Published: September 02, 2011
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.
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? [[[PAGE]]]
If the occasional financial panic were the only consequence of financial innovation, it would be fairly easy to argue that the long-term benefits far outweigh the temporary costs. To fully assess the costs, however, we may need to dig much deeper than a mere financial crisis. If we consider the aptly named Great Depression, we see an initial financial collapse that spiralled unabated into a near-complete economic collapse. Not only did shares lose value, but people lost jobs around the world. To dig deeper, we turn from the lessons of history to a critical analysis of modern innovations. First, consider the crisis derivatives and liquidity indexes that are beginning to emerge. Big names such as Citigroup, the CBOE and Pimco are looking at offering products tied to market dislocations, tail events and financial crises. So far, these proposals have been met with some scepticism both in the blogosphere and in carefully phrased neutral articles in the financial press. The main questions for the media in examining the details all revolve around a single topic: who is creditworthy enough to provide such protection?
Specifically, how would sellers of such protection be required to fund their transactions? In the absence of prohibitively expensive full funding, the creditworthiness of the seller during the crisis replaces the risk of the crisis itself. In the (assumed) event of a crisis, such a product could increase systemic risk and exacerbate the very crisis or event it is designed to protect against.
Misaligned incentives lie at the heart of most arguments that vilify financial markets, but they are not the only concern.
The financial consequences for the risk-takers and hedgers, such as the protection sellers in said products, are at least clear: significant funding requirements and credit risk. The potential consequences for the wider economy are more subtle, and at the same time extensive. Taxpayer bailouts, recession and sovereign instability have resulted from more than one financial crisis. Avoiding such upheaval is therefore clearly in the public’s best interest. Is it then sensible to allow market participants to possess an incentive to create or perpetuate such a crisis? Consider that speculators in crisis derivatives 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 focuses on potential products. In reality, many products that already trade in huge volumes can produce a similar skew in incentives. Take for example the process of short-selling. Short-selling means selling something that we don’t own in order to, hopefully, buy it back later at a lower price. These days, it is one of those things that everyone learns about in finance class. All MBAs attend a seminar at some point that explains the reliance of Black-Scholes hedging techniques on short-selling, or the ability to reach a complete market through 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 or even 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 compromise to make Germany’s contribution towards a Greek bailout more palatable to the public. Politics aside, the regulator made a stunningly simple argument in support of the ban: the financial marketplace does not have the right to disturb the peace. The regulator alleged that, at that time, market speculators were creating so much volatility that it was spawning real economic, social and political problems. Having seen riots on the streets of Athens, it’s difficult to dispute these claims.
Again, the issue of incentives raises its head, with speculators looking for profit and firms looking to hedge exposures, effectively minimising losses and the need to sell or short assets. The sudden spike in supply drives down values and creates volatility that can threaten the stability of not only firms, but governments too. Misaligned incentives lie at the heart of most arguments that vilify financial markets, but they are not the only concern. The confluence of scale and self-fulfilling prophecy must also bear some of the burden.
Put more simply, market participation creates market influence, and the greater the participation, the greater the influence. Through the last 60 years, many economists and statistics students have invented and adapted models to analyse market movements. Causality and correlation amongst movements in asset values comprise a significant chunk of econometric research and statistical debate, but this single observation has always been, and remains to be, one of the least convenient features when modeling markets. Although often disregarded, this property is difficult to dispute. For example, 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, its share price is likely to rise – at least temporarily.
Since believing is seeing in the markets, if enough people believe that a firm – or country – cannot repay its debt, then no one will lend to it, resulting in the outstanding debt becoming worthless, and eventually rendering the entity unable to borrow. Given the on-demand nature of modern management within both firms and government, this disappearance of short-term funding effectively leads to bankruptcy.
Hedge funds and sovereign wealth funds have become excellent examples of the present global imbalance of wealth. This imbalance means that it’s possible for a small group of hedge funds to corner the market on large debt issues. The consequent price implications have the power to destabilise a not-so-small country’s economy and government, perhaps without the money managers having any intention of doing so. Consequently, even the practice of people selling what they already own can create huge problems when it happens en masse. Profiteers taking on further speculative short positions can only aggravate an already dire situation. [[[PAGE]]]
For a civilised capitalist society, this is a situation that we can potentially accept. Those who have the money have always also possessed the power, effectively making the rules that affect us all. The fact that money equals power isn’t exactly breaking news. Nevertheless, shouldn’t we be considering the debate philosophically as in the case with medical research, which is, just because we can, does it mean we should? Often such discussions are dramatised by apocalyptic predictions and life-and-death decisions, whereas financial innovation stays more neatly in the realm of money and politics. Difficult as it may seem to face unemployment or even homelessness, it is hardly an assured death sentence.
Market participation creates market influence, and the greater the participation, the greater the influence.
Until financial innovation crosses the boundary into real, life-and-death matters, it is unlikely that its costs can be directly related to fundamental medical ethics. We argue that this line is not ahead of us, it’s behind us. With that said, quickly answer this question: what’s your retirement plan? If you even entertained the word ‘pension’, consider this: from the perspective of the organisation paying your pension, the sooner you die, the less they have to pay you.
Some may argue that pensions are hardly a financial innovation because they’ve been around for decades. More specifically, they only gained popularity in post-industrialised societies, and generally after WWII. That’s not recent, but in the grander scheme of things, it’s not all that long ago either. Pensions have several close relatives that generate the same conflict of interest between provider and recipient including but not limited to, health insurance for the terminally ill, reverse mortgages and secondary markets for life insurance.
While it is hard to envision large multinational insurers hiring squads of hit men or setting plagues upon the Earth, as these markets evolve and risks get transferred, the potential for conflicting interests leading to actual murders increases. Allegedly unscrupulous dealers, uninformed buyers and callous third-hand investors arguably permeated the mortgage and housing space, creating a bubble that popped. Fraudsters such as Madoff have emerged in droves as the crisis draws questionable practices into the light. In the end, it might not seem like such a stretch of the imagination for charlatans to go from stealing your life savings to stealing your life.
What risk managers desperately need to consider is that more of the same may not be sufficient.
The most recent financial crisis has opened the door for risk managers to recreate their roles within financial institutions. Increasing regulatory demands, more management interest and higher profile CROs all demand affirmative action with losses, tightened budgets and staff cuts quickly translating into demands that mean, “Do more with less.”
More elaborate models, faster machines, more elegant reports or cleaner data are all admirable goals. They would allow risk managers to provide more thorough, better quality analysis. What risk managers desperately need to consider is that more of the same may not be sufficient. Is it more important to compute VaR with 2% accuracy, or to ensure that all product types are going through a rigorous measurement and review process? Is it more important to insure a building against wind damage, or to have a functioning disaster recovery site?
All managers eventually learn that the higher they rise within an organisation, the bigger the opportunities, and the bigger the problems that need to be overcome. As the role of risk managers expands, so too does the need to address larger issues such as incentives, self-fulfilling prophecies, ethics and matters of the public good, if for no other reason than to protect the firm and its stakeholders from the reputational risks inherent in perceived malfeasance.
This may be easier said than done, but no one ever said that balancing profitable financial innovation against its inherent risks would be painless!
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