Financial innovation and the financial infrastructure [update]

As part of its series on financial innovation, the Economist magazine carried an article in which it discussed the role of financial infrastructure.

FAILURE IN THE financial crisis had many fathers. There were failures of regulators, bankers, shareholders, borrowers and economists. But two in particular were closely tied to the way financial innovations work. One was a failure of plumbing—the infrastructure of the markets and the back offices of financial firms. The other was a failure of the imagination. 

Actually, the failure of the plumbing and the failure of imagination are linked.  It is the back office that has the information that is needed so that risk can be assessed.

As Yves Smith observed on Naked Capitalism, nobody on Wall Street was compensated for creating transparent, low margin products.  To the extent that the back office lags financial innovation, it creates the opportunity for opaque products to be developed and sold.

Infrastructure often lags when an innovation takes off. Remember how markets move over time from being customised to becoming more standardised. When products are standardised and demand is high, finance’s manufacturing, sales and distribution channels can pump out a vast supply....

Looked at from the perspective of the back office, products move from customized, where it is tracked in an excel spreadsheet, to standardized, where it is tracked in a relational database.

In an ideal world, as the product moves from customized to standardized and sales volume takes off, the relational database is there at the moment of standardization to support the growth.

In the real world, the relational database for tracking all the product information, like terms, trails the growth in volume because it must be designed and built.  As a result, significant growth occurs and is supported by the customized spreadsheet.

[Some] argue that having a bigger haystack of data makes it harder to find the really important needles. Others want a lot more information. 

Given 21st century information technology, it is better to error on the side of providing a lot more information.  Unless all market participants know in advance what the really important needles are in the haystack, it is better to take the whole haystack and let the market participants subsequently discard what they think are the unimportant needles.

Each market participant can easily find what they think are the important needles using modern database technology.  For example, they can drilldown into the data.

No national regulator can see all of the financial system: an American regulator can see the CDS exposures of American banks to French banks, for instance, but is not allowed to see the counterparty risks of the French lenders in turn.... 

Given concerns about financial contagion, this is wholly unacceptable.

This is a problem that is easily solved by requiring each bank to provide ultra transparency and disclose on an on-going basis its current asset, liability and off-balance sheet exposure details.

Then all market participants, not just the national regulator, could see not just the CDS exposures of American banks to French banks, but also the counterparty risks of the French lender in turn.

“Margining and technical policy and back-office monitoring of positions against collateral are unsexy but it is the stuff to be focused on,” says Mohamed Norat of the IMF. 

This is particularly true when it comes to innovations that pledge to transfer or reduce risk. 

Many of the instruments and techniques that were most lauded before the crisis were designed to package risk and shift it away from people who did not want it towards those who did. 

More transparency might have made it clear that risk was simply being concentrated somewhere else, or was not really leaving banks’ balance-sheets at all. 

Or, more transparency might have allowed the market participants who supposedly wanted the risk the information they needed so that they could accurately assess and price the risk.

This weakness in infrastructure compounded a behavioural one. Finance is at its most dangerous when it is perceived to be safe. One element in the financial crisis was a failure to understand the risks inherent in various products until it was too late... 

Investors do not necessarily think through all the risks embedded in these new instruments (for example, that a national housing bust would render the tranching within CDOs useless) and buy them enthusiastically. When those risks materialise, there is a destabilising flight to safety. 

“The standard argument for financial innovation is that there are gains from trade, but that model crumbles if you suppose that people do not fully understand the risks,” says Mr Shleifer.... 

Why was there a failure to properly assess the risks in various products?  Because as Yves Smith said it was the intention of Wall Street from the get go to innovate opaque products that hid the risk.

This analysis rings true of much of finance: people are liable to forget about the risks of products that have already blown up as well as misjudge those that have been newly created. 

The euro zone’s debt crisis has shown that risks even in long-established instruments like government bonds can be underestimated. 

These are problems with the practice of risk management and not just a consequence of financial innovation.

But innovations are particularly susceptible to the problem of self-delusion. If they go wrong early enough, they are unlikely to get off the ground. But once they reach a sufficient scale without a big blow-up, nobody believes that they might be flawed.

Given Wall Street's incentives, it is a bad assumption to believe that because a product has not had problems that all the risks of the product are known and that it will not have problems in the future.

Update
In a Naked Capitalism post, Satyajit Das reviews the Economist magazine's series on financial innovation.  He observes

There is no acknowledgement [in the series] that much of what is called financial innovation is economic rent extraction, exploiting lack of transparency as well as information and knowledge asymmetries. 

There is no discussion of the destructive bonus culture which encourages certain behaviours in financial institutions. Thomas Philippon and Ariel Reshef have estimated that around 30-50% of the extra pay bankers received compared to similar professionals is attributable to economic rents. 

In a January 2009 speech, Lord Adair Turner, chairman of UK’s Financial Services Authority, observed that: “Much of the structuring and trading activity involved in the complex version of securitized credit was not required to deliver credit intermediation efficiently, but achieved an economic rent extraction made possible by the opacity of margins and the asymmetry of information and knowledge between…users of financial services and producers…financial innovation which delivers no fundamental economic benefit, can for a time flourish and earn for the individuals and institutions which innovated very large returns.” 

The unpalatable reality that few, self interested industry participants and their cheerleaders are prepared to admit is that much of what passes for financial innovation is specifically designed to conceal risk, obfuscate investors and reduce transparency. 

The process is entirely deliberate. Efficiency and transparency is not consistent with the high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits. The Report does not canvas this issue.

Mr. Das has nicely summarized why financial regulators must error on the side of too much transparency.