Financial Innovations and the Risk Paradox

Abstract

This study argues that opposing opinions on the net benefits of financial innovation can to an important degree be explained by assessing carefully the implications of the so-called risk paradox: financial innovations resulting in potentially improved risk profiles of individual financial institutions and higher standards of living, on the one hand, with an increase in financial fragility, market risk and systemic risk, on the other. Before the global financial crisis of 2007-2009, there was the prevailing view that the widespread and growing use of derivatives was shaping a revolutionary new banking landscape that had become more flexible, efficient and resilient in large part due to financial innovations such as derivatives and securitization. The emergence of new financial instruments and institutions was generally considered as welfare enhancing in the sense that financial markets were judged as more complete. It was widely believed before the global crisis that risks were more accurately priced and better shared. However, the global crisis has radically changed this assessment, revealing the dark side of the risk paradox. Stronger links between universal and investment banks and capital markets and financial innovations played a decisive role in the rapid increase in complexity and leverage of the banking system. As a result, different types of risks manifested themselves in new and complex forms that were severely mispriced. This resulted in increased financial fragility, contagion and systemic risk and aggravated therefore the severity and complexity of the risk paradox. However, the paper argues that when all risks are properly identified, measured and priced, the risk paradox would vanish. The paper identified 3 necessary conditions for the proper pricing of risk. An improved capacity to price risks would also mean that (more) sophisticated risk management systems (incorporating as building blocks a wide range of derivatives and risk measures) could in principle be used to mitigate the severity of the risk paradox. However, the paper notes that in many circumstances these fairly strict pricing conditions are unlikely to be fulfilled, in particular in a fast-moving, innovation driven financial landscape. In fact, risk managers have been relying too much on quantitative risk management models. Although these models were much more sophisticated than in the past, they were not capable to deal with the complexities and ‘hidden’ vulnerabilities of the new financial landscape. Moreover, with the unfolding of the financial crisis, it became apparent that during the Great Moderation excess optimism had prevailed with risks chronically underpriced or simply ignored, while revealing the dark side of the risk paradox. The risk paradox should therefore be taken as a serious challenge for market participants and regulators alike, both in the traditional banking system as well as the so-called shadow banking system.