The international finance industry has gone out of its way to harm its own reputation in recent years. But, says David Lascelles, we should not lose sight of the fact that financial innovation is fundamentally a productive force –

The urge to innovate in the financial world is enormously – almost uncontrollably – strong. The quest for new techniques, new products and new markets is never-ending, all driven by intense competition in a truly global marketplace.

You only have to look at the past few years to see a bewildering display of takeover artistry, newfangled derivative products, technology gizmos and infinite variations on plain, old-fashioned lending to support this claim.

Yet, as we now know, the urge to innovate can be an intensely dangerous thing, too. While many of the innovations of recent years have delivered huge benefits by, for example, helping investors to hedge risk or enabling industries to restructure themselves, they also create new dangers.

Unfamiliar instruments open up new forms of risk, the urge to be first forces people to cut corners, financial and ethical standards start to collapse, and it can all end in tears. Enron was a classic example of innovation abuse: it exploited new techniques not for honest purposes but to deceive.

The financial turmoil of recent months has driven home the message that financial innovation is a double-edged sword. Many people have even begun to wonder whether there might be only one edge – the one that destroys. But that is going too far.

The balance sheet on innovation is still broadly positive. Vast numbers of people, companies and governments have benefited from the improved access to finance and broader investment opportunities that innovation has opened up in recent years.

How many “ordinary” people realize that the guaranteed returns on their savings and pensions depend on sophisticated derivative techniques, or that their fixed-rate mortgages use complex swap arrangements between banks? To constrain innovation could damage not just the bad boys on Wall Street but also wider society.

What is clear, however, is that new pressures are being brought to bear on innovation – to account for itself, to have regard for wider issues than simply making money, and to address concerns that are moving rapidly up the social agenda, such as the environment.

At the regulatory level, an expanding rulebook is forcing tougher standards on licensing and disclosure. At the political level people want to be convinced all is ethical and positive. In short, the context for innovation is changing.

How are the financial markets likely to respond? With difficulty.

Financial innovation is a powerful beast and it will not easily be tamed. This is partly because of the nature of the financial markets, in which competition drives everything, to say nothing of the nature of bankers themselves, who tend to be highly motivated, impatient of regulation and uninterested in propositions that lack a clear link between effort and reward.

This applies whether we are talking about the way in which banks and bankers conduct themselves, or about the services and products they provide. This is not meant to imply that banks and bankers are fundamentally unethical, only that they have priorities. And these are focused on making money.

Two themes illustrate these points. The first is the conduct of the banks themselves.

Riddled with conflicts

Recent events have exposed many flaws in the way banks are structured and managed. In particular, they have shown that they are criss-crossed with conflicting interests that make it unclear whether they are acting for their clients or for themselves, for the buyer or the seller.

The clearest example is the furore on Wall Street over the role of analysts who issued glowing recommendations for share offerings by dotcom companies at the height of the 1990s technology boom. Supposedly independent, these recommendations turned out to be no more than advertising material.

There has also been controversy over the way banks manage their internal trading operations: are they acting for their own or their clients’ accounts? And if a bank is simultaneously a lender to, an investor in and a corporate finance adviser to XYZ Corporation, which of these roles really drives the relationship?

It is possible to list dozens of ways in which investment banks suffer from potential conflicts, which the urge to innovate and increase business can easily compromise. A lot of these have to do with the fact that banks are multifunctional creatures.

In some ways, this is healthy. It can enhance efficiency by allowing banks to bundle up products and cut costs, and it can boost innovation by giving bankers greater outlets for their skills.

But it can also threaten the integrity of a bank. Both Merrill Lynch and Citigroup, to name but the most prominent examples, have had run-ins with the regulators over their failure to manage internal conflicts.

The answer to this problem might be to break up some of the large groups. Ironically, though, many of the world’s largest financial centres have only recently dropped rules that had imposed a separation of roles on banks.

In London, the deregulation known as “Big Bang” in the 1980s allowed banks to become members of the Stock Exchange and to develop an investment banking role. In the US, the 1999 repeal of the Glass-Steagall Act ended nearly 70 years of recession-imposed separation between commercial and investment banking.

In the absence of a return to statutory separation, the solution will have to come through tougher regulation and stronger standards of governance in the banking sector. Philip Augar, a UK investment banker who has made a study of these issues and is currently preparing a book on them, believes that banks cannot survive in their present form unless they come clean about their conflicting interests and reveal more about their internal workings.

He proposes strict internal separation between, for example, those who advise companies on their finances and acquisition deals, and those who conduct research and trade those companies’ stocks. He says banks should also be quite clear when they are dealing on their own or their clients’ accounts and make their proprietary trading operations entirely separate.

Others have proposed that banks become holding companies, under which the separate arms can operate as independent entities. This would create legal separation without new laws having to be passed.

Whatever route is taken, the aim would be to undo the damage that has been done to bank reputations in the past couple of years and restore confidence to the markets. Reforms might even bring down the cost of finance by ensuring that everyone – buyers and sellers – gets a better deal.

But can the financial markets respond to wider pressures for “responsible” finance, for a definition of profit that includes softer social factors such as the environment and sustainability?

Clearly, if the financial markets were able to give better terms to companies, governments or individuals that adopted worthy principles, the cause of socially responsible finance would advance by leaps and bounds. This is also an area in which innovation could play an important role in developing techniques to make it all work.

But again, change entails big challenges. It is still uncertain whether responsible finance (whatever that may actually mean) can become a natural feature of the markets. Despite mountains of research, no one has yet shown conclusively that a company which adopts sustainable principles and cares for the environment really meets the test of delivering superior value to the shareholder.

Shareholders themselves also hold mixed views. Although the “ethical” investment business is growing and institutional investors such as the CalPERS pension fund in California take an active stance, the view that sustainable companies should command better financial terms has yet to take root in the market mainstream.

Sustainability yardsticks

Nonetheless, innovation is already at work. A mini-industry is evolving to cater to the interests of people, particularly investors, who want a more sustainable world.

The earliest innovators were the rating agencies that popped up to identify “sustainable” companies. They used various yardsticks, some ethical, some involving a more hard-nosed, risk-based approach.

Next on the scene were the compilers of stock indices who began to track the stocks of companies that scored well with the raters. Dow Jones was among the first with its Dow Jones Sustainability Index, followed by the Financial Times-Stock Exchange (FTSE) with its FTSE4good index. This in turn encouraged ethical fund management, which is now attracting increasing flows of funds.

However, these may just have been easy early gains for innovation. Although progress has been impressive so far, it has only begun to nibble at the edges of the fund management business. In London, the world’s largest international fund management centre, a survey showed that only 3% of stock analysts considered sustainability a key issue. “Green” funds still amount to less than 1% of the stock market total.

The difficulty lies in persuading the markets that there really is measurable value in sustainability. Although its proponents point to advantages such as a long-term approach, stability, appeal to quality recruits and sound management, this still lies more in the realm of hope than reality.

The stock indices and rating systems show a variable performance. Indeed a recent Copenhagen Business School study showed that a specialist rating agency such as the UK’s Safety and Environmental Risk Management, which focuses on companies’ financial risk rather than their ethical standards, is a more reliable guide to performance than agencies using “softer” measures, which suggests that money still talks with a loud voice.

The markets want indicators that measure shareholder value, not just ethical commitment. Nor will it be easy to encourage them to take a longer view: short-termism is deeply rooted.

It is probably becoming more so as countries increasingly sign up to what has been dubbed the Anglo-Saxon financial model, which is based on stock markets rather than banks. But if the innovation challenge lies in marketbased solutions, rather than regulatory enforcement, that should appeal to banks.

Among the more successful innovations are markets for pollution permits, in which companies compete to buy the right to emit carbon, sulphur, waste and so on. Many of these markets are now operating and, though small, they have shown that they are effective at putting a price on the right to pollute, and on producing waste-minimization solutions, which are much cheaper than alternatives such as tax and regulation.

The problem is that many people with an interest in the environment, such as pressure groups and the government, mistrust the markets (or, in the government’s case, would rather go down the taxation route in order to harvest revenues) and prefer to limit the role they can play. This is particularly the case in Europe.

The way ahead

Although the finance industry has gone out of its way to harm its own reputation, we must not lose sight of the fact that innovation is a force for good. There is a danger that the drive to bring banks to heel will result in rules that constrict the flow of new ideas.

There is also a wider risk that pressure to force markets to reward ethical principles will create distortions. For example, the London Principles drawn up by social activists “insist that debt and equity prices should reflect environmental and social risks”, as if this can be done by diktat.

Sadly, the recent turmoil struck just as growing numbers of private investors were becoming accustomed to dealing in financial markets, through e-brokers, for example. This was also a time when banks were beginning to put together new products based on derivative techniques, such as exchange-traded funds, single stock futures and covered warrants, to help the small investor.

Market collapse and financial scandal will set all that back years. The hope must be that better rules and firmer self-policing by banks will restore confidence and get things back on track.

Much will be lost if innovation loses its edge.

David Lascelles
David Lascelles is co-director of the Centre for the Study of Financial Innovation, a London-based think-tank. He was formerly banking editor and resources editor at the Financial Times.