While we were out some people who keep to a less rigorous vacation schedule than we do wrote some stuff about complexity in finance. Lisa Pollack at FT Alphaville started the ball rolling by attributing increasing complexity in finance to increasing smartness in the financial industry. This is a delightful theory if you are or were in the financial industry, particularly if you were tasked with developing financial instruments, so we’ll go ahead and endorse it.
Others, however, disagree. Here is a very nice thing at Interfluidity that various financial pundit types found life-changing:
Like so many good con-men, bankers make themselves believed by persuading each and every investor individually that, although someone might lose if stuff happens, it will be someone else. You’re in on the con. If something goes wrong, each and every investor is assured, there will be a bagholder, but it won’t be you. …
If the trail of tears were truly clear, if it were as obvious as it is in textbooks who takes what losses, banking systems would simply fail in their core task of attracting risk-averse investment to deploy in risky projects. Almost everyone who invests in a major bank believes themselves to be investing in a safe enterprise. Even the shareholders who are formally first-in-line for a loss view themselves as considerably protected. The government would never let it happen, right? Banks innovate and interconnect, swap and reinsure, guarantee and hedge, precisely so that it is not clear where losses will fall, so that each and every stakeholder of each and every entity can hold an image in their minds of some guarantor or affiliate or patsy who will take a hit before they do….
This is the business of banking. Opacity is not something that can be reformed away, because it is essential to banks’ economic function of mobilizing the risk-bearing capacity of people who, if fully informed, wouldn’t bear the risk. Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper. Insufficient economic risks are taken to sustain growth and development. You can have opacity and an industrial economy, or you can have transparency and herd goats.
This is delightful too, and features goats; my guess is that it’s mostly wrong but I don’t count that against it. One objection to it – though not a decisive one – is that it is wrong about the psychology of the people creating the financial complexity. People who design swaps and reinsurance and guarantees and capital structures actually want to know, really really clearly, what happens when things go bad. Part of the proliferation of complexity – not opacity, complexity – is the desire to have that definition. That’s what a CDO is. It’s slicing the world into possible future states and clearly defining who gets what payouts in those future states. Simple banking is “I will put equity into a bank, you will put a deposit in, I’ll loan out the money and whatever we get back goes first to you then to me.” Complicated banking is “that, but also if we don’t get the money back because of reason X, insurer A pays; and if we don’t get it back because of reason Y, noteholder B pays; etc.” Complexity is a move toward greater definition, greater clarity about where losses will fall, not less.
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