Financial Innovations and Issuer Sophistication in Municipal Securities Markets

48 Pages Posted: 8 Jun 2014

See all articles by Stephan Whitaker

Stephan Whitaker

Federal Reserve Bank of Cleveland

Date Written: June 6, 2014

Abstract

When local governments default or file for bankruptcy, it is often because public officials misunderstood the risks associated with innovative financial products. If unsophisticated municipal bond issuers were to widely adopt a high risk financial product, this could harm taxpayers and investors, as well as destabilize the financial system. This analysis uses municipal bond issuers’ total debt outstanding as a proxy for their sophistication and investigates the relationship between sophistication and adoption of financial innovations. Using comprehensive data on securities issued between 1992 and 2012, 25 innovations are identified. Products with these features were uncommon in the 1990s, and expanded their market share after 2000. The 600 issuers that back 75 percent of the outstanding debt adopted 21 innovations for a greater fraction of their new issuance, relative to the approximately 40,000 smaller market participants. When innovation-linked debt issuance is measured relative to annual expenditures, the mid-level jurisdictions adopted innovations to a significantly greater extent than either states and sophisticated jurisdictions or unsophisticated jurisdictions. The results suggest oversight should be concentrated on mid-level local governments where past innovations have made the greatest inroads.

Keywords: Financial innovation; Public financial management; Municipal bonds

JEL Classification: H74; G28; R51

Suggested Citation

Whitaker, Stephan, Financial Innovations and Issuer Sophistication in Municipal Securities Markets (June 6, 2014). FRB of Cleveland Working Paper No. 14-04, Available at SSRN: https://ssrn.com/abstract=2446979 or http://dx.doi.org/10.2139/ssrn.2446979

Stephan Whitaker (Contact Author)

Federal Reserve Bank of Cleveland ( email )

East 6th & Superior
Cleveland, OH 44101-1387
United States
216-579-2040 (Phone)

HOME PAGE: http://www.clevelandfed.org/research/economists/whitaker-stephan-d

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