

Playing with fire


See article

Readers' comments





Finance does have an 'off' button - it's called bankruptcy. The specter of failure prevents much mischief in life - finance should be no exception.

In our rush to shield people from consequences, we set the stage for even more bad behavior.


Financial innovations are sometimes difficult to market if the potential buyer knew the underlying odds. Take for example a simple insurance product. The only way an insurance company can make money is to ensure that the edge is on their side much like a house edge in a Vegas or Monte Carlo casino. The two are mathematically similar.

When I took a course in exotic options many years ago, I discovered or rather had a eureka moment that risk (i.e. risk transfer) products all have that characteristic. The buyer of the product, if he was rational and had all the statistical data and the proper probability models, probably shouldn't buy the products at all because for the vast majority of the time, he will not need it. The edge is always on the sell side, if not, the seller will likely have trouble paying out the claims if the triggering event actually happens.

But insurance are good things to have access to especially if used in the proper way, i.e., as actual insurance against some kind of contingency. Many of the risk transfers are useful to protect a portfolio against catastrophic losses. However, too many traders these days try to use these risk products as primary vehicles for profit. That's like hoping to get rich from crashing your car for the insurance pay-out. It's dangerous and not as profitable as one might think.


The Economist has missed out on one important landmark:

The First commodities futures trading in Osaka Rice Market in 1700.


Financial innovations have really done a lot of good to financial innovators. All the others are losers who must pay for them.

Daveycool in reply to hedgefundguy

This is an interesting observation. I think Ben Bernanke (I know) did say that we can't really inflate our way out of our debt. But at least for those things that are not "indexed" such as mortgages, it will work since the mortgage debt amounts stay fixed a consumer could use the cheapened money to pay it off.

The problem is social security and medicare related expenditures, i.e., the government part of debt. Now that's really a problem. Maybe we can rejigger the indexing algorithm to cheat cost of living adjustments which unfortunately will impoverish mostly the elderly, the sick, and the poor disproportionately. That sounds heartless.

There is really no easy solution except to grow the economy and that likely means somehow to improve liquidity, not necessarily the money supply.

Mike Atwood

What drivel. The article admits that financial innovation's benefits are difficult to quantify. It therefore denies the costs, otherwise it would disprove its own thesis of a positive cost-benefit.

Most financial innovation benefits banks and the financial industry, at a cost paid by governments and the economy as a whole.



Really why is that? Why couldn't banks issue more equity to make more loans? Or sell more bonds?

Make the banks keep the loans and the risk on their books.


"Reconviction rates among the prisoners recruited to the scheme will be measured against a national database of prisoners with a similar profile, and investors will get payouts from the Ministry of Justice if the Peterborough cohort does better than the rest." Do I understand this correctly? The better the Peterborough rehabilitation goes, the more the investors get? Where is the motivation for the local authorities to perform? It should be: the better they do, the less the investors get. The investors will be rewarded by a safer society. The worse the rehabilitation, the more the investors should get, both as a consolation for a more dangerous living environment and as a message to Peterborough to get its act together.

Cristiano Machiavelli

Financial innovation certainly can do a lot of good, just as innovation in any industry enhances growth prospects and efficiency. The problem is recent financial innovation has been explosive, with a dizzying amount of products being brought to the market before they are adequately understood. It is upsetting that few remember banking was once a "profession" where the customer was highly valued for entrusting his money in the respective financial institution. Now it is regarded as a dirty business, and rightfully so, as the customer has become irrelevant. Bankers only want to line the pockets of their shareholders (often themselves; conflict of interest??!!!). The Economist is right that financial innovation has both benefits and costs. Even more so in pointing out that the intentions of those behind financial innovation have the potential to amplify the consequences.


I'm glad the Economist has at last made out a detailed case for the finance industry, and, not being an expert I find these articles illuminating - as far as they go.
Surely though, in the name of efficiency, something must be wrong when finance takes up more than a small percentage of GDP (and a large percentage of corporate profits). The incentive for those within the industry is to churn and deal as much as possible, with a few cents here and there staying on those sticky fingers...
What percentage of transactions are useful in the sense that they're not zero sum games? Someone wins and someone loses (probably those furthest from the action, i.e. me). My pension funds charge around 1.5% p.a. for producing lousy returns - so I guess we're the suckers, but what can we do?

Cat On A Mat

Financial innovation is good for the future. It brings growth and prosperity, unfortunately, the risk aversion lies between debtors and creditors on trust and goodwill. With strict safeguard regulations, and worthy financial handlers, finanical innovation will do no wrong.

The problem to our concern is strictly greed from those at the top that creates wrongdoing, while the handlers below follow eyes fold as command. This situation creates massive growth and opportunities on an up pace unhealthily, while more and more people misbehave and are turning to gung-ho borrowers to pocket wealth without ever care to calculate the risk factors and social responsibilities off their debts.

No matter what financial-innovative ideas we can think of, rules need to set forth and strictly safeguard our society from the smarts, so they can no longer cheat, gamble and temper with the financial system off their own personal greed and temptation.

Personally, I certainly do not want to see financial institutions or insurance companies bring forth the brink of another financial catastrophe in the near future.




It takes a thief to catch a thief. Just saying.

PS I used to be a banker.


Your chart says "Securitisation of US mortgages begins" in 1970. I thought the GSEs existed to do that since the New Deal.

Maybe I'm wrong and they just dealt with whole mortgages back then.

"Ginnie Mae had guaranteed the first mortgage passthrough security of an approved lender in 1968"

Brecon Clovis

I am very interested in the Peterborough scheme to give a return on investment relating to the improved performance of criminals.

Are the criminals thenselves allowed to invest in the scheme?

If one of the investors bribed the criminals would this prevent him receiving payments under the shceme?

Best wishes,
Heath Lewis


Latest blog posts - All times are GMT
Writing worth reading: Dark matter
Babbage March 15th, 14:43
Bits and mortar: Babbage visits Ada's
Babbage March 15th, 10:22
Deportations: A kinder expulsion
Democracy in America March 14th, 21:38
Blasphemy laws: Wrong on so many levels
Erasmus March 14th, 17:20
Keynes and Hayek: Prophets for today
Free exchange March 14th, 16:43


Products & events