NBER WORKING PAPER SERIES FINANCIAL INNOVATIONS IN .
NBER WORKING PAPER SERIESFINANCIAL INNOVATIONS ININTERNATIONAL FINANCIAL MARKETSRichard M. LevichWorking Paper No. 2277NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts AvenueCambridge, MA 02138June 1987Prepared for the conference on "The Changing Role of the United States and theWorld Economy" organized by the National Bureau of Economic Research, March5—8, 1987. I am grateful to participants in the conference on "Capital MarketDevelopments and Financial Stability" organized by the Ditchley Foundation andthe Graduate School of Business of the University of Chicago and held at DitchleyPark, England for coninents on a related paper, and to Michael Dooley and MartinFeldstein for helpful coments on an earlier draft of this paper. JulapaRungkasiri provided efficient research assistance. Support from the MellonFoundation is gratefully acknowledged. The research reported here is part ofthe NBER's research programs in International Studies and Economic Fluctuations.Any opinions expressed are those of the authors and not those of the NationalBureau of Economic Research.
NBER Working Paper #2277June 1987FinancialInnovations in International Financial MarketsABSTRACTThe central theme of this paper is that financialinnovation has become a major force effecting the UnitedStates and other developed economies. The common features ofthe process include product innovation, securitization,liberalization of domestic financial market practices,globalization of markets, and increased competition amongfinancial institutions. The paper offers a review of theproduct and process changes that have occurred ininternational financial markets, an analysis of the factorsleading to these changes, and an examination of theimplications for both financial market participants andmacroeconomic policy makers.Richard M. LevichGraduate School ofBusiness AdministrationNew York University100 Trinity PlaceNew York, NY 10006212—285—8924
FINANCIAL INNOVATIONS IN INTERNATIONAL FINANCIAL MARKETSI. IntroductionA wave of financial innovation begun in the early 196 Os is nowsweeping throughout theUnitedproducing major changes in theStates and other developed economies,financiallandscape. While the detailsof the process differ country by country, there are several commonfeatures including (i) Innovation ——thedevelopment of new financialproducts and markets, (ii) Securitization —- a greater tendency towardmarket—determined interest rates and marketable financial instrumentsrather than bank loans (iii) Liberalization —-ofdomestic financialmarket practices either through explicit deregulation or a breakingdown of conventions, (iv) Globalization -- as national barriers erodeand financial markets grow more integrated and (v) Increasedcompetition among financial institutions with many of the traditionaldistinctions between commercial banks, investment banks and securitiesfirms becoming blurred in the process.1A major feature of this process has been the introduction of awide variety of new products that trade in new market settings,thereby reducing the reliance upon banks for traditional creditinstruments and credit evaluations. Many of these new products (e.g.currency and interest rate swaps, currency and interest rate options)are of obvious assistance for risk management purposes ——theindividualtoenableor firm to tailor the various dimensions of risk (e.g.currency, maturity, credit, interest rate, default, and so forth) moreprecisely than before. Other products (e.g. Note Issuance Facilitiesand Eurocurrency Commercial Paper) appear to directly reduce the costof funding a desired financial position. The basic principles1
underlying today's new financial products are being extended and re—applied to yield still more products.2It is not an exaggeration to claim that these developments arehaving a profound impact on all aspects of the financial servicesindustry. For individual employees, innovation has affected the jobof the typical bank "lending" officer at major money—center banks, the human capital needed to perform well and even thedefinition of normal business hours. At the level of the financialservices firm, innovation has affected the geographic location ofdescriptionactivities, the financial product line, the risks that are beingtraded or carried, the identity of the major players and the intensityof competition. Non—financial firms are faced with a vast array offinancial choices —— new financial markets and products, each withtheir own risk and return properties ——thatrequire increasinglysophisticated analysis. Naturally, all of these factors feed intomacroeconomic performance. Policymakers and regulatory agencies arekeen to understand the potential benefits (or costs) of these newproducts, new procedures and new players and to incorporate these newfactors into macroeconomic policies and regulatory decisions.The general theme of this paper is to provide a broadassessment of these recent developments surrounding financialinnovation including their impact on financial stability and nationalpolicymaking. This theme suggests several basic questions:i) What financial product and process changes have occurredover the last 20—25 years in U.S. and interhationalfinancial markets?ii) What factors account for these changes?iii) What are the implications of these changes for individualsand the aggregate macro—economy from both a positive andpolicy perspective?2
The purpose of this paper is to lay a foundation that will addressthese questions.We begin in Section II by outlining the dimensions of theinternational financial marketplace. Data presented on the volume ofactivity in the Eurocurrency and Eurobond markets offer a goodreflection of the general phenomenon in financial markets ——mushrooming volume, transforming markets once thought to be. ancillaryor for a specialized few into major centers of activity. Data on theextentof securitization and on trading in new risk management andfunding vehicles (e.g. futures, options, and swaps) are alsopresented. Again the picture is one of securities or markets thatvirtuallywerenon—existent a decade ago, but now have grown to substantialimportance.In SectionIII, we present an overview of the types of newfinancial products that are available and their functions. Severalfinancial market innovations are described to illustrate theirworkings and recent evolution and to demonstrate how the products addvalue for market participants. These examples also illustrate how newfinancial products might be engineered from existing products. This isimportant to demonstrate that the new instruments need not add newprice risk to the system, but by adding liquidity and newintermediaries, they may contribute additional credit or liquidityrisks.The causes of financial market innovation are explored in SectionWe first consider the demand for financial market services in a"Perfect Capital Market" setting, and then argue that financial marketIV.innovations may be viewed as attempts to overcome real world market3
imperfections. A distinction is made between imperfections that areran—made (e.g. taxes, regulatory barriers, and information disclosure)versus those that segment domestic markets and are naturally present(e.g. transaction costs, heterogeneous expectations, and heterogeneousconsumption/investment/risk preferences). Innovations that overcomethe former may directly thwart national economic policies, includinguseful pndential policies, while innovations that overcome thelatter tend to increase economic (allocational) efficiency.The implications of financial market innovation are discussed ontwo levels. First, in Section V1 we examine the consequences ofinnovation on financial market prices, international pricerelationships and financing opportunities. Then in Section VI, weanalyze the consequences of innovation for macro-prudential policy andbroader macroeconomic policy.On the markets side, innovations act to reduce the impact ofmarket imperfections, whether man—made or natural. As a result, weshould expect to observe greater capital mobility, greater similiritythe cost of funds in alternative capital markets, greaterintegration of international capital markets and greatersubstitutability among assets as a result of improved hedginginopportunities.On the policy side, there are two major concerns. One is whetherrecent innovations have the capacity to impose negative externalitieson society. As stated above, innovations act to reduce the impact ofmarkets imperfections, including those macro—prudential policiesdesigned to improve welfare by safeguarding the financial system. Onespecific concern is that the innovative process has led to a kind of"regulatory arbitrage" with financial institutions attempting to lower4
their costs and expand their activities by seeking out the leastregulated environment. These shifts in activity have raised fears thatinnovation may increase the risk burden on financial institutions andadversely affect the safety and soundness of the financial system.These fears are compounded by the prospect of nations competing forfinancial services activity by further reductions in the regulatoryburden.Securitization poses another specific example of potential welfarelosses associated with financial innovation. Securitization and theincreased use of financial intermediaries place the burden of creditevaluation on a larger pool of participants; the increase in marketlinkages may itself be seen as a source of added risk. To some extent,this may be because the new instruments lack transparency (i.e. theyare not well understood) and they have not stood the test of two orthree business cycles. Increased reliance on the market system (i.e.adequate information disclosure of off—balance sheet items, marking—to-market of financial positions, and so forth) may provide anadequate remedy for some of these fears.The second major policy concern is the impact of financialinnovation on macroeconomic policies in general and monetary policy inparticular. At one level, these concerns are operational. Theavailability of variable rate financing and hedging techniques makesthetiming and incidence of monetary policy more uncertain. Andrelated to this, the increasing ease of substitutability betweenassets and new techniques of obtaining credit may reduce the meaningand usefulness of traditional monetary and credit aggregates asindicators of monetary policy.5
A more fundamental concern is that greater internationalmobilityof capital and tighter integration of financial markets has alteredthe channels through which monetary policy works, ultimatelythreatening the welfare gains associated with international trade.Innovation appears to have reduced (to various degrees in differentcountries) the ability of authorities to adopt direct quantitativecontrols over credit or interest rate ceilings. With the effectivenessof the credit and controls channels reduced, it appears that monetarypolicy now has a greater impact on exchange rates, directly effectingthe real competitiveness of domestic manufacturing. A countryfollowing a comparatively tight domestic monetary policy is thereforelikely to lose international competitiveness, possibly setting offdemands for trade protection. To the extent that countries seek toreduce the variability of exchange rate movements, the new financialenvironment limits the scope for effective and independent domesticmonetary policies.Viewed in isolation, the recent wave of financial innovationsholds the potential to produce an international allocation of capitalthat is more consistent with economic risk/return considerations andallocational efficiency. An erosion of the gains from trade inmanufactures and commodities would represent significant potentialwelfare losses. The major policy question, then, is whether free tradeis antithetical to capital liberalization. Dealing with this addeddimension of policy coordination will be the challenge for policymakers in the years to come.6
II. Dimensions of International Financial MarketsThe international financial marketplace has undergone a tremendousexpansion in terms of the variety of products, the volume oftrading,and the capitalized value of available securities. The data presentedin this section suggest that a variety of financial markets, whichwere in their infancy or non—existent two decades ago, have grown tobecome major centers of activity and influence. The growth of thesemarkets demonstrates their significance and potential implications forinvestors, corporate managers, and national policymakers. We begin byreviewing the growth of three traditional international financialmarkets ——theforeign exchange market, the Eurocurrency market andthe Eurobond market. Then data on the rise of securitization arepresented, followed by measures of activity in the markets forfutures,. options and swaps.A.Foreign Exchange and the Euro—marketsThe foreign exchange market, the inter—bank market for theexchange of bank deposits denominated in different currencies,hasin one form or another for centuries and could hardly becalled a modern innovation. In recent times, the foreign exchangemarket has been organized as a dispersed, broker—dealer market withexistedhigh—speed telecommunications systems linking together the variousparticipants in this worldwide, 24-hour market. The volume andefficiency of the market is such that the spread between bid and offerprices in the spot market is often one—tenth of one percent, or less,the major currencies.The data in Table 1 suggest the tremendous volume of activityhandled in the foreign exchange market and its recent growth. Surveyscarried out within the last year indicate that London is the mostfor7
active foreign exchange trading location with transactions totalling 90 billion per day. New York is the second most active center trading 50 billion per day, and Tokyo is close behind with 48 billion perday. The total for these three centers is 188 billion per day. Addingin the contributions from other centers (e.g. Frankfurt, Zurich, HongKong and Singapore), worldwide foreign exchange could possibly exceed 250 billion per day, or more than 60 trillion per year.3 With anorder flow of this size, many times in excess of world GNP and worldtrade, it becomes easy to understand the depth and speed of theforeign exchange market.Insert Table 1 hereFor comparison, daily trading volume in New York in 1977 wasestimated to be only 5 billion, one—tenth of the estimated volume in1986. The growth of trading in New York over this period was probablygreater than that in London, and therefore overstates the worldwidegrowth in foreign exchange trading. Nevertheless, foreign exchangetrading clearly grew at a faster pace than other nominal magnitudesover this ten—year period. The figures for New York also indicatechanges in the composition of trading, away from. the Canadian dollarand certain European currencies and toward the Japanese yen andDeutsche mark.The Eurocurrency market has a much shorter tenure than the foreignexchange market. The Eurocurrency market, a market for depositsdenominated in a currency different from the indigenous currency ofthe financial center, began to take shape in the early 1960s. TheRussians played an important role in the early development of the8
market. They were reluctant in those Cold War days to hold theirdollars (needed for internationaltrade transactions) in U.S.u.s.accounts. Instead, they deposited their dollars in Paris with anaffiliate of a state—owned, Russian bank.4 Thetrue stimulus to theEurocurrency market, however, was the differential regulation betweenoffshore and onshore banking operations. Particular u.s. bankingregulations (i.e. interest rate ceilings on time deposits, mandatoryreserve requirements held at zero interest,and mandatory depositinsurance) became increasingly costly throughout the l960s, resultingin a greater share of banking activity being pushed offshore. Theinnovation in the Eurocurrency market is an example of "unbundling" --inthis case, taking the exchange risk of one currency (the U.S.dollar, for example) and combining it with the regulatory climate andpolitical risk of another financial center.Insert Table 2 hereThe data in Table 2 indicate the growth of the Eurocurrencydeposit market, from roughly zero in 1960 to over 3.0 trillion on agross basis and over 1.5 trillion on a net basis (netting out allinterbank deposits) in 1986. The market, once exclusively dollar—denominated, has now stabilized to become roughly 75—80% dollar based,with the currencies of other industrialized countries making up theremainder of the market. The Eurocurrency market was once small enoughto be ignored; today it rivals U.S. financial markets in terms ofsizeand importance. The short—term lending rate in the Eurocurrencymarket (LIBOR, or London Interbank Offer Rate) as it has beendetermined largely by free—market forces, has become the referencerate for many onshoreloan agreements, floating rate notes and other9
contracts as well as Euromarket loans.Over the years, because of its rapid growth and apparent lack ofregulation, the Euromarket has been feared by some as a source ofmacroeconomic instability or as a wobbly pyramid prone to crisis.Nearly all Eurocurrency banks are major players in their parent'sdomestic market and could be subject to regulation via this angle. In1974, central bankers from the Group of Ten issued a general statementof responsibility (the Basle Concordant) indicating that countrieswould extend lender—of—last—resort facilities for the solvency oftheir Eurobanks.5 The motivation here may have been to encouragenational banking authorities to pay closer attention to their membersEurobanking operations and to reduce the public's fear of aninternational banking panic. In 1980, the BIS announced anotheragreement requiring banks to produce consolidated statements of theirworldwide activities, including offshore assets and liabilities. Thisconsolidation would enable bank examiners to monitor the quality ofoffshore lending on the same basis as domestic offices.Eurocurrency markets and Eurobanking operations have become acommonplace feature in international finance. In 1981, the UnitedStates acknowledged the importance of these new offshore markets andauthorized the establishment of International Banking Facilitieswithin existing u.s. banking institutions. IBF5 are not subject to theregulations that apply to domestic banking activity (reserverequirements and deposit insurance, in particular) and are free toengage in many offshore banking arrangements with non—residents.6The Eurobond market developed at approximately the same time asthe market for Eurocurrency deposits. Again, differential regulation10
between offshore and onshore securitiesactivities played a key rolein stimulating the development of the market. In 1963, the UnitedStates adopted the so—called Interest Equalization Tax, effectivelyanexcise tax on American purchases ofnew or outstanding foreign stocksand bonds. To no one's surprise, the lETeffectively closed foreignersaccess to the U.S. bond market; to the surprise of some, the marketsimply migrated offshore to London and Luxembourg. Other costly u.s.regulations(further international capital controls and a 30%withholding tax on interest payments to foreigners) nurtured theenvironment for the Eurobond market.The remarkable growth record of the Eurobond market is presentedin Table 3. From the first Eurobond floated in 1957, the volume ofnewofferings reached 6.3 billion in 1972. Two years later, the UnitedStates abolished the lET and its capital control program. Eurobondunderwritings plunged to 2.1 billion in 1974 and the financial presswas anticipating the death of the market. But Eurobonds and U.S. bondscontinued to differ in several important ways ——investorsinEurobonds paid no withholding tax and held bearer securities, andissuers of Eurobonds avoided co
Financial Innovations in International Financial Markets ABSTRACT The central theme of this paper is that financial innovation has become a major force effecting the United States and other developed economies. The common features of the process include product innovation, securitizatio
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