FRBSF Economic Letter
2007-05; March 2, 2007
Financial Innovations and the Real Economy: Conference Summary
This Economic Letter summarizes the papers
presented at the conference “Financial
Innovations and the Real Economy” held at the
Federal Reserve Bank of San Francisco by the Bank’s
Center for the Study of Innovation and Productivity on
November 16–17, 2006.
This conference featured seven papers that address the
impact of innovations in the financial sector on the
real economy. The papers can be divided roughly into three
groups.
The first group examines how innovations in financial
markets affect consumer spending and borrowing. The second
group
focuses on how new financial instruments may help firms
mitigate risk but, in so doing, may also increase the
risk to the overall financial system. The third group explores
how financial innovations affect business borrowing behavior,
and how that behavior may increase the volatility of
financial
variables but decrease the volatility of real variables,
such as employment and output.
Financial innovations and the consumer
The paper by Campbell and Hercowitz begins by observing
several facts about the composition of U.S. household
debt and the ways it has changed over time. One stylized
fact
is that household debt has increased sharply since
the 1980s. The authors argue that deregulation (in
particular,
several laws passed in the early 1980s) increased competition
in the consumer lending market, spurring financial
firms to provide more services at lower cost to households.
For instance, as the costs of tapping into home equity
were
greatly reduced and down payment requirements were
lowered,
many households may have become more willing to acquire
a greater amount of debt that is collateralized by
their houses (the single largest source of debt for
U.S. households).
One way to gauge the potential importance of financial
innovation on consumer borrowing behavior is to develop
a model that analyzes how changes in regulations would
affect consumer behavior and then see if the model’s
predictions match what is observed in the data. To
that end, the authors construct a general equilibrium
model
of savers and borrowers. The general equilibrium concept
is important because it recognizes that, for every
dollar of money borrowed, someone must be willing to
lend that
dollar. It has been documented that many U.S. households
are net borrowers, while a minority are net savers.
Therefore, in the Campbell-Hercowitz model, there are
two types of
consumers: net borrowers and net savers. They show,
through a variety of exercises, that their model is
consistent
with much of the data.
The paper by Dynan, Elmendorf, and Sichel addresses
how financial innovation may help consumers smooth
consumption
over time. In their previous research (2006), these
authors argued that innovations in financial markets
could be
one of the reasons that the economy has become less
volatile since the mid-1980s. Their argument is that
financial
innovations
have enhanced the ability of businesses and consumers
to smooth their spending in the face of swings in income.
In this paper, they focus on the household level. They
analyze income and spending from a data set that tracks
individual households over time and find several interesting
patterns. Among these, the volatility of annual income
at the household level was higher after 1984 than before,
even though aggregate volatility in the economy declined.
They explore possible reconciliations of these divergent
patterns. Finally, the authors find that, at the household
level, spending has become less responsive to changes
in income, especially when income falls. Financial
innovations, such as easier access to home equity,
may account for
this
last fact.
The final paper in this group differs substantially
from others in that it focuses on financial services
provided
to the very poor in Guatemala. Authors de Janvry, McIntosh,
and Sadoulet examine the role of credit bureaus (institutions
that gather and make available people’s credit
histories) and the information consumers have about
credit bureaus
in the demand and supply of credit.
It has long been recognized that the poor in developing
countries have little, if any, access to credit. One
of the many reasons is that banks are unsure about
which borrowers
would be good credit risks, a situation that credit
bureaus might help alleviate. In addition, if consumers
were
aware that credit bureaus exist, they might be more
likely to
pay back their loans and to undertake less risky activities
to avoid having an adverse credit report that would
lessen the prospects for future borrowing. To measure
the extent
to which the introduction of credit bureaus affects
borrower and lender behavior, the authors exploit a
randomized
experiment in Guatemala. Their results suggest that
credit bureaus
do indeed help lenders identify low-risk borrowers
and increase the supply of credit. They also find that
those
borrowers who are educated about the role of credit
bureaus in providing credit ratings are more likely
to pay back
their loans than less educated borrowers.
Financial innovations and firms: Risk-sharing and systemic
risk
Financial innovations arguably have improved lenders’ risk
management and have made firms that want to borrow less
dependent on particular lenders. Ashcraft and Santos look
for empirical support of this notion by focusing on a particular
innovation, namely, the credit default swap (CDS) market,
where a CDS is an insurance contract that pays the insured
party if a specific borrower defaults. Specifically, they
examine whether CDS transactions, which supposedly lower
corporate funding costs, have led firms to issue more debt
and operate with higher leverage ratios. Using market data
starting in 2001, they do find that a firm’s
borrowings in the syndicated loan market and its operating
leverage
both increase after the firm begins having its name
traded in the CDS market. However, they do not find
any evidence
that this increase in credit supply is being driven
by lower spreads or weaker nonprice terms on syndicated
bank
loans. Hence, the mechanism by which this financial
innovation facilitates increased corporate borrowing
requires further
analysis.
Similarly, the larger systemic effects of financial
innovation in corporate lending are not yet fully understood.
New
financial instruments like CDS are widely believed
to facilitate risk-sharing across financial intermediaries
and, hence,
to have reduced the probability that difficulties at
a single intermediary could affect the entire financial
system.
However, because financial innovation is spreading
financial
risks more widely, some observers have raised concerns
that new, unforeseen risk concentrations among less-prepared
market participants could amplify certain adverse shocks,
which would increase systemic financial risk. Some
commentators also have argued that these concerns are
particularly
strong in the current environment, since many of the
markets for
the recent financial innovations have not yet been
through a prolonged period of stress, such as a deep
economic
recession.
Gai, Kapadia, Millard, and Perez lay out a model economy
in which adverse macroeconomic shocks could lead to
asset “fire
sales” that raise the probability of a systemic financial
crisis. Financial innovations should diminish this probability,
since they give firms greater access to funding and thereby
diminish firms’ need to sell their assets so quickly
during a recession. However, this greater liquidity also
leads firms to borrow more than before, which makes them
more vulnerable to adverse shocks. The model’s
trade-off between a reduced frequency of systemic shocks
and a potential
increase in their severity perfectly reflects the overall
uncertainty that policymakers face regarding the current
rapid pace of financial innovation.
Financial innovations and firms: Borrower and lender
behavior
In many models of the real economy, the financial sector
plays no important role. The assumption is that asset
prices simply reflect real fundamentals, with no feedback
from
financial markets to the real economy. However, models
with financing frictions suggest that innovations in
financial markets should have important macroeconomic
implications.
Jermann and Quadrini discuss the impact
of financial innovation on the volatility of debt, equity,
and output.
They argue
that, although the real sector of the economy has
become less volatile in the past few decades, the volatility
of the financial structure of firms has increased.
To explain
this observation, they construct an economic model
where business cycle fluctuations are driven by asset
price
shocks. Because of financial frictions, increases
in
asset prices
affect firms’ ability to produce, which then
affects the real side of the economy. For example,
lenders who
are worried about default will limit the size of their
loan exposure relative to the borrower’s net
worth; if asset prices rise, the borrowing constraint
is relaxed
and firms can increase employment and investment. Innovations
in financial markets that allow for greater financial
flexibility of firms—reflecting either increased
ability to borrow or increased ability to substitute
equity for debt—thus
reduce the volatility of employment, investment,
and output.
Wang also argues that innovations in financial markets
should lead to higher financial volatility but lower
real volatility. In her model, firms face shocks
to demand for
their products. In the face of these shocks, firms
would like to use inventories to smooth production,
which would,
in turn, minimize overall production costs. However,
smoothing production would cause cash flow to be
highly volatile.
If firms face an increasing premium for obtaining
external financing—reflecting, perhaps, the difficulty that
lenders have in verifying exactly why the firm wants to
borrow—then firms would also like to smooth cash
flow. This incentive to smooth cash flow thus restricts
the extent to which firms choose to smooth production.
Financial innovations that affect the size of the external
financing premium (and its relationship to the amount of
financing) allow firms to have more volatile cash flow
but smoother employment and output. Wang then models how
information technology has affected the premium charged
by banks and other financial institutions. In particular,
she argues that advances in information and communication
technology have greatly lowered the marginal cost of collecting,
processing, and transmitting information in general and
credit information in particular (for example, by using
computer-based credit scoring models). As a result, banks
today make loans not only to more borrowers but also to
smaller borrowers.
Mark Doms
Senior Economist
John Fernald
Vice President
Jose A. Lopez
Senior Economist
Conference
papers
Ashcraft, Adam, and Joao Santos. “Has
the Development of the Structured Credit Market Affected
the Cost of
Corporate Debt.”
Campbell, Jeffrey, and Zvi Hercowitz. “The
Macroeconomic Transition to High Household Debt.”
Dynan, Karen, Douglas Elmendorf, and Daniel Sichel. “Financial
Innovation and the Great Moderation: What Do Household
Data Say?”
Gai, Prasanna, Sujit Kapadia, Stephen Millard, and
Ander Perez. “Financial
Innovation, Macroeconomic Stability, and Systemic Crises.”
de Janvry, Alain, Craig McIntosh, and Elisabeth Sadoulet. “The
Supply and Demand Side Impacts of Credit Market Information.”
Jermann, Urban, and Vincenzo Quadrini. “Financial
Innovations and Macroeconomic Volatility.”
Wang, Christina. “Financial
Innovations, Idiosyncratic Risk, and the Joint Evolution
of Real and Financial Volatilities.”
Reference
Dynan, Karen, Douglas Elmendorf, and Daniel Sichel.
2006. “Can Financial Innovation Help to Explain
the Reduced Volatility of Economic Activity?” Journal
of Monetary Economics 53(1) (January) pp. 123–150.
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of the Federal Reserve Bank of San Francisco or of the
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