Financial Engineering 255
LESSONS FROM THE FINANCIAL CRISIS
The fi nancial crisis that started in 2007 has highlighted several shortcom-
ings concerning the role of fi nancial engineering and fi nancial innovation.
These vulnerabilities were not evident during the boom and high growth
period but became a signifi cant factor as the crisis developed. There are a
number of frictions and market imperfections that lower the effectiveness
of fi nancial innovation. These have become much more apparent during
the current crisis as primary market issuance and secondary market trading
of some innovative fi nancial instruments fell sharply and led to a serious
liquidity crisis.^1
While fi nancial innovations have made a signifi cant contribution to
economic development, it is worthwhile examining their negative aspects —
their complexity, remoteness, liquidity issues, and lack of transparency — and
the impact they have had on the fi nancial crisis.
Some of undesirable and unwanted aspects of fi nancial engineering
include increased complexity, remoteness, liquidity issues, and lack of trans-
parency, which are discussed further below.
Complexity
Increased globalization and fi nancial integration has given rise to highly inter-
connected markets which respond quickly — and sometimes unexpectedly —
to external events. Financial products developed with payoffs linked to
different asset classes and with exposure to multiple markets have led to com-
plicated products requiring a delicate balance. With high customization to
meet specifi c market views, fi nancial innovation has created a new breed of
exposure: exposure to complexity. Increased complexity has made it diffi cult
for market players, on both demand and supply sides, to fully comprehend all
payoffs and exposures in all possible states of the world and has led to greater
complexity across the fi nancial system. This complexity has made the task of
regulators and supervisors that much more diffi cult.
Incomplete Information and Customization
The vision of a world of complete and effi cient markets for risk depends on
having full information. This full - information requirement sounds deceptively
simple but is actually extremely onerous. An investor needs to know the map-
ping between states of the world and the pay offs they would receive in each
state as well as the likelihood of these states of the world materializing. It entails
not only understanding the details of highly complex contracts but also the
effects of the interplay between exposures and contracts of all the other agents
in the economy. Not surprisingly, many of the problems that have occurred
over the crisis have arisen out of incomplete and asymmetric information.
Because many fi nancial products are so highly customized, it is often
not easy to fully grasp their inherent risks. An over-reliance on quantitative