Editor's Choice

Financial innovation for suckers

A reader of Felix Salmon's blog named Chris seems to have written the comment heard 'round the blogosphere, about financial innovation and risk:

The person most willing to take on risk is the one unaware he is doing so. He charges no risk premium…

The resulting market equilibrium is that the guy who is unaware of the risk ends up loaded with it. Then the music stops.

Salmon's gloss on this is that it serves to explain investment banks' profits during the recent bubble: "They charge their clients a lot of money to take risk off their hands, and then they transformed that risk, using sophisticated financial engineering, into instruments which didn’t, on their face, look risky at all, and which could easily be sold to risk-averse investors. Bingo, massive profits." This means that financial innovation had become a matter of making risk disappear, not managing it better, as was so often insisted a few years ago (all that talk about how CDOs spread risk and made everyone safer, etc.). Financial innovations had become, as Salmon notes, "tools of obfuscation" in the hands of investment bankers. Further proof that the market for financial products is a market for lemons.

One might argue further that the innovation was designed to trick not gullible investors but the rating agencies those investors relied upon, only it's probably true that the rating agencies were in on the scam all along and didn't need deceiving -- they got paid when the instruments become AAA rated, and they helped the banks figure out how to make them pass muster.

It seems obvious that regulation should aim to prevent hiding risk from being a profitable business. If there is to be an overseer of systemic risk, that regulator's main function would be precisely to ensure that risk is visible and not tucked away in the shadow-banking system. The larger question is whether there is any way to direct innovation efforts toward things that actually help society rather than destroy it in the name of private gain.

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