Over the last half century, finance has made remarkable progress explaining the pricing of financial assets. In relying on portfolio theory, however, mainstream pricing models tend to ignore investor preferences for certain asset types. This is a mistake. In a new paper forthcoming in Harvard Business Law Review and available here, I weave recent empirical findings on the demand for “safe assets” with an institutional account of how financial intermediaries increase the effective supply of such assets to demonstrate how investor preferences can drive financial innovation and radically alter the structure of the financial system. By moving beyond abstract concerns about regulatory arbitrage to a granular account of when and how financial regulations can undermine the very aims they are designed to achieve, the paper shows how to improve the rulemaking process to help regulators understand the systemic ramifications of their actions.
Much of modern corporate finance rests on the assumption that investors care only about maximizing their risk-adjusted returns. Even if some investors prefer certain types of financial assets, those preferences are assumed to disappear in the aggregate as other investors rebalance their portfolios accordingly. This assumption has enabled economists to craft and refine a cohesive framework for pricing a wide array of financial assets. But it provides little explanation for the increasing complexity of financial instruments and markets and cannot explain the spread of innovations like securitization. Taking investor preferences seriously helps fill these gaps.
Once investors value financial instrument characteristics other than risk-adjusted returns, innovations that increase the supply of the desired instruments become viable. These innovations can entail repackaging cash flows from existing financial instruments, using derivatives to create new instruments with the desired characteristics, or combining these and other techniques. By finding new ways to connect capital with value-creating projects, financial innovations driven by investor demand can promote price efficiency and lower financing costs.
But they also have negative side effects. Investor-driven innovation often entails the creation of complex new structures, new interconnections, and new types of instruments. These developments increase rigidity, create new mechanisms for contagion, and lead to new information gaps. Investor-driven financial innovations can thus contribute to systemic fragility and, at times, may even inhibit efficiency.
Understanding investor-driven financial innovation is critical to ensuring that financial regulations achieve their intended aims. Over the past decade, financial institutions have faced increasingly complex and demanding standards with respect to both sides of their balance sheets. Banks must hold more capital relative to their assets and must hold proportionately more “high-quality liquid assets”; parties to derivative transactions face increasingly stringent collateral requirements; and institutional investors wanting to park cash in a mutual fund now must hold a fund backed only by government and quasi-government short-term debt. These are but a few of the ways that the post-crisis reforms have fundamentally altered the demand for particular types of financial assets. Nonetheless, regulators have paid relatively little heed to how these interventions might affect investor preferences or alter the structure of the financial system. This is a problem. Whenever a law requires or creates incentives for institutions to hold particular types of financial assets, it can increase demand and drive innovation. Although this is not a new insight, the lack of a framework for explaining when and how the law contributes to innovation has made it too easy for regulators to disregard these dynamics. My article brings into focus the mechanisms through which changes in the law alter financial system structure and resilience and provides concrete guidance for how to improve the rulemaking process to address these dynamics.
The article’s first contribution is descriptive. It provides one of the first comprehensive accounts of “investor-driven financial innovation”—what it is, when it arises, and why it matters. This account combines empirical evidence demonstrating that investor demand affects financial asset pricing and production with an institutional account of the reasons for demand discontinuities, how these discontinuities have led to particular financial innovations, and some consequences of those innovations. In weaving together findings from different fields of study, this analysis is more than just the sum of its parts. It paints a new and more striking picture of the importance of constrained capital in driving innovation than could be gleaned from any of the source materials. In so doing, it helps to answer the fundamental questions that persist regarding the reasons for financial innovation.
The article’s second contribution is to identify the legal interventions most likely to trigger innovation. That financial market participants will seek to minimize the cost of regulatory compliance, creating the possibility of unintended consequences, is well known. The focus here is on a specific mechanism: When will a law so alter investor preferences as to encourage innovation? In providing a framework to answer this question, the analysis goes beyond generalized notions of regulatory arbitrage to provide a structured way for regulators to consider the impact of a rule change on markets. The framework proffered emphasizes the need to develop a baseline that takes into account market-based reasons investors will at times prefer certain types of assets and the need to cover the costs of developing and utilizing innovative techniques. This frame provides some surprising insights into the regulations most likely to drive innovation.
Putting these pieces together, the article concludes by explaining how to improve rulemaking to address the impact of constrained capital on the structure and resilience of the financial system. First, in showing how investor preferences can drive innovation, the article focuses attention on a mechanism through which changes in the law affect the development and spread of innovative instruments. Second, in providing a framework for recognizing those interventions most likely to spur innovation via the identified mechanism, the article provides regulators a means for identifying when they should reconsider the prudence of a given action in light of its systemic consequences. The core claim is that when undertaking interventions likely to have a meaningful impact on aggregate investor preferences, regulators should be compelled to estimate the magnitude of the proposed impact and provide a written analysis of how the system may evolve in response to the intervention. As a starting point, these analyses should be required whenever regulators propose rules that force or encourage regulated entities to hold specific types of financial assets, or when they seek to change existing rules in ways that could affect the supply or demand of so-called safe assets—an asset class particularly likely to spur systemically important innovation.
Compelling regulators to consider how an intervention will affect the aggregate demand for a given class of financial instruments could serve as a critical first step in modifying the rulemaking process to better address the systemic ramifications of particular interventions. This proposal thus complements recent work on the shortcomings of cost-benefit analyses in financial regulation and the importance of a macroprudential approach when regulating financial markets. Although regulators are likely to confront significant data and modeling charges when first undertaking the proposed analyses, the very process of identifying and seeking to address such deficiencies should enable regulators to develop a more sophisticated understanding of the intended and unintended consequences of their actions. In time, these processes could also spur a mapping of the financial system, enabling regulators to identify better ways to consider new approaches to enhancing the resilience of the system.
This post comes to us from Professor Kathryn Judge at Columbia Law School. It is based on her recent article, “Investor-Driven Financial Innovation,” available here.