Do we need new controls, or should we improve the effectiveness of existing ones?

The following article ties in perfectly my research, thus I felt i should share.

WEF urges new controls on financial innovations

Sarah Krouse

27 Apr 2012

Financial innovations, blamed for exacerbating the financial crisis, still face a major perception problem, but a new report says that they should continue to be developed – with better controls.

Photo credit: World Economic Forum, Andy Mettler

Photo credit: World Economic Forum, Andy Mettler

The study, published on Friday by the World Economic Forum and consultancy Oliver Wyman, outlined steps that firms and regulators should take to ensure the responsible development of financial innovations – which include products such as collateralised debt obligations and credit default swaps. The WEF urges stress tests, market trials and changes in incentive structure to stem potential negative outcomes.

At the report’s centre is an outline of the fundamental issue with new products: that they have no track record and therefore no historical data that can be used for reference. The group encouraged testing that acknowledged unknowns and anticipated potential problems.

It also called for more ‘extreme scenario’ stress tests and intervention when products mutate in the markets in potentially dangerous ways.

Banks and other institutions have the responsibility to adjust their enterprise risk management systems to account for risks from new products, educate their boards about new innovations and revise their new product approval processes, the report said.

New approval processes should include market trials similar to those used by the pharmaceutical industry, giving more attention to innovations that come from existing products, and better tracking of products in the market throughout their lives and as they become more widespread.

Regulation should have a lighter touch, allowing for new innovations, the report said, but its authors encouraged collaborations so that both regulators and institutions understand new risks.

To avoid incentivising inappropriate selling of products, as many mortgage brokers were accused of in the boom, the study recommended clawbacks and deferring incentives for products with longer lives, perhaps spreading bonus payments over three to six years

The group also called for an overall “customer orientation” with simple, transparent products appropriately matched to clients’ needs.

By identifying potential negative impacts during the development of new innovations, the groups said they hoped “that the industry will continue to be granted the latitude and enjoy the self-confidence to pursue innovation as a path to individual profit, to industry profit and to wide societal benefits.”


My Thoughts                                                                                                                   Reading this article, I am forced to ponder whether we need new controls, or have to strengthen the effectiveness of existing ones. A review from the literature on structures for governing financial innovation currently suggest that there are quite a lot of controls in place for governing financial activity. Although these do not target regulating the innovation process specifically, it how innovations once they have been commercialized are used. These governance mechanisms are normally regulations enforced externally (by legal sanctions through self-regulatory  and independent governmental organizations) or internally using corporate governance structures. Considering that mechanisms have always existed to govern financial activity, I am of the opinion that there is more of a need for strengthening the effectiveness of controls to govern financial activity. Nevertheless, new controls that monitor the innovation process must be introduced.

Mapping out the financial innovation Landscape


Where do most financial innovations occur? What are the processes followed for financial innovation? Who are the stakeholders involved in the financial innovation process? These are some of the questions I have been investigating recently in order to describe and map out the financial innovation landscape. My findings from reviewing the secondary literature seem to show that complexity and reconfiguration are emerging themes in the financial innovation process. It is no shock therefore that financial innovations especially in the 20th and 21st century have mainly been about using already existing instruments, practices and technologies in new ways. The unbundling of risks and characteristics of already existing products to form new combinations has also been another major approach that has contributed thousands of financial innovations to society today.

Financial innovations are not confined to just one quadrant of Francis and Bessant’s 4Ps framework (product, process, position and paradigm) for exploring innovation space.  However it seems most financial innovations are sat at the product and process quadrants. To this end,  organizations seem to use aspects of new product/process development approaches coupled with stage gating techniques when creating financial innovations. With regard to stakeholders, a complex interactive web has been identified to exist. This is because, most stakeholders (individuals, financial institutions, non-financial institutions, technology-related institutions, governments etc.) play multiple roles (e.g. innovators, end-users, intermediaries etc.) at different times and at the same time. In summary it can be said that the financial innovation landscape is poorly characterized as no formal model for financial innovation exists.

Responsible bankers?

Recently, a friend forwarded this very interesting piece to me and I have been thinking about quite a lot of things about responsibility in financial services and how we need to think incentives to encourage responsibility. See below for the article.


Why I Am Leaving Goldman Sachs


Published: March 14, 2012

TODAY is my last day at Goldman Sachs. After almost 12 years at the firm — first as a summer intern while at Stanford, then in New York for 10 years, and now in London — I believe I have worked here long enough to understand the trajectory of its culture, its people and its identity. And I can honestly say that the environment now is as toxic and destructive as I have ever seen it.

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To put the problem in the simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about making money. Goldman Sachs is one of the world’s largest and most important investment banks and it is too integral to global finance to continue to act this way. The firm has veered so far from the place I joined right out of college that I can no longer in good conscience say that I identify with what it stands for.

It might sound surprising to a skeptical public, but culture was always a vital part of Goldman Sachs’s success. It revolved around teamwork, integrity, a spirit of humility, and always doing right by our clients. The culture was the secret sauce that made this place great and allowed us to earn our clients’ trust for 143 years. It wasn’t just about making money; this alone will not sustain a firm for so long. It had something to do with pride and belief in the organization. I am sad to say that I look around today and see virtually no trace of the culture that made me love working for this firm for many years. I no longer have the pride, or the belief.

But this was not always the case. For more than a decade I recruited and mentored candidates through our grueling interview process. I was selected as one of 10 people (out of a firm of more than 30,000) to appear on our recruiting video, which is played on every college campus we visit around the world. In 2006 I managed the summer intern program in sales and trading in New York for the 80 college students who made the cut, out of the thousands who applied.

I knew it was time to leave when I realized I could no longer look students in the eye and tell them what a great place this was to work.

When the history books are written about Goldman Sachs, they may reflect that the current chief executive officer, Lloyd C. Blankfein, and the president, Gary D. Cohn, lost hold of the firm’s culture on their watch. I truly believe that this decline in the firm’s moral fiber represents the single most serious threat to its long-run survival.

Over the course of my career I have had the privilege of advising two of the largest hedge funds on the planet, five of the largest asset managers in the United States, and three of the most prominent sovereign wealth funds in the Middle East and Asia. My clients have a total asset base of more than a trillion dollars. I have always taken a lot of pride in advising my clients to do what I believe is right for them, even if it means less money for the firm. This view is becoming increasingly unpopular at Goldman Sachs. Another sign that it was time to leave.

How did we get here? The firm changed the way it thought about leadership. Leadership used to be about ideas, setting an example and doing the right thing. Today, if you make enough money for the firm (and are not currently an ax murderer) you will be promoted into a position of influence.

What are three quick ways to become a leader? a) Execute on the firm’s “axes,” which is Goldman-speak for persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit. b) “Hunt Elephants.” In English: get your clients — some of whom are sophisticated, and some of whom aren’t — to trade whatever will bring the biggest profit to Goldman. Call me old-fashioned, but I don’t like selling my clients a product that is wrong for them. c) Find yourself sitting in a seat where your job is to trade any illiquid, opaque product with a three-letter acronym.

Today, many of these leaders display a Goldman Sachs culture quotient of exactly zero percent. I attend derivatives sales meetings where not one single minute is spent asking questions about how we can help clients. It’s purely about how we can make the most possible money off of them. If you were an alien from Mars and sat in on one of these meetings, you would believe that a client’s success or progress was not part of the thought process at all.

It makes me ill how callously people talk about ripping their clients off. Over the last 12 months I have seen five different managing directors refer to their own clients as “muppets,” sometimes over internal e-mail. Even after the S.E.C., Fabulous Fab, Abacus,God’s work, Carl Levin, Vampire Squids? No humility? I mean, come on. Integrity? It is eroding. I don’t know of any illegal behavior, but will people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals? Absolutely. Every day, in fact.

It astounds me how little senior management gets a basic truth: If clients don’t trust you they will eventually stop doing business with you. It doesn’t matter how smart you are.

These days, the most common question I get from junior analysts about derivatives is, “How much money did we make off the client?” It bothers me every time I hear it, because it is a clear reflection of what they are observing from their leaders about the way they should behave. Now project 10 years into the future: You don’t have to be a rocket scientist to figure out that the junior analyst sitting quietly in the corner of the room hearing about “muppets,” “ripping eyeballs out” and “getting paid” doesn’t exactly turn into a model citizen.

When I was a first-year analyst I didn’t know where the bathroom was, or how to tie my shoelaces. I was taught to be concerned with learning the ropes, finding out what a derivative was, understanding finance, getting to know our clients and what motivated them, learning how they defined success and what we could do to help them get there.

My proudest moments in life — getting a full scholarship to go from South Africa to Stanford University, being selected as a Rhodes Scholar national finalist, winning a bronze medal for table tennis at the Maccabiah Games in Israel, known as the Jewish Olympics — have all come through hard work, with no shortcuts. Goldman Sachs today has become too much about shortcuts and not enough about achievement. It just doesn’t feel right to me anymore.

I hope this can be a wake-up call to the board of directors. Make the client the focal point of your business again. Without clients you will not make money. In fact, you will not exist. Weed out the morally bankrupt people, no matter how much money they make for the firm. And get the culture right again, so people want to work here for the right reasons. People who care only about making money will not sustain this firm — or the trust of its clients — for very much longer.

Greg Smith is resigning today as a Goldman Sachs executive director and head of the firm’s United States equity derivatives business in Europe, the Middle East and Africa.

Gathering from this piece, it is evident that the willingness and commitment for one to uphold his/her personal values is crucial in responsibility.  For Gregg Smith, it has taken more than a decade to stand up to what he believes and values. In deed this is a step in the right direction. But can we say responsibility is just about walking away from the immoralities in our financial system? What could he have done differently? how should we conceptualize responsibility in the financial sector? These are questions we need to explore further.

Bill Moyers | John Reed on Big Banks’ Power and Influence | Truthout

Bill Moyers | John Reed on Big Banks’ Power and Influence | Truthout.

How Goldman Sachs helped mask Greece’s debt


The 2,500 year-old Parthenon – still standing while Greece crumbles

Yesterday European finance ministers agreed a second bailout for the Greek Government, worth more than 130 bn Euros. In light of the country’s staggering debt, and the risk it poses to the health of the entire Eurozone, it now appears that Greece should not have been permitted to join the Euro in the first place. So, why was it?

Nick Dunbar’s film on last night’s BBC Newsnight set out to provide at least part of the explanation.

The film shed new light on a slight of hand orchestrated by the investment bank Goldman Sachs, that allowed a large chunk of Greek public debt to seemingly disappear, and for the country’s finances to appear in better shape than they were in reality.

Back in 2001, the Greek government was pondering how it could meet the conditions of Euro membership. A key requirement of the Maastricht criteria, five criteria that determine whether an EU country is ready to adopt the euro, was that member states show ‘directionality’ in their public debt.

This meant that the country’s debt ratio needed to be going down year on year: ‘The national debt should not exceed 60% of GDP, but a country with a higher level of debt can still adopt the euro provided its debt levels are falling steadily’.

The solution they came up with was not to cut spending or raise taxes, as Dunbar incredulously points out, but to attempt to hide their debt. Enter Goldman Sachs, global investment banking and asset management company.

Newsnight revealed that one of the Goldman Sachs bankers hatched an ingenious plan to strike a financial deal called a ‘swap’ with the Greek Government, using it to hide 2.8bn Euros of national debt. The deal was legal but completely secret.

Back in 2003, Nick Dunbar revealed the existence of this deal. Far from ‘making something out of nothing’, as the Greek authorities alleged, Dunbar was very much on the right track. The new revelation made in last night’s film was that of the role played, or perhaps more accurately not played, by the European accounting agency, Eurostat.

Goldman Sachs passed Newsnight an email showing that they covered themselves by discussing the deal with Eurostat. Eurostat dismiss this discussion as having only concerned ‘general clarifications’, and maintain that they only became aware of the deal in 2010.

But regardless of exactly when European institutions, such as Eurostat, became aware of this deal, major concerns remain over why more attention was not paid to the employment of untested and unregulated financial products by European States. emerging from the innovation boom in the banking sector.

The deals were commonplace, Goldman Sachs said in their statement to Newsnight: ‘The swaps were one of several techniques that many European governments used to meet the terms of the [Maastricht] treaty.’

Last night’s film gained access to one of the key figures responsible for the deal, Christoforus Sardelis, then head of the Greek Public Debt Management Agency. He had been tasked with the job of bringing the national finances in line with Maastricht criteria.

With hindsight, it’s apparent to Sardelis that the deal was problematic. Under its terms, Goldman Sachs has made millions from the Greek government, yet the original 2.8bn Euros of debt has now ballooned to 5.7bn Euros. Nevertheless, this is a drop in the ocean of Greece’s £350bn debt.

To Sardelis, the deal may have been a bad one, but it wasn’t the cause of his country’s current woes, he says in the film. ‘It was a very sexy story, between two sinners, but the European crisis is not the child of the sex we had with Goldman Sachs’, he, rather salubriously, commented.


What is financial innovation?


According to the Oxford Dictionary, the term finance can be used as both a noun and a verb in slightly different ways. While it refers to the monetary resources of a state, organization or person when used as a noun, it can also mean, not only providing funding for a person or an enterprise, but also managing effectively large sums of money when used as a verb.  Despite the slight variations in what the concept of finance means, it is evident that money is a key factor in finance; thus it can be said that the history of finance, spans thousands of years into history, starting from when the concept of money was introduced. To this end, it can be argued that financial innovation has been since the existence of man; and the advance of civilization has played a great role in its development overtime.

Although we mostly tend to think about financial instruments for investments (such as bonds, stocks, options, swaps, futures and other structured financial products) when the term is used, it actually encompasses a lot more to include process management products and services such as point of sale terminals, debit and credit cards, credit scoring, electronic trading and on-line, mobile and telephone banking among others. In general innovation theory, most researchers have highlighted the element of “newness” as key in defining innovation. However, in practical terms, it can be said that nothing is entirely new in itself. Thus experts in financial innovation explain that financial innovation involves not only the creation and popularization of new financial products, processes, markets and institutions, but the unbundling and reassembling of the characteristics and risks of already existing instruments to form different combinations. It is interesting to note that financial innovations are largely incremental but very complex and globalized. Therefore the riskiness of financial innovations do not derive from the creation of radical innovations, but from the development of several incremental improvements to already existing products in a very complex and globalized context.

Surprisingly, research undertaken so far suggest that the financial innovation landscape is poorly characterised and no model of financial innovation exists. This is quite alarming as we cannot attempt to address the negative concerns of financial innovation without understanding the process within which it is developed. Probably, we can take clues from the new products/service development process in financial institutions as a way of developing a model for financial innovation as a whole. To this end, it can be inferred that the financial innovation process has similarities with the traditional stage-gate model, comprising four or five stages (e.g. problem recognition, concept development, market research and assessment, concept testing and implementation). Nevertheless, financial innovation differs slightly as it involves what is known as the “innovation spiral”; a process where one financial innovation begets another. Further, financial innovations normally have a short lead time, with development and commercialization taking place within months and days respectively. These suggest that the financial innovation process is a complex one; and this is probably a justification for why a model of financial innovation, does not seem to exist at the moment.

Financial Innovation and the Dilemma of Control


Innovation has been with us for a long time, and its overall contribution to finance and welfare has been positive. Nevertheless, its core benefits to society have recently been questioned following the financial crisis in 2007/2008; where financial innovation has received various criticisms from the media, the public, policy makers and top economists in society. As a result, controversies exist on the merits and dangers of financial innovation; and on the responsibility or irresponsibility with which it is conducted. To this end, there are agreements among stakeholders on the need to create a more responsible approach to handling financial innovation; and actors have become interested in finding ways to preserve the benefits of financial innovation, while at the same time limiting the effects of financial innovations that prove harmful.

Is this a realistic and attainable goal? Do we have a choice if we are to ensure that the financial crisis is not repeated again? Can stakeholders distinguish beneficial innovations from harmful ones early enough to reduce, if not eliminate, the negative impacts of financial innovations? Here the issue is one of uncertainty, ignorance and the dilemma of control; and clearly, this is not an easy task as researchers point out that for most economic and financial decisions, we do not know what all the consequences of the outcome will be; and as such will be exposed to some degree of uncertainty regarding the wider impacts of financial innovations.

The complexity of this issue is even more aggravated when it is understood that financial innovation, comparable to many forms of technological innovation, may be commercialized even before relevant authorities can consider their danger, or even know about their existence. This may also be compounded by the rapidity and complexity of financial innovation itself . Thus, a dilemma of control, may emerge; as by the time undesirable consequences become visible, the innovation is locked in; and making a change has become expensive, difficult and time consuming. These arguments lead to questioning how adequate or robust current mechanisms, including regulation, for governing financial innovations are in predicting the wider impacts of financial innovations before they occur.

Research suggests that financial regulation lags financial innovation itself as regulation in the financial industry have normally focused, to a large extent, on filling in the regulatory gaps identified after each financial crisis. Significant time lags of this type are common for many forms of innovation; and this suggest that experiences in anticipatory governance, and emerging concepts of responsible innovation in these other fields may have read across to the governance of financial innovation. These suggest that financial innovators cannot predict all the possible consequences of their innovations before commercialization; thus the key to addressing the issue of the dilemma of control may be in making the right decisions under conditions of uncertainty, and establishing a framework for responsible financial innovation to support this.

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