financial innovation and life as we know it

7/31/2019 Financial Innovation and Life as We Know It

1/6

14

DECEMBER

2010TH!NK


2/6

Financial innovation has had an enormously positiveimpact on every aspect of our everyday lives. Overthe last 300 years alone, weve dramaticallyimproved our standard of living, enjoying the com-forts of such progression along the way. If we asked

historians to identify the most fundamental of these advance-ments from a financial perspective, we would undoubtedly geta long list including: the emergence of coins as a medium oftrade, the advent of insurance, the move from coins to papermoney, the introduction of stock markets, the shift away fromthe gold standard and the creation of derivatives.

Each of these innovations was deeply entangled with funda-mental changes in the actual economy. In modern terms, if youthink about everything youve done today, every action haslikely involved the result of a financial innovation. Youve prob-ably done some work (to earn money), maybe bought a coffeeor lunch (using said money) and of course, you had to get towork (in a car youre still making payments on, perhaps?) fromhome (which, if you own it, likely has a mortgage). Withoutfinancial innovations, your day would have been completely dif-ferent. Maybe youd be sharing a home you built with yourfamily. The house would likely be small, because you wouldvehad to take time away from growing crops and raising orbutchering livestock to feed your loved ones.

FINANCIAL

THE WIDESPREAD IMPACTOF FINANCIAL PRODUCTSON OUR LIVES

by Diane Reynolds

KNOW IT

INNOVATION

& LIFE ASWE

15

DECEMBER

2010TH!NK


3/6

FINANCIAL INNOVATION = FINANCIAL CRISIS?


4/6

Generally, financial innovations arent thought of as a causefor financial crisis, but in each of the cited examples, theywere. For example, the move from coins to paper money,which largely coincided with the introduction of stock mar-kets in Britain and France, created a bubble far beyond theimagination of modern financiers. When the bubble burst,the resulting public unrest and distrust nearly caused the col-

lapse of their respective empires and put even thedeeply-embedded monarchies at risk. The following centurywas marred by numerous false-bubbles and crashes in theever-evolving stock markets and banking systems. Similarly,the move away from the gold standard, or rather theattempts to maintain the gold standard, played a significantrole in the Great Depression of 1929-1933 and possibly evenin the start of the Second World War.

Historical evidence therefore leads us to the reasonable con-clusion that financial crises are one cost of financialinnovation and frighteningly, the more radical the innova-tion, the more dire the resulting crisis is likely to be. As with

all things, the multitude of benefits derived from financialinnovations does not come without the cost of periodicfinancial crises.

Following the logic of an innovation from its original incep-tion to the outcome of a crisis can be explained along theselines. A small group of people create a new tool, otherwiseknown as an innovation. As these experts use their new tool,others copy it for their own purposes, and in the case offinancial innovations, profit. The tool becomes mainstream;its seen as a panacea, the solution to a wide range of prob-

lems. Before we realize it, sledgehammers and saws are beingrepurposed to make coffee or swat flies.

INDUSTRY-WIDE CONSEQUENCES

The financial crisis of 2008 highlighted several systemicweaknesses; amongst them were innovations tendency tooutpace both systems and common management under-standing. Many risk-takers in the CDO market are stillcrying foul over their lack of understanding: how could asecurity turn out to be worthless when it was AAA-rated?Complexity now ranks amongst the biggest challenges inimplementing ERM and managing risk at all levels of the

organization. From Barings Bank to AIG, the echoing storyof senior management failing to fully appreciate the intrica-cies of risks taken in order to generate huge returns hasreverberated across the decades.

Post-financial crisis, the practice of risk management hasbeen placed under a microscope. Boards, shareholders,

regulators, the media and even public interest groups aredemanding more risk information, more risk management,better planning and more accountability for risk. The roleand profile of risk managers has changed, begging thequestion, does the scope of risk management also needto change?

THE REAL COST OF FINANCIAL INNOVATION

If the occasional financial panic was the only consequenceof financial innovation, it would be fairly easy to argue thatthe long-term benefits far outweigh the temporary costs. Tofully assess the costs however, we may need to dig muchdeeper than a mere financial crisis. If we consider the aptly-

named Great Depression, we see an initial financial collapsethat spiraled unabated into a near-complete economic col-lapse. Not only did shares lose value, but people lost jobsaround the world. To dig deeper, we turn from the lessonsof history to a critical analysis of modern innovations.

First, consider the crisis derivatives and liquidity indexes thatare beginning to emerge. Big names such as Citigroup, theCBOE and Pimco are looking at offering products tied tomarket dislocations, tail events and financial crises. So far,these proposals have been met with some skepticism both in

the blogosphere and in carefully phrased neutral articles inthe financial press. The main questions for the media inexamining the details all revolve around a single topic: whois creditworthy enough to provide such protection?

Specifically, how would sellers of such protection berequired to fund their transactions? In the absence of pro-hibitively expensive full funding, the creditworthiness of theseller during the crisis replaces the risk of the crisis itself. Inthe (assumed) event of a crisis, such a product could increasesystemic risk and exacerbate the very crisis or event it isdesigned to protect against.


5/6

THE DILEMMA OF INCENTIVES

The financial consequences for the risk-takers and hedgers,such as the protection sellers in said products, are at leastclear: significant funding requirements and credit risk. Thepotential consequences for the wider economy are more sub-tle, and at the same time, extensive. Taxpayer bailouts,recession and sovereign instability have resulted from morethan one financial crisis. Avoiding such upheaval is thereforeclearly in the publics best interest. Is it then sensible to allowmarket participants to possess an incentive to create or per-petuate such a crisis? Consider that speculators in crisisderivatives could easily arrive at an unethical position, where

they have incentives that are contrary to the public good.

If this discussion seems abstract, it may be because it focuseson potential products. In reality, many products that alreadytrade in huge volumes can produce a similar skew in incen-tives. Take for example the process of short-selling.Short-selling means selling something that we dont own inorder to, hopefully, buy it back later at a lower price. Thesedays, it is one of those things that everyone learns about infinance class. All MBAs attend a seminar at some point thatexplains the reliance of Black-Scholes hedging techniques onshort-selling, or the ability to reach a complete marketthrough shorting certain securities. Yet macroscopically

speaking, taking a significant short position is equivalent to

betting on the demise or failing of something real a firm oreven a country.

When the German regulator acted unilaterally to ban short-selling of certain bonds and stocks, the markets cried foul.Some financiers saw this move as largely political, as a com-promise to make Germanys contribution towards a Greekbailout more palatable to the public. Politics aside, the reg-ulator made a stunningly simple argument in support of theban: the financial marketplace does not have the right to dis-turb the peace. The regulator alleged that, at that time,market speculators were creating so much volatility that itwas spawning real economic, social and political problems.Having seen riots on the streets of Athens, its difficult to dis-pute these claims.

Again, the issue of incentives raises its head, with specula-tors looking for profit and firms looking to hedge exposures,effectively minimizing losses and the need to sell or shortassets. The sudden spike in supply drives down values andcreates volatility that can threaten the stability of not only

firms, but governments too. Misaligned incentives lie at theheart of most arguments that vilify financial markets, butthey are not the only concern. The confluence of scale andself-fulfilling prophecy must also bear some of the burden.

SELF-FULFILLING PROPHECY

Put more simply, market participation creates market influ-ence, and the greater the participation, the greater theinfluence. Through the last 60 years, many economists andstatistics students have invented and adapted models to ana-lyze market movements. Causality and correlation amongstmovements in asset values comprise a significant chunk of

econometric research and statistical debate, but this singleobservation has always been, and remains to be, one of theleast convenient features when modeling markets. Althoughoften disregarded, this property is difficult to dispute. Forexample, if a major bondholder sells a large block of bonds,the price falls, resulting in a widened spread. If a well-respected pundit praises a firm on national television, itsshare price is likely to rise at least temporarily.

Since believing is seeing in the markets, if enough peoplebelieve that a firm or country cannot repay its debt, thenno one will lend to it, resulting in the outstanding debtbecoming worthless, and eventually rendering the entity

unable to borrow. Given the on-demand nature of modern

Misaligned incentives

lie at the heart of most

arguments that vilify

financial markets, but

they are not the only

concern.


6/6

management within both firms and government, this disap-pearance of short-term funding effectively leads tobankruptcy.

Hedge funds and sovereign wealth funds have become excel-lent examples of the present global imbalance of wealth.This imbalance means that its possible for a small group ofhedge funds to corner the market on large debt issues. Theconsequent price implications have the power to destabilizea not-so-small countrys economy and government, perhapswithout the money managers having any intention of doingso. Consequently, even the practice of people selling whatthey already own can create huge problems when it happensen masse. Profiteers taking on further speculative short posi-tions can only aggravate an already dire situation.

A QUESTIONOF ETHICS

For a civilized capitalist society, this is a situation that wecan potentially accept. Those who have the money havealways also possessed the power, effectively making the rulesthat affect us all. The fact that money equals power isnt

exactly breaking news. Nevertheless, shouldnt we be con-sidering the debate philosophically as in the case withmedical research, which is, just because we can, does it meanwe should? Often such discussions are dramatized by apoc-alyptic predictions and life-and-death decisions, whereasfinancial innovation stays more neatly in the realm of moneyand politics. Difficult as it may seem to face unemploymentor even homelessness, it is hardly an assured death sentence.

Until financial innovation crosses the boundary into reallife-and-death matters, it is unlikely that its costs can bedirectly related to fundamental medical ethics. We argue that

this line is not ahead of us, its behind us. With that said,quickly answer this question: whats your retirement plan?If you even entertained the word pension, consider this:from the perspective of the organization paying your pen-sion, the sooner you die, the less they have to pay you.

Some may argue that pensions are hardly a financial inno-vation because theyve been around for decades. Morespecifically, they only gained popularity in post-industrial-ized societies, and generally after WWII. Thats not recent,but in the grander scheme of things, its not all that long agoeither. Pensions have several close relatives that generate thesame conflict of interest between provider and recipient

including but not limited to, health insurance for the termi-

nally ill, reverse mortgages and secondary markets for lifeinsurance.

While it is hard to envision large multinational insurers hir-ing squads of hit men or setting plagues upon the Earth, asthese markets evolve and risks get transferred, the poten-tial for conflicting interests leading to actual murdersincreases. Allegedly unscrupulous dealers, uninformed buy-ers and callous third-hand investors arguably permeatedthe mortgage and housing space, creating a bubble thatpopped. Fraudsters such as Madoff have emerged in drovesas the crisis draws questionable practices into the light. Inthe end, it might not seem like such a stretch of the imagi-nation for charlatans to go from stealing your life savingsto stealing your life.

CHANGING RISK MANAGEMENTS FOCUS

The most recent financial crisis has opened the door for riskmanagers to recreate their roles within financial institutions.Increasing regulatory demands, more management interestand higher profile CROs all demand affirmative action with

losses, tightened budgets and staff cuts quickly translatinginto demands that mean, Do more with less.

More elaborate models, faster machines, more elegantreports or cleaner data are all admirable goals. They wouldallow risk managers to provide more thorough, better qual-ity analysis. What risk managers desperately need toconsider is that more of the same may not be sufficient. Is itmore important to compute VaR with 2% accuracy, or toensure that all product types are going through a rigorousmeasurement and review process? Is it more important toinsure a building against wind damage, or to have a func-

tioning disaster recovery site?

All managers eventually learn that the higher they rise withinan organization, the bigger the opportunities, and the biggerthe problems that need to be overcome. As the role of riskmanagers expands, so too does the need to address largerissues such as incentives, self-fulfilling prophecies, ethics andmatters of the public good, if for no other reason than toprotect the firm and its stakeholders from the reputationalrisks inherent in perceived malfeasance.

This may be easier said than done, but no one ever said thatbalancing profitable financial innovation against its inher-

ent risks would be painless!

What risk managers

desperately need to consider

is that more of the same

may not be sufficient.

financial innovation and life as we know it

Documents