Derivatives - Financial Management Collection

Financial Management (Financial Management Association), Fall, 1993 by Henry T.C. Hu, Melissa Lunt

MISUNDERSTOOD DERIVATIVES: THE CAUSES OF INFORMATIONAL FAILURE AND THE PROMISE OF REGULATORY INCREMENTALISM

Excerpted and abstracted with permission of The Yale law Company and Fred B. Rothman & Company. The underlying work originally appeared in The Yale law Journal, Volume 102, Number 6, April 1993, pp. 1457-1513. Copyright |C~ 1993 by The Yale Law Journal Co., Inc., Yale Law School, 401A Yale Station, New Haven, CT 06520.

New financial products are being introduced throughout the industrialized world at an unprecedented rate. Innovation has been especially striking in the market for over-the-counter (OTC) derivatives. Moreover, the OTC derivatives market has enjoyed enormous growth in volume. On a crude, "notional amount" basis the market for selected OTC derivatives reached four trillion dollars by year-end 1991, eight times its level five years before. Such activities are concentrated in those large, money center financial institutions central to the world's financial system. The size of these markets and the prominence of the market players mean that the stakes in the derivatives game are high. Moreover, because they are novel, complex, and opaque, derivatives activities look risky.

Thus, it is not surprising that regulatory concern over OTC derivatives activity has grown along with the OTC derivatives market. Some industry leaders and regulators worry that OTC derivatives could cause the next great banking crisis.

Analysis of regulatory concerns leads to a striking puzzle and a corresponding dilemma. Many regulators -- as well as some bankers -- believe that, too often, bankers know too little about the risks of their derivatives pose to the banks themselves. This poses the puzzle: how could banks suffer from such systematic informational failures? Banks have put many of their best and brightest to work on these new financial products. How could such knowledgeable sellers, as opposed to investors or consumers, not have adequate information?

Although there is neither consensus nor conclusive evidence regarding the existence of such structural informational failure on the part of banks, there is no such disagreement regarding regulatory informational failure. Observers agree that regulators know less than the bankers and that they know too little. If the puzzle is why banks know so little, then the dilemma is how can regulators, who know even less, be effective. How can the blind guide the nearsighted?

Hu offers a partial explanation of the puzzle. The basic analytic framework begins with the premise that information is a commodity created from a production process built upon the new financial science that has emerged in the past two decades. Using this framework, banker informational failure is analyzed from several different perspectives.

From an economics standpoint, "inappropriability" and other theories drawn from the economics of industrial R & D can illuminate allocative problems associated with financial R & D. Under certain circumstances, inappropriability can contribute to aggregate informational failure even if individual banks may, in the aggregate, be spending enormous (and individually rational) amounts on developing bank-specific risk information.

From a psychological standpoint, cognitive biases might explain underproduction of information relevant to certain kinds of risks, especially legal ones. "Threshold effects," "availability effects," and "expert effects" may lead bankers to underestimate the privately optimal amount of investment in bank-specific risk information.

From the principal-agency perspective, the same theories that would normally imply excessive managerial aversion to risk-taking and underinvestment could, when applied to the OTC derivatives context, lead to excessive risk-taking and overinvestment. For example, many of the material risk exposures on certain derivatives occur years after the execution of the transaction; since employee turnover in the derivatives industry is high, the "negatives" may arise long after the rocket scientist is gone. So, an employee's short term focus may have the counter-intuitive result of the entity making too many, rather than too few, long-term investments.

Hu also sketches possible pathways to resolving the dilemma in the hope that they would serve as springboards for more extended analysis by regulators, market participants, and academics. Financial science differs from traditional science in ways that are highly relevant to the resolution of this dilemma. Because financial science violates traditional scientific norms of "openness" and "universalism," original government research probably can only play a limited role. These differences also provide fresh reasons for why information flows unevenly to regulators, and they highlight the concomitant importance of institutionalizing the transfer of financial technology from the private sector to the government.

In light of the foregoing, Hu argues for consideration of a number of incrementalist pathways, "incrementalist" in the sense that they involve gradual, reversible change. These include: (1) an institutionalized risk assessment mechanism involving centralized reporting by banks and certain other market participants about their products, exposures, and theories; (2) user fees that could provide regulators with the requisite resources and political cover needed to utilize private third party expertise; (3) encouragement of collective action through such mechanisms as trade associations; and (4) the mandatory (but confidential) disclosure to regulators of the incentive structures of derivatives personnel.