Airs – Ian Lance Taylor

Financial Complexity

The current news about bad management of credit risks by banks reminds me of one of my ongoing concerns about the modern financial markets. Modern finance is very large and very complex. Once upon a time financial markets were relatively straightforward: you bought stocks, bonds, future, options. These are not simple instruments, but it’s fairly easy to understand the risk. These days, people have constructed a broad range of so-called derivatives, which are basically bets on a formula. The inputs to the formula are more-or-less real things with market prices. The formula itself, however, is almost arbitrarily complex.

There is nothing wrong with derivatives per se. However, it can be very difficult to understand exactly what the risks are. When the inputs to the formula are combined, it takes some thought to understand how changes in the inputs affect the output. It then takes a lot of thought to understand what would be likely to change the inputs, and how the inputs might move together or separately. Poorly understood inputs caused the collapse of Long Term Capital and Enron (Enron was a fraudulent company which would have eventually collapsed in any case, but the specific collapse was triggered by some bad bets they made–although arguably those bets were themselves fraudulent actions by the CFO).

There is also nothing wrong with wealthy people taking poorly-understood risks with their money. My concern is that many different organizations are making the same bets without realizing it. That means that many organizations could run into trouble at the same time. And that would be big trouble for the global financial system.

I think we’re seeing a small taste of that now, though in a simpler way. Many organizations invested in mortgate securities. Almost none of them properly understood the risks. A long series of banks is now taking big write-downs because of their bad investments. The damage is not too large–most people do pay their mortgages in the end, and evena foreclosure retains some value–so the mortgage securities are mostly not entirely worthless. But still we see that many different organizations, with different policies, all made the same sort of mistake.

If that happens in a big way–e.g., many people bet against some currency collapse, but it collapses anyhow–we could see some serious pain in the financial system. And that could be very bad for the economy as a whole.

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Ian Lance Taylor

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4 responses to “Financial Complexity”

  1. ncm Avatar
    ncm

    From what I’ve read, the banks are astonishingly successful at valuing the most arcane of instruments (astonishing to me, anyway) but are structurally unable to apply their understanding. This is because the punishment for passing up a potential profit, when everybody else is taking a profit (even if it’s just “on paper”), is enormously greater than for taking a loss when everybody else is also. In other words, fund managers, Institutionally, are obliged to take great risks or be replaced by somebody else who will.

    Lots of people were predicting the Crash in 1999, but anybody who acted on it was excoriated in the financial press for missing out on the gains of 2000.

  2. ncm Avatar
    ncm

    By the way, the best place I know to learn often astonishing minutiae of economics is Cal professor Brad Delong’s blog, “Grasping Reality with Both Hands”, at http://delong.typepad.com/ . Delong also aggregates links to relevant political coverage from more other blogs than I can conceive of following.

  3. Ian Lance Taylor Avatar
    Ian Lance Taylor

    I think you are generally right on the ability of banks to put a value on financial instruments. My concern is slightly different: are banks (and other large investors) properly evaluating the risks? Some errors in evaluating risk are inevitable. Random errors are not problematic. Systematic errors can be very serious. I’m concerned that there are systematic errors in pricing in the market, which will not be revealed until some unusual event occurs.

    Thanks for the pointer to the blog.

  4. Airs – Ian Lance Taylor » Financial Complexity 2

    […] Almost six months later, I’ll look back at my earlier post about financial complexity. Considering the continuing troubles of the financial markets, it seems clear that I underestimated the degree of the problem. But I think I was generally correct in pointing out that the complexity of modern markets helped hide the nature of the bets that institutions were making. Many institutions thought that they had only a controlled amount of exposure to the mortgage market, only to find out that they were wrong. They had lent money to other institutions, which had made derivative bets, which were founded on the mortgage market, and problems rebounded back to institutions which thought they were acting soundly. […]

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