Financial Innovation: Can Frankenstein be the Hero?

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Financial innovations have in recent years transformed the world. The transformation has however been for the worse. In order to understand how this transformation has come about one must evaluate the innovations that started the transformation.

Financial innovations have in recent years transformed the world. The transformation has however been for the worse. In order to understand how this transformation has come about one must evaluate the innovations that started the transformation. Financial innovations such as Collateralised Debt Obligations (CDO’s) are designed with the intention of managing risk. It is understandable that such a product is popular, and it is therefore natural that a market will accept and embrace it. With any invention it is the introduction of context (scalability) that proves the relevance, impact and value of the invention. In short: the invention becomes an innovation. In the process, instruments like credit default swaps, CDO’s of ABS (asset backed securities) and many other mutations of the CDO concept were created. Co-creation was flourishing and so was the profit from selling and creating the mutants. Banks got innovation-fever, and like workaholic Dr. Frankensteins, sent their mutants into the markets.

 

The context was just right for the banks to innovate. Deregulation allowed for experimentation. Low interest rates promoted investments with high degrees of leverage, hence enforcing the impact of the new innovative products. Finally, the interconnected financial markets allowed for a global context in which to test the products. This innovation-friendly environment allowed for a positive transformation to happen that brought prosperity to many. However, as uncontrolled, bad mutants left the banks the transformation turned into a global recession. Mutants like CDO’s filled with subprime mortgages were sold as safe investments, and presented many investors with the equivalent of playing Russian roulette with a fully loaded gun.

 

As the economies around the globe begin to show signs of survival after the attack of these uncontrolled mutants, it is now likely that increased restriction and regulation is being enforced on financial innovation. To many, financial innovation is evil and must never happen again. This view is however not only wrong, but potentially costly. The problem with this view is exactly what created the crisis: a poor understanding of the CDO concept. Very few banks, investors, rating agencies and regulators understood the complex product. The favourable context allowed for the belief that all the mutants were good and safe. Banks and credit rating agencies had to file for bankruptcy as a result of this belief. The bankrupt companies were acquired by the few, stronger competitors who did have an understanding of the products. The result is now a more concentrated competitive landscape with more companies labelled “too big to fail”. These companies need better ways to manage the added risk by not only becoming bigger companies, but also the risk associated with some of the toxic assets acquired in the process.

 

The CDO concept allows for risk management, and it will not only be unwise to ban this type of financial product but potentially devastating for national economies if these “too big to fail” companies have to be bailed out by governments, as a result of not being able to manage the added risk. This offers a paradoxical situation where complex financial innovation has caused a crisis, but more of the same is needed in order to get out of the mess.

 

Let us not lynch financial innovation and the CDO concept – Frankenstein, as hideous as he might be, is not an evil icon. The CDO concept has the potential to become the same.