- 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
Using Finance to Manage Risk and Democratize Access to Capital
All types of enterprises involve risks, many of which are difficult to quantify. The role of finance is to understand those risks and provide the institutional framework to resolve them and build linkages to the capital markets.
As Robert Shiller has noted, numerous financial innovations arose from attempts to insure risk. Coincident with the growth of global trade in the seventeenth century came an increased understanding of probability theory—and, with it, the creation of actuarial tables for various risks. Initially, Shiller explains, only narrow risks were insured, such as death, the sinking of ships, or destruction by fire. Gradually, insurance extended to disability, floods, and accidents. Today he sees financial innovation broadening the use of risk management, extending it to new classes of risks that limit global growth, such as income inequality.29
Increasingly, managing complex risks within a firm requires the integration of finance into all aspects of accounting, corporate strategy, and industrial organization. Capital structure comes to reflect and enable those strategies. The ability to measure and monitor risk has taken a leap forward with information technology, and major innovations have arisen to manage newly conceptualized factors. The underlying technologies of telecommunications and data processing have had a transformational effect on this field.
Financial innovation and information technology intersect most profoundly around the issues of overcoming information asymmetries and improving the ability to price risk. Lenders that faced difficulties in determining who was creditworthy or monitoring performance after a loan or investment was made paved the way to new advances in fundamental credit analysis and scoring geared toward overcoming problems of adverse selection and moral hazard. New credit and investment products that can build on valuation methodologies derived from larger relational database management have the capacity to overcome problems of asset pricing models. Breakthroughs in financial IT have improved methods of assessing market risk and the fragility or strength of portfolio mixes.
Fundamental analysis is based on an honest evaluation of the financial conditions, management, and competitive advantages of a business or project; this process necessarily includes scrutiny of production, distribution, earnings, interest rates, and management. The ability to conduct such analysis underlies all valuations of firms and projects, encompassing projections of their performance and calculation of the credit risk involved in extending them financing.
The financial instruments introduced over time are built on this essential ability to ascribe, measure, and monitor value. Improving the means and methods of valuation is central to overcoming the information barriers of price discovery—a major goal of financial innovation. The components subject to valuation can be translated into equity, debt, and combination (hybrid) structures, running the spectrum of external and internal financing methods available. The linkage of savings into investment is the key process at the heart of finance, and these tools make the translation between the two possible.
The proposition inherent in financial innovation is that the expansion of finance can improve productivity in a way that will solve economic, social, and environmental problems, thereby leading to job creation and better standards of living. Financial innovations can align interests to achieve poverty reduction (through microfinance and impact investing), entrepreneurial growth (through small business financing), the mitigation of environmental problems (through markets for emissions permits and transferable fishing quotas), and medical cures (through new financing strategies to support the R&D process). The objective of finance, as with economics in general, is to overcome problems of scarcity by increasing prosperity.
The recent meltdown did not halt the evolution of financial innovation. On the contrary, the need for fresh solutions has never been greater. Innovations can lay the groundwork for reconstructing a more robust set of institutions and instruments, ultimately building a new global economy based upon sustainability and wider participation.
By examining both history and contemporary case studies, this book explores how innovations can deliver the benefits of finance to increasingly broader segments of the population, expanding access to capital and opportunity.