Financial Innovations and Issuer Sophistication in Municipal Securities Markets

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.