Credit Suisse and the cost of financial engineering

201603-stocksnap-moneyHere’s the first paragraph of a recent Bloomberg article:

Credit Suisse Group AG Chief Executive Officer Tidjane Thiam, who said he was blindsided by a buildup of illiquid trading positions that will probably spark a first-quarter loss, pledged to make deeper cost cuts.

It seems like you can’t go a week without this kind of news. Firms that rely on financial engineering to turn a profit take huge risks. And often, the risks aren’t well communicated, or well understood.

It’s a big problem for our economy. Wealth continues to flow toward the financial sector. Capturing that wealth requires big, risky bets.

Unfortunately, those risky bets are often complex, and they’re delicately timed. On paper, they look like standard procedure. In practice, they can cause enormous harm, if not outright catastrophe…as with the Great Recession.

This is one reason it’s so important for scientists and engineers to get more involved in the broader business. Innovation is a buzz word for a reason. Everyone is clamoring for it. Even financial firms. But when you get too clever around financial innovation, society as a whole suffers.

There is certainly a place for financial innovation. The more quickly capital can find a productive use, the better. Financial innovation can remove a lot of the inefficiencies that impede the flow of capital.

All of this works to a point. Past this point, though, you get to financial innovation for the sake of manipulating balance sheets or income statements. Then you have a problem.

The costs are real, as the Bloomberg article details:

Some of Europe’s largest banks have cut their trading businesses as regulators step up scrutiny of riskier activities while a slump in energy costs and cooling emerging-market growth eroded revenue.

Financial innovation creates bubbles. Not just bubbles in asset values, but bubbles in employment. Real people are losing real jobs, because Credit Suisse thought they were creating value in ways they weren’t.

Also, look at the comment in the above quote about slumping energy costs. A lot of these bets were speculative. If commodity prices didn’t move the way Credit Suisse hoped, they’d be on the wrong side of those bets. History shows how badly the market can predict commodity prices. Not a smart bet.

Financial firms are of course going to pursue financial innovation. It’s what they know. The alternative is to remain stagnant and drown. That’s why regulation is so important. If, as a society, we want to constrain the downside risk of financial innovation, we need to set and enforce some standards.

The Credit Suisse case shows us the cost of gratuitous financial engineering. As scientists and engineers, the economy needs us to supply real, technology-driven innovation. We need to create real value, not the fictitious nonsense that Credit Suisse is chasing.

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