Book Review: Smart Money

Bankers have always been an easy target, but during the financial crisis they were vilified. Even as we claw our way back towards some semblance of economic normalcy, the reputation of bankers remains tarnished. One doesn’t have to be an Elizabeth Warren to wonder whether finance is as constructive an enterprise as it should be.

Andrew Palmer, business affairs editor of The Economist, is an optimist, as the subtitle of his recent book Smart Money indicates: How High-Stakes Financial Innovation Is Reshaping Our World—for the Better.

Palmer argues that what really lay behind the 2007-2008 crisis was not “out-of-control financial wizardry” but “the humble mortgage.” In fact, he asks, “Could it be that the real lesson to be drawn from recent financial history is that the industry suffered from too little innovation, not too much?” (p. 65)

There is an illusion of safety about property, and “the most natural place for money to flow is where it feels safest.” But, as a former chief risk officer of HSBC noted, “banks are leveraged and property is leveraged, so there is double leverage,” which in a property crash turns into a double whammy. (p. 73)

Castle Trust, a British mortgage venture, tries to solve this problem of double leverage by sharing out the risks. It “offers a product called a partnership mortgage, in which the firm lends 20 percent of a property’s value but asks for no monthly interest or capital repayments. Instead, when the home owner sells up, he or she has to repay the original loan amount and give Castle Trust a 40 percent share of any house-price gain. Conversely, if prices have gone down, Castle Trust will shoulder a 20 percent share of the losses.” (p. 74) So far new home owners haven’t responded enthusiastically to this offer. Growth in the business has come from people remortgaging, even though here the firm does not share in the downside.

Another way in which innovative finance can make a difference is through social-impact bonds, where private investors fund social programs and are paid back from public funds, with a bonus if targets are met. “The theory is that successful projects ought to translate into savings for the public purse, which can be used to pay investors without any additional public spending.” (p. 80) Prisoner rehabilitation and homelessness are two areas that have been tackled using SIBs.

Palmer explores several other examples of innovative finance—a drug-development megafund, the brainchild of Andrew Lo; a retirement planning tool, SmartNest, designed by Robert Merton; equity crowdfunding; peer-to-peer lending; alternatives to payday lending using big data; prize-linked savings schemes. By the way, ZestFinance has found that “there are slight differences in the payment outcomes of people who type their names differently (that is, between those who use capitals for the initial letters and then lowercase letters, those who write their names out entirely in uppercase, and those who just use lowercase). People who write their names out in capitals for the initial letters and then lowercase turn out to be more creditworthy.” (p. 160) A word to the wise.

Palmer believes that “financial innovation has made enormous contributions to society in the past, and it is primed to do so again. … The balance that regulators have to strike is watchfulness for the risks that can cause real economic damage and tolerance for the ideas that can produce real benefits.” (p. 191)