Financial innovation tends to be a bit of a bad word these days. But while I and many other people are in favor of an overhaul of our regulatory system, that still leaves open the question of how the system should be managed.
A reader pointed me to a 2005 paper by Zvi Bodie and Robert Merton on the “Design of Financial Systems.” They argue that neoclassical finance theory – frictionless markets, rational agents, efficient outcomes – needs to be combined with two additional perspectives: an institutional approach that focus on the structural aspects of the financial system that introduce friction and may lead to non-efficient outcomes; and a behavioral approach that focuses on the ways in which and the conditions under which economic actors are not rational (see my post on bubbles, for example). The paper walks through examples of how to think about some real problems we face, such as the fact that households are increasingly being forced to make important decisions about retirement savings, but generally lack the knowledge and skills to make those decisions. One of their arguments is that while institutional design may not matter in a pure neoclassical world, it does matter in the world of irrational actors: deposit insurance to stop bank runs is an obvious example.
Some of the content may be tough going, but in general the paper offers one perspective on how to think about the relationships between markets, institutions, and individual behavior that make up our financial system.
The Baseline Scenario 
This statement grabbed my attention:
“Derivative securities … function as adapters among … incompatible domestic systems …. widespread use of derivatives … provided an effective offset to dysfunctional country-specific institutional rigidities.”
It reminds me of Michael Lewis’ description of the synthetic CDO, that via deriviatives new homeowners were being fabricated “from whole cloth.”
So, if you don’t want to deal with Hugo Chavez, you can just create a shadow Venezuela out of derivatives, that behaves (financially speaking) just like the real one, and trade with the shadow nation. In fact, why stop with just one, when you can create an unlimited number of Venezuelas?
Financial engineering, indeed.
Also noteworthy:
“Today no major financial institution … can function without the computer-based mathematical models … based typically on the Black-Scholes option pricing methodology.”
The Mandelbrotians have been saying for years that Black-Scholes is based on a faulty premise (that markets follow Gaussian laws). Yet even after this unprecedented failure of the models there has been no wholesale reexamination of the theory, least of all by Merton (as evidenced by his comments on the panel hosted by Harvard two months ago).
Isn’t it about time to stop tweaking the faulty models and start over?
Without mathematical models of high sophistication banks would be unable to generate level 3 assets which can be valued against ‘unobservable’ inputs.
The major banks cannot run without these sophisticated models because they have riffed all the middle-management folks that used to follow and understand the individual businesses and positions with sophisticated human judgment.
There are two fairly apparent mechanisms.
1. Pools that operate as a brake. When the big deregulation bill was passed in the late 90’s, Gramm did not put in what Treasury wanted, which was a coverage or insurance pool funded by market participants for certain derivative instruments. Note that AIG has now become infamous for writing instruments based on its credit and then not setting aside reserves because their models showed no or negligible default risk.
2. Decouple bonuses from the present. This is simple and obvious. The incentive has always been to cobble together deals, get the bonus and then maybe even be elsewhere when the deal fell apart. This got out of hand over the last decade and so individuals made many millions on deals that then destroyed their companies (and many lives and the entire financial system). If you don’t get paid today, then people aren’t rewarded for selling crap today. The mechanisms for doing this are simple in this computerized age.