Financing the Future: The Evolution of Finance

Learn to move beyond the noise and reclaim the concept of
financial innovation. Throughout history, advances in financing
have expanded opportunities and democratized societies, and their
potential is still ready to be grasped today.
It was a perfect storm. Beginning in 2007, a cascade of extreme
events rocked the global financial system, outstripping the risks
imagined by central bankers, financial professionals, and
policymakers. Within a year's time, international stock market
declines had destroyed trillions of dollars in wealth. In the wake of
the housing meltdown and the ensuing "Great Recession," pension
systems remain fragile and household balance sheets are a wreck.
A confusing alphabet soup of acronyms (think CDOs squared, then
cubed, and stuffed with SIVs, CMOs, CLOs, and CDSs) dominated
the headlines. With their leverage levels on steroids, many financial
institutions and firms had gorged on these overly complex
products. The press was aghast to learn that some CEOs didn't
have a grasp on the convoluted products on which their traders
had placed staggering bets.
The financial crisis of 2007–2009 brought many chickens home to
roost in global capital markets. Some $9 trillion of assets in the
United States alone had been securitized. By fall 2008, lower-grade
securities had been reworked into roughly a half-trillion dollars'
worth of long-term capital instruments (through collateralized debt
obligations) and $1.2 trillion of short-term money market
instruments (through asset-backed commercial paper and
structured investment vehicles). These were underwritten by
almost $800 billion of private mortgage insurance, issued by bond
insurers that ultimately backed a total of more than $2 trillion of
debt. The whole conflict-ridden system was hedged in a murky
$45 trillion credit default swap market—a fine mess, indeed. When
the underlying asset bubbles began to implode, liquidity froze and
markets cratered. 1
Fear and loathing of Wall Street is once again loose in the land, but
precious little analysis has been offered to distinguish genuine
innovation from the churning out of copycat devices designed to
conceal the shakiness of the underlying assets, and far too prone
to exacerbating systemic risk. The long and storied tradition of real
financial innovation—the drive to build new tools that increase
clarity in valuation and promote capital formation for productive
enterprises—was co-opted during the bubble years, perverted into
schemes meant to obfuscate and create opacity in asset pricing.
The purpose of this book is to move beyond the noise and reclaim
the concept of financial innovation. Throughout history, advances
in financing have expanded opportunities and democratized
societies—and their potential is still ready to be grasped today. If
the right tools are deployed responsibly, financial innovations have
the capacity to help us shape a more sustainable and prosperous
future.
Finance, at its core, is the catalyst for launching productive
ventures and the most effective tool for managing economic risks.
Today that process takes place with split-second global
transactions and cutting-edge software, but the essential concepts
of finance are timeless and rooted in antiquity.
To fully grasp the underpinnings of modern finance, it is useful to
note the seminal—and ever more sophisticated—innovations that
have marked its evolution, whether it was the first use of credit in
Assyria, Babylon, and Egypt more than 3,000 years ago, or the
introduction of the bill of exchange in the fourteenth century. 2
Many of these advances democratized economic participation,
such as when consumer credit took hold in the 1700s. (By the
early part of the twentieth century, tallymen were hawking clothes
in return for small weekly payments. 3 ) Home mortgages, the
founding of stock markets and exchanges, and the wider
availability of farm and small-business credit and investment
followed in turn.
Financial innovation not only threw open the door to a vast
expansion of land, home, and business ownership—broadening
prosperity in ways that were unimaginable in earlier centuries—but
it also eventually devised ways to value intellectual property. That
ability to transform ideas into new industries dramatically
quickened the pace of change. By the mid-1980s, Nobel laureate
Merton Miller correctly noted, "The word revolution is entirely
appropriate for describing the changes in financial institutions and
instruments that have occurred in the past 20 years." 4
Multiple studies have documented the positive and profound
effects of consumer and business finance on economic growth.
Any country that forgoes the building of deep, broad financial
institutions and markets is also likely to forgo growth. Cross-
country comparisons show that nations with higher levels of
market development experience faster aggregate growth and
smaller income gaps with the wealthiest nations. Recent empirical
estimates suggest that if emerging nations doubled bank credit to
the private sector as a percent of gross domestic product (GDP),
they could increase annual GDP growth by almost 3%. Doubling
the trading volume in their securities markets would increase GDP
growth by 2%. 5
At its best, finance can be used to balance the interests of
producers, consumers, owners, managers, employees, investors,
and creditors. At the risk of stating the obvious, these disparate
actors on the economic stage often fail to get along, for a whole
host of reasons. When they don't, economic value is destroyed,
business plans are laid to waste, new technologies and ideas
wither on the vine, and scarcity—the ultimate bane that economics
seeks to overcome—prevails.
The purpose of finance, carried out with technology and
sometimes a dash of art, is to create a capital structure that aligns
the cooperating and sometimes conflicting interests within an
enterprise—whether private, public, government, or nonprofit—
toward a common objective. Finance mediates among these
interests, addressing the frictions and risks inherent in
transactions.
It is through the design and construction of a capital structure that
a public or private enterprise finances its assets and leverages
them into a greater flow of productivity, innovation, and enterprise.
Capital structure is the way a firm, household, enterprise, or
project (even those involving partnerships of public and private
actors) allocates its liabilities through debt, equity, and hybrid
instruments. These operating and investment decisions affect the
value of any good or service that is produced.
The cash flow through an enterprise is as vital to its survival as
oxygen. It must be distributed based on various claims from
creditors, owners, employees, and so forth. Capital structure
allocates shares of that cash flow pie and seeks to grow it. Finance
seeks to optimize the sustainability of cash flow, creating positive
feedback loops among all the relevant players. Financial
frameworks can serve as both carrot and stick, creating incentive
structures that maintain an enterprise and enable it to grow.
As Bradford Cornell and Alan Shapiro have demonstrated, financial
innovations and business policies can increase the value of an
individual firm through the complex web of contracts that binds
investors, management, employees, customers, suppliers, and
distributors. Strengthening relations with noninvestor stakeholders
through management and employee incentives, increasing the
confidence of suppliers and customers, and linking public and
private interests can increase the value of an enterprise. 6
Innovation can also be used to resolve information asymmetries—
that is, the situation in which some market participants have
information that others do not, thereby making markets inefficient
and costly to all. Information asymmetries are a core challenge in
finance, increasing the risk of unknowns and uncertainties in any
transaction, especially those concerning interest rates. Finance
assigns costs to the risks of undisclosed information that might
eventually emerge. In bridging these gaps between parties, their
claims on the cash flows from any enterprise can be assigned,
priced, packaged into a financial product, and exchanged.
Finance is more than simply a method of allocating capital. When
harnessed correctly, it has the capacity to drive social, economic,
and environmental change, transforming ideas into new
technologies, industries, and jobs.
Overcoming the remaining gaps in capital access and sound
market structure represents the challenge and opportunity of our
age. We can understand and resolve an array of urgent global
problems—financial crises, environmental degradation, world
hunger, post-conflict reconstruction, housing, and disease—if we
carefully analyze them through the lens of finance.
The Language of Finance
Finance emerged as a social construct from the way people gave
voice to their day-to-day economic interests, defined them, and
sought to measure and manage them in real markets. In many
cases, the words they devised live on in common usage today,
underlining the fact that, despite its sophisticated high-tech profile,
the fundamental role of finance remains much the same as it ever
was.
One way to understand finance at its most elemental level is to
walk through an example of how a social unit becomes
sustainable, a process Figure 1.1 illustrates. Imagine any basic
unit of social organization: a family, a household, a community, a
business, a nonprofit, or a project. Common to all is the necessity
of enterprise—that is, undertaking activities that will define, build,
and strengthen the unit as it seeks to transform and survive from
one set of circumstances to another, whether it be a growing
season, a market cycle, a time of life, or a natural disaster. Finance
provides the means to bridge uncertain circumstances, such as the
costs of discovery, retirement, illness, new technologies, family
additions, or a future college education. Innovations that can lower
the cost of these objectives are the subject of financial history.