Financial innovation is a good thing, but it requires the financial authorities to remain alert.
Readers may recall that I used the term "Alphabet Soup" in an earlier Viewpoint article to describe the many abbreviations of financial products—CDO, CLO, SIV, ABCP, CDS*, and so on—that have been plaguing the financial systems of the developed markets since the summer of last year. I wonder whether readers have tried Alphabet Soup. If not, it is definitely worth doing so, if only to achieve a better understanding of the continuing financial stress in the United States and Europe, and learn a few lessons from it.
Alphabet Soup is quite thick and creamy, and you cannot see through it, no matter how hard you try. And when you do get to the bottom of it, you probably find you have already had too much. When I was a child, I found Alphabet Soup quite tasty and good value for money, to the extent of wanting more of it and stocking up, quite like an investor seeing a highly rated financial instrument earning an attractive rate of return. But now that I am older, I prefer greater transparency and so I normally go for a consommé, but I still like to try Alphabet Soup now and then to try and find my favourite combinations of letters.
The Alphabet Soup description of exotic structured products can in fact be generalised to refer to financial innovation, which of course is a good thing, as I have often mentioned, if it is properly harnessed, with prudent risk management, to make financial intermediation more efficient and not, as it often turns out, for the purpose of pursuing the private interests of the financial intermediaries. The question, of course, is how best to harness it, having regard to the many lessons that have been learnt in the past year of financial turmoil in the developed markets. Discussions on this are still going on, in many international forums, involving national authorities and international standard-setting bodies.
I see three dimensions in which improvements can be made. First, increase the transparency of the Alphabet Soup. Although this may not be to the liking of many concerned, particularly those bringing the Alphabet Soup to the market (indeed, I also have doubts as to whether a clear Alphabet Soup would sell as well), it is in the long-term interest of us all, in terms of maintaining financial stability. And transparency is not all. To many investors, even the clearest description of the wide range of underlying assets making up an exotic structured product may not mean much. This is particularly so when the product has been sliced into different tranches of different seniority, once or even several times. Second, therefore, like cigarettes, the Alphabet Soup may require appropriate and reliable health warnings from those who are in a position to issue them. Here the rating agencies will just have to do a better job to regain the confidence of investors, removing the perceived and actual conflicts of interest they have been involved in. Third, the scrutiny applied to the ingredients making up the Alphabet Soup should be tightened. This is to ensure that the quality of the underlying assets going into the production line of financial innovation is up to objective, minimum standards. This can be achieved through appropriate supervisory requirements, for example, maximum loan-to-value and loan-to-income ratios for mortgages. If the consequence of so doing is that less soup, or less-tasty soup, is brought to the market, so be it: the long-term health of the financial system and the economy must come first.
I am hopeful that specific proposals for improvement in all three areas will be forthcoming, although very much still in the context of the recent wave of financial innovation, which took the form of (sometimes incomplete) credit-risk transfer through the "originate-and-distribute" model of securitisation. But there is always the possibility of another wave of financial innovation, with totally different characteristics, springing up and getting around whatever improved framework is established for ensuring financial stability. Financial authorities will need to be always on the alert.
17 July 2008
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