You've got to know when to hold 'em. Know when to fold 'em. Know when to walk away.
-- Kenny Rodgers
The key to winning at poker, according to popular belief, is to pick up the "tells" of your opponents at the table. "Tells" are unconscious signals, betraying players' attempts to mislead. Financial innovators also have "tells." Institutional "tells" are found in press releases, quarterly reports and management commentary.
Especially with financial innovation, a press release - information needlessly provided to other players - is usually a bluff. No press release at all, on the other hand, is often a good indicator of a strong hand. Why? Because financial innovations, the ones that endure, happen rarely and change the world. No publicity needed. Real financial innovations intimidate the poker table. They threaten to move the center of gravity of the chips. The financial establishment cringes. Fearful regulators attempt to bar the door.
This past week I argued that JPMorgan Chase's (NYSE:JPM) recent announcement of an innovation initiative is a bluff. JPM unconsciously signaled a weak hand in financial innovation by announcing an innovative "moonshot." The first of two "tells" of JPM's weak hand is the word, "moonshot." Real financial innovation doesn't need hyperbole.
Reading the comments on the JPM article, it occurred to me that my analysis of JPM was based on a list of "tells" and their relationship to the essence of finance. To see through an innovation bluff, it helps to consider one stark reality of finance. Finance is too important.
The role of innovation in finance.
To understand financial innovation; understand finance. Finance shouldn't matter much - certainly less than it does. Finance is incidental to commerce. Finance produces no goods and services of its own, only aiding, sometimes impeding, activities that really matter - production of goods and services. So, real financial innovation characteristically reduces the financial cost or risk associated with producing real goods and services or is simpler. Financial innovation eliminates the waste of the past.
And real financial innovation results in a financial system easier for the public and investors to understand. A second "tell" of false innovation is complication. If an innovation is complicated, it will ultimately prove unimportant - smoke and mirrors.
A third tell is expense. Important financial innovations reduce expenses through replacement of something costlier.
Financial scholarship mirrors financial innovation.
This practical list of characteristics, that financial innovation:
- is self-evidently important because it replaces old technology,
- is simple,
- and cost-reducing,
is mirrored by the historically significant innovations of financial scholars. Modigliani and Miller, for example, destroyed the financial textbooks of their day by observing that debt policy doesn't matter. They didn't improve old debt policy analysis. They eliminated it. Self-evidently important. Simpler. Cheaper. And disruptive to old ways of doing things.
To this day, untold hours are wasted on regulation and analysis of debt policy, despite Modigliani and Miller's work. Debt policy is considered unendingly in Dodd Frank and other bank regulations, for example. Dodd Frank is essentially a burdensome examination of bank debt policy in minute detail.
Sharpe ripped up the finance textbooks a second time, pointing out that to split one's portfolio into two simple investments (one, a proxy for "everything risky;" the other, a risk-free security) is an improvement on the long-winded, unnecessarily obscure, process of portfolio planning still in antiquated common practice.
These two scholarly innovations destroyed or marginalized several chapters of every finance textbook of their time. Today, after more than 40 years, the markets have begun to pay heed to Sharpe, adopting true financial innovations - stock index futures and index ETFs.
So, both important financial innovation and important financial scholarship, like Alexander the Great's sword, unravel the Gordian Knot with a single stroke. Real financial innovation is central to simplifying something that is basically complex - the process of moving real resources. The financial side of markets, exchanging titles to ownership of real property, should be cheap and easy.
Financial institutions are transactions modus operandi
The paradox that drives formation of financial institutions: Profit in finance reduces total financial market equity value. Innovation comes through replacement of the big and unwieldy by the small and simple. But by replacing old technology, innovators grow explosively.
That's the paradox. Financial innovation produces explosive growth for the innovator. But this creativity destroys more old equity than the new equity it creates, shrinking financial equity as a whole and freeing resources for real production of goods and services.
If innovators understood that their success was rooted in competitors' baggage, they would find a way to spin off their successes before those successes themselves become baggage. Institutions like Blackstone and CME Group (NASDAQ:CME) may be failing to learn the lessons the dealer banks [for example, JPM and Goldman Sachs (NYSE:GS)] teach them. I can still describe the CME's MO. But what on earth is JPM's MO?
Banks have forgotten that reality. So, to succeed, watch what the banks are doing. Then do something better. This, according to Blackstone Group (NYSE:BX) CEO Steven Schwartzman, is his plan. There's a reason this is wisdom. Finance is a self-destructive industry. If evolution is how species succeed, financial institutions need something that outdoes evolution; continuously replacing and destroying themselves to stave off extinction. Hyper-adaptation?
While the determinants of short- to medium-run performance of financial institutions are legion, the long-run performance every financial institution is based on a very few factors:
- Astute analysis of change in the financial environment
- Expeditious reaction to change
- An institutional identity - a firm-specific approach to future opportunity
- Diversification of product within this special identity
But opportunities to establish a new identity and replace the old order are rare. Consequently, successful financial institutions forget their own identity; and with it, the secret to their own success. The dealer banks have certainly forgotten theirs.
There have been two consequential changes in the financial environment since we stood under the buttonwood tree.
- The sea-change in market risk that occurred in rough coincidence with the collapse of the Bretton Woods Agreement.
- The replacement of human and mechanical activity with computer activity.
All consequential financial innovation since 1970 has been a reaction to these two factors. The collapse of Bretton Woods produced the rise of the dealer banks. Computerization of finance will produce their demise.
The dominant error of financial institutions of our time is a failure to let go of yesterday's triumphs - these old triumphs are today's defeats. The smaller, privately held, new non-banks are outperforming the old dominant dealer banks because they have not picked up the baggage of the past. The dealer banks ignore the conflict between what they want to do, and what they have done.
But the reality of financial innovation is there is never a fit between what needs to be done and what has been done. A real financial innovation is a killer. It does not enhance the ways of the past. It replaces them. The dealer banks cannot cut off their hand when it offends them. Thus, they cannot create.
In following articles, I will apply these "tells" to some real and not-so-real purported financial innovations of the recent past.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.