April 26, 2011

AND REGULATION CAN REVEAL THE RISK:

Pride and Prejudice: Contrarian Speculation on Wall Street’s Future (Peter A. Coclanis, April 21, 2011, The American)

The financial industry certainly has its problems and it deserves its fair share of the blame for the onset of the Great Recession. Moreover, quants and the innovative financial products they “engineered” were at the center of many of the problems that arose. But quants are human (more or less!) and engineering innovations of all types have always been prone to problems early on. Although one can take the analogy too far—obviously, the innovations produced by financial engineers are not based on physical laws in the same way that innovations in construction, electrical, or chemical engineering are—in all of these areas it is humans doing the innovating. And humans, being mortals, sometimes misjudge, miscalculate, and make mistakes.

A quarter century ago, in his classic book To Engineer is Human, Henry Petroski demonstrated rather convincingly that failure is indispensable to successful design. Problems virtually always arise when engineers innovate—think here of collapsing bridges, exploding engines, and crashing airplanes—and, once problems are exposed, engineers have generally set to work on such problems and been able to surmount them over time. In so doing, they have enhanced efficiency and improved people’s lives in many, many ways.

A similar process will likely occur in financial engineering as well. In the past, other types of financial innovations—the discounting of bills of exchange, the creation of futures markets, the advent of non-investment grade (“junk”) bonds, etc.—have had rocky starts and have faced plenty of opposition. Over time, such innovations have generally proved their worth. The same may well hold true even for many of the so-called exotic financial instruments created in recent decades; certainly, some forms of securitization have already shown their value. To fully realize the potential of recent financial innovations, though, we need to develop more sophisticated models of financial markets, learn how to evaluate risk more accurately, and better understand the complexities of human behavior. We will need to make sure that we get right the context in which financial innovation occurs, whether through more effective regulation, better incentive structures, or more training in business ethics, if not all of these things.

But I’m confident that we can do what is necessary, and I’d place my money in particular on places such as D.E. Shaw (which, admittedly, has been having a tough time of late), where brilliant people work and merit rules. Paul Volcker’s line about the ATM being the most important financial innovation of the past 25 years is a good one, but it might not be accurate if Wall Street’s meritorious quants can be tamed. Don’t bet against them.


Posted by at April 26, 2011 6:07 AM
  

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