"Financial innovation tends to be a bit of a bad word these days. But while I and many other people are in favor of an overhaul of our regulatory system, that still leaves open the question of how the system should be managed.
A reader pointed me to a 2005 paper by Zvi Bodie and Robert Merton on the “Design of Financial Systems.” They argue that neoclassical finance theory ( KANTIAN ) - frictionless markets, rational agents, efficient outcomes - needs to be combined with two additional perspectives:( 1 ) an institutional approach ( KANTIAN ) that focus on the structural aspects of the financial system that introduce friction and may lead to non-efficient outcomes; and ( 2 ) a behavioral approach ( EXISTENTIAL ) that focuses on the ways in which and the conditions under which economic actors are not rational (see my post on bubbles, for example). The paper walks through examples of how to think about some real problems we face, such as the fact that households are increasingly being forced to make important decisions about retirement savings, but generally lack the knowledge and skills to make those decisions. One of their arguments is that while institutional design may not matter in a pure neoclassical world, it does matter in the world of irrational actors( HUMAN AGENCY EXPLANATIONS ): deposit insurance to stop bank runs is an obvious example.
Some of the content may be tough going, but in general the paper offers one perspective on how to think about the relationships between markets, institutions, and individual behavior that make up our financial system."
Here are some interesting quotes:
"Instead of examining each as competing alternatives, our central methodological thesis for implementing a functional theory of financial institutions is a synthesis of the neoclassical, the new institutional, and the behavioral perspectives on finance. We call this attempt to synthesize these three perspectives, Functional and Structural Finance (FSF).( IT'S A REASONABLE APPROACH, INTEGRATING KANTIAN AND EXISTENTIAL EXPLANATIONS )
"Derivative securities designed to function as adapters among otherwise incompatible domestic
systems were important contributors to effective integration. In general, the flexibility created by the widespread use of derivatives as well as specialized institutional designs provided an effective offset to dysfunctional country-specific institutional rigidities. Furthermore, derivative-security technologies provide efficient means for creating cross-border interfaces without imposing invasive, widespread changes within each system."( THIS IS A MAIN USE OF DERIVATIVES )
"This pipeline analogy captures much of what has been happening during the past twenty years in the international financial system. Financial engineers have been designing and implementing derivative contracts to function as efficient adapters that allow
the flow of funds and the sharing of risks among diverse national systems with different institutional shapes and sizes. More generally, financial innovation has been a central
force driving the financial system toward greater economic efficiency. Both scholarly research and practitioner experience over that period have led to vast improvements in our understanding of how to use the new financial technologies to manage risk.
As we all know, there have been financial “incidents,” and even crises, that cause some to raise
questions about innovations and the scientific soundness of the financial theories used to engineer them. There have surely been individual cases of faulty engineering designs and faulty implementations of those designs in finance just as there have
been in building bridges, airplanes, and silicon chips. Indeed, learning from (sometimes even
tragic) mistakes is an integral part of the process of technical progress.3
However, on addressing the overall soundness of applying the tools of financial engineering, it is
enough to note here the judgment of financial institutions around the world as measured by their
practice.Today no major financial institution in the world, including central banks, can function without the computer-based mathematical models of modern financial science. Furthermore, the specific models that these institutions depend on to conduct their global derivative pricing and risk-management activities are based typically on the Black–Scholes option pricing methodology."
Okay, this section doesn't exactly ring true anymore. However, the tools can still be effectively used, only with much more caution and a more realistic approach to the world. One can argue that is what they're doing in this paper, but their triumphalism does sound discordant today, at the very least.
With its foundation based on frictionless and efficient markets populated with atomistic and rational agents, the practical applicability of the neoclassical modeling approach is now challenged by at least two alternative theoretical paradigms. One, New Institutional Economics, focuses explicitly on transaction costs, taxes, computational limitations, and other frictions.5 The other, Behavioral Economics, introduces non-rational and systematically uninformed
behavior by agents.6 In contrast to the robustness of the neoclassical model, the prescriptions and predictions of these alternatives are manifestly sensitive to the specific market frictions and posited behavioral deviations of agents.7 Perhaps more latent is the strong sensitivity of these predictions to the institutional structure in which they are embedded. There is a considerable ongoing debate, sometimes expressed in polar form, between the proponents
of these competing paradigms. Those who attack the traditional neoclassical approach assert that the overwhelming accumulation of evidence of anomalies
flatly rejects it.8 They see a major paradigm shift to one of the new alternatives as essential for
progress. Defenders of the neoclassical paradigm respond that the alleged empirical anomalies are either not there, or that they can be explained within the neoclassical framework, and that in either case, the proposed alternatives do not offer a better resolution.9 That debate so framed is best left to proceed anomaly by anomaly and we say no more about it here.
Instead, we take a different approach. Rather than choose among the three competing theoretical perspectives, we believe that each, although not yet of the same historical significance, can make distinctive contributions to our understanding and each has its distinctive limitations." ( I WOULD AGREE WITH THIS )
Households today are called upon to make a wide range of important and detailed financial decisions that they did not have to in the past. For example, in the United States, there is a strong trend away from defined-benefit corporate pension plans that require no management decisions by the employee toward defined-contribution plans that do. There are more than 9000 mutual funds and a vast array of other investment products. Along with insurance products and liquidity assets, the household faces a daunting task to assemble these various components into a coherent effective lifetime financial plan. Some see this trend continuing with existing products
such as mutual funds being transported into technologically less-developed financial systems.
Perhaps this is so, especially in the more immediate future, with the widespread growth of relatively inexpensive Internet access to financial “advice engines.” However, the creation of all these alternatives combined with the deregulation that made them possible has consequences: deep and wideranging disaggregation has left households with the responsibility for making important and technically complex micro-financial decisions involving risk—such as detailed asset allocation and estimates of the optimal level of life-cycle saving for retirement—decisions that they had not had to make in the past, are not trained to make in the present, and are unlikely to execute efficiently in the future, even with attempts at education. The availability of financial advice over the Internet at low cost may help to address some of the information-asymmetry problems for households with respect to commodity-like products for which
the quality of performance promised is easily verified. However, the Internet does not solve the
“principal–agent” problem with respect to more fundamental financial advice dispensed by an agent.That is why we believe that the future trend will shift toward more integrated financial products and services, which are easier to understand ( NECESSARY ), more tailored
toward individual profiles ( GOOD ), and permit much more effective risk selection and control. ( NECESSARY )
Of course, this is the rational for financial innovation, but it must meet the required standards to be useful. So far, this seems doubtful, although, again, I don't blame the investments.
The preceding examples of behavioral distortions of efficient risk allocation and asset pricing all involve cognitive dissonance of individual agents.However, there is another dimension of potential behavioral effects that is sociological in nature in that it derives from the social structure of the financial system. Sociological behavior is neither under the control
of individuals within that social structure nor a direct consequence of simple aggregation of individual cognitive dysfunctions. A classic instance within finance is the Self-Fulfilling Prophecy (SFP),41 applied for instance to bank runs: a bank would remain solvent provided that a majority of its depositors do not try to take their money out at the same time. However, as a consequence of a public prophesy that the bank is going to fail, each depositor attempts to withdraw his funds and in the process of the resulting liquidity crisis, the bank does
indeed fail. Each individual can be fully rational and understand that if a “run on the bank” does not occur, it will indeed be solvent. Nevertheless, as a consequence of the public prophesy, each depositor decides rationally to attempt to withdraw his savings and the prophecy of bank failure is fulfilled. As we know, one institutional design used to offset this dysfunctional collective behavior is deposit insurance. There are of course others. ( THIS WAS THE EXAMPLE MENTIONED, AND IT IS THE REASON FOR DEPOSIT INSURANCE, AND IT WORKS IN PREVENTING A RUN. ONE OF THE SUGGESTIONS WHICH I BACKED WAS TO HAVE GOVERNMENTS EXPLICITLY GUARANTEE A MAJOR PORTION OF THE SYSTEM IN ORDER TO SLOW DOWN THIS RUN, WHICH IS JUST ANOTHER NAME FOR THE FLIGHT TO SAFETY. IN OTHER WORDS, THAT'S WHAT THE GOVERNMENT IS DOING NOW. THE TRICK IS FINDING THE RIGHT LEVEL OF BACKING, IN THE SAME WAY THAT THE FDIC DETERMINES THE AMOUNTS AND TERMS OF DEPOSIT INSURANCE )
"Improving technology and a decline in transactions costs has added to the intensity of that
competition. Inspection of Finnerty’s (1988, 1992) extensive histories of innovative financial products suggests a pattern in which products offered initially by intermediaries ultimately move to markets. For example: • The development of liquid markets for money instruments such as commercial paper allowed money-market mutual funds to compete with banks and thrifts for household savings. • The creation of “high-yield” and medium-term note markets, which made it possible for mutual funds, pension funds, and individual investors to service those corporate issuers who had historically depended on banks as their source of debt financing.
• The creation of a national mortgage market allowed mutual funds and pension funds to
become major funding alternatives to thrift institutions for residential mortgages. • Creation of these funding markets also made it possible for investment banks and mortgage brokers to compete with the thrift institutions for the origination and servicing fees on loans and mortgages.
• Securitization of auto loans, credit-card receivables, and leases on consumer and producer
durables, has intensified the competition between banks and finance companies as sources
of funds for these purposes. This pattern may seem to imply that successful new products will inevitably migrate from intermediaries to markets. That is, once a successful product becomes familiar, and perhaps after some incentive problems are resolved, it will become a commodity traded in a market. Some see this process as destroying the value of intermediaries. However, this “systematic” loss of successful products is a consequence of the functional role of intermediaries and is not dysfunctional. Just as venture-capital firms that provide financing for start-up businesses expect to lose their successful creations to capital market sources of funding, so do the intermediaries that create new financial products expect to lose their successful and scalable ones to markets. Intermediaries continue to prosper by finding new successful products and the institutional means to perform financial functions more effectively than the existing
ones, all made possible by the commodization of existing products and services.( I WOULD SAY THAT THE INTERMEDIARIES TOOK ADVANTAGE OF THE MARKET )
"Consider, for example, the Eurodollar futures market that provides organized trading in standardized LIBOR (London Interbank Offered Rate) deposits at various dates in the future. The opportunity to trade in this futures market provides financial intermediaries with a way to hedge more efficiently custom-contracted interest-rate swaps based on a floating rate linked to LIBOR. A LIBOR rather than a US Treasury rate-based swap is better suited to the needs of many intermediaries’ customers because their cash-market borrowing rate is typically linked to LIBOR and not to Treasury rates. At the same time, the huge volume generated by intermediaries hedging their swaps has helped make the Eurodollar futures market a great financial success for its organizers. Furthermore, swaps with relatively standardized terms have recently begun to move from being custom contracts to ones traded in markets. The trading of these so-called “pure vanilla” swaps in a market further expands
the opportunity structure for intermediaries to hedge and thereby enables them to create more customized swaps and related financial products more efficiently. ( I'M SURE THIS SEEMS NAIVE NOW, BUT IT IS IMPORTANT TO UNDERSTAND HOW THESE INVESTMENTS WERE SUPPOSED TO FUNCTION )
"A well-established legal and transactional infrastructure for swaps together with the enormous scale of such contracts outstanding51 set conditions for the prospective use of swaps and other contractual agreements to manage the economic risks of whole countries in a non-invasive and reversible fashion.52 Thus, countries can modify their risk exposures separately from physical investment decisions and trade and capital flow policies. This application of financial technology offers the potential for a country to mitigate or even eliminate the traditional economic tradeoff between pursuing its comparative advantages, which by necessity requires it to focus on a relatively few related activities and achieving efficient risk diversification, which requires it to pursue many relatively unrelated activities." ( AGAIN, IT SEEMS NAIVE, BUT IT'S HOW SWAPS WERE SUPPOSED TO WORK )
"We have framed and illustrated by examples the FSF approach to the design of financial systems.We conclude here with some observations connecting the design and implementation of a well-functioning financial system with the broader economic issues of promoting long-term economic growth ( TRUE ). Nearly a half century ago, Robert Solow’s fundamental work on the long-run determinants of economic growth concluded that it was technological progress ( I TEND TO AGREE ), not high rates of saving or population growth, that account for the vast bulk of growth. Subsequent studies have tried to reduce the unexplained residual by adding other measurable inputs. A large body of recent research work suggests thatwell-functioning financial institutions promote economic growth( WE DON'T HAVE THOSE ). These conclusions emerge from cross-country comparisons,53 firm-level studies,time-series research,55 and econometric investigations that use panel techniques.56 And in their historical research, North (1990), Levine (2002), Neal (1990), and Rousseau and Sylla (2003) have all concluded that those regions—be they cities, countries, or states—that developed the relatively more sophisticated and well-functioning financial systems were the ones that were the subsequent leaders in economic development of their times. An integrated picture of these findings suggests that in the absence of a financial system that can provide the means for transforming technical innovation into broad enough implementation, technological progress will not have a significant/substantial impact on the economic development and growth of the economy. Therefore, countries like China or even Japan, that need to undertake restructuring of their financial systems, should consider not only their short-run monetary and fiscal policies, and not only the impact of these policies on national saving and capital formation, but also how changes in their financial institutions will affect their prospects for long-term economic development ( I AGREE ). But substantial changes and adaptations in the institutional implementation will be necessary in different countries. There are at least two reasons:
(1) national differences in history, culture, politics,
and legal infrastructure( I AGREE ), and (2) opportunities for
a country that is in the midst of restructuring its
financial system to “leap frog” the current best practices
of existing systems by incorporating the latest
financial technology in ways that can only be done
with “a clean sheet.”( I AGREE )
There is not likely to be “one best way” of providing financial and other economic functions( VERY TRUE ). And
even if there were, how does one figure out which one is best without assuming an all-knowing benevolent ruler or international agency? One must take care to avoid placing the implementation of all economic development into one institutionally
defined financial channel( TRUE ). Fortunately, innovations in telecommunications, information technology, and financial engineering offer the practical prospect for multiple channels for
the financing of economic growth. Multiple channels for capital raising are a good idea in terms of
greater assurance of supply at competitive prices. They also offer the prospective benefits of competition to be the best one in a given environment at a given point in time (TRUE ).
Much of the traditional discussion of economic policy focuses on its monetary, fiscal, currency
management aspects and on monitoring capital and trade flows. These are important in the short
run, and thus also in the long run, in the sense that one does not get to the long run without
surviving the short run. However, if financial innovation is stifled for fear that it will reduce the
effectiveness of short-run monetary and fiscal policies (or will drain foreign currency reserves), the consequences could be a much slower pace of technological progress( THIS WOULD NOT BE GOOD ). Furthermore, long-run policies that focus on domestic saving and capital formation as key determinants of economic growth do not appear to be effective( BUT THEY ARE IMPORTANT ). Policies designed to stimulate innovation in the financial system would thus appear to be more important for long-term economic development ( I AGREE )."
Okay. Read this paper. It's like a Rorschach Test. If you agree with me, it will make sense, and you will likely find these investments like Derivatives to have positive value, and look elsewhere for the cause of our current crisis. If you find the paper naive and silly now, in light of current events, then the complexity and product argument probably works for you.
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