Innovation and Complexity in Finance

This week the business news was dominated by Goldman Sachs. The SEC charged it with securities fraud. While Goldman denies any wrongdoing and will “vigorously defend its reputation”, it is actually its reputation that may be permanently damaged. The SEC may find it difficult to pin Goldman down in court, but in the court of public opinion, Goldman may find it hard to redeem itself. Felix Salmon does a great job of covering this. John Gapper has a nice piece in the FT that sums it all up rather well.

Here are a couple of observations about the Goldman Abacus deal. All parties involved – Goldman, ACA, IKB, ABN Amro and Paulson – are financial firms. While the assets being packaged into the CDO were mortgages, they were far removed from the houses that were bought using mortgages. There was no purpose that this deal served in the “real” economy.

George Soros in an op-ed in the FT today:

Whether or not Goldman is guilty, the transaction in question clearly had no social benefit. It involved a complex synthetic security derived from existing mortgage-backed securities by cloning them into imaginary units that mimicked the originals. This synthetic collateralised debt obligation did not finance the ownership of any additional homes or allocate capital more efficiently; it merely swelled the volume of mortgage-backed securities that lost value when the housing bubble burst. The primary purpose of the transaction was to generate fees and commissions.

The deal was a complex deal. So complex that ACA and IKB didn’t understand it well enough to ask the right questions. Neither of them are bit players. ACA was happy to let Paulson pick the mortgages that went into the structured product since they thought he was long and on the same side of the deal as they were. IKB, similarly didn’t look at the underlying assets too closely because they thought Paulson was investing too.

There are many occasions in business when trust compensates for an incomplete understanding of the parameters of a deal. In such situations you prefer working with a specialist with a reputation, like say IBM for technology. But in this case, ACA and IKB, both financial firms, couldn’t deal with the complexity of the transaction and trusted (or at least ceded control to) Goldman. And they got taken to the cleaners. ACA is no more and IKB had to be bailed out by the German government. ABN Amro is now part of RBS which was bailed out by the British government.

And here’s my point. Maybe there is such a thing as too much financial innovation. Maybe too much of this innovation is to create complexity for its own sake, to keep changing stuff just to keep clients confused and uninformed. Low information clients are the most profitable clients.

In the consumer finance world complexity creates fine print. Fine print creates profits. Credit cards, banks – they don’t make money by being upfront and transparent. With financial institutions the game has to change, since they have lawyers who can read the fine print. So what do you do? You “innovate”. You create structured products that are mind-bogglingly complex. You avoid transparency. You avoid instruments that can be marked-to-market.

Besides clients and counter parties, constant financial “innovation” also keeps the regulatory bodies confused. They don’t understand these new financial instruments to effectively regulate or police them. In the meanwhile, the smart players on Wall Street are raking it in.

Which is why Wall Street doesn’t like exchange traded derivatives. Products would have to be simplified, standardized. Change would slow down. Spreads would come down and so would bonuses.

Innovation in services is hard to pin down – is it useful or is it smoke? Again, looking at credit cards business, developing a product that allows your teenage son to use your credit card at certain merchants to a certain limit – that’s useful innovation. But a product that has low APRs but gives you only 5 days to pay your bill before hitting you with late fees – that’s innovation that is designed to make more money off of customers who don’t read the fine print.

The problem is that it is very, very difficult to make rules such that the good kind of innovation is unimpeded while preventing the bad kind. That’s why we need ethical business leaders. Today, the credo in the corporate world and especially on Wall Street is – maximize your bonus without committing an unlawful act. In many cases this is stretched to “without getting caught”. Regulation can’t keep up with this. There has to be some self regulation.

We need more companies like Google. “Do no evil” might sound corny but it says that the company tries. That’s more than you can say about Goldman Sachs.

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3 Responses to Innovation and Complexity in Finance

  1. Jose says:

    Not only in the world of consumer finance, even in Information Technology, companies do create complex terms to confuse clients. The intent is to deliver old wine in a new bottle or sometimes deliver water disguised as wine:) In order to interest/impress the client, thousands of terms/jargons – that no one really understands – are created everyday in the presentations.

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  2. Krishna says:

    Basab, So generous of you to have given the so-called savvier finance firms a reprieve while saying trust ( in savvier GS) compensates for incomplete understanding of a derivative instrument. I don't think they trusted Goldman. I seriously allude it to their gross incompetence. In other words, that's as far as they could go in piecing it out… all the while reposing complete trust their ability to flush it down the throat of other unsuspecting fools that would stand to lose their shirt and more.

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  3. v p kochikar says:

    It’s completely true that much financial “innovation” consists of creating complexity designed to benefit the innovator rather than the customer. However it may not be entirely fair to single out the financial industry on this score – sadly, the same approach permeates and is indeed often central to “innovation” in every single industry. Having researched innovation for a living (so to speak!) For the past few years I’ve produced a list of over 50 such “innovations”, and the list is completely secular wrt industries. What’s even more interesting, the “innovations” in this list collectively represent revenues running into billions of dollars!

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