- The Language of Finance
- What Is Financial Innovation?
- The First Financial Innovations: From Capital to Credit
- Financial Innovations in the Age of Discovery
- The Rise of Financial Capitalism
- Landmarks in Financial Innovation
- Did Financial Innovation Cause the Crisis?
- Using Finance to Manage Risk and Democratize Access to Capital
The Rise of Financial Capitalism
New financial innovations emerged with the explosion of global trade in the seventeenth century. When the Treaty of Westphalia (1648) ended the bloody and protracted Thirty Years' War, the Holy Roman Empire broke apart into 300 sovereign political entities, creating a structural need to finance these nation-states and territories, along with the enterprises that fueled their economies.
Amid the turmoil of the Thirty Years' War, the Dutch managed to establish and defend a thriving merchant fleet, financing their commercial supremacy through long-distance trade through the Baltic, Russia, and the East and West Indies. These wealthy merchants minimized the need for cash by issuing liquid trade receipts backed by a unified system of payments. Amsterdam reigned as Europe's center of commercial credit, extending credit on the basis of bills of exchange payable in Holland. This was the dawn of modern public finance, with the introduction of debt instruments backed by taxes dedicated to a specific purpose, such as erecting levees to hold back the sea or building great sailing ships for trade. As in England, the demand for capital gave rise to joint stock companies—and to the world's first organized securities markets.13
The Dutch, British, and French created alternative structures of finance—merchant banks, money markets, and information networks for private credit and public finance. Each nation developed new capacities for transportation, communications, and storage, and financial innovations were necessary to fund long-distance trade, industry, and military expansion.
The British, however, eventually reshaped the rules of the game. By the beginning of the eighteenth century, they were relying not just on financial institutions alone, but on a combination of institutions and financial markets. The British were embroiled in a succession of wars during the eighteenth and early nineteenth centuries, and the need to fund these campaigns led to a financial revolution. Peter Dickson has argued that the ability of the British to fund their government debt so effectively was an important factor that enabled them to regularly defeat the French for more than a century, despite the fact that their population was roughly one-third that of France.14 This sturdy British architecture proved flexible to shocks and changes, while elsewhere in Europe, the reliance upon financiers and credit institutions stunted the development of financial markets. Without capital markets at work, excessive volatility distorted the prices of assets. Capital was priced to protect entrenched interests instead of financing new and more efficient producers. Payment systems and monetary regimes in much of Europe were subject to the vagaries of politics, but the British capital markets promoted efficiency and productivity.
Rail, steel, and coal emerged as the backbones of a new industrial economy by the 1800s. The resulting economic and geographic integration of markets created vast new demands for capital. Significant external financing was especially needed for rail systems, which required mighty infusions of investment and labor. New forms of equity and debt securities appeared at this time, from the use of common and preferred stock to various income-related debt instruments and equipment trust certificates.
In more recent times, the dramatic expansion of public equities and the initial public offering market after World War II led to the ability to finance large-scale manufacturing and new mass-consumer markets, from aviation and automobiles to entertainment. The automobile–rubber–oil industrial cluster that drove U.S. economic growth in the twentieth century demanded huge capital investment.
The 1970s brought soaring inflation to the United States, and against this backdrop, interest rate derivatives appeared. These instruments (based on the right to exchange a given amount of money at a set interest rate) now enable 80% of the world's top companies to control cash flow.15 By the beginning of the 1980s, businesses were struggling with unimagined challenges in dealing with interest rate and current exchange rate risks. Industrial manufacturers found that exchange rate shifts could wipe out price advantages because of the absence of hedging mechanisms. This situation could and did drive corporate bankruptcies and sovereign debt insolvency in the developing world. The "new" asset of interest rate derivates provided the ability to pay or receive an amount of money at a given interest rate. That interest rate derivative market is now the largest in the world, estimated at more than $60 trillion.
High-yield corporate bonds were also devised around this time as an attempt to create longer-term, fixed-rate financing for growth companies and even emerging industries that could not get financing elsewhere. These new bonds were especially useful to companies that had been shocked by the interest rate spikes of bank lending in the 1970s or stymied by banks' reluctance to lend to the high-potential businesses of the future based on their prospective cash flows instead of their existing book assets. Iconic names such as News Corporation, Barnes & Noble, Turner Broadcasting, Time Warner, McCaw Cellular (later AT&T Wireless), and Cablevision turned to the high-yield market to finance growth.
Mortgage-backed securities also emerged in the 1970s as the demand for housing spiked, far outstripping the ability of government agencies to provide sufficient liquidity for home lending. Yes, overcomplexity and leverage were layered onto the backs of these instruments during the bubble years, but mortgage-backed securities worked smoothly for decades. Securitization contributed in a monumental way to the development of the mortgage market by tapping into a broader base for funding and providing vital liquidity.
Market innovators have never stopped searching for new strategies that can address price instability and risk. Later chapters of this book detail the most visionary financing concepts currently being deployed to reboot the housing market, protect the environment, promote faster medical cures, and tackle a host of other social problems.