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Virtues of being simple

The ongoing crisis in the U.S. financial sector has been attributed to, among other things, the complexity of financial instruments that were aggressively promoted and marketed by some of the world’s leading banks and institutions. Since July last year, when the sub-prime crisis in the mortgage market first surfaced, it is becoming clearer by the day that in the name of financial innovation some highly unacceptable risks were taken and questionable practices adopted. People with poor credit records were encouraged to borrow. Those sub-prime loans were then sold to investment banks who then packaged them into marketable, complex instruments, the idea being to spread the risks and garner liquidity. However far from achieving those salutary goals, the questionable practices cloaked in complexity have landed the U.S. financial system in a mess. The seriousness of the malaise is best illustrated by the fact that no one knows who owns the bad debts. Worse, banks do not seem to know the extent of risks in some of the instruments they have created or, for that matter, when and where to expect them. Rating agencies too have been complicit and it is likely that regaining the trust in the financial system will take a long time after policy makers get a handle on the crisis and manage to resolve it.

This is of course not the first time that the presumed virtues of complex financial products have been questioned in the developed world or, for that matter, in India. In fact, recently in India, one class of hedging instruments going under the broad category of derivatives has been in the news for wrong reasons. Some companies have alleged, often in law suits, that banks sold them derivatives, such as interest rate forwards and multi-currency swaps, without explaining the attendant risks. While a legal remedy will take time to get, it is good to bear in mind that it is not the instruments — whether derivatives or any other — that are at fault. Rather, it is the lack of transparency in constructing them and the failure to communicate the risks to the buyer that seem to be at the root of the ongoing confrontation. Complex instruments need not be opaque but to ensure that they are indeed transparent banks should develop an adequate level of expertise. Those who buy those instruments should be made aware of the risks involved, and this presupposes that the buyers have at least a basic knowledge of how they work. Very often, even in the U.S., what were meant to be risk-hedging instruments appeared speculative in retrospect.

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