Wednesday, September 29, 2010

Overinvestment in financial expertise

One conventional story about the 2007-2008 financial crisis is that some bright financial bankers created complex financial instruments that have then been traded by people who did not understand them, thus leading to mispricing and ultimately to a major market correction. In other words, financial advisors were not too bright. No, Wall Street has hired a lot of PhDs, so how could this happen?

Vincent Glode, Richard Green and Richard Lowery present a theory that would yield identical outcomes, but because there is too much investment in financial expertise. They build a model where financial intermediaries hire experts to create, manage and trade complex financial instruments. This allows them to extract some of the consumer surplus created by these instruments. But the intermediaries are competing with others that do the same thing. The fact that this investment in expertise is made may make the surplus disappear under some circumstances, for example some information shocks.

Thus the competition between financial intermediaries boils down to an arms race, where each move is privately beneficial but socially neutral, and sometimes even harmful. All the bright people hired by Wall Street have created very complex instruments and information systems that lead to adverse-selection problems. When a shock occurs, the fact that they have more information makes that others think they are going to sell lemons, and nobody trusts them. Markets come to a halt. In a sense, the financial intermediaries suddenly wish they would not have all this expertise, so that they do not come under the suspicion of offering bad assets. Maybe firing all of them is the solution.

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