Editorial

Simple Finance

“Financial innovation” was all the buzz on Wall Street until the end of 2008. Wall Street cheerleaders explained that new financial products were unlocking new ways to make money with reduced risk.

Among the many lessons of the financial crisis is that, when it comes to financial products and arrangements, “new” and “complicated” are not synonymous with “good.” Financial complexity — whether it is complicated products (like tricky mortgage terms or credit default swaps), complicated accounting (including through use of off-balance sheet maneuvers), or complicated organizational structures — brings inherent problems.

Above all, complexity introduces confusion by all market players.

Consumers are the most victimized. Millions of home buyers were tricked by complicated mortgage terms into accepting predatory loans that stripped them of a lifetime’s savings.

But even the supposedly sophisticated investor is regularly tripped up by complexity. Witness the high-wealth individuals and funds who lost their money with the flim-flam artist Bernard Madoff.

Even Wall Street firms themselves could not navigate the complicated world they created. After its effective takeover by the U.S. government, it became clear that insurance giant AIG was not aware of all of the credit default swaps into which it had entered. The vaunted risk models of the “quants” — mathematics and physics Ph.D.s working on Wall Street — failed utterly to predict the housing bubble and collapse. Three of the top five Wall Street investment banks were so ensnared in money-hemorrhaging complicated arrangements that they no longer exist.

Beyond confusion, complexity tends to introduce interconnectedness. In the case of mortgage-backed securities (pools of mortgages, traded as bonds), proponents said this interconnectedness would dilute risk. Some loans in a pool might go bad, but not all, went the theory. Instead, it is now clear that interconnectedness amplified risk and spread it throughout the financial system.

Complexity also overwhelms regulatory capacity. No one in the financial regulatory system has a good handle on who owes what to whom. Over the last decade, most regulators didn’t try hard to maintain a sense of this information — or the systemic risks it posed — but much crucial information is unknowable even to diligent regulators.

It’s time to adopt a regulatory presumption against financial complexity and to close the cult of financial innovation. The purveyors of complicated financial products and arrangements should be forced to prove their social value. This approach suggests a number of specific policy interventions:

First, financial dealings must be much more open and comprehensible (“transparent”). Off-balance sheet accounting, for example, should be banned. But transparency is only a first and very partial step.

Second, some financial products should be banned. For example, “synthetic CDOs” involve bets by parties about the outcomes of transactions in which they have no direct stake. They serve no social purpose and should not be permitted.

Third, the precautionary principle should be applied to the financial world. New financial products for consumers should not be permitted unless they have received pre-marketing approval from regulators convinced that they help and do not harm or deceive consumers. New Wall Street products should be permitted only if they can show they serve social purpose, and regulators determine they do not pose inappropriate systemic risk.

Fourth, financial institutions should be smaller and less integrated. The breakdown of the division between commercial banking and other financial services, and the interconnections among the entire financial sector, were the preconditions for the current crisis to be so severe.

Fifth, there must be a massive de-leveraging of the financial system, meaning there must be much less use of borrowed money by lenders and speculators. This will reduce risks and shrink the overall financial sector. De-leveraging is happening now, but new regulations must ensure it is a permanent condition.

Sixth, a financial transactions tax should be imposed, particularly on financial derivatives and other exotic instruments. This will slow and scale back the pace and size of financial trading and speculation.

Finally, at the global level, countries must have freedom to adopt capital controls, so that they can de-link their financial systems from the global financial system, or at least reduce their interconnectedness with, and vulnerability to, global financial flows.

As the United States, and the rest of the world, aims to escape from the deepening financial and economic crisis, “simplify” should be the watchword.