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Risks or benefits from financial innovation?

Financial innovations, while possibly beneficial under normal economic conditions, may amplify shocks in times of crisis. They are blamed for banks taking excessive risks, and for a general erosion of lending standards leading to the financial crisis.

That’s a general concern voiced by many in the industry, although before the crisis, market participants and regulators were praising the benefits of financial innovation. But new research from three academics from Rotterdam School of Management, Erasmus University (RSM) and Tilburg University indicates that their effects are influenced by the way they are used by the main players in the financial system 

If, for instance, financial innovations are used to improve risk management and risk control, they can insulate the financial system against negative shocks. Or they may increase speculative risk-taking by financial institutions and cause institutions to become dependent on the functioning of the markets for these innovations. In this case financial innovation can result in greater vulnerability in times of stress.

The three researchers, Dr Lars Norden of RSM with Tilburg University PhD student Consuelo Silva Buston and Professor Wolf Wagner examined banks’ trading in credit default swaps (CDS), which some thought had contributed to the worsening debt crisis in Europe. The appeal of financial innovations was not improved by recent news that hedge funds might have bought Greek debt and simultaneously have taken positions in CDS markets.

These views contrasts sharply with those held prior to the crisis of 2007 - 2009, when market participants and regulators were praising the benefits of financial innovation. In 2005, the chairman of the Federal Reserve, the US central bank (FED) said credit derivatives contributed to the stability of the banking system by allowing banks to measure and manage their credit risks more effectively. The pre-crisis view is not an unusual one – financial innovations have for most part been viewed positively in the last century.

“Despite the current controversy surrounding financial innovation, there is still surprisingly little evidence of how financial institutions are actually using credit derivatives,” said Dr Lars Norden of RSM. “There is also little evidence of how this affects institutions under adverse conditions.”

The researchers’ recent analysis of the effects of using credit derivatives on bank behaviour in the syndicated loan market indicated banks' gross positions (the sum of protection bought and sold) in credit derivatives are significantly negatively related to the loan spread they charge to the average corporate borrower. 

By contrast, banks' net positions (protection bought minus protection sold) in credit derivatives do not display any association with loan spreads. 

The researchers argue that these findings suggest the presence of risk management effects from credit derivatives are inconsistent with other channels through which credit derivatives may affect loan pricing. Chiefly, this is because risk management does not require banks to shed net risk but other channels do.

While the risk management effect in the study is larger for borrowers that are more likely to be actively traded in credit derivative markets, the researchers also provide evidence that the risk management benefits extend to firms that are unlikely to be traded in the credit derivative market. Risk management benefits are thus passed on to the entire portfolio of borrowers and not only the borrowers whose credit risk can be easily traded. This result suggests that active credit portfolio risk management reduces a bank's overall (marginal) cost of risk-taking.

Interestingly, the researchers also find that risk management benefit persisted during the financial crisis of 2007-2009, and banks who actively manage their corporate credit portfolios with credit derivatives cut back lending by significantly less than other banks. Risk managing banks also do not seem be more aggressive as their pre-crisis lending levels are comparable to other banks. There is therefore no evidence for increased risk-taking arising from credit derivatives use, they say. 

Research suggests that policy makers may need to take a balanced view on financial innovation and may want, in particular, to differentiate according to the type of financial innovation say the researchers.  For example, there is compelling evidence that securitization products have contributed to financial system risk. Research suggests that securitization lowers lending standards at banks and leads to less monitoring. 

Securitization markets were also heavily affected by the crisis. The existence of these markets may thus have served to increase systemic risk in the financial system. By contrast, credit derivatives on individual firms may have played a positive role, at least where bank lending is concerned.

This of course does not preclude other negative effects of such derivatives – for example because they increase counterparty risk and opacity in the financial system. Improving the disclosure of banks’ CDS trading activities, however, can help to mitigate these effects.

The study is currently available at the Social Science Research Network (SSRN) under: ssrn.com/abstract=1800162. It is also currently under review at a top US finance journal.

Rotterdam School of Management, Erasmus University is consistently ranked amongst the top 10 business schools in Europe. It is located in the international port city of Rotterdam where core Dutch values of openness, flexibility and acceptance of diversity have attracted businesses on a global scale. Our emphasis is on groundbreaking research and practices relevant to business; our primary focus is on developing business leaders who carry their innovative ideas into a sustainable future. Our portfolio includes a broad array of bachelor, master, doctoral, MBA and executive education programmes. www.rsm.nl

For more information on RSM or on this release, please contact Marianne Schouten, Media & Public Relations Manager for RSM, on +31 10 408 2877 or by email at mschouten@remove-this.rsm.nl.