Let's not kill financial creativity, but unleash for it

I thought with this posting I would divide the post into topic areas that I would refer back to the future.

Animal Spirits

Over the last year there has been a lot of demonization of Wall Street, Bankers and just about anything associated with the financial industry.  During good times, prior to 2007, very little attention was paid to the computer aided financial innovation which sparked to boom and lead to the bubble bursting in 2007.  Lack of regulatory oversight was the most important factor leading to the current Global financial meltdown.  Government regulators, economists, bankers and politicians falsely believed that we were living in a "different era" where the "free market" should not be burdened by regulation, because the  markets could regulate themselves. The great economist John Maynard Keynes used the term "Animal Spirits" to describe emotion and effects to describe human behavior.  Animal Spirit lead to the irrational exuberance that was combined with computer-aided financial creativity has lead to what we are now experiencing with the economic meltdown.   Before this financial meltdown most business leaders, government officials and most economists believe in universal rationality. When former federal Reserve chairman Alan Greenspan testified before congress that he was wrong in his belief that people and financial institutions act rational, it was an end of an era.

So what's next for the financial institutions? Certainly governments around the world will impose more regulation, but what else can be done to reduce systemic risk to the global financial system? I would argue that was is needed is more transparency and injection of what I call "Wiki DNA".

Financial markets and the Wiki DNA

Everyone is familiar with Wikipedia the free global online encyclopedia with millions of articles in dozens of languages.  Wikipedia collaborative style of authoring has forever changed the human knowledge landscape, because prior to Wikipedia, institutions both private and public, where the authority and decimator of knowledge.  Wikipedia collaborative style of publishing allows anyone to express their point of view about a topic and shows when their is conflict about a topic from various contributors.  Wikipedia has over 50 million unique visitors every month, it is a major destination on the Internet. There is no chief editor or controlling authority that determine what will and will not be published. Individuals and institutions contribute to Wikipedia with no financial incentive, only out of their sense of sharing.  What if we injected the Wikipedia DNA into our financial systems and regulations.  What would that look like?  Financial institutions could still be innovative within a regulated environment that probably require more capital and  less leveraging.  The one requirement I would say is that new financial instruments and their ratings from the ratings agencies are published in an standard open format and available to anyone over the Internet.  Some information would be excluded to protect privacy of the issuer, but could be tracked with a universal id assigned to a particular instrument. Open dissemination of financial information, such as financial instruments would lead to new millions examining the information with new software tools and websites, some of these resources would be free and open like a Wikipedia and others maybe created by new start-ups companies focused utilizing this deluge of information.  Combine the social innovation which is in the Wikipedia DNA with regulations and I belief we can have systemic risk management and innovation in the financial markets.  

Next I'll cover at a high level the technologies availabe today to unleash a new financial industry risk management framework.

How to reshape the financial industry and unleash a wave of innovation

I usually think hard and long about many topics. I sometimes think I should write a blog about a particular topic, but somehow I don't get around to it because my ideas are what I consider incomplete.  Well today I'm breaking with that train of thought and I'm going to write about what I'm thinking even if I consider it incomplete.

I've been thinking about the so called "Toxic assets" that are the bases for the current recession and financial meltdown.  I worked briefly for a financial trading company in Houston a few years ago as an IT consultant developing a back office system to close to the trades of commodities such as oil, gas and others financial products.  I enjoyed the work and the environment which gave me the opportunity to see up close how traders work and the financial markets work.  My undergraduate degree was in Economics and I'm a business and technology junky.  

I've been listening, reading and thinking about solutions to the problem that has beset the U.S. and the world economy.   Here are some basic background facts.

1.  The U.S. economic bubble was created by a low interest rates and a glut of savings flowing in from Asia to the U.S. and around the world as Mr. Bernanke recently acknowledged in a speech.  

2. Wall Street firms sold a variety of structured-financial instruments based on pools of assets or cash flow of the underlying assets. 

3. These  financial instruments were given AAA ratings, the highest rating, which equate to low risk for the investor by the rating agencies such as Moody's Investor Service, Standard & Poor Ratings Services and Fitch Ratings. 

The Obama Administration will be proposing sweeping regulation of the financial sector to reduce the systemic risk that unregulated financial institutions pose to the economy, but there has been little or no effort to address the crisis of confidence in the value of structured-finance securities which has caused credit markets to be frozen.  I will propose a information sharing framework that can be used to reduce the the information asymmetry about the value structured-financial  securities and unleash a wave of innovation that can reshape the financial industry and reduce market risks.  Stay tuned for my next post, "Let's not kill creativity, but unleash for it".

Can IT lead the U.S. out of the recession?

The U.S. economy in deep recession which hasn't been seen since the great depression, and it been forecast by many to last at least until the end of 2010.  Can IT sector of the economy signal the recovery of the economy has a whole? I recently read a McKinsey Quarterly published a study that showing five downturn and recovery from recessions (1973-75, 1980-82, 1990, 2001) and the current recession recovery which began in Q3 2008. The sectors of the economy listed in the study were:

Consumer discretionary

Energy

Financial

Health care

Industrial

Information technology
Materials

Telecommunications services

Utilities

Each of the above sectors of the economy was given four sequences (Lead, Lag, In line, No effect) related to how they performed in the recovery phase.  According to McKinsey Quarterly history suggest that in three of the four most recent recessions, higher consumer discretionary and IT spending led the way to recovery and the current recession seems to be following a similar pattern. Looking at the IT sector companies earnings before interest, taxes, and amortization (EBITA) will be carefully watched by executives across all industries and market watchers.

As an avid follower of business news, I noticed business news focus on the earnings of Cisco (CSCO).  Many analyst view Cisco as a bellweather/ground hog of the tech industry and the economy as a whole thus it should indicate the start of a recovery.  So keep an eye on Cisco earning (EBITA) for the near future.

Success, Failure, learning and Innovation (Part 1)

I recently had a epihany will reading a blog posting by Miko Matsumura of the website formerly known as the SOA center. Innovations is a by product of Power distribution, which more recently popularized in Chris Anderson's book the Long Tail.   I propose that break thru innovation can follow the power curve distribution.  Consider the following.

Power law graph

Thomas Edison supposedly had 1,600 experiments fail before he invented the light bulb, but a friend asked him why he was wasting so much time on the project when he wasn't accomplishing anything, Edison replied, "Of course I'm accomplishing something. I've learned 1,600 ways it doesn't work!"

Edison's "failures" if graphed would look like the yellow long tail of the above graph with the successes in the green area eventually leading to the invention of the light bulb.  Another less visionary way of looking at Edison's innovation is the "80-20 Rule" which stated simply is that approximately 80% Edison's experiment failed (ways it didn't work) and 20% meet with some degree of success before his ultimate success.  No one knows for sure what the actually distribution of Edison's experiment were, but this my theory of how innovations occur over time. More examples to follow this post.

TJL

Internet as a Free-Scale Network

This blog is my attempt to dive deep into topics that interest me the most. I'm a Systems Analysis/Architect with a background in Economics so my interest span the business world and the computing/technical world.

I'm always looking for a patterns and/or theory in nature, as well as the Internet. The Internet futile grounds in which I can analyze it's various ecosystems and compare or contrast with nature. Albert-Laszlo Barabasi back in 1999 introduced the concept of a "scale-free network" whose degree of distribution follows a power law.

To put this in laymans terms there are many events in a scale-free networks such as the Internet has many nodes, which are websites, of which 80 percent have a few links and 20 percent have a large number of incoming links. The 80-20 rule, also formally known as Pareto Principle, states that for many events, 80% of the effects come from 20% of the causes. The priciples of the 80-20 rule was popularized in 2004 by Chris Anderson's book titled "The Long Tail". I hope to delve deeper into the scale-free networks nuts and bolts and their implication for business models. More to come soon.