Sunday, January 1, 2012

Financial amnesia and the need for financial history

CFA UK discusses costs of financial amnesia. This is a very important lesson for all of the quant technocrats who have invaded Wall Street and London. There are few who can name any of the past financial crises that have befallen Wall Street. 

From CFA UK's Response to the Joint Committee on the Draft Financial Services Bill:

Financial amnesia is when financial market participants forget or behave as if they have forgotten the lessons from financial history. Financial market participants are composed of two main groups, regulated financial firms and regulators. Despite the history of bitter experience, the same mistakes occur with alarming regularity (see Appendix 1). The three key lessons that participants appear to forget are:  

Lesson 1: "Innovation", the illusion of safety and "this time it’s different": "The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version" (Galbraith).The expansion of credit plays a key role in fuelling "innovation" while the creation of an illusion of safety results in a "this time it's different" approach that enables the continuation of unsustainable activity and risk taking. Sadly, each time it is always the same and never different.

Lesson 2: Regulated financial firms are prone to failure: It has been presumed that regulated financial firms by acting in their own self interest and in the interests of their shareholders, impose market discipline. History has demonstrated that because failure to impose market discipline is not uncommon, over-reliance on market forces can be misleading.

Lesson 3: Ineffective regulation. The frequency of market failure places a greater onus on the regulator to be more effective in encouraging and imposing market discipline. Sadly, regulators focus on the symptoms of failure rather than its root causes. Furthermore, regulators often ignore the root cause of their own inability to act promptly and thereby contribute to the risk of systemic governance failure. 

It used to be that Wall Street was run by the liberal arts majors of the Ivy League but now the engineers and economics majors rule. There is nothing wrong with economics majors except that thy have focused on quantitative skills over liberal arts and social sciences. Engineers have never been taught the value of history as part of their education. There is only so much time for study but history in finance and economics has not been given any value. Being trained in the late 70's and early 80's, I can say that there was no required course in economic history.

"Let it be emphasized once more, and especially to anyone inclined to a personally rewarding skepticism in these matters: for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius." - John Kenneth Galbraith 

from the investment blog

"Progress is cumulative in science and engineering but cyclical in finance." - Jim Grant 

The three lessons from the report are important, but the most important lesson may be that extraordinary profits will eventually be taken out of the market.High returns or profits cannot continue forever. History has proved that high profits from innovation cannot last and competition may mean that the initial or first mover may not be the one who is able to gain all of the profits. High returns can exist for short  time periods but cannot last forever.

The key to innovation is that even though it may occur throughout industries and in finance the behavior of investors is still fairly constant. Innovation in finance has increased speed of communication, but not what is communicated or how it is interpreted. Innovation has increased with new financial products, but that does not mean that behavior has changed. Markets are still ruled by greed and fear. 

While these ruling factors of greed and fear may not be historical, we come back to the fact that events that occur in finance follow a similar pattern. In the simplest framework, bubbles do occur. The type of bubble may be due to new innovations which may to some make this time different, but bubbles do occur regardless of what we have learned. The laws of economics still prevail. If there are extraordinary profits in some new industry, there will be new entrants and these new entrants from increased competition will force down the prices of overvalued companies.

Lesson 2 may not be that regulated firms are prone to failure but that all firms are prone to failure regardless if they are regulated. The markets are dynamic and those firms that do not change or adapt will be failures if there are regulation. Regulation may slow the process and it may change the mix of failures but it cannot top unprofitable firms that do not have a good business model from continuing. 

Lesson 3 is not that regulation is ineffective but that its objectives may not be well-defined or the objectives may be set to solve  problem that does not exist. Put still differently, the law of unintended consequences is such that a regulatory solution may create new problems that did not exist before. We may also find that the intent of regulation may be very different from what it turns into years later. The problem of mission of yesterday may be changed for something different years later which creates the chance for failure. 

History is a necessary part of finance even if it just used a a form of validation of theory. 

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