recently developed financial products have become emblematic of our present financial crisis. Indeed, innovation, once held up as the solution, is now more often than not perceived as the problem. I think that perception goes too far, and innovation, at its best, has been and will continue to be a tool for making our financial system more efficient and more inclusive. But, as we have seen only too clearly during the past two years, innovation that is inappropriately implemented can be positively harmful. In short, it would be unwise to try to stop financial innovation, but we must be more alert to its risks and the need to manage those risks properly. My remarks today will focus on the consumer protection issues raised by financial innovation. First, though, I want to say how pleased I am to join you for the sixth biennial Federal Reserve System Community Affairs Research Conference. We all want to see our communities grow and thrive, especially those that have been traditionally underserved. But the people in this room know as well as anyone that, when it comes to consumer protection and community development, good intentions are not enough. Hard-won knowledge, as exemplified by the empirical work presented here during the past two days, is required. I applaud your diligent and toughminded research in analyzing what works and what doesn't. Only with such knowledge can efforts to spread prosperity more widely become increasingly effective. Sources of Financial Innovation Where does financial innovation come from? In the United States in recent decades, three particularly important sources of innovation have been financial deregulation, public policies toward credit markets, and broader technological change. I'll talk briefly about each of these sources. The process of financial deregulation began in earnest in the 1970s, a period when stringent regulations limited competition and the range of product offerings in the markets for consumer credit. For example, Regulation Q, which capped interest rates on deposits, hampered the ability of depository institutions to attract funding and thus to extend credit. Restrictions on branching were a particularly significant constraint, as they limited the size of the market that individual depository institutions could service and thus their scope to reduce costs through economies of scale.1 The lifting of these regulations, especially branching restrictions, allowed the development of national banking networks. With national networks, the fixed costs of product innovation could be spread over larger markets, making the development and marketing of new products more profitable. Many public policy decisions have affected the evolution of financial products and lending practices. One particularly important example was the Community Reinvestment Act of 1977 (CRA), which induced lenders to

find ways to extend credit and provide services in low- and moderate-income neighborhoods. Another important set of policies was the government's support for the development of secondary mortgage markets, particularly through the government-sponsored enterprises, Fannie Mae and Freddie Mac. Secondary mortgage markets were rudimentary and thin in the 1970s; indeed, the Federal Reserve's Flow of Funds accounts do not even record private securitization activity until the early 1980s. As secondary mortgage markets--an important innovation in themselves--grew, they gave lenders both greater access to funding and better ability to diversify, providing further impetus to expansion into new markets and new products. On the technological front, advances in information technology made possible the low-cost collection, processing, and dissemination of household and business financial data, functions that were once highly localized and, by today's standards, inefficiently managed.2 As credit reporting advanced, models for credit scoring gradually emerged, allowing for ever-faster evaluation of creditworthiness, identification of prospective borrowers, and management of existing accounts. All these developments had their positive aspects, including for people in low- and moderate-income communities. Prior to the introduction of the CRA, as you know, many of these communities had limited access to mortgages and other forms of consumer credit. Subsequent innovations in financial products and services, processes, and technology helped at least some underserved consumers more fully enter the financial mainstream, save money, invest, and build wealth, and homeownership rates rose significantly. Yet with hindsight, we can see that something went wrong in recent years, as evidenced by the currently high rates of mortgage delinquency and foreclosure, especially in minority and lower-income neighborhoods. Indeed, we have come almost full circle, with credit availability increasingly restricted for low- and moderateincome borrowers. And the damage from this turn in the credit cycle--in terms of lost wealth, lost homes, and blemished credit histories--is likely to be long-lasting. One would be forgiven for concluding that the assumed benefits of financial innovation are not all they were cracked up to be. A number of factors explain the recent credit boom and bust, including problems stemming from financial innovation. From a consumer protection point of view, a particular concern has been the sharp increase in the complexity of the financial products offered to consumers, complexity which has been a side effect of innovation but which also has in many cases been associated with reduced transparency and clarity in the products being offered. I will illustrate the issue in the context of some familiar forms of consumer credit: credit cards, mortgages, and overdraft protection. Credit Cards, Mortgages, and Overdrafts: Some Instructive Examples The credit card is an example of financial innovation driven by technological advance, including improvements in communications, data management, and credit scoring. When the first general-purpose credit card was issued in 1952, it represented a way to make small loans more quickly and at a lower cost than the closed-end installment loans offered by retailers and finance companies at the time. Moreover, this form of credit doubled as a means of payment. Card issuers benefited by spreading fixed costs over multiple advances of credit, over larger customer bases, across geographic areas, and among many merchants.3 From the consumer's perspective, credit cards provided convenience, facilitated recordkeeping, and offered security from loss (by theft, for example).4 Their use gradually expanded among American families, rising to 43 percent in 1983 and to 70 percent by 2007. Among lower-income families, usage increased from 11 percent in 1983 to 37 percent in 2007.5 Mortgage markets saw similar product innovations. For example, in the early 1990s, automated underwriting systems helped open new opportunities for underserved consumers to obtain traditional forms of mortgage credit. This innovation was followed by an expansion of lending to borrowers perceived to have high credit risk, which became known as the subprime market. Lenders developed new techniques for using credit information to determine underwriting standards, set interest rates, and manage their risks. As I have already mentioned, the ongoing growth and development of the secondary mortgage market reinforced the effect of these innovations, giving mortgage lenders greater access to the capital markets, lowering transaction costs, and spreading risk more broadly. Subprime lending rose dramatically from 5 percent of total mortgage originations in 1994 to about 20 percent in 2005 and 2006.6

Innovation thus laid the groundwork for the expansion of credit card and mortgage lending that has taken place over the past 15 years or so, as well as some other forms of credit like auto loans. However, while innovation often brought consumers improved access to credit, it also brought increased complexity and an array of choices that consumers have often found difficult to evaluate properly. Take the case of credit cards. In the early days, a card may have allowed the user to make purchases or obtain cash advances, with a single, unchanging annual percentage rate, or APR, applied to each feature. Card fees were typically limited to an annual fee, a charge for cash advances, and perhaps fees for making a late payment or exceeding the credit limit. In contrast, today's more-complex products offer balance transfers and treat different classes of purchases and cash advances as different features, each with its own APR. In addition, interest rates adjust much more frequently than they once did, and the array of fees charged for various features, requirements, or services has grown. More-complex plans may benefit some consumers; for example, pricing that varies according to consumers' credit risk and preferences for certain services may improve access to credit and allow for more-customized products. Growing complexity, however, has increased the probability that even the most diligent consumers will not understand or notice key terms that affect a plan's cost in important ways. When complexity reaches the point of reducing transparency, it impedes competition and leads consumers to make poor choices. And, in some cases, complexity simply serves to disguise practices that are unfair and deceptive. Mortgage products have likewise become much more complex. Moreover, in recent years, the increased complexity has sometimes interacted with weakened incentives for good underwriting, to the detriment of the borrower. The practice of securitization, notwithstanding its benefits, appears to have been one source of the decline in underwriting standards during the recent episode. Depending on the terms of the sale, originators who sold mortgage loans passed much of the risk--including the risks of poor underwriting--on to investors. Compensation structures for originators also caused problems in some cases. For example, some incentive schemes linked originator revenue to particular loan features and to volume rather than to the quality of the loan. Complexity made the problem worse, as the wide array of specialized products made consumer choices more difficult. For example, some originators offered what were once niche products--such as interest-only mortgages or no-documentation loans--to a wider group of consumers. And, we have learned, loan features matter. Some studies of mortgage lending outcomes, after controlling for borrower characteristics, have found elevated levels of default associated with certain loan features, including adjustable rates and prepayment penalties, as well as with certain origination channels, including broker originations. 7 Although these results are not conclusive, they suggest that complexity may diminish consumers' ability to identify products appropriate to their circumstances. The vulnerabilities created by misaligned incentives and product complexity in the mortgage market were largely disguised so long as home prices continued to appreciate, allowing troubled borrowers to refinance or sell their properties. Once housing prices began to flatten and then decline, however, the problems became apparent. Mortgage delinquencies and foreclosure starts for subprime mortgages increased dramatically beginning in 2006 and spread to near-prime (alt-A) loans soon thereafter. By the fourth quarter of 2008, the percentages of loans 60 days past due, 90 days or more past due, and in foreclosure were at record highs.8 Credit cards and mortgages are not the only product classes for which innovation has been associated with increased complexity and reduced transparency. I will cite one more example: overdraft protection. Historically, financial institutions used their discretion to determine whether to pay checks that would overdraw a consumer's account. In recent years, institutions automated that process with predetermined thresholds. Although institutions usually charged the same amount when they paid an overdraft as when they returned the check unpaid, many consumers appreciated this service because it saved them from additional merchant fees and the embarrassment of a bounced check. However, technological innovations allowed institutions to extend the service, often without consumers' understanding or approval, to non-check transactions such as ATM withdrawals and debit card transactions. As a result, consumers who used their debit cards at point-of-sale terminals to make retail purchases, for instance, could inadvertently incur hundreds of dollars in overdraft fees for small purchases. In response to this problem, the Board last December proposed regulatory changes that

would give consumers a meaningful choice regarding the payment of these kinds of overdraft fees, and we expect to issue a final rule later this year. Protecting Consumers in an Era of Innovation and Complexity In light of this experience, how should policymakers ensure that consumers are protected without stifling innovation that improves product choice and expands access to sustainable credit? The first line of defense undoubtedly is a well-informed consumer. The Federal Reserve System has a long-standing commitment to promoting financial literacy, and we devote considerable resources to helping consumers educate themselves about their financial options.9 Consumers who know what questions to ask are considerably better able to find the financial products and services that are right for them. The capacity of any consumer, including the best informed, to make good choices among financial products is enhanced by clear and well-organized disclosures. The Board has a number of responsibilities and authorities with respect to consumer disclosures, responsibilities we take very seriously. In the past year or so, the Board has developed extensive new disclosures for a variety of financial products, most notably credit cards, and we are currently in the midst of a major overhaul of mortgage disclosures. In designing new disclosures, we have increased our use of consumer testing. The process of exploring how consumers process information and come to understand--or sometimes misunderstand--important features of financial products has proven eye-opening. We have used what we learned from consumer testing to make our required disclosures better. For example, our recently released rules on credit card disclosures require certain key terms to be included in a conspicuous table provided at account opening; we took this route because our field testing indicated that consumers were often already familiar with and able to interpret such tables on applications and solicitations, but that they were unlikely to read densely written account agreements. We have also learned from consumer testing, however, that not even the best disclosures are always adequate. According to our testing, some aspects of increasingly complex products simply cannot be adequately understood or evaluated by most consumers, no matter how clear the disclosure. In those cases, direct regulation, including the prohibition of certain practices, may be the only way to provide appropriate protections. An example that came up in our recent rulemaking was the allocation of payments by credit card issuers. As creditors began offering different interest rates for purchases, cash advances, and balance transfers, they were also able to increase their revenues through their policies for allocating consumer payments. For example, a consumer might be charged 12 percent on purchases but 20 percent for cash advances. Under the old rules, if the consumer made a payment greater than the minimum required payment, most creditors would apply the payment to the purchase balance, the portion with the lower rate, thus extending the period that the consumer would be paying the higher rate. Under these circumstances, the consumer is effectively prevented from paying off the cash advance balance unless the purchase balance is first paid in full. In an attempt to help consumers understand this practice and its implications, the Federal Reserve Board twice designed model disclosures that were intended to inform consumers about payment allocation. But extensive testing indicated that, when asked to review and interpret our best attempts at clear disclosures, many consumers did not demonstrate an understanding of payment allocation practices sufficient to make informed decisions. In light of the apparent inadequacy of disclosures alone in this case, and because the methods of payment allocation used by creditors were clearly structured to produce the maximum cost to the consumer, last year we put rules in place that will limit the discretion of creditors to allocate consumers' payments made above the minimum amount required. We banned so-called double-cycle billing--in which a bank calculates interest based not only on the current balance, but also on the prior month's balance--on similar grounds; we found from testing that the complexity of this billing method served only to reduce transparency to the consumer without producing any reasonable benefit. These actions were part of the most comprehensive change to credit card regulations ever adopted by the Board. Similar issues have arisen in the mortgage arena. Many of the poor underwriting practices in the subprime market were also potentially unfair and deceptive to consumers. For example, the failure to include an escrow account for homeowners' insurance and property taxes in many cases led borrowers to underestimate the costs of homeownership. In this case, allowing greater optionality--which we usually think of as a benefit--had the adverse effects of increasing complexity and reducing transparency. Restricting this practice was one of the

new protections in the residential mortgage market that the Board established in a comprehensive set of rules released in July. Banning or limiting certain underwriting practices, which the new rules do for the entire mortgage market, also helps to address the incentive problems I discussed earlier. For institutions that we supervise, these incentive issues can also be addressed by requiring that lenders set up compensation plans for originators that induce behavior consistent with safety and soundness. Where does all this leave us? It seems clear that the difficulty of managing financial innovation in the period leading up to the crisis was underestimated, and not just in the case of consumer lending. For example, complexity and lack of transparency have been a problem for certain innovative products aimed at investors, such as some structured credit products. Conclusion I don't think anyone wants to go back to the 1970s. Financial innovation has improved access to credit, reduced costs, and increased choice. We should not attempt to impose restrictions on credit providers so onerous that they prevent the development of new products and services in the future. That said, the recent experience has shown some ways in which financial innovation can misfire. Regulation should not prevent innovation, rather it should ensure that innovations are sufficiently transparent and understandable to allow consumer choice to drive good market outcomes. We should be wary of complexity whose principal effect is to make the product or service more difficult to understand by its intended audience. Other questions about proposed innovations should be raised: For instance, how will the innovative product or practice perform under stressed financial conditions? What effects will the innovation have on the ability and willingness of the lender to make loans that are well underwritten and serve the needs of the borrower? These questions about innovation are relevant for safety-and-soundness supervision as well as for consumer protection. In sum, the challenge faced by regulators is to strike the right balance: to strive for the highest standards of consumer protection without eliminating the beneficial effects of responsible innovation on consumer choice and access to credit. Our goal should be a financial system in which innovation leads to higher levels of economic welfare for people and communities at all income levels.

Footnotes 1. For a listing of these rules, see Dean F. Amel and Daniel G. Keane (1986), "State Laws Affecting Commercial Bank Branching, Multibank Holding Company Expansion and Interstate Banking," Issues in Bank Regulation, vol. 10, no. 2 (Autumn), pp.30-40. Research indicates that non-interest expenses, wages, and loan losses all declined following the lifting of branching restrictions leading to lower loan prices. Also, the lifting of geographic restrictions lead to larger and more diversified banking institutions. See Randall S. Kroszner and Philip E. Strahan (forthcoming), "Regulation and Deregulation of the U.S. Banking Industry: Causes, Consequences, and Implications for the Future," in Nancy Rose, ed., Economics of Regulation, NBER Conference Volume. Return to text 2. Board of Governors of the Federal Reserve System (2007), Report to the Congress on Credit Scoring and Its Effects on the Availability and Affordability of Credit, (Washington: Board of Governors, August). Return to text 3. Dagobert L. Brito and Peter R. Hartley (1995), "Consumer Rationality and Credit Cards," Political Economy, vol. 103 (April), pp. 400-33. Return to text Journal of

4. Board of Governors of the Federal Reserve (2006), Report to the Congress on Practices of the Consumer Credit Industry in Soliciting and Extending Credit and their Effects on Consumer Debt and Insolvency (Washington: Board of Governors, June). Return to text

5. See note 4, Report to the Congress on Practices of the Consumer Credit Industry, table 6; and Board of Governors of the Federal Reserve System (2007), 2007 Survey of Consumer Finances, Board of Governors. Return to text 6. See Chris Mayer and Karen Pence (2008), "Subprime Mortgages: What, Where, and to Whom?" Finance and Economics Discussion Series 2008-29 (Washington: Board of Governors of the Federal Reserve System, June); and Inside Mortgage Finance (2007), The 2007 Mortgage Market Statistical Annual vol. 1; The Primary Market (Bethesda, Md.: Inside Mortgage Finance Publications). Return to text 7. Lei Ding, Roberto Quercia, Wei Li, and Janneke Ratcliffe (2008), "Risky Borrowers or Risky Mortgages: Disaggregating Effects Using Propensity Score Models," Working Paper (Chapel Hill, N.C.: UNC Center for Community Capital). See also Elizabeth Laderman and Carolina Reid (2009), "CRA Lending During the Subprime Meltdown (470 KB PDF)," in Revisiting the CRA: Perspectives on the Future of the Community Reinvestment Act, pp. 115-33 (San Francisco: Federal Reserve Bank of San Francisco, February). Other studies do not find evidence of consistent harm from stemming from certain practices or products. See, for example, Morgan J. Rose (2008), "Predatory Lending Practices and Subprime Foreclosures: Distinguishing Impacts by Loan Category," Journal of Economics and Business, vol. 60 (January-February), pp. 13-32; and Christopher L. Foote, Kristopher Gerardi, Lorenz Goette, and Paul S. Willen (2008), "Just the Facts: An Initial Analysis of Subprime's Role in the Housing Crisis," Journal of Housing Economics, vol. 17 (December), pp. 291-305. Return to text 8. Mortgage Bankers Association (2009), National Delinquency Survey, MBA, March. Return to text 9. See, for instance, materials on the Consumer Information portion of the Federal Reserve's website. Return to text Return to top 2009 Speeches
Last update: April 17, 2009

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Paper to be presented at the International Schumpeter Society Conference 2010 on INNOVATION, ORGANISATION, SUSTAINABILITY AND CRISES Aalborg, June 21-24, 2010

Financial Innovation and the Financial Crisis

Jim Stewart Trinity College Dublin jstewart@tcd.ie
Id: 374

ISS SCHUMPETER Conference 2010 Innovation, Organisation, Sustainability and Crises Aalborg University, Denmark, 21-24 June 2010

Financial Innovation and the Financial Crisis

Jim Stewart School of Business, Trinity College, Dublin
Email: jstewart@tcd.ie
2

Financial Innovation and the Financial Crisis

The message of Schumpeter for our times is that market-oriented economic development requires two analytically distinct sets of entrepreneurs; the innovators in product and process and the innovators in finance. Hyman Minsky (1990) Innovation plays a key role in economic development, through the development of new products, new processes and in increasing productivity. The focus of this paper is on innovation in the financial sector. Some have argued that financial innovation has a key role as a source of economic growth. The financial crisis has also drawn attention to the role of financial innovation in introducing instability and deep recession. This paper in particular examines one financial innovation - referred to as the shadow banking system, the essential feature of which is that it was either unregulated or subject to light touch regulation. 1. The contribution of Minsky The dominant paradigm in dealing with the current financial crisis is to reduce Government expenditures. This is the proposed solution to the Greek crisis is an example (see the IMF conditionality programme available at http://www.mnec.gr.). Portugal Spain, and other countries have also announced programmes to reduce government expenditures including wage cuts. Commentators often cite Ireland (Barkham, 2010) as a role model in dealing with the financial and economic crisis. Yet in the week these announcements were made and following the recent intervention in Greece, stock markets fell. Commentators writing in the financial press generally support these policies, but at the same time report fears that retrenchment in European countries may result in a double dip recession (Oakley, 2010). Some economists for example, Stiglitz, Krugman, argue that the policy prescriptions from Keynes are the most appropriate response to the current crisis. But as argued by Minsky Keynesian arguments neglect the role of finance in causing cycles. Minsky argues that Keynesian economics as largely implemented does not take sufficient account of finance, because the role of finance was implicit rather than explicit in the General Theory. Minsky argues that .. implicit in the analysis in the General theory is the view that a capitalist economy is fundamentally flawed because the financial system necessary for capitalist vitality and vigor. ..contains the potential for runaway expansion, powered by an investment boom. (Minsky 1975, pp. 11-12). Minsky states:..in a boom the ingenuity of bankers is directed at turning every possible source of temporarily idle cash into a source of financing for either real operations or financial position making. (Minsky, 1975, p. 143).
3

This expansion is ended because accumulated financial changes render the financial system fragile so that not unusual changes can trigger serious financial difficulties. (Minsky, 1975, p. 12).

Minsky argues that booms and busts are an inherent feature of every economiy where financial innovation is driven by market forces. (Minsky, 1009, p. 60). The General Theory had much to say about uncertainty. Skidelsky (2009, p. 84) states uncertainty pervades Keyness picture of economic life. A situation of certainty is often assumed in financial and economic analysis, as in the standard Fisher-Hirschleifer analysis of investment decision making (Stewart, 2000). If a framework based on probabilities is developed this is almost always done in the context of assuming events follow a normal distribution. Keynes however assumes the view of the future is subject to sudden and violent changes (Minsky p. 67). Uncertainty leads to volatility in investment even though production relations are stable (Minsky p. 68), and quotes the famous statement by Keynes that When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done (Minsky p. 90). Minsky argues policies pursued by governments have led to a fragile financial system, and the real economy behaves in quite a different way with a fragile financial system. It is much more prone to cycles. The fragility of the financial system is related to the extent to which units are dependent upon refinancing their positions in long assets in smoothly functioning short-term financial markets (Minsky, 1975, p. 163). Minsky argues the problem is that Keynes never explicitly developed a theory of the boom and the crisis and he never articulated a model or an explanation of how the liability structure of firms, banks, and other financial institutions evolve. It is not sufficient to advocate Keynesian type policies, or indeed other policies without analysing the role of finance in the current crisis. 3. The Key Role of Financial Innovation In his Nobel lecture Merton (1997, p. 108) identifies innovation as a central force driving the financial system towards greater economic efficiency. Merton in this lecture emphasised financial innovation resulting from academic research in finance via the development of options and derivatives. Merton argues that contracting technology has increased risk sharing, lowered transaction costs and reduced information and agency costs (Merton, 1997, p. 88). The development of derivative securities has allowed very diverse financial systems to become much more integrated and helped create the global economy (Merton, 1997, p. 89). Apart from the development of markets devoted exclusively to trading options and derivatives, the development of these new products has had an impact on new firm formation, for example firms specifically dedicated to trading strategies using these new instruments. More fundamentally trading in derivatives markets has become an integral part of the operation of financial institutions such as
4

banks because a derivative when purchased with the underlying asset may be equivalent to an insurance policy, which prevents the value of the asset combined with the option falling below the exercise price of the option. Merton does not discuss with the issue that derivatives also allow speculation where there is no economic interest in the underlying asset. Financial innovation has resulted in the securitisation of mortgage loans, collateralised debt obligations, and credit default swaps to name but a few. Some have argued that financial innovation, in particular financial innovation associated with risk management has been a major source of growth in particular for the US economy (Bernstein, 1996). Baily et al (2008), have argued that financial innovation such as securitisation has been an extremely positive innovation for credit markets . In contrast Minsky argues that booms associated with financial innovation will inevitably lead to a subsequent collapse. Minsky states Economies with financial innovations that

are driven by market prospects are structurally conducive to booms and busts.. (Minsky, 1990, p 60). It is not surprising that Minsky has become one of the most quoted economists in recent economic policy debate (Kay, 2010). Hence a number of issues arise as follows: (1) What determines financial innovation and (2) is it necessarily the case that financial innovation is followed by collapse? This paper considers the causes of the current crisis in terms of financial innovation and in particular the emergence of the shadow banking system with particular reference to the Irish Financial Services Centre in Dublin. The Causes of Financial innovation: Merton versus Miller Miller argues frequent and unanticipated change in regulatory and tax codes have been the main forces for financial innovation. This argument is supported by others for example, Calomiris (2002, p. 312-313) argues that costly regulations gives incentives for new financial products, services and intermediaries. In contrast Merton (1990b) argues that the forces driving innovation are:- (1) Demand to complete the markets; (2) lowering transaction costs (3) reduction in agency costs due to asymmetric information or incomplete monitoring. Merton and Bodie in their textbook state :"Generally, financial innovations are not planned by any central authority but arise from the individual actions of entrepreneurs and firms" (Merton and Bodie , Finance, Prentice-Hall, 1998, p. 33). Some Examples of Financial Innovation followed by Collapse The successful innovation by Drexel Burnham Lambert in the junk bond market in the US led to a large increase in the number of junk bond issues (from $1.3 billion in 1981 to
5

$32.4 billion in 1986) and very large profits. The innovation was to provide an underwriting service and a market for junk bonds, enabling a much wider spread of investors to purchase junk bonds (Milgrom and Roberts, 1992, pp. 485-489). The subsequent collapse led to the bankruptcy of Drexel Burnham Lambert, the jailing of several of the key players (Boesky, Milkin, Drexel), and partly explained the problems with the Savings and Loan Associations3 . Long Term Capital Management was probably the best known managed fund specialising in arbitraging between different markets and is an example of a firm whose strategy was based on academic research in finance. The key innovation by LTCM and similar financial firms was to develop trading strategies which involved identifying and separating the option component of a financial instrument. In 1995 and 1996 LTCM earned net returns for investors of 40%, and a return to LTCM of 63% and 57% respectively (Dunbar, p. 170). In 1997 LTCM had total equity of $4.72 billion, assets of $129 billion, liabilities of $124.5 billion, and a derivatives position of $1.25 trillion (Dunbar, 2002, p. 191). However by September 2008 LTCM losses amounted to $4.6 billion and the New York Federal Reserve Board organised a capital injection by other financial institutions and the eventual liquidation of LTCM. The fund was liquidated in 2000. The development and collapse in the value of debt based on subprime mortgages and in the value of various forms of financial instruments (ABS, CDO, SIVs) and subsequent losses at banks and other financial institutions has resulted in the most widespread financial crisis since the great depression. One early estimate by the IMF was that losses on loans and securities would amount to $1400 billion for banks, (Financial Times 13/11/08). This estimate was raised to 2200 billion in January 2009, 2400 million in April 2009 and remained unchanged in September 2009 (IMF Global Financial Stability

Report various issues). These estimates exclude losses on derivatives as they are regarded as transfers of wealth from one party to another. Banking losses were estimated to amount to $3400 billion (IMF October 2009). One reason for these large losses by banks, is that they issued securities such as collateralized debt obligations (CDOs) but then failed to sell these bonds but rather kept them as investments . More recently the development and growth of the Credit Default Swaps market has been blamed by some for exacerbating the crisis and more recently threatening the stability of members of the Euro such as Portugal and especially Greece (Rickards, 2010). Essentially the problem with these instruments is that they allow insurance but with no insurable interest. Innovative financing also enabled Greece to massage its true borrowing and at considerable cost in terms of fees to the Greek State (Hope et al. 2010). However there are also examples of financial innovation which are long lasting, have had a significant impact on financial systems, and while they may have contributed to financial instability have survived through time. Porta et al (1997) argue that the legal system has a considerable influence on the financial system and can in turn affects the choice between internal and external finance. More generally there is widespread
6

agreement that there is a relationship between the financial system and economic growth. Several studies support and cite the contention of Schumpeter (1912) that the financial system is important for growth and innovation. 4. The causes of the Current Crisis There are many causes of the current crisis perverse incentives, poor regulation including widespread belief that markets were efficient and rational in the sense of the efficient markets hypothesis. Financial innovation magnified these faults. A common assumption that financial innovation did not require change and innovation in financial institutions has a number of implications and may partly explain the subsequent crash. For example corporate governance issues are ignored. Financial crashes invariably reveal agency problems between management, equity owners and bondholders, between external validation agencies such as credit rating agencies and auditors, and between regulators and regulates. In the current crisis agency issues have arisen between credit rating agencies and bondholders and between credit rating agencies and regulators. The failure of financial innovation to be regulated and monitored in an appropriate way is seen by many as one of the causes of the current crisis. As noted above some have argued for example, Bernstein (1996) argues that financial innovation associated with risk management has been a major source of growth in particular for the US economy. Bernstein states:- The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk (p. 1), and that the normal distribution forms the core of most systems of risk management (p. 144). In contrast Taleb (2007) describes the normal curve as an intellectual fraud (Taleb, p. 229) and argues that many characteristics of financial markets cannot be described by a normal distribution. Baily et al (2008), have argued that financial innovation is a very positive force in our economy, but add that it also creates problems (p. 7) and that financial innovators and regulators are in a race, and the regulators will always lose that race (p. 93), but it matters how much they lose by. Schiller also warns against financial regulation that may stifle innovation and that regulators rather than discouraging complexity in financial products should promote innovation-enhancing financial regulation (Schiller, Financial Times 27/9/09). However many regulators and others see unregulated financial innovation as being a major cause of the crisis (Turner Review, pp. 47-49, Volcker, New York Times February 5, 2009). In addition many of the instruments

created by recent financial innovation were administered in low tax financial centres/tax havens, resulting in an unregulated financial system. The conjunction of new financial products organised by financial firms located in low tax financial centres led to the development of a shadow banking system. The emergence of the shadow banking system is central to the current crisis.
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5. Emergence of the Shadow Banking System In the crisis involving Northern Rock, the Financial Times argued that the greatest regulatory concern is:.. .. ..the supervision of so-called conduits, off-balance sheet vehicles which borrow money, finance loans, and generally behave just like banks. Most of this activity is regulatory arbitrage it exits to avoid the restrictions placed on banks and supervisors appear to have ignored it. If there is to be reform then this is the place to start. (Financial Times, Leader, The Right Response to Northern Rock, October 1, 2007). The ECB in an analysis of the effects of the crisis on bank funding, states that one noteworthy feature was the large increase in banks off-balance sheet financing prior to the crisis, and continues that many banks had financial vehicles that were not included in their balance sheets, but which made investment decisions for which their parent companies were liable (ECB, p. 10). The Turner Report also notes the growth of the unregulated shadow banking system (Turner Report, p. 21; see also Roubini, 2008; Martin Wolf, 2008). Goodman (2010) comments that the shadow banking system came to specialize in innovations that created the illusion that risk was being responsibly manged; in crucial cases they actually intensified the dangers. The shadow banking system consists of non-bank financial institutions that borrow short term and lend long term , such as securitised investment vehicles (SIVs), hedge funds, conduits, money market funds, etc. These financial institutions are subject to risk and uncertainty. One source of risk arises from liquidity, but in contrast to banks, nonbank financial firms do not have access to central bank lending facilities, but rather relied on interbank lending for liquidity and as a source of funding. There were exceptions as in the case of Long Term Capital Management. Once this market collapsed those financial firms dependent on the inter-bank market as a source of funds either found that the cost of funds increased dramatically or were unable to raise funds at any price. Some banks were so dependent on the interbank market that even though they could access Central Bank lending, they were either nationalised (Northern Rock), or part nationalised (Royal Bank of Scotland) or in the case of US banks received considerable amounts of state aid in the form loans and cash in exchange for assets. In particular as noted earlier, liquidity difficulties with subsidiaries in the IFSC led to liquidity and threats of insolvency within the group as a whole in the case of four German banks with subsidiaries in the IFSC . A further source of risk is poor or non-existent regulation. This is because of the location of shadow banking type activities in off shore financial centres one of whose main advantages was light touch regulation and in recognised tax havens such as the Cayman Islands. This source of risk typically only becomes apparent in a crisis. As a consequence when markets became aware of the risk associated with these firms, liquidity is reduced, increasing risk further.
8

The existence of hedge and other funds, often controlled by a firm located in a low tax regime/tax haven (Bender, 2010) is a key feature of the shadow banking system. These funds may be organised as a special purpose vehicle, thus disguising the true ownership

and liability in the event of default. These off balance sheet vehicles also featured in the dot.com crisis involving the collapse of Enron and other firms. Their advantage is that capital adequacy ratios are disguised meaning that the group as a whole has adequate capital ratios and hence is less risky. Their location in a tax haven reduces tax, but perhaps more important, is also associated with light touch regulation. 6. The Irish Financial Services Centre (IFSC) in Ireland Financial centres such as the Irish Financial Services Centre (IFSC) formed a major part of the shadow banking sector. Developing and maintaining a financial centre in Dublin is a major part of current Irish Government Policy. The annual Finance Act often amends or introduces new legislation to enhance the attractions of financial firms located in Ireland. For example the most recent Finance Act (2010) makes it easier to move the location for funds to move from locations such as the Cayman Islands to Dublin (Grene, 2009). State agencies including the Industrial Development Authority (IDA) (http://www.idaireland.com/home/) and the Central Bank are required by law to support the IFSC. The Central Bank and Financial Services Act (2003) required the Central Bank is to promote the development within the State of the financial services industry 1. This requirement is now being removed. The IFSC along with Luxembourg are the two main centres for administering hedge and other funds in Europe. In 2008 the IFSC approximately 8000 funds were located in the IFSC, with 1560 billion of assets (Johnson, 2008). These funds are also often quoted on the Irish Stock Exchange in order to comply with regulatory requirements. The Irish Stock Exchange states:The Irish Stock Exchange is recognised worldwide as a leading centre for listing investment funds. With over 4,400 funds and sub-funds listed, the ISEs combination of effective and prudent regulation, flexibility of approach and efficient and timely processing of listing applications has proved attractive and cost effective. The ISE continues to provide a dynamic listing framework to meet market demands and trends2. The Irish stock exchange (as well as the Luxembourg exchange) are recognised as major world centres for listed international bonds. In 2007, at the start of the financial crisis, the Luxembourg stock exchange accounted for 46% of international bonds, followed by the Irish Stock Exchange with 26%. In contrast the New York Stock Exchange had a share of just over 4.1% (Source: PricewaterhouseCoopers, 2008, p. 2). In 2009 there were 70,287 listed international bonds quoted on five stock markets (Luxembourg Stock Exchange, 2010). The five stock markets include NYSE Euronext, London Stock Exchange and Deutsche Borse. In the year 2009 the Luxembourg Stock Exchange accounted for 43 % of all issues and the Irish Stock Exchange a further 25%. In
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comparison the next largest in terms of listed bonds, accounted for 18%. This represents a slight fall in market share since 2007. The Irish Stock Exchange states that seeking a quotation for a fund has benefits in terms of source country investors because there may be restrictions in investing in unlisted securities or securities that are not listed on a recognised, regulated stock exchange 3. Hence a quotation on the Irish Stock Exchange enables a fund to market to these institutional investors. The Irish Stock Exchange also states that the Exchange has standards of regulation to stockbrokers and listed companies which are acknowledged to be among the highest in Europe4, and as a result the Irish Stock Exchange is recognised as an appropriate regulator from the market authorities in many jurisdictions including Japan and the United States.

In spite of these stated high regulation standards many of the funds that have collapsed in value because of liquidity difficulties, are listed on the Irish Stock Exchange. The collapse of the subprime market in turn led to large losses at subsidiaries of three German landesbanks (Sachsen Bank, IKB, and WestLB) located in the IFSC. The largest and potentially most serious losses occurred at Depfa Bank, an Irish registered bank located in the IFSC which became a subsidiary of Hypo Bank in 2007. Losses at these banks required large amounts of State aid from the German Government. This issue is discussed later in this paper. Hedge funds quoted in Dublin are often managed in London but domiciled in a tax haven/low tax regime. As a result of the financial crisis there was an estimated outflow from hedge funds of $400 billion in 2008 (Financial Times, 21/1/09). This outflow led to a restructuring and closure of hedge funds. Of three funds announcing a closure on one day (Mackintosh, 2009), all were managed in London, quoted in Dublin but domiciled in a tax haven. For example, one of the funds (Lansdowne Partners) had seven funds consisting of 148 sub funds quoted in Dublin and all but one, were domiciled in the Cayman Islands. A second firm (Rab Capital) had seven funds and 23 subfunds quoted in Dublin, 19 were domiciled in the Cayman Islands, three in the Isle of Man, and one in the British Virgin Islands, and the third firm (New Star) had three main funds and eight subfunds quoted in Dublin, and all were domiciled in Bermuda. The IFSC dominates financial flows for the Irish economy. Table (1) shows total foreign investment in Ireland for the period 2003-2008. The table shows that foreign direct investment reached a peak in 2003 and has since fallen. In contrast total foreign investment in the IFSC has continued to rise until 2007 and fell in 2008 reflecting the financial crisis. In 2008 IFSC investment was over 13 times the size of foreign direct investment and approximately 11 times the size of GNP.
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Table (1) The growth of the IFSC in Dublin: Total foreign Investment in Ireland ( billion)
(1) This number may understate IFSC type activities, as these are no longer required to locate at the IFSC see Stewart (2008) for a further discussion. Source: CSO (2009) and (2008), International Investment Position, Table 1 and 3.

Competition between financial centres is considerable and this in turn has led to reduced regulation. Historically hedge funds were often domiciled in the Cayman Islands, Bermuda of the British Virgin Islands, but more recently European jurisdictions such as Channel Islands, Ireland and Luxembourg have been streamlining regulation amongst other factors to attract funds. One effect of this is that in Ireland if the relevant documents are provided to the regulator by 3 p.m. and fund will be authorised the next day (Steward, 2008)6. In 2008, Luxembourg introduced a new law, so that as long as the fund manager notifies the regulator within a month of launch, the fund can enjoy pre-authorisation approval. Steward comments that unlike the Irish regulator, the regulator in Luxembourg does not scrutinise promoters. An important issue is where responsibility for regulation rests. The role of tax havens and locations with light touch regulation however has not been subject to any criticism or suggestions for reform in the current banking crisis. For example an editorial in the Financial Times laid the blame on the difficulties faced by German banks exclusively with the structure of the German banking industry and State owned banks (Banking Bother, 3/9/07). The Irish Financial Regulator has been quoted as saying that the Irish regulator had no responsibility for entities whose main business is raising and investing in funds based on subprime lending.7 Part of this issue is a conflict between financial

firms who might like to locate activities which incur lowest cost (least regulated) and lowest tax, and the requirements of the location of investors/liabilities of these firms who are concerned with conduct of business type regulation for example, greater protection of investors and regulation that will prevent systemic risk to the financial systems in the parent country. Part of this conflict is demonstrated by the debate on regulating the fund management industry within the EU. The industry would like to locate outsourced activities in any jurisdiction. This position was supported by regulators in Germany, France and the UK (F.T. January 14 2008). In contrast Luxembourg and Ireland opposed this position and wish to maintain the current system where there are restrictions on outsourcing. Thus Luxembourg and Ireland as centres of the fund management industry have a considerable number of employees involved in administration of funds. However an issue that has arisen in relation to the current arrangement is whether these funds even
2003 2004 2005 2006 2007 2008 Direct 176.435 152.446 138.626 118.824 138.362 120.954 Portfolio 542.200 720.952 1025.902 1223.683 1329.908 1183.690 Other 389.807 443.796 556.906 678.293 838.713 995.659 Total 950.469 1108.442 1721.428 2020.800 2306.983 2300.303 Represented by IFSC1 813.336 975.357 1300.223 1566.668 1727.005 1645.535 11

though they may have an administrative presence are adequately supervised and if in fact they have key decision making functions. The recent Madoff and Stanford cases also illustrate some of the regulatory and other issues involved with financial firms located in tax havens8. 7. The IFSC and Securitised Investment Vehicles A front page article in the Financial Times (Sakoui, 2008) cites a plan to restructure an SIV called Cheyne Capital after 10 monthes of negotiations, but without referring to the fact that Cheyne capital and its funds are quoted on the Irish Stock Exchange. The same article refers to further restructuring at four more SIVS (Golden Key, Mainsail, Whistlejacket and Rhinebridge). Again all funds were quoted on the Irish Stock Exchange. The implications of a quotation is that the funds were regulated by the Irish Financial Regulator, were subject to the rules of the Irish Stock exchange, and if managed by an incorporated entity in Ireland, this entity would be subject to Irish company law, and accounting regulations, yet the location of funds and the market where they were quoted receives very little (if any) attention. There are numerous connections between funds involved in the subprime crisis and the IFSC. There are over 4000 investment funds and many more subfunds, quoted on the Irish Stock Exchange. Many of these funds assets consisted of subprime loans. In order to be quoted on the Dublin Stock Exchange they must be sponsored by a local stock broking firm (Mostly Davy and Goodbody Stockbrokers) documents must be lodged with the regulator, and in the case of an entity incorporated in Ireland, Company Registration Office. In return fees are paid to the Irish Stock Exchange and to the sponsoring broker. Regulators in the resident country of potential investors may require securities to be listed on a recognised stock exchange. These investment funds may in turn be owned by a legal entity (the so called conduits), managed by a firm based in the IFSC, as in the case of Rhinebridge and IKB or in the case of the conduit Ormond Quay, managed by Sachsen Bank (Ireland) which was in turn a wholly owned subsidiary of Sachsen Bank. Banks and investment funds were not the only entities involved in sub-prime loans at the IFSC. A Treasury management firm operating at the IFSC, Dublin (GMAC-RFC) which

is a wholly owned subsidiary of the Residential Financing Corporation of the US and in turn owned by General Motors, was extensively involved in mortgage lending in the US. The web site of this firm states:GMAC-RFC, one of the largest private mortgage conduits in the United States, has led the mortgage industry for over two decades. A pioneer in the field of mortgage securitization, we continue to build on our track record of success. Our relationships lastand the mortgage lenders that we partner with grow and prosper along with us (Source:- https://www.gmacresidentialfunding.com/lenders/). In total over 40 funds quoted on the Irish Stock Exchange have been the subject of media reports indicating financial difficulties9.
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8. Bear Stearns and the IFSC The collapse of Bear Stearns and its subsequent takeover by JP Morgan in March 2008, was one of the early indicators of the severity of the current crisis. The first public indication of problems at Bear Stearns emerged when a Bear Stearns hedge fund announced considerable losses (Business Week June 12, 2007), and a second fund announced a smaller loss (Bear Stearns High-Grade Structured Credit Strategies). Lenders attempted to reclaim loans (Bajaj and Cresswell, 2007). On June 22nd Bear Stearns pledged $3.2 billion in loans (Cresswell and Bajaj, 2007), but this was insufficient to prevent further withdrawals. redemptions were suspended and both funds filed for bankruptcy approximately six weeks after the first announcement of losses. Both funds were incorporated in the Cayman Islands where they were liquidated (Bloomberg August 7 2007). While key executives at both funds faced prosecution in the US (Thomas, New York Times, 20/6/08), they were acquitted in November 2009 (Kouwe and Slater, 2009). One puzzling aspect is that the reported reason why Bear Stearns attempted to rescue these funds was because of reputational risk rather than a contractual obligation (Baily, et al. p. 52). This failed intervention is likely to have been a key component of the collapse of Bear Stearns. Bear Stearns had several investment vehicles listed on the Irish Stock Exchange. These consisted of two investment funds (Bear Stearns Offshore Fund of Hedge Fund Series and Bear Stearns Offshore Leveraged Fund of Hedge Fund Series), and seven debt securities divided into 69 sub funds with a total issued value of $7.069 billion. Bear Stearns also operated three subsidiaries in the IFSC, Dublin through a holding company (Bear Sterns Ireland Ltd.). Table (2) shows the main features of the holding company: 1. Capital ratios are very low and have fallen since 2004, $1 of equity financed $119 of gross assets In contrast the minimum Tier 1 ratio for commercial deposit taking banks (equity/risk weighted assets) is 4% although all deposit taking banks have ratios substantially in excess of this.. 2. Most assets and liabilities are short term. 3. Although profitable no dividends were paid. Most capital consists of contributed capital reserves. 4. There are large intra-group assets and liabilities most likely representing extensive intra-group transactions.
13 Table (2) Assets and Liabilities of Bear Stearns Ireland Ltd. $ billion Year Gross Assets Ratio

of Equity/ total assets2 Financial Assets held for Trading Securities purchased under agreements to sell to group companes1 Reserves -capital contributed Retained Profits Number Employed 2007 61.218 0.85 48.4 3.01 0.378 0.14 141 2006 36.033 1.25 27.5 5.34 0.271 0.11 114 2005 14.231 2.05 7 .4 3.49 0.201 0.90 85 2004 9.228 2.27 3.5 3.23 0.154 0.55 69 2003 7.315 1.77 3.0 3.22 0.105 0.25 67 2002 6.889 1.53 4.0 2.22 0.105 0.00 61 Notes (1) Other intra-group transactions are described as loans receivable from an affiliate and market and client receivables;. While intra-group liabilities are described as market and client payables, swap agreements and forward contracts and short term borrowings. (2) This is similar to Tier 1 capital ratio. The main difference is that assets are not risk weighted.

The accounts also state that the group and subsidiaries are regulated by the Irish Financial Services Regulatory Authority. One of the subsidiaries is an authorised bank requiring considerable disclosure and compliance activity. Despite the location of managed funds in Ireland and substantial operations including an authorised bank the Irish regulator does not feature in any media analysis or discussions relating to the insolvency and subsequent take-over of Bear Stearns. In an interview, the Irish regulator appears to consider the remit of the regulator is to Irish banks that is banks which have their headquarters located in Ireland. The regulator is reported as stating that he meets the chief executive of the Irish Banks at least once a week (Clerkin, Sunday Business Post, May 11, 2008). Bear Stearns is not an isolated example in relation to the use made by US financial institutions of the IFSC . Lehman Brothers had four debt securities with approx. $27 billion issued and five funds administered from the IFSC and quoted on the Irish Stock Exchange in September 2009. The minimum subscription of which varied between $0.25 million and $5 million, although one of the funds had a minimum subscription of $2500. In addition there are 10 Lehman subsidiaries incorporated in Ireland under the companies Acts. The prospectus of one of these states:The company may employ investment techniques and instruments for efficient portfolio management.. .. Under the conditions and within the limits stipulated by the Central Bank under the UCITS regulations Prospectus of Lehman Bros Alpha Fund PLC 2003, p. 11)
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Another prospectus states the company is a collective investment scheme organised as a company and authorised by the Financial Services Regulatory Authority (p. 19) all the capital of the company is invested via another Lehman subsidiary located in the Cayman Islands. Both prospectuses state that the company is tax resident in Ireland Apart from Bear Stearns and Lehman Brothers, most if not all large banking and insurance companies have securities quoted on the Irish Stock Exchange. For example. AIG had three funds listed in Dublin with an issued value of $1298 million) and one debt security; Merrill Lynch had one investment fund and 2 debt funds; Goldman Sachs had 31 investment funds and 2 debt funds; UBS has numerous quoted debt instruments on the Irish Stock Exchange. 9. German Banks and the IFSC German banks in particular had considerable connections with the IFSC. Deutsche Bank had quoted notes and trust certificates to the value of 160 million, the trustees of which are registered in the Cayman Islands; Deutsche Bank (Luxembourg) also had 433 million in debt instruments quoted on the Irish Stock Exchange, and Deutsche Investment Managers had three funds quoted on the Irish Stock Exchange (February 2009). Commerzbank has three debt securities quoted on the Irish Stock Exchange with a value of 1.30 billion, and 800 million. All three are domiciled in Delaware. Of particular interest are German banks with subsidiaries in the IFSC, that required State aid (Sachsen Bank, IKB, West LB and Hypo). Sachsen bank had securities quoted on the Irish Stock Exchange with a value of $92 billion. Sachsen Bank also had 200 million invested in Synapse Investment Management, managed in Dublin, which became insolvent. Sachsen bank was taken over by LBBW in 2007. LBBW had two funds quoted on the Irish Stock Exchange. The offices of LBBW were searched by German state prosecutors in Stuttgart in December 2009, because of suspected breaches of trust involving investing in subprime loans since 2006 and which are likely to result in large losses (Sackmann, 2009). At the start of the subprime crisis IKB had exposures of 16 billion to the sub-prime market ((Bacchus 2008-2 plc, prospectus) and total exposure to risky investments of 24 billion (BBC News 21/8/08).. An investment vehicle owned and run by IKB, Rhinebridge, with securities quoted on the Irish Stock Exchange of at least 370 million was forced into liquidation in 2007 and in 2008 IKB was taken over by Lonestar a US private equity firm. West LB had one investment fund and quoted securities with a value of 1.587 billion. Although West LB was reported as having a hugh exposure to US subprime investments (Morajee, 2008). Depfa Bank which became a subsidiary of Hypo Bank in 2007, had numerous quoted debt securities with the nominal value of debt instruments of 12.6 billion, and $5.2 billion as well as other currencies. Hypo bank largely as a result of this takeover, required funds of 102 billion in state aid, 50 billion in the form of loans and a further 52 billion in state guarantees. The German State has made a capital contribution of 3 billion to Hypo and may need to contribute a further 7 billion (Wilson, 2009). Hypo Bank became a wholly state owned in October
15

2009. The main reason for the collapse of Hypo Bank was due to short term funding difficulties by its Irish subsidiary Depfa Bank (Bloomberg, 31/10/08; Der Spiegel, 10/6/2008). The head of the German financial regulator Bafin is quoted as saying that the rescue of Hypo had prevented a run on German banks and the collapse of the European finance system (Scaly, 2009). This bank made large losses because of overdependence on short term borrowing and the subsequent rise in short term interest rates5. Other issues have arisen in relation to the lack of transparency and risk in financial products sold by

Depfa bank. In particular many municipal authorities in the US issued variable rate loans from Depfa without understanding the risk of much higher interest payments (Duhigg and Dougherty, 2008)6. Similar issues have arisen in Italy (Segreti, 2010). The operation of German owned banks at the IFSC in Dublin, also provide a useful example of issues arising from ineffective cross border supervision. The de Larosiere Report notes (p. 40) that failures in home country supervision if inadequate, as in the case of the Icelandic banks, can create significant difficulties for other countries. Fonteyne et al (2010, p.9) identify three cases which a European crisis management framework should focus:- (i) systemic importance in an EU country outside the home country; (ii) systemic importance because of size to the EU; (iii) systemic importance in an EU home country with substantial cross border activities. None of these categories cover the case of the four German owned banks operating at the IFSC (Depfa, IKB, Sachsen Bank and WestDeutsche LB). These banks posed large risks to the source country Germany, and in one case (Depfa Bank) systemic risks to the source country but most of their operations in terms of liabilities, assets and profits were outside Germany in another EU country. Hence a fourth category needs to be added to the above categories (iv) systemic importance to an EU country but with incorporated and controlled largely in another EU country. There were failings in source country regulation (Germany), in the case of these four German owned banks but these failings were compounded by failures in source country regulation (Ireland), and failure of coordination between both regulators. The case of Depfa Bank is an illustration of problems with source country regulation. Prior to takeover by Hypo Bank in 2007, and following a company restructuring, Depfa was an Irish incorporated entity since 2003, with its seat of government in Ireland, but with German subsidiaries and extensive operations in Germany and with shares listed and mostly traded in Frankfurt 16. Hence from the period 2002 to 2007 the main regulator of Depfa was the Irish regulator during a period when financial strategy and policies were developed which eventually led to a crisis for Hypo Bank. It is doubtful that if Depfa had remained an independent entity that the Irish regulator would have provided liquidity, even if the sums were a fraction of those eventually required. In addition Hypo bank had a subsidiary (Hypo Real Estate Bank International) whose headquarters were located at the IFSC since 2003 (IDA, Dublin Report, Autumn 2003). One of the key problems with the regulation of German banks in the IFSC was the difficulties with cross border supervision as described in the de Lasoriere Report, (pp. 7374). Nevertheless these entities were subject to considerable potential regulatory
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requirements in Ireland, for example they required a licence to operate from the Central Bank and must submit extensive documentation. Table (3) shows State aid to four German Banks located in the IFSC as a result of losses on subprime and other securities. Table (3) State Aid to German Banks with operation in Ireland and Quoted Securities on the Irish Stock Exchange Name of Bank Amount of State Aid IKB1 12.0 billion Sachsen Bank2 2.8 billion West LB3 6.4 billion in guarantees and 3 billion equity injection under consideration. Hypo bank (Depfa

Bank)4 102 billion of State aid, 50 billion of which consisted of guarantees. Source: F.T. 18/2/09 .
(1) http://www.german-info.com/press July 7 2009 (2) Europa Press release:- State aid: Commission approves restructuring of Sachsen LB, 4 June 2008. (3) Reuters 16/11/09 and Worldnews.com 7/11/09 (4) Problems at Depfa bank was the main reason for difficulties faced by Hypo Bank and its eventual rescue.

One commentator has reports that total losses at all of German Landesbanken could total 800 billion or one third of GDP (Munchau, 2010). Depfa Bank Depfa bank, following a reorganisation became an Irish registered company whose headquarters were in the IFSC in 2003, and was taken over by Hypo Bank in 2007. Largely because of Depfa, Hypo had the most serious problems amongst German Banks as a result of the financial crisis and required the largest State aid. From 2003 to 2006 the Irish regulator was the main regulator of Depfa Bank. One of the features of Depfa bank was the high ratio of equity to assets. In 2006 equity amounted to 2.77 billion and assets 223 billion (Table 4). The regulator allowed such a high level of leverage because risk weighted assets according tp Depfa amounted to just 33 billion. The problem was that the assets Depfa Bank held were in fact highly risky. Depfa bank was the worlds largest guarantor to act as buyer of last resort to variable rate bonds (Duhigg and Dougherty, 2008). These bonds had in the initial stages low rates of interest which in later years increased. Thus their risk was a function of the time date of the bond. Duhigg and Dougherty state:- By 2006 Depfa was the largest buyer of last resort in the world, standing behind $2.9 billion of bonds issued that year alone. In effect Depfa bank was acting as an insurance company without hedging any of the risks involved. The other main form of risk was in the form of financing. The 229 billion in assets were financed by short term deposits from banks (63 billion, other deposits ( 31 billion) and debt securities in issue (103 billion).
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Table (4) Assets and Liabilities of Depfa Bank 2005-07 billion 2007 2006 2005 Gross Assets 217.9 222.9 228.6 Risk weighted assets 44.9 33.3 24.08 equity 2.95 2.77 2.30 Financed by Debt Securities in Issue 62.8 102.8 101.6 Deposits from Banks 89.8 63.2 67.0 Other Deposits 30.2 31.1 28.8 Source: Annual Report and Accounts of Depfa Bank With such high leverage the gap between interest income and interest expense was narrow. For 2007 Depfa reported interest and other income of 6.8 billion and interest and other charges of 6.5 billion. As interest rates rose following the collapse of Lehman Brothers, the cost of funding also rose. The margin between interest revenue and costs of funding became negative. Depfa Bank became regarded as being highly risk and sources of funding were withdrawn, precipitating a liquidity crisis and the eventual rescue.

Sachsen LB Sachsen Bank was one of the most widely reported examples of a German bank which made losses on subprime funds. SLB Europe received a full banking Licence from the Central Bank of Ireland in February 2000. The main losses occurred through a conduit called Ormond Quay, based in the IFSC, Dublin, but in addition large losses were made on a fund quoted on the Irish Stock Exchange and run by Synapse Investment Management. Sachsen Bank operating in Ireland (Sachsen Bank Europe PLC) employed 45 people, approximately 12% of the total employees of the bank. Table (5) shows that from 2003 Sachsen Bank in Ireland has accounted for most of the group profits. For the year 2006 the Group as a whole reported 20 million in gross profits but for the same period the IFSC based firm reported a profit of 22 m. This means that the group outside Ireland reported a loss of 2 million. Thus the Irish subsidiary accounted for all of the group profits even though employing a minority of group employees.
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Table (5) Sachsen LB Europe Plc, Gross assets, Profits and Employees million
(1) Defined as shareholder funds/total liabilities and shareholder funds

Source:- Annual Reports of Landesbank Sachsen Girozentralle available at http://www.sachsenlb.de. Annual Reports of Sachsen LB Europe. The 2005 accounts of Sachsen LB Europe footnote (3) a state:- the quality of the portfolio is of the highest level and continues to reflect the diverse nature of the bank and the majority of credit portfolio exposure is to Euroland. As regards interest rate exposure footnote (3) b(i) and footnote (27) a sensitivity analysis was used assuming an increasing in interest rates of 0.08% basis points. In fact interest rates on interbank borrowings during the crisis increased by several hundred basis points. As in the Bear Stearns case the ratio of equity to total funds is low and has fallen through time. IKB IKB bank made large losses and faced considerable difficulty in raising finance largely as a result of an off balance sheet conduit known as Rheinebridge (Financial Times, March 28, 2008). This conduit was quoted in Dublin. The investment strategy was to borrow short term commercial paper to purchase higher yielding higher assets. Although quoted on the stock market the largest shareholder is the state owned Kfw development bank. This bank has now been sold to a US based private equity Group called Lone Star. West LB WestLB had several subsidiaries operating in the IFSC in Dublin. In April 2008 the Bank reported losses of 1.6 billion after writedowns on subprime loans of over 2 billion. One of these funds (Kestrel) was responsible for further losses of 473 million in 2008 (Carswell, 2009). There are several reasons for the collapse of German banks in the financial crisis. One reason is the failure of regulation. Another contributing reason may have been fraud. The
Year Gross Assets Sachsen LB Sachsen LB Value of securities on Balance Sheet

Gearing Ratio % Gross Assets of Sachsen Group Profits of Sachsen Bank LB Profits of Sachsen Group Dividends of Sachsen LB Employees of Sachsen LB 2001 1563.085 1411.032 8.1 11.751 0.0 37 2002 2317.932 2317.932 6.1 17.014 0.0 26 2003 3816.993 (6.5%) 3816.993 3.8 58549.0 33.016 (58.9) 56.208 25.0 33 (5%) 2004 4899.46 (8%) 3182,235 2.9 60559.0 41.147 (64.3%) 63.941 35.0 38 (5.9%) 2005 4890.453 (7%) 3058.571 2.9 68420.0 50.579 (280%) 18.098 57.5 46 (7.7%) 2006 67760.0 82.953 19

SEC has brought fraud charges against Goldman Sachs in relation to the sale of a CDO fund based on US residential mortgages (Abacus 2007-AC1) to IKB. This issue is also likely to arise in relation to other large banks such as Merrill Lynch, Citi, UBS and Deutsche Bank (Jenkins, 2010). It may also involve other German banks as victims such as WestLB and Sachsen Bank (Wilson and Jenkins, 2010). 7. Conclusion The subprime crisis and the emergence of the shadow banking sector and subsequent collapse described in this paper is an example of a Minsky process. Financial innovation is a pervasive aspect of market based economies. Minsky has argued that a boom based on financial innovation necessarily results in a collapse. Minsky argues part of the solution to instability by financial innovation is through regulation that is through constraints on debt levels both for the personal sector and the corporate especially the financial sector. The emergence of the shadow banking sytem illustrates the problem of regulating complex financial products, operating across a number of different jurisdictions one or

more of which may be a tax haven. The recent controversies in relation to Goldman Sachs illustrates the issue of information asymmetries between purchasers of complex instrument and those who create and market them (Schwartz and Dash, 2010). It also illustrates conflicts of interest that allows one party to the contract to exploit information asymmetries. Underlying these issues is the issue of the whether derivates have any social value (Soros, 2010) or economic value (Grantham, 2010). In this context the much criticised unilateral action by Germany to ban certain derivative trading in Germany is likely to be followed by other countries ((Wiesman, et al., 2010; Ewing, 2010). The enforced liquidation of the Carlyle Capital Corporation which in February 2008 was reported as managing $21.7 billion in funds (New York Times 14/3/08) is a good example of the difficulties in regulation following from different country locations of discrete parts of the group. The New York Times comments (March 14, 2008) that Carlyle Capitals problems also provide a glimpse into the challenges faced by the usually secretive hedge fund industry because, unlike most such funds, Carlyle Capital is publicly listed.. While true that Carlyle Capital was publicly listed in Amsterdam it was registered in Guernsey to benefit from a low tax regime (Guardian Newspaper 14/8/08). Seven of its funds were listed on the Dublin Stock Exchange, three of these funds were registered in the Cayman Islands, and a further three were registered in the Cayman Islands and Delaware. These and other examples cited in this paper confirm the need for extensive regulatory and other institutional reform, There is especially an urgent need to take into consideration the use of low tax regimes/tax havens by financial firms. For countries based in the EU this is likely to mean an EU based regulator as in the ECB model.
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This paper argues that financial innovation undertaken in conjunction with institutional change may be long lasting and to have considerable favourable economic effects. Financial innovation that is not associated with institutional change will not be long lasting and will eventually result in financial collapse. Footnotes (1). See Wall Street Journal 5/12/91 in relation to Lincoln Savings and Loan Association which collapsed with liabilities of $2.5 billion large due to falls in the value of junk bonds. In another case Columbia S & L purchased bonds from Drexel Burnham Lambert for $4 billion which subsequently fell in value to $2.5 billion. Source: Wall St. Journal 1/10/91. (2) Central Bank and Financial Services Authority of Ireland Act 2003, section 5 (b). This clause has been omitted from proposed legislation reforming financial regulation in Ireland. See Central Bank Reform Bill, 2010. (3) See Irish Stock Exchange Why List, available at http://www.ise.ie, (4). See Irish Stock Exchange Why List, available at http://www.ise.ie. (5). See Irish Stock Exchange Why List, available at http://www.ise.ie (6) In relation to debt instruments the Irish Stock Exchange states that The Exchange have committed to very aggressive and specific turn-around times on all documents submitted i.e. a three day turn-around on the first draft of the document and two days on subsequent drafts. In addition the exchange states the procedures for listing have been simplified particularly for debt issuance programmes. Housekeeping requirements and other administrative procedures have been minimised. available at :- http://www.ise.ie/. In 2007 Qualifying Investor Funds may be authorised by the regulator on a filing only basis, so that there is no prior review of documentation. Qualifying investor Funds are most frequently used

by hedge funds, fund of hedge funds, equity funds, and others Source:- Dillon Eustace, Important Changes to Authorisation Process for Irish Domiciled QIFs, available at http://www.dilloneustace.ie. (7) According to one newspaper report, the Financial Regulator distanced itself from the issues concerning firms located at the IFSC, and is quoted as saying it is not required to police the activities of vehicles such as Ormond Quay (Clerkin, Sunday Business Post, September 2 2007). The Irish regulator has been reported of being informed about difficulties in relation to Sachsen LB (a bank incorporated and registered in Ireland) three years before its collapse (Ihle, 2009). Ihle also states:The Irish regulator has repeatedly disclaimed any oversight of unregulated investment vehicles operating out of Ireland . In 2007 the regulator stated in relation to difficulties with subprime funds located at the IFSC:21

.. .. it is important to point out that some of the particular investment vehicles that have recently encountered difficulties and the small number of those that happen to be based in Ireland are special purpose companies, invested in by professional investors, including financial services firms, who are generally regarded as having adequate professional expertise available to them when undertaking such investments. Internationally the approach therefore has been that these vehicles do not require close regulatory oversight. Our regulatory system here is no different in this regard to that in other jurisdictions, including the rest of the EU. Indeed our regulatory regime is recognised as conforming to international best-practice standards. (See speech to the Irish Bankers Federation National Conference (11/9/2007). (8) The Madoff case involved Luxembourg and the Stanford case, Antigua. French investors channelled up to 500 million to Madoff via UCIT funds quoted in Luxembourg and Dublin (F.T. 26/1/09. Regulation in Luxembourg has been subject to extensive criticism (F.T. 30/1/09). However despite two Irish funds also investing with Madoff (Irish Independent, 15/1/09) and suing HSBC Trust Services (Ireland) and PWC (Irish Independent 30/1/09) there has been no public criticism of Irish regulation in this case. The Stanford fraud case also involved low tax jurisdictions in this case Bermuda. (9) Fifteen of these funds are listed as either having been liquidated or being on a watch list on the Hedge Fund Implode-o-meter web site. See:- http://hfimplode. com. (10). Hypo Bank reported a loss for the quarter ending 30 September 2008 of 3.1 billion, of which 2.5 billlion related to Depfa Bank Source Irish Times 13 November 2008. In August Hypo stated that it expects to make losses until 2012 (Financial Times, 7, August, 2009). In October 2009 the final 10% of shares not owned by the State were purchased by Germany's financial markets stabilisation fund SoFFin (Financial Times September 29, 2009). Hypo recently announced the establishment of a bad bank to which 210 billion of asset would be transferred (Financial Times 22/1/2010). Most of these assets relate to its Irish subsidiary Depfa Bank. (11) What has not received much comment is that both a former President of the Bundesbank (Tietmayer) and a former Governor of the Irish Central Bank (Maurice OConnell) were on the Board of Depfa Bank for part of this period 2005-06. The auditors were PriceWaterhouseCoopers, who are also auditors of another German bank located at the IFSC, Sachsen Bank, who also experienced large losses through

their Irish operations. References Baily M. , Litan R. and Johnson, M. (2008), The Origins of the Financial Crisis, Brookings Paper, Fixing Finance Series, paper no. 3.
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