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Regulation or innovation?

Robert Shiller, one of the world’s most influential economists, used an FT op-ed column last year to argue for more financial innovation. He claimed it was not innovation (as in slice-and-dice mortgage-backed securities, etc, AKA toxic assets) that caused the sub-prime crisis and the credit crunch, but lack of it. Shiller said we need more financial innovation so we can have things like mortgages that include insurance against falling house prices and redundancy.

I fear the learned prof, like many residents of Financeland, has spent too much time away from mundane surreality (where people know everything about I’m A Celebrity but do not know what they will live on in retirement).

Shiller argued we do not have a problem with complicated gadgets even though we do not have a clue how they work. True, but that is because we don’t need to – we know whether they work or not and that is all we need. With complex financial products, though, we don’t know whether they work or not. Not only that, the people who make them often don’t know, and nor do the regulators. In fact it is even worse, because the nature of financial markets is there is no way anyone can know whether some complex products will work or not. Take structured products, where the best you can say about any possible outcome is “probably”.

This is where Shiller goes wrong, and the regulators too. Would you buy a mobile phone that “probably” works in Europe, or a TV that “may work” in HD? Of course not. Shiller argues, I think correctly, that most people are overly cautious with finance because they don’t understand.

One reason is we know that gadgets are governed by the laws of physics. But what are the laws governing financial gadgets? Until recently, many of the profs would have said finance theory provided those laws. You would not want to have to argue that in court today.

Financial products are different from things. They are mainly promises and if those promises are broken or are too weaselly phrased, people will not buy. Financial markets are unpredictable but it is possible to limit the unpredictability. It’ is in the public interest to do so, because we are very poor at probabilistic reasoning. That means if there is a wide range of possible outcomes, we will tend to view the proposition as more risky than it is based on the actual distribution of outcomes, so we will consistently err in our financial decisions. You are not going to change hard-wired biases in human reasoning like this with a smidgeon of money education in schools. The best that regulators can do is create a framework for products with a narrower range of outcomes that we can assess with our limited reasoning capacities.

Is that possible? Of course. Regulators initially did a good job in setting rules that governed occupational final-salary pensions and with-profits life insurance. Those were apparently simple products, underneath which lay a lot of complexity. Regulators did not stay up to speed with the complexity, so they did not prevent abuses of the rules, hence the terminal decline in both products.

Shiller argued that given freedom, firms will use financial engineering, derivatives etc to create better products. The evidence is not in favour.

But history shows that prescriptive product regulation can enable the creation of products Joe Soap can understand, buy and benefit from. That is a positive approach to financial complexity and innovation which delivers a public benefit.

There is an alternative – finance theory’s freedom mantra. “Anything goes,” including toxic stuff like precipice bonds, provided you have ticked the FSA’s process boxes. A system that regulates everything about financial products – except the products. Welcome to Blunderland.

Chris Gilchrist is director of Churchill Investments and editor of The IRS Report


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