Financial engineering has gone on too long, too far already

Last updated: 06 March 2009

It's time we got back to fundamentals and simplicity

Author : D Thyagarajan/DNA

Much has been said and written about the meltdown in financial markets. What has happened is so large in scale and the import for emerging economies like India so serious that more debates and comments will continue for a long time.
Investment banking, at least of the Wall Street kind, is dead.
Is it a disaster or a blessing in disguise for the emerging markets? Probably the latter.
Is there a lesson from it all? Yes, most certainly — go back to fundamentals and grandpa's simple logic and approach.
The financial sector is supposed to play a supplementary role to the real economy. At the end of the day, people cannot eat, wear, stay in, travel in, or be medically looked after by money.
Human beings' fundamental needs are met by the real economy consisting of manufacturing and core services. Financial sector is meant only to facilitate and enable the real economy function smoothly.
In the last few decades, however, finance and banking became too big and important for anybody's good. A system, which was meant to help the real players manage risk, was itself spawning huge varieties of risks and unleashing these on unsuspecting real sector companies.
Maybe financial engineering was taken too far, far beyond what was necessary for business. While the initial intent in introducing new products is often to address business risks, these products have a tendency to be used for speculation rather than for covering risks of underlying business transactions. Also, once introduced in the market, some of these products grow uncontrollably and become too big financial Frankensteins, as it were.
Derivatives typify this. Take the example of credit default swaps (CDS). The market size of CDS is $62 trillion, four times the GDP of the US. When Delphi defaulted, bankers made 10 times the value of bonds from bonds they did not hold by issuing Delphi CDS indicating CDS was working more as a profit centre than a risk management tool.
In India also, the derivatives market has been active for a number of years. Many corporates and banks have entered into swap contracts they did not fully understand. The media was full of news about corporates and banks going to courts on these derivatives contracts. I have seen swap contracts in the Indian market where the payoff equation runs into two full lines with half a dozen brackets and special characters. It is a nightmare even for fairly well-informed finance professionals.
The parties to such transactions need to ask some simple questions - What is the purpose of such transactions? Are they really protecting the interests of the organisation they represent by entering into such contracts with Gordian knot like complexity? Was there a need for committing the organisation to such contracts?
Too much of financial engineering has proved detrimental and from the overall system point of view, such products have served just the opposite purpose, i.e. they have created risk rather than contain risk.
History is replete with cases of manufacturing companies making huge losses from derivative contracts they did not understand. While the concept or the product itself may not be bad, the villain is the intent, method and the way in which these products were used by the managers.
Such complicated products also lead to other problems. It is very difficult to regulate such products. Basel II document for capital adequacy for banks is very voluminous and very complex even for seasoned professionals. Similarly, operating manuals for such products tend to be very voluminous and complicated. As regards regulation, the west typifies the 'form over substance' syndrome. Reams of paper, intimidating manuals and battalions of legal eagles cannot save the situation if the fundamental substance that should underpin every financial transaction, viz. the right intent, fairness and prudence, is absent.
The Fannie Maes, Freddie Macs and Lehmans of this world represent excesses in one form or the other. Blind pursuit of growth at any cost, which was the main cause of the super normal growth of mortgages in the US, suited many vested interest groups such as the senior management of these organisations, who got rewarded based on growth and profits and politicians who were very happy to play along as they saw the economy booming though on fragile foundations.
Emerging markets were aping the West dangerously close. Governments, regulators and business managers of emerging markets will do well to learn a lesson or two from this crisis.
It is time for all market constituents — the lenders, borrowers, intermediaries, the regulators and the government to learn from these mistakes and go back to fundamentals and increasingly opt for simplicity.
Incidentally, in April this year, Crisil had announced the concept of complexity ratings, formally launched by the finance minister. This was a welcome product, but it does not seem to have become popular. The foregoing makes a compelling case for making the whole market move towards simplicity.