By FRANK PARTNOY
In 2012, The Economist published a 14-page special report on financial innovation entitled “Playing With Fire.” It opened with the line “Financial innovation has a dreadful image these days.” The goal: rehabilitate that image.
The report’s author, Andrew Palmer, then the magazine’s finance editor, attempted to shift focus away from the infamous subprime mortgage bets that nearly brought down the financial system. Instead, he pointed to several new deals bubbling up in unexpected corners of the markets. Palmer began in Peterborough, England, site of the first-ever “social-impact bond,” a novel — and humanitarian — transaction that sought to reduce recidivism among prisoners.
Prison reform is not typically in the same paragraph as financial derivatives, but Palmer argued that the Peterborough deal did what financial innovation is supposed to do: match the needs of different people and institutions, so that all can be better off. Investors in the Peterborough social-impact bonds paid cash into a prisoner training program; in exchange, they received a promise of future payments from Britain’s Ministry of Justice if the prisoners committed fewer crimes than did other groups. The deal promised a win-win-win: Prisoners would learn life skills and a trade, government would spend less money on prisons, and investors would earn an attractive return. Palmer raved about the tripartite deal: “Here, surely, is a financial innovation that even the industry’s critics would agree is worth trying.”
The Peterborough pilot program deserved more than a brief mention in a magazine piece, and it now anchors the second half of Palmer’s fascinating book. Palmer is a muscular, efficient writer; he relates in-person interviews and statistical evidence with ease and humor. The chapter on social-impact bonds tracks one man who, after being in and out of prisons for decades, “turned his initial work placement into a full-time job at a builders’ merchant. He was in work, in accommodation, paying his own bills. . . . His life had improved because of a dose of financial creativity.”
There are now social-impact bonds that direct money to various social needs: finding and supporting adoptive parents for hard-to-place children, keeping children out of foster care, getting homeless “rough sleepers” off the streets. With the first American social-impact bond, investors are financing a rehabilitation program for adolescents at the Rikers Island correctional facility, and will be paid back, with interest, if reduced recidivism goals are met.
Palmer connects the Peterborough story to other ways finance can be “a force for good.” Novel insurance-like policies help biotechnology firms raise funds for risky clinical trials. “Human-capital contracts” enable college students to obtain money for school without borrowing, by committing to pay a fixed percentage of their income after they graduate. Online lenders, such as Kabbage and OnDeck, use mathematical algorithms to assess the health of small businesses, and provide capital when big banks will not.
The first half of the book is also provocative, but lacks the original reporting of the second half and is smug in its sweeping, often unsupported conclusions. The opening sentence of Chapter 1 promises much: “The history of financial innovation is also the story of human advance.” But what follows is lined with unsubstantiated assertions and cherry-picked history.
The rhetoric in the early pages reminded me of claims by Merton Miller, a Nobel laureate economist at the University of Chicago, who was in many ways the father of financial innovation. Miller praised complex financial instruments, in large part because they helped institutions avoid the law. He applauded bankers for cleverly avoiding government attempts to interfere with markets. Yet Palmer does not address Miller’s arguments, or even cite him. It is a material omission — like a book on sonnets that does not mention Shakespeare — particularly because Palmer’s ultimate point is the opposite of Miller’s: that financial innovation is beneficial because it addresses broad social needs, not narrow private ones.
Fortunately, the second half of the book rehabilitates the first. Palmer’s vignettes show how innovation can, and should, involve more than bankers getting rich, playing games and dodging rules. Today, upstart companies are nipping at the heels of the major banks, seeking to profit by doing good. That is the right kind of smart money.
How High-Stakes Financial Innovation Is Reshaping Our World — for the Better
By Andrew Palmer
285 pp. Basic Books. $27.99.