There were some two dozen sessions, panels and workshops on innovation and design at the recent World Economic Forum in Davos and nearly all of them were packed with CEOs, top managers from corporations and NGOs. But the snarky gossip in the hallways was “look what innovation gave us with subprime and Soc General.” The meaning here was that financial innovation is blowing up the financial system and leading to a serious economic downturn, if not outright recession.
How are we, those of us in the innovation space to respond to this? Because a serious response is really needed. Here’s my analysis and please send in yours.
The disaster in the subprime area is due to a very bad innovation process. New products were created by very smart people but they weren’t prototyped. They weren’t tested out in the real world. The SIVS and CDOs and other financial products were based on sophisticated mathematical formulas that seemed to work out ok. The rating agencies gave many of them triple A ratings on the basis of these formulas plus past histories of mortgage deliquencies. But
most of these products were not tested out for a reasonable period of time to see if they worked. There incentive system worked so that each layer of the financial system profited by selling the products, not for their performance. So they spread like wildfire.
Prototyping is key to innovation. Testing is key to innovation. Both were missing steps with the subprime financial products.
With the French bank Societe Generale $7 billion trading loss, the innovation problem was risk management. Risk is essential to innovation. Soc Gen is known for its financial innovation. And that young trader operated in an environment of high risk with new financial products. So far so good. But higher risk requires better risk management. Better oversight. Improved risk measurement. That is where the managers of Soc Gen failed. They created a terrific culture of taking risk (especially for the staid world of French banking) but then failed to manage that risk properly.
Facinating lessons in innovation. What are your thoughts?
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