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Did Innovation Get A Bad Name At The World Economic Forum In Davos?

Posted by: Bruce Nussbaum on January 29, 2008

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?

Reader Comments

Victor Lombardi

January 29, 2008 5:31 PM

Actually, the products worked great. By their own criteria, they made a great deal of money and people had homes they wouldn't have had otherwise. Everyone had incentives to keep doing what they were doing. That's what a prototype would have proved.

Scenario planning may be a better tool to use in this circumstance. It was no mystery that these loans would lead to foreclosures. Scenarios could have simulated a different reality, like where to place incentives on a party to avoid this problem. If the Federal Reserve, for example, was ultimately responsible, law makers might have been more proactive.

Gong Szeto

January 29, 2008 5:39 PM

it is an interesting proposal to integrate more "prototyping" and "testing" activities in the development of new financial instruments.
i agree that these are most certainly keys to the innovation process, but i also think that one has to own up to the level of difficulty of prototyping "systems" versus "tangible products" being orders of magnitude higher. in the case of these financial instruments, they are packaged as "products", but they are virtual - a set of rules, terms, conditions that are codified as something that can be consensually exchanged. really hard to test these things as they are driven by the desire to find esoteric loopholes in a system to maximize the ability to profit based on only a handful of people truly understanding the ramifications of them.

it is also a culture that is fundamentally top-down and fast-moving, always seeking ways to game the system beneath the scrutiny of regulators. this is also an interesting problem contrasting the dynamics of risk and incentive. i seriously doubt there is anyone who looked at the problem in its entirety (it is a complicated system with differing levels of risk and incentive depending on what type of actor you are in this system).

perhaps it is the role of the regulators (government) to act as the big-picture managers, perhaps the referree to all future innovation activities, because there really isn't any built in incentive for the private players to rigorously test new ideas if ultimately they can profit from short-term gains, and pay the price later. perhaps the current crisis (including the socgen debacle) will help to redefine risk management across all the various points of this complex system.

but as for your suggestion to better prototype and test, well, this mama is huge with the hugest players (and egos) involved, nevermind the government having to get involved with oversight and maybe even laws. sarb-ox has taken years to get traction, and even that was totally reactive. sarb-ox also kicked off the huge growth of private equity, since no one wants additional levels of regulation and oversight - take the companies private and you can do whatever you want. this actually has serious ramifications for the integrity of the public markets if you can imagine.

they will always find a way to game the system, bruce, always. and our culture is one that worships the svengali's of finance. there has to be a very, very deep culture shift in the finance community before we see change on a societal level that the financial industry actually has joe sixpack's best interest in mind. underlying this all is the dark side of unbridled capitalistic activities of the few, the powerful. their "values" are not prototyping-friendly. re-engineer the value system, then you have a shot at change. a culture that seeks to "game the system" is not a culture that prototypes in the best interest of society at large. they may care about their own risk, but the incentive structure offloads risk onto others. it all sucks pretty much, IMHO.

Brian @ DASO

January 29, 2008 6:11 PM

Blaming the financial crisis on innovation is like blaming 9/11 on religion. Lets not shy away from the ugly truth on this stuff. People have the ability to make any good idea look bad. Did we blame innovation for the Enron scandal? No, but perhaps because the real issue - a handful of unethical executives - were more easily spotted. The complexity of the financial crisis makes the guilty more difficult to spot. So, in the meantime, we lash out at everything...including the truly good things.

Paul Tran

January 29, 2008 7:03 PM

Following an innovation process is key. Using tools to accomplish this is just as important since innovation is a complex procedure. Once an idea is formed, it must be taken through a process of feasibility and collaborated with experts to determine how to best implement the idea. It seems to me that managing innovation is just as important to the innovative idea itself.

Pete Mortensen

January 29, 2008 7:23 PM

Victor's right, but I would go so far as to say that even Scenario Planning would have been over-kill - it was abundantly clear that these alleged financial innovations were found for mass foreclosures, particularly in the Bay Area, where people have been buying homes at prices two to three times what they could have afforded with equivalent incomes 10 years ago. Not only has it put people in serious financial straits, it has encouraged speculation and artificially driven the cost of home ownership through the roof here.

What led to this colossal mess right now? A focus on innovation and novelty that failed to put people and their best interests first. Prototype and test all you like, but unless you're focusing on solving the right problem, you'll innovate your way to disaster. And the only way to be sure of that is to truly understand the ordinary folks whose economic decisions fund your 401k and salary. I'm sure these financial institutions focused on making home-ownership more accessible. Perhaps they should have reframed the problem into making home-ownership more sustainable and affordable in the long term. An interest-only mortgage makes it possible for almost anyone to own a home - for a little while. But it's disastrous in the long term.

Venting a bit, but I think the blame lies at the feet of an industry is out of touch with the lives of ordinary folks.

Brian Bone

January 29, 2008 9:36 PM

Let's not confuse pure greed with innovation.


January 29, 2008 9:48 PM


January 30, 2008 1:07 AM

Linking innovation and prototypes/scenarios/etc. is an interesting topic. The definition of success needs to be framed in short-term or long-term. The innovative financial products were successful in the short-term (made money for providers and increased the available loan supply). However, the long-term impact is obviously painful and there is plenty of blame to be spread around.

The systemic view says to consider all possible angles. One question though ... how do you balance the creative process leading to innovation with the need to test, prototype or scenario plan for reasonable results?

James Todhunter

January 30, 2008 1:37 AM

The financial issues cited don't highlight problems with innovation at all.

In the case of Societe Generale, the issue is simply a failure in management to ensure the proper controls were in place prevent abuse of their internal systems. This has nothing to do with innovation.

As to the sub-prime debacle, this is not a problem with innovation per se, but simply an example of what happens when individuals let short term greed become the dominant factor in their decision making. There is no question that the vehicle used to generate the loans was very successful. Proto-typing would not have been a safety-net here. There is equally no question that it was easy to forecast that the pigeons would come home to roost at the first sign on economic stagnation. However, this later factor was simply not a concern of the people generating the loans in a market where the loans are quickly repackaged and sold. This is not a failure of innovation--it is simply a failure of human character.


January 30, 2008 10:55 AM

I think it is very unfair to say that innovation got a bad name in WEF in Davos. What happened at Soc General has nothing to do with financial innovation. It is an obsessive financial voyeurism perpetuated by a single indidvidaul, perhaps aided by accomplices. True innovation adds value to the organisation not bringing about financial destruction. Let's not confuse innovation with a criminal deviousness.

Gregg Fraley

January 30, 2008 2:01 PM

Oversight is where things went terribly wrong at Soc General, not innovation.

The sheer magnitude of the trades being made should have sent red flags to top management. If the system did not it is terribly flawed. If the system did flag those trades -- and they were ignored it's just poor management, greed, or both.

Wouldn't it be great if the discussion at DAVOS was more about enabling more innovation in the world's economies, and less about arcane financial instruments that only serve, or screw up, large financial institutions.

James Ransdall

March 25, 2008 10:07 PM

I don't think you can innovate away the Commutative Law of Addition. The fact is that a high volume of low quality loans went into the front-end of the derivative sausage machine and, lo' and behold, what came out the other end was USDA Prime, or the financial equivalent as rated by Moody's, et al. It was simply a matter of time until the Law of Large Numbers caught up with the scheme. And it was a scheme. To fault "innovation" is misplaced, because at some point this became fraud.


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