Nigel Jenkinson: Financial innovation - what have we learnt?
Speech by Mr Nigel Jenkinson, Executive Director, Financial Stability, Bank of England, to
the Reserve Bank of Australia Conference on "Lessons from the Financial Turmoil of 2007
and 2008", Sydney, 14-15 July 2008.
This speech is co-authored with Adrian Penalver and Nicholas Vause.
* * *
Section 1: Introduction
1. At last year's conference, we presented a paper highlighting the profound impact of rapid
financial innovation, deregulation and capital market integration on the performance, risk and
management of the global financial system. We particularly noted the benefits of financial
innovation.1 We argued that the development of new financial instruments has created
opportunities for households and corporates to improve their management of financial risks
and has facilitated the smoothing of consumption and investment over time and across
different states of the world. But we also emphasised that the breakdown of barriers to the
supply of financial products and the large volume of risk pooling and shifting within and
across borders has increased the network interconnections within the global financial
system. That has added to the system's complexity. And we underlined that understanding
and addressing the corresponding evolution of financial system risks poses major challenges
for financial institutions and for financial stability authorities.
2. The past year has seen these potential major challenges turn into real practical problems.
We are now almost a year into a credit crisis centred around a sudden evaporation of market
liquidity for many structured credit products that rapidly spilled over into wholesale bank
funding markets and beyond, given a complex web of interconnections.2 So it is an
opportune moment to review whether the financial innovation of recent years that created
such structured products has indeed been a positive force, as argued by Alan Greenspan3,
for example, or whether financial innovation has been a malign development, producing
"financial weapons of mass destruction" in the words of Warren Buffett4?
3 There is clearly some force in both arguments. On balance, we continue to see
considerable benefits to households and corporates from the broadening of choice in
financial products and from improvements in the completeness of financial markets. But
equally, the severe pressures and strains of the past year have highlighted the
pervasiveness of some market frictions that have a major bearing on system-wide behaviour
and dynamics, amplifying and transmitting shocks. Action to lower these frictions is
consequently important to capture the full benefits of innovation and to ensure that these are
durable.
4 This paper explores these issues further. Section 2 provides a short reminder of the
staggering extent of financial innovation in recent decades. Section 3 sets out the theoretical
vision of how financial innovation offers the potential for substantial improvements in the
capability of corporates and households to manage financial risks. Section 4 highlights the
obstacles to fulfilment of that vision given the imperfections in financial markets. Lessons for
the future and possible policy responses are discussed in Section 5, while Section 6
concludes.
Section 2: Trends in financial innovation
5 The pace of change in financial markets in recent years is truly remarkable. A few statistics
help to illustrate this point and set the scene:
•
The outstanding value of interest rate swaps and other derivatives reached almost
$600 trillion or some 11 times annual global GDP by the end of 2007, according to
the BIS. Ten years ago the value was around $75 trillion (2 1⁄2 times GDP) (Chart 1).
The global derivatives market expanded almost 50% during 2007.
Chart 1 Outstanding Notional Amounts of
Derivatives
US$trillions
Interest rate contracts
700
Foreign exchange contracts
Credit default swaps 600
Equity-linked contracts
500
Commodity contracts
Unallocated 400
300
200
100
0
98 99 00 01 02 03 04 05 06 07
Source: BIS.
•
The credit default swap (CDS) component has experienced explosive growth. The
outstanding value of CDS contracts has surged to more than five times the
outstanding principal of global corporate bonds by the end of 2007. Yet only three
years' ago, at end-2004, the CDS market was only some 85% of the size of the
corporate bond market. The CDS market is now by far the more liquid market for
trading credit risk.
• The outstanding value of commodity derivatives outstanding has risen from around
$400 billion in 1998 to $9 trillion at the end of 2007.
• Options markets have also grown very strongly. For example, the outstanding
principal of interest rate options has increased from $8 trillion to $57 trillion in the
past decade.
•
Innovation and the removal of barriers to cross-border activity has spurred global
capital market integration. For example, turnover in foreign exchange markets has
tripled since the BIS survey in 2001. And cross-border asset holdings have
outpaced the strong growth in the global stock of financial assets.
•
Markets offering investors ready-made portfolios rose very rapidly in advance of
the credit crisis. Issuance of asset-backed securities (ABS) globally was
$1460 billion in the first half of 2007, up from $425 billion 9 years previously. There
was rapid expansion in the market for collateralised debt obligations (CDO) from
$75 billion in the first half of 2005 to $200 billion in the first half of 2007. And
innovation spawned greater complexity. Investment banks launched a series of
highly complex products such as constant proportion debt obligations (CPDO) and
re-securitisations of CDOs and ABSs (so called CDO-squared and CDOs of ABS).
• Demand for such tailor-made products has plummeted over the past year, while
other markets such as the corporate CDS market have continued to expand
rapidly. A possible explanation and assessment of the implications is set out in the
remainder of the paper.
Section 3: Financial innovation: a broadening of choice
6 A crucial function of the financial system is to help companies and households to manage
risks. The discharge of this function depends on the type of financial products or contracts
made available to companies and households to hedge and take on risk exposures in close
alignment with their individual risk preference and tolerance, as well as the capability of the
institutions that make up the financial system to manage the risk inherent in these products.
The focus of this section is on how innovation in financial instruments extends the choice of
risk management products available to companies and households, moving us closer
towards a vision of liquid markets in state contingent securities. But it must also be borne in
mind that imperfections within financial markets will affect the performance of these
innovative financial products, that may in turn limit their availability. Such frictions may thus
impact on the ability of the financial system to support corporate and household risk
management. That is covered in section 4.
7 As an illustration of the potential benefits of innovation in contract design and broadening
choice, consider the market for corporate credit risk. In previous decades, the only securities
available to investors wishing to invest in corporate debt were corporate bonds. One might
call such assets "natural assets" as the same instrument that is issued by the borrower is
also that held by the investor. In this example, the role of the financial system is simply to
facilitate the intermediation between end borrowers and end investors, and, in some cases,
to provide a secondary market in the asset, intermediating between alternate end investors.
There is no transformation of the asset.
8 Financial engineering can, however, decompose the returns on a corporate bond into
different fundamental components or "atoms" of risk:
•
For example, credit default swaps can be used to separate the return on a corporate
bond into the compensation for default risk and the compensation earned on a
riskfree security. An investor wanting to make an inter-temporal transfer without taking
on any credit risk, for example, could then buy a bond and purchase credit default
swap protection, thus retaining exposure to the cash flows on the risk free
component of the underlying instrument. Synthetically, this expands the volume of
low risk investment portfolios. On the other side, a market is created for those who
specifically want to trade default risk which allows cleaner pricing of this dimension
of risk. Efficient markets for each element should raise the efficiency of the
corporate bond market as a whole, with attendant benefits for both borrowers and
investors.
•
Furthermore, because credit default swaps have different maturities, investors
could, for example, buy the corporate bond and retain the resulting exposure to
default risk in the near term. But they could also buy protection against default at
longer horizons, about which they may be more uncertain.
•
Moreover, nominal corporate bonds can also be separated into a nominal and
inflation-linked risk component if the corporate also issues inflation-indexed bonds.
Investors can utilise these instruments to buy or sell protection against exposure to
inflation risk.
As noted above, the markets for single-name corporate credit default swaps have become
more liquid than the underlying bonds given the flexibility and specificity they provide to
endinvestors.
9 The underlying components of risk can, of course, also be recombined by financial
engineering to create new financial products with different risk characteristics. Extending the
above example, single-name credit default swaps have been pooled together into
standardised indices. That creates a synthetic market in generalised corporate credit risk,
enabling investors wishing to hedge or establish a new position linked to macro-economic
risk to do so. And there are many parallels such as products tracking equity indices or
commodity prices or emerging market debt to name but a few.
10 The value of standardised indices to financial intermediaries can be illustrated by
considering a credit default swap dealer, who may find at the end of a day's trading that they
have been a net seller of default protection on several dozen corporates. The dealer could
hedge such a position by buying protection on the standardised indices. The hedge would of
course not be perfect as in all likelihood the firms in the standardised indices would not be an
exact match to those whom the dealer had sold protection. But because indices are relatively
liquid and thus cheaper to trade, the dealer may decide that the resulting saving in
transaction costs may outweigh the residual "basis" risk that results from the hedge being
imperfect. And through competition, the benefit would tend to be shared by corporate
borrowers and investors in corporate credit risk.
11 Taking the example further, investors who wish to take exposure to generalised corporate
credit risk but who wish to limit their potential losses can do so through trading options
contracts on the standardised indices. The array of options with different "strike prices",
which represent the thresholds beyond which the options do or do not pay out, allows market
participants to express opinions about the distribution of possible future aggregate corporate
conditions.
12 Credit default swaps are not the only way an investor can engineer a targeted exposure to
credit risk. Alternatively, an investor can take a position on corporate credit risk by
purchasing a securitised product such as a collateralised debt obligation (CDO). In this case,
a pool of assets such as corporate bonds is created and the payment streams produced by
these are allocated to different classes or tranches depending on the default experience.
This allows investors to take positions on the scale of default losses in the underlying asset
pool.
13 Stepping back, the extended example above highlights how financial engineering has
facilitated the decomposition of corporate credit risk into different subcomponents and the
recombination of these subcomponents into new financial products with different risk
characteristics. There are many other examples across the financial system. The consequent
broadening of the range of financial products has improved choice and the matching and
tailoring of products to customer needs. For instance, the ability of non-financial corporates
to manage their risks has been transformed by their increasing use of derivatives to hedge
interest rates and currency risk as well as their exposures to commodity prices. And
notwithstanding the current squeeze on the availability of credit (and withdrawal of many
products), households have also benefited from a significant expansion in the range of
saving and borrowing products compared to the position 20 years ago.
14 The practical examples described above clearly demonstrate the benefits of financial
innovation. Enhancing the capability to transform and transfer risk, and thus improving the
matching of the supply of risk products to the demands of end investors offers the prospect
of lower risk premia and greater financial efficiency. And that in turn should lower the cost of
capital for firms and improve the ability of households to smooth their lifetime consumption
and to insure against unexpected outcomes.
15 Taking an even further step back, there is a beguiling vision of financial innovation taking
us closer towards a world of more complete and efficient markets for state-contingent
contracts. The ability to decompose and trade the distribution of many dimensions of
fundamental risks creates a potential lattice of efficient risk prices which can then, by
arbitrage, be used to price efficiently the combinations of these risks embedded in "natural
assets" and in "synthetic assets" structured to meet investor demand.
Section 4: Frictions and Market Imperfections
16 The previous section described how financial innovation has widened the range and
choice of financial products available to corporates and households to facilitate improved risk
management. But it also noted the potential importance of market imperfections and frictions
in the provision of such contracts. One year on from the onset of the current credit crisis,
what have we learned about the performance of the financial system and such market
imperfections?
17 Looking broadly, an important lesson from the past year, is that these frictions appear
more powerful than market participants and financial authorities previously judged. They
pose substantial barriers and practical limitations to the achievement of a stylised vision of
full, complete, and efficient markets in fundamental components of risk. Five areas of
potential weakness are highlighted in turn: incomplete information; alignment of incentives;
liquidity in financial markets; robustness of market infrastructure; and system dynamics.
Incomplete information
18 The vision of a world of complete and efficient markets for risk depends on full
information. This full information requirement sounds deceptively simple but is actually
extremely onerous. An investor needs to know the mapping between states of the world and
the pay-offs they would receive in each state as well as the likelihood of these states of the
world materialising. This means not only understanding the details of highly complex
contracts but also the effects of the interplay between exposures and contracts of all the
other agents in the economy. So not surprisingly, many of the problems that have occurred
over the past 10 months have arisen out of incomplete and asymmetric information. There
are a number of dimensions.
19 First, it is very difficult to ascertain the pay-off distribution for many instruments. For
example, a mezzanine CDO tranche might have attachment and detachment points of say
7% and 10%, meaning that for losses on the underlying collateral of less than 7% they
continue to pay out at par, but become worthless when losses reach 10%. The pay-offs to
such instruments are therefore highly sensitive to quite minor changes in expected credit
conditions. In a full-information world with known probability distributions, instruments with
such highly sensitive pay-offs are no more difficult to price than any others. But when lack of
complete information makes the future uncertain, in a Knightian sense, contracts with highly
sensitive pay-offs to slight changes in credit conditions become increasingly risky. Moreover,
innovative instruments inherently will not have a long run of performance data. Those
seeking to summarise their likely performance using statistical metrics based on limited data
and drawn from very benign circumstances have a very difficult task. Many investors in
RMBS and ABS CDOs linked to US sub prime mortgages have been surprised by the extent
to which the performance of these instruments has fallen short of even their worst
expectations. Securities with complex pay-offs, therefore, are highly vulnerable to increased
macroeconomic uncertainty.
20 Second, information loss is built into the securitisation process because of the separation
between the originator of the loan and the end investor. Chart 2 illustrates how information is
lost at every step in the chain of risk transfer. To some extent, holding a diversified pool of
underlying loans acts as protection against a lack of information about idiosyncratic risk. But
the experience of the past year has shown that diversified pools and seniority in the tranche
structure may not provide adequate protection against highly co-ordinated or "systemic" risk.
Chart 2 - Information Loss
Source: BIS Committee on the Global Financial System
21 Many investors had, of course, also delegated their monitoring responsibility to credit
rating agencies. This offered, potentially, a very significant efficiency gain. Rather than many
investors paying privately to be moderately informed - with corresponding substantial
replication of investment analysis - credit rating agencies were paid to be well informed and
to make this information public. But we now know that rating agencies were also unable to
overcome these same underlying information problems and have been forced to make
multiple down-grades to many of their ratings of structured credit products and to modify the
models they use for ratings. A major problem for the market as a whole has been that once
investors collectively lost trust in rating agencies, the next most informed participants in the
market were a long way behind. As a result, there was a step-change down in the level of
confidence in the likely performance of these assets and a consequent system-wide increase
in the risk premia required to hold such assets. With hindsight, information generation and
processing was too reliant on a limited number of rating agencies, and there was too much
confidence in the ability of individual rating agencies to solve the highly complex information
problems underlying some securities.
22 Third, it is very hard to determine counterparty credit risk for state-contingent securities. In
a world of full information, the state-contingent survival of counterparties would be known
and nobody would accept contracts from those who could not honour them - at least not
without a substantial price discount by way of compensation. But when investors cannot
know the full network of exposures in the financial system, it is extremely hard to estimate
where the ultimate incidence of losses from an extreme shock will occur. The failure of your
counterparties' counterparty can shift you up the queue of potential losers quite quickly.
Moreover, the fear of potential counterparty risk itself quickly affects the behaviour of
individual firms and thus leads to a collective lowering of risk appetite.
23 These problems are potentially the most acute for what might be called tail-risk products.
During the boom, tail-risk products, like deeply out of the money options, seemed an easy
way to make money. The protection seller could collect a steady stream of premia with the
extremely unlikely prospect of having to make a very large payment. Since these sorts of
contracts offer "deep" insurance, it is important to the system as a whole that they are held
by the most robust institutions. Here, the theory of risk transfer was that risk would be
reallocated to those most able to bear it. In practice, though, those most willing to take these
risks have in some cases turned out to be those who understood the risks the least and thus
were prepared to take it on at too low a price. This problem is extremely hard to guard
against because of the difficulty in determining whether a counterparty who is insuring you
against risk (or a chain of counterparties) fully understands what they have taken on and
have the capacity to make good on their commitment in adverse states of the world. In recent
months, banks have been forced to write down the value of contracts that they had bought
from monoline insurers to guarantee the payments promised by their holdings of highly-rated
CDOs linked to US sub prime mortgages. With the likelihood of such guarantees being called
upon appearing very small, the monolines wrote a large volume of such guarantees. But
more recently, this prospect has become a distinct possibility, and one that threatens the
viability of some of the monoline insurers, and thus their perceived ability to pay.
Incentives
24 These information problems are difficult enough when risk is treated as exogenous. And
in a world of full information, "nature" can be the only source of uncertainty. But in practice
when there is a lack of information and uncertainty about actions, the incentives facing
individual actors become very important and can lead to endogenous risk creation within the
financial system.
25 These incentive problems have been clearly apparent in risk transfer markets. As has
been widely described elsewhere, if loan originators do not have sufficient capital at stake,
5
they will not screen potential borrowers adequately. In the US sub-prime mortgage market,
rewarding loan originators by volume of issuance was a recipe for lax credit assessment
standards. But even when originators seem to have an economic stake in performance, for
example by holding some of the "first loss" or equity tranche of a securitisation, this is not
sufficient to guarantee incentive compatibility, as it is possible to hedge the exposure to the
equity tranche through a separate market transaction.
26 There is, though, also a more subtle problem. As mentioned above, holding a diversified
pool provides protection against idiosyncratic risk. But the absence of a concentrated
exposure can also limit the incentive to monitor individual loans, and thus the pooling of risk
ex ante ex
may lead to a reduction in the overall level of risk screening and monitoring post.
It was the combination of these misaligned incentives that proved such a problem in the US
sub-prime mortgage market. Individual end-investors had little incentive to monitor the
performance of loan originators, perhaps presuming that originators had sufficient stake in
the securitisation to provide market discipline. Issuers, though, transferred much of the risk
and did so comprehensively, as they needed to demonstrate that they had transferred risk
irrevocably before they could get capital relief. But in the absence of adequate monitoring,
originators could chase volume at the expense of lending standards.
27 Therefore, two elements at the heart of the benefits of financial innovation - the ability to
pool and transfer risk - contributed to an endogenous increase in the level of underlying
credit risk.
28 There is also a potential incentive problem arising from the separation of legal ownership
from economic exposure - although this is at the moment a possible difficulty for the future.
Credit default swaps transfer the risk of economic loss to the seller of protection but the right
to trigger covenants or put a firm into administration remains with the underlying asset
holder. A protected asset holder, therefore, has little incentive to monitor a company closely
and trigger covenants or force it into administration at the first signs that its business may
have become unsustainable. And the seller of protection lacks an alternative legal remedy.
Companies may therefore continue to operate for longer than they did in the past once they
get into trouble. So, the use of credit default swaps may reduce the probability of default but
increase loss given eventual default.
Liquidity
29 These problems of incomplete information, and misaligned incentives have had a major
impact on the market liquidity of innovative financial instruments.
30 As described above, misaligned incentives in origination and distribution allowed the
provision of sub-prime mortgages to households with very little prospect of repayment and
significant vulnerability to modest changes in economic circumstances. So any investor trying
to estimate the distribution of likely future delinquency rates amongst sub-prime borrowers
would not only have to consider the range of macroeconomic outcomes but also how much
this effect would be amplified by poor credit risk screening. This would be an extremely
difficult variable to quantify. But because of the sensitivity of complex securities to small
changes in loss rates, differing judgements about the quality of risk screening could make a
material difference to the value of the instrument. The recognition that risk screening and the
availability and quality of information on the performance of complex products was
significantly weaker than previously anticipated, as for example investors lost confidence in
the quality of credit ratings, led to a substantial increase in the risk premium required to hold
such assets. These effects made the valuation of assets extremely uncertain and contributed
to the rapid evaporation of secondary market liquidity.
31 There is also an important and fundamental tension between the capability of financial
engineering to tailor financial products to meet individual investor demand more effectively
and secondary market liquidity. The more closely a specific financial instrument is matched
to the risk preferences of an individual investor, the harder it is to find another investor willing
to trade that exact instrument in the event of a shock to those risk preferences.
32 In other words, the improved matching of risk to an individual's risk profile has given rise
to an increase in basis risk within the system. As one illustrative example, any investor
wishing to hedge any exposure to the US sub-prime mortgage market over the past year or
so would have little alternative but to trade in the standardised ABX indices (which
themselves have often been relatively illiquid) rather than in the specific instrument they held.
The developments over the past year have illustrated that hedges have often provided less
effective than envisaged, and that there was a significant under-pricing of the inherent basis
risk of many innovative structured instruments at the point of origination, given the lack of
secondary market liquidity for such specific risk. Looking forward, it is quite likely that there
will be greater unbundling of complex instruments into standardised components that are
likely to be liquid and readily traded with low transactions costs, and bespoke elements that
will command a higher risk premium given their inherent illiquidity.
Strengthening financial infrastructure
33 Because of the specificity of the risk, innovative financial products are rarely exchange
traded. Non-standardised products require the services of a broker-dealer to trade. But over
the counter (OTC) trading is vulnerable to many operational risks. In particular, investors are
exposed to the default of the major broker-dealer counterparties. This was a significant
concern to counterparties of Bear Stearns when it was in distress before being taken over by
JP Morgan. To moderate such concerns in the future, private sector initiatives are being
developed to introduce a central clearer to the CDS market. Such initiatives are very
welcome. Although the net positions of CDS dealers generally represent only a very small
fraction of their gross positions, because these gross positions have grown so rapidly in
recent years, inter-dealer positions can sometimes be very significant - even after netting. A
central clearer that would offset any long bilateral positions that one bank had with another
with any short positions that the same bank had with a third bank, could significantly reduce
the counterparty risk in the CDS market. A leading proposal at present is centred on the
Clearing Corporation, which is jointly owned by eleven major banks and other trading
platforms.
34 Counterparty risk, as described above, is particularly corrosive for liquidity in financial
markets. Investors become concerned not only with the soundness of their immediate
counterparties but their counterparties' counterparties, and so on. When risk crystallises it
can be unclear which financial institutions have been adversely affected. As a result of
limited disclosure and transparency, investors may limit the supply of funds to a much
broader array of counterparties than necessary. This helps to explain why all banks found it
more difficult to raise funding when the deterioration in the performance of sub prime assets
became apparent, even though it would later be revealed that some banks were more
exposed than others.
35 A further challenge is that the markets for innovative financial instruments can grow very
rapidly, outstripping the capacity of back offices to keep up with trading. Towards the end of
2005, CDS trading had run ahead of the processing of trades to the extent that the major
CDS dealers on average had unconfirmed trades outstanding that were equivalent to a
couple of weeks of trading volume. If the reference entities underlying these CDS trades had
defaulted, it would not have been clear - at least for some time - who was owed money by
whom. The international authorities then set the major CDS dealers targets to reduce
volumes of unconfirmed trades, which subsequently fell significantly. But a backlog of
unconfirmed trades did start to cumulate again during the early months of the recent financial
turmoil, although this has also diminished over the past six months. Furthermore, the
proportion of new CDS trades that are confirmed electronically and hence immediately has
increased sharply from around 50% when concerns were raised in 2005 to over 90% at
present.
36 It is also important that innovative financial products are documented sufficiently carefully
and that their risks are accurately communicated to potential investors. The more complex
the instrument, the greater the scope for misunderstanding. Investors have recently incurred
significant losses on complex securities like CDOs and a number are expected to sue for
mis-selling. HSH Nordbank is already suing UBS for the mis-selling of CDOs, for example,
and Banca Popolare di Intra has a lawsuit against Bank of America for the same reason.
Wingecarribee Shire Council is also suing Lehman Brothers for the mis-selling of CDOs.
System dynamics and the amplification of shocks
37 The frictions of incomplete information, imperfect incentives and inherent illiquidity of
bespoke financial instruments may also be amplified by adverse dynamics within the
financial system itself. For example, poorly-designed remuneration structures and short-term
performance targets may encourage "herding" behaviour within the financial system that
raises the costs of taking a contrarian view. And there are also well-documented concerns
that regulatory design pays insufficient attention to the risk of procyclicality6.
38 It also appears to be the case that many firms failed to take sufficient account of the likely
behaviour of other firms, and thus of system properties, when designing stress tests and
contingency plans. They were far too confident in their ability to exit or hedge positions in
high risk instruments, where trades were highly crowded, and were consequently
underprepared for the evaporation of market liquidity.
39 Moreover, there are some financial instruments (such as mortgage-backed securities
where the mortgages have prepayment options), where the dynamic hedging behaviour of
holders can amplify the price movement, as dynamic hedging can lead to additional short
hedging positions bein