Financial innovation leads to greater risk

Financial innovation apparently leads to greater risk in markets, an economist from Massachusetts Institute of Technology (MIT) wrote in the Quarterly Journal of Economics.

But isn’t financial innovation supposed to diminish risk? Well, in theory, yes.

New financial instruments based on the housing market played a key part in the 2008 financial crisis.

However, author Alp Simsek, assistant professor in MIT’s Department of Economics, adds that those very instruments can potentially help spread risk more evenly throughout the marketplace. They allow for debt to be traded more extensively rather than concentrated in too few hands.

Simsek argues that even in theory, financial innovation does nothing to reduce portfolio risk. It has the opposite effect, by creating situations where parties become more polarized in their views regarding the value and risks of certain investments.

Simsek said:

“In a world in which investors have different views, new securities won’t necessarily reduce risks. People bet on their views. And betting is inherently a risk-increasing activity.”



 

In Simsek’s article – “Speculation and Risk Sharing with New Financial Assets” – he explains why he believes this is the case.

He argues that the risk in portfolios needs to be divided into two categories:

  • Simply inherent risks – these types are inherent in any real-world investment.
  • Speculative variance – this applies to new financial instruments created to generate bets based on opposing worldviews.

Simsek acknowledges that financial innovation is not without benefits, for example, it may spread data around world markets. However, it will not, overall, lead to lower risks for investors.

Simsek said:

“Financial innovation might be good for other reasons, but this general kind of belief that it reduces the risks in the economy is not right…. and I want people to realize that.”

We beg to differ

Let’s have a look at the family of financial instruments based around home mortgages to see why Simsek argues that “risk-reduction” financial innovation is not a risk reducer at all. These include:

  • Mortgage-backed security – a bundle of mortgages sold as a bond.
  • Collateralized debt obligation – a bundle of mortgage-backed securities.
  • Credit default swap – fundamentally, insurance on these kinds of debt.

Overall risk is spread if a bunch of mortgages is wrapped into a bond and sold on the markets; it can also lead to lower mortgage rates. Since the lender no longer has to hold all the loans, its position is less vulnerable (fewer defaults to worry about), putting it in a better position to lend at lower rates.

Simsek wrote “Moreover, these kinds of financial instruments separate home loans into distinct tranches, based on apparent risk – meaning that hedge funds with high risk tolerance could acquire the higher-paying, riskier loans, and pension funds could acquire the seemingly safer tranches.”

There is always a certain amount of risk in any investment in mortgages, because nobody knows what might happen in the housing market tomorrow.

However, what happens when the credit default swap enters the mix? Credit default swap is essentially a side bet between, say banks and reinsurance companies, about the future of the housing market, with one outcome – a winner and a loser.

The “bet” is an example of the kind of speculative variance that originates from a “belief disagreement”.

On closer analysis of the standard tool used to evaluate portfolio risk, the CAPM (capital-asset pricing model), which has been in use for about fifty years, this kind of distinction is inherent in its equations, Simsek believes.

Simsek said:

“If you do the math, [portfolio risk] naturally breaks down into two components, as you increase assets, this speculative part always goes up, when disagreements are large enough, this second effect is dominant and you end up increasing the average [portfolio risks] as well.”

Model research

Admittedly, his conclusion is based on a model. However, much of economics involves models, which describe and illuminate complex realities.

Simsek said “You build models, and if you’re lucky enough, the model speaks back.”

Simsek believes that risk theory needs to be re-assessed, especially after the disastrous results of financial innovations linked to the housing market in the last few years.

When referring to the investment bubble that blew many Wall Street firms apart, even prominent ones that needed government bailouts, Simsek said “What happened at the time seemed inconsistent to me with what we learned in finance courses.”

Speculative variance can also be found in the commodities markets, Simsek added.

At this year’s meeting of the American Economic Association, Darrell Duffie, a professor of finance at Stanford University’s Graduate School of Business, said of Simsek’s paper “He goes deep and he’s very careful and rigorous and clear.”

Although there have been several studies about belief disagreements, and much work done on financial innovation, Duffie added “but as far as I know this is the only paper that puts the two together.”

Further research is needed, Duffie said, to test Simsek’s theory about belief disagreement and speculative variance. “It’s a pure theory paper, so you often want to have someone come along afterward and measure empirically how big the effect is.”

Simsek says he would welcome empirical research probing his model. “[it would be beneficial for economists] to engage in a quantitative analysis, asset by asset, to think about the net effect [of speculative variance]. That’s a tough question, but one I think we should tackle going forward.”

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