December 05, 2010
A New Framework For Finance
The problem in finance that lead to the 2008 collapse is intellectual, not criminal. Wall Streeters genuinely believe in their sophisticated mathematical models. They have not been trying to lie, cheat, or steal. They believe that their work generates higher efficiency, better liquidity, and huge benefits for society. Many on Wall Street are still fundamentally puzzled by the events that lead up to the Lehman collapse.
Obviously Wall Street is missing something.
The crisis... has served to discredit mainstream finance theory, and especially its key idea, that capital markets are efficient. The idea that prices are always right and that capital markets exert their own self-discipline—the so called efficient market hypothesis—has received a deadly challenge.
So the real question is an engineering question: if we cannot build a stable financial system on MPT and the EMH, then what principle are we missing? How does one build a financial system that can stand up under its own weight?
The boxed quote above is from banker-turned-LSE-economist Paul Woolley. Woolley has proposed that classical financial models are missing one basic, but fundamental detail. By adding this detail back in, he offers up a more modern analytical framework for finance that might just be the salvation of the world economy.
Bankers are People Too
Wolley noticed that booms and busts like Lehman 2008 can be understood by modeling the fact that investors do not invest directly, but through investment managers that collect their own fees.
He suggests that the basic reason for many market failures is information asymmetry: investment managers using innovative techniques have far better information than the principal investors. Bankers rationally exploit this asymmetry to extract high rents while shirking as much responsibility as the market will withstand. Escalating rents eventually lead to ballooning use of opaque management, fragile pricing, and market collapse. By turning the camera of economic modeling inward onto the banking industry itself, Woolley outlines a model explaining the mechanisms leading to astronomical risk-taking in periods of financial innovation.
This chapter advances an alternative paradigm that seems to do a better job of explaining reality. Its key departure from mainstream theory is to incorporate delegation by principals to agents. The principals in this case are the end investors and customers who subcontract financial tasks to agents such as banks, fund managers, brokers, and other specialists. Delegation creates an incentive problem insofar as the agents have more and better information than their principals and because the interest of the two are rarely aligned.... Introducing agents both transforms the analysis and helps explain many aspects of mispricing and other distortions that have relied until now upon behavioral assumptions of psychological bias.
The above is from Woolley's chapter in "The Future of Finance: the LSE Report", which is available to read here. He proposes a number of policy fixes based on this analysis (mainly centered around changing incentive systems for bankers).
Better than Throwing Stones
A recent piece in the New Yorker discusses Woolley's work and asks "What Good is Wall Street?" The article attributes several colorful quotes to Woolley:
“Why on earth should finance be the biggest and most highly paid industry when it’s just a utility, like sewage or gas?” Woolley said to me when I met with him in London. “It is like a cancer that is growing to infinite size, until it takes over the entire body.”
“There was a presumption that financial innovation is socially valuable,” Woolley said to me. “The first thing I discovered was that it wasn’t backed by any empirical evidence. There’s almost none.”
But Woolley has done something better than just throw stones at the banking industry. By advocating that we must model bankers as independent agents with different information and motivation than principal investors, he has proposed a new quantitative framework for finance, and a possible new way forward.Posted by David at December 5, 2010 08:48 AM
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