Financial Engineering’s Fallout

This crisis is a moral crisis. Instruments and techniques can be used for the good or for its opposite. The mathematical models of finance we have developed do not include the human implications they lead to. We, as academics, have not paid attention to the moral implications of the financial engineering we promoted, while our theories have been the true engine of the changes of practice. It is time to reinstate moral reflection in financial thinking, as is done in other sensitive areas (biology, medicine and others). Finance is not an abstract mathematical theory but truly a social structure with a deep impact on the system and the individuals in the system.

Financial engineering pervaded practices from the homeowner (accepting complex subprime loans) to the originator (the bank) to the separation from underwriting (pushed back to the investor via securitization) to the structuring and its evaluation (by investment banks and rating agencies). All throughout, this financial engineering had deep human implications that have not been analyzed. And few finance academics who specialized in advanced financial techniques, despite their deep knowledge of financial engineering, have mastered the understanding of what these practices lead to in human behaviors and choices. In order to understand the impact of financial practices, one needs to be aware of the complex interdependencies that link corporations, their suppliers and clients, their competitors and the banks and individuals involved.

Business leaders should understand from the crisis that they tend to underestimate risk. Leaders tend to be overconfident. This is why they are leaders. One does not lead with self-doubt. One leads by giving a direction for others to follow — which of course leads to underestimating and typically mishandling known and unknown risks. This leadership has led to major failures. Good thinking about risk requires good risk practice — and not just a lip-service corporate governance practice with risk models that one does not believe in. A good risk practice goes beyond mere risk management; it includes risk identification, risk assessment, risk management and risk structuring.

Moreover, good risk practice comes with questioning one’s own positions. Many CEOs have been driving their businesses with a directional view. This remains important but can be improved drastically by, in parallel, preparing for risks and turning them into potential opportunities.