Monsters in the Closet

In the latter part of the 19th Century, mathematical innovation had become a source of scandals that shook the scientific world and beyond.
Top theoreticians such as Giuseppe Peano and Georg Cantor were producing "monsters," mathematical objects that defied common sense, such as an infinite space-filling curve and mind-boggling logical paradoxes, such as the nonexistence of the set of all sets. Monsters were proliferating, threatening the confidence scientists had in mathematics.

The current crisis in the financial markets has some features in common with this episode. Complex structured finance products, like securitized subprime mortgages or credit derivatives, are the "monsters" of today. Just as some scientists doubted the very foundation of their disciplines then, some bankers today have lost trust in their peers and even in the markets. Just as mathematicians called for "clarification," policymakers and investors are calling for "transparency."

The crisis is serious.
Ten weeks after liquidity dried up in some U.S. and European financial markets, we are not seeing the light at the end of the tunnel. Banks do not trust their peers, suspecting each other of carrying too many risky assets in their books. Consequently, banks pass their higher funding costs and risks on to their customers, either by making credit more expensive, or by becoming more selective. And that matters for the real economy: in the euro area, for instance, 75 percent of the corporate debt issued since 1997 is made of good old bank loans. Hence, the financial crisis is forcing banks to tighten credit conditions, which in turn will have an impact on the real economy and, possibly, on jobs.

This particular crisis is yet another chapter of the secular battle between innovation and regulation. Banking debacles in the 19th century and during the Great Depression resulted in strict regulation. More recently, the financial markets were thoroughly deregulated following Margaret Thatcher's "big bang." The result was a huge variety of new financial theories and products, including (most recently) things like credit derivatives or synthetic asset-backed securities. These products have, in general, helped allocate risk and resources more efficiently.

However, there were two catches.
First, the very complexity of the new products created a wide knowledge gap between producers and buyers. Too many managers bought products they did not fully understand. Too many sellers were not able to translate the risks hidden in obscure financial equations into simple words. Innovation has advanced faster than the expertise of financial officers, ratings agencies and even regulators, as the failure of two German banks has shown. This knowledge mismatch will correct itself and does not call for regulation: excessively complex financial products will wane for lack of appetite.
The second catch is more worrying. The meltdown of the U.S. subprime-mortgage market has unveiled an uncomfortable truth about asset-backed securities: they were not correctly priced, because the data used to estimate probabilities of default could not go back far enough in the past to encompass several periods of crisis similar to today's subprime problems. Downgrading the value of their risky assets from what models indicated they should be, to the more sober numbers that real buyers and sellers are paying, will be a long and painful process, because it will require more defaults to estimate the fair price of risks. This could be politically unpalatable.

There is no doubt that more transparency in banking would be good, more realistic pricing would be sane, and that more competition between credit agencies would help. This is, broadly speaking, what EU Finance ministers have just agreed to push forward as part of a road map for financial stability. However, their pledge to "look closely at nonregulated debt markets" hints that they are tempted to use the regulatory stick to replace over-the-counter, tailor-made financial instruments with securities traded in regulated exchanges. That could dramatically reduce the flexibility and the variety of financial products that companies are currently using to hedge risks. Such a heavy-handed reaction would be counterproductive: in free-market economies, nothing may stop innovation, but overregulation may push it to hide in dark corners and shady firms.

Imagine what would have happened if, in 1900, politicians had decided to ban mathematical monsters and regulate the production of theorems, for fear of further scandals. Of course, such nonsense did not happen. Instead, it took several years of self-discipline and hard work to clearly define and tame the monsters and restore trust in mathematics. The key word here is self-discipline. One can only hope that the financial industry will show enough of it to lighten the hand of policymakers.