12 July 2015

CapX Reviews: Smart Money


Today’s world is a product of financial innovation, explains Andrew Palmer in his new book Smart Money. Comparing the Mesopotamia era where payments were in the form of livestock, to the aftermath of the second world war where cigarettes were used as means of exchange in the black market, and to present day where almost all exchanges are completed  via electronic money into bank accounts, Palmer shows how finance has changed its course throughout history. Since the earliest civilizations, finance has served as a means to help people meet their objectives, “whether providing a way of storing wealth, of connecting capital with investors, or sharing and managing risk”.

Amongst all objectives, Palmer writes that the real driver of financial innovation is resolving information failure. One example he uses are early banks, and how they have resolved limitations of relationship-based finance. By functioning as an intermediary between the lender and the borrower, the first banks provided a means for which experts could “assess the creditworthiness of borrowers”. Another example is the rise of derivatives in the 1970’s as “instruments to manage the risk of interest rates moving up and down, currencies fluctuating, and borrowers defaulting”. With both the ancient world and the modern world, financial development has therefore always served to help societies tackle big problems and is usually accompanied by a period of economic growth.

The entrepreneurs of today have shaped financial innovation in a way that has both addressed big social issues whilst also limiting state intervention. Palmer explains in detail the emergence of “social-impact bonds” (SIB), bonds in which private investors fund prisoner rehabilitation programs and are then paid back from public funds. The financial phenomenon’s goal is to start a new market that will reduce reconviction rates in Britain and provide a means of delivering more cost-effective spending, as the government must only pay back investors if certain targets are met. Another advantage is that there is more longevity in the capital provided, in comparison to government-led contracts that attempt to solve large social issues during a two-year span. Social-impact bonds therefore offer a promising avenue away from cost-ineffective state-run social programs.

Regardless, the financial system has much vulnerability, with property at the forefront. The subprime mortgage crisis in 2007-2008 underlined the problems of carrying excessive debt and “funding long-term assets through short-term borrowing”. Palmer argues that, without constant innovation, many of the industry’s greatest vulnerabilities may never be resolved, such as the behavioural and institutional flaws surrounding home ownership. At the same time, he highlights how recent financial innovations like peer-to-peer lending companies (where lenders directly match borrowers and investors directly without the need of an intermediary) also present problems. The main risks is that these businesses may suffer more and lose the confidence of investors if a large number of borrowers begin to default. Another issue is “whether they can continue to grow without compromising on the features that make them successful” and ultimately “whether is it possible to do a better job of serving less creditworthy borrowers”.

Palmer concludes that, regardless of all the challenges faced by financial innovators, financial entrepreneurs have opportunity to rethink one of the most complex industries with the potential of creating large societal benefits. Smart money shines a positive light on the prospect of financial innovation as “tremendous good will come out of the financial industry in the coming years”.

Smart Money: How High-Stakes Financial Innovation is Reshaping Our World-For the Better. Andrew Palmer, Basic Books, RPP £18.99

Lorenzo De Simone is a CapX contributor.