Risk Management Technology in Financial Services

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Innovation in finance 7

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The quantitative reasoning of mathematicians, physicists and engineers blends with

the qualitative thinking of economists and other professionals, and

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This cross-fertilization of know-how and action models opened new horizons in

analysis, which has now been institutionalized; but in the 1950s it was a ‘first’.

As long as their products and services were plain vanilla, banks did not feel the

urge for instituting and financing think-tanks. But in the early 1970s, with the end of

the Bretton Woods agreements, which led to flexible currency exchange rates, things

started to change. Risk management requirements (Chapter 2), derivative financial

instruments (Chapter 3) and a marketplace more competitive than ever promote the

concept of a laboratory of ideas.

Over the space of a few years, the foreign exchange markets became vibrant

requiring brains and tools able to prognosticate. Also in the early 1970s, the Black-

Scholes algorithms were made feasible to price options, with a pricing mechanism

which became generally accepted and the options market took off. As globalization

progressed trading in forex and in options became favored products of financial

institutions – but exposure, too, mounted.

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The deregulation of banking in the late 1970s/early 1980s intensified competition

among banks, bringing attention to innovation as a way of keeping the upper

ground.

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It also promoted a strong sense of institutional pragmatism, which accentuated the

need for analysts, as a way of studying the ever-growing financial forces.

The first think-tank in the banking industry was the Advanced Systems Group

(ASG), of Morgan Stanley, instituted in the late 1980s. Others followed. ASG was

a small R&D laboratory compared with laboratories in the manufacturing industry,

but a big one in finance. Its produce was innovative derivative instruments, with an

income of $50 million per year. The RAND of the banking industry was born.

1.3 Challenging the obvious

This section includes three short case studies which superficially look like being miles

apart. Yet, as the careful reader will find, they are well connected because they share,

and address, the same notions which confront any physicist, banker, strategic planner

or decision maker worth his or her salt:

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Challenging the ‘obvious’, and

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Using imagination and guts in overtaking the incumbent – whether this is a theory,

concept, or company.

Challenging what may look ‘obvious’ is so fundamental because a basic principle

in science is to assume nothing. The possibility is always present that even the most

famous theory will be proved wrong (see Chapter 6). Acceptance without questioning

is yesmanship – and, therefore, anathema to the research spirit.