Financial Innovation and Life as We Know It
by Diane Reynolds, Senior Director, Algorithmics
Financial innovation has had an enormously positive impact on every aspect of our everyday lives. Over the last 300 years alone, we’ve dramatically improved our standard of living, enjoying the comforts of such progression along the way. If we asked historians to identify the most fundamental of these advancements from a financial perspective, we would undoubtedly get a long list including: the emergence of coins as a medium of trade, the advent of insurance, the move from coins to paper money, the introduction of stock markets, the shift away from the gold standard and the creation of derivatives.
Each of these innovations was deeply entangled with fundamental changes in the actual economy. In modern terms, if you think about everything you’ve done today, every action has likely involved the result of a financial innovation. You’ve probably done some work (to earn money), maybe bought a coffee or lunch (using said money) and of course, you had to get to work (in a car you’re still making payments on, perhaps?) from home (which, if you own it, probably has a mortgage). Without financial innovations, your day would have been completely different. Maybe you’d be sharing a home you built with your family. The house would likely be small, because you would’ve had to take time away from growing crops and raising – or butchering – livestock to feed your loved ones.
Financial innovation = financial crisis?
Generally, financial innovations aren’t thought of as a cause for financial crisis, but in each of the cited examples, they were. For example, the move from coins to paper money, which largely coincided with the introduction of stock markets in Britain and France, created a bubble far beyond the imagination of modern financiers. When the bubble burst, the resulting public unrest and distrust nearly caused the collapse of their respective empires and put even the deeply-embedded monarchies at risk. The following century was marred by numerous false bubbles and crashes in the ever-evolving stock markets and banking systems. Similarly, the move away from the gold standard, or rather the attempts to maintain the gold standard, played a significant role in the Great Depression of 1929-1933 and possibly even in the start of the Second World War.
The multitude of benefits derived from financial innovations does not come without the cost of periodic financial crises.
Historical evidence therefore leads us to the reasonable conclusion that financial crises are one cost of financial innovation and frighteningly, the more radical the innovation, the more dire the resulting crisis is likely to be. As with all things, the multitude of benefits derived from financial innovations does not come without the cost of periodic financial crises. Following the logic of an innovation from its original inception to the outcome of a crisis can be explained along these lines. A small group of people create a new tool, otherwise known as an innovation. As these experts use their new tool, others copy it for their own purposes, and in the case of financial innovations, profit. The tool becomes mainstream; it’s seen as a panacea, the solution to a wide range of problems. Before we realise it, sledgehammers and saws are being repurposed to make coffee or swat flies.
The financial crisis of 2008 highlighted several systemic weaknesses; amongst them were the tendency of innovation to outpace both systems and common management understanding. Many risk-takers in the CDO market are still crying foul over their lack of understanding: how could a security turn out to be worthless when it was AAA-rated? Complexity now ranks amongst the biggest challenges in implementing ERM and managing risk at all levels of the organisation. From Barings Bank to AIG, the echoing story of senior management failing to fully appreciate the intricacies of risks taken in order to generate huge returns has reverberated across the decades.
Post-financial crisis, the practice of risk management has been placed under a microscope. Boards, shareholders, regulators, the media and even public interest groups are demanding more risk information, more risk management, better planning and more accountability for risk. The role and profile of risk managers has changed, begging the question, does the scope of risk management also need to change?