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Complexity in Financial Products

A number of financial products are complex in nature & rating their risk factor is often inaccurate. This is largely because what seems complex to one might not be complex to another

Over the last few days, I've read a couple of news articles in which Mr. Chidambaram appears to be angry. Since I was just reading about each occasion, I couldn't tell if he was actually angry or not, but he made some comments that incorporated more direct criticism than is customary from this man of measured words. First, on 25th March, he spoke in Singapore about how 'lax supervision' had led to the current financial crisis in the US. (In the same speech he also spoke very strongly against the increasing conversion of the world's food supplies into fuel but that's not my kind of topic).

Then, on Friday, he strongly criticised the increasing complexity of financial products, saying that there was no need for complex products. He was also critical of the role played by US rating agencies in helping Wall Street create products that could then be rated in a saleable manner. What made these comments all the more interesting were that they were made at a function organised by a rating agency to launch a service that grades financial products by complexity.

I must confess that it really gladdens my heart to see Mr. Chidambaram speak out bluntly against both 'lax regulation' and overly complex finanical products. As the experience of US and Europe shows so starkly, lax regulation and complex products benefit the financial industry while leaving their customers and the economy as a whole open to severe risks. And it's not as if this hasn't happened in India at all. The 'surprise' forex losses by some banks and corporates, and the bitter legal battle that is brewing between companies that bought complex forex hedging products and the banks that sold these shows that problems of complexity are not limited to foreign shores only.

All this means that a grading of the complexity of financial products should be a good thing, right? I'm not so sure. This actually reminds me of a conversation about credit ratings I had many years ago with a senior banker. In those days, I naively used to think that ratings must be useful for bankers to figure out whether a borrower was creditworthy. Not so, this gentleman told me. "There are only two ratings actually," he said, "those who are going to return your money, and those who aren't. And a banker knows which borrower is which. Ratings are only for formal purposes."

The complexity of financial products is a similar concept. If an investor (whether individual or professional) examines a product and finds himself unable to figure out whether it's simple or not, well then it can't possibly be simple, right? I think it's self-evident that if you need someone else to tell you whether a product is complex, then it is complex. Can you imagine a situation where a corporate's CFO examines a product and analyses it from every angle and just cannot figure out whether it's simple or complex. So to solve his problem he goes to a rating agency which gives him a piece of paper certifying the product as being of some complexity level that is acceptable. What use is this piece of paper? That should be obvious to everyone in the financial industry--when the product blows up in everyone's faces they'll all use the piece of paper to try and save their reputations and their jobs.

Anyhow, let's leave such fine strategies and subtle tactics to the sophisticated world of professional finance. For the individual looking after his or her own personal interests, simplicity and complexity are not absolutes that can be measured like length and width. Complexity, like some other things, is in the eye of the beholder.