First of all, was it true? Secondly, if it was, why? And thirdly, if indeed there was an arbitrage opportunity then how could we unlock its value? I remember feelings of frustration. Somehow we couldn’t quite see how to reconcile some of the essential differences, including regulatory and accounting distinctions. To say nothing of the language or jargon used in the two sectors. Well, the rapid growth of the derivatives industry during the late 1980s changed all that! All sorts of new instruments for exploiting arbitrage opportunities like the one I described came into being. The different aspects of risk were unpicked and recombined. Those developments depended partly on new information technology. And, together with securitisation the functional divide was crossed. That evolution provided colossal commercial opportunities and enhanced general economic value. I recall this because it’s a good example of how technical advances, some rocket science and market forces have changed the fortunes and capabilities of two great industries. And today, even though we don’t have full integration we certainly have greatly increased interdependence and linkages. Just take the involvement of the insurance industry in credit risk transfer as an example. And just as with a lot of interdependencies you get network effects with undoubted economic benefits on the one hand, but potential vulnerabilities on the other. Maybe I can start by making a few observations on the vulnerabilities - increased risk to firms or the overall financial system - that were less significant until the interconnections appeared.
To illustrate why some authors have gone as far as calling this “the credit rating crisis” (Benmelech and Dlugosz, 2009) consider that before the crisis more than half of the structured finance securities rated by Moody’s carried an AAA rating and, during the period 2007-2008, the tranches rated by Moody’s that were downgraded was close to thirty six thousand, where nearly one third of downgraded tranches bore the AAA rating. This is a complex issue, especially due to the prevailing incentives in this sector. A recurrent area of criticism on the incentives side is the simultaneous role of advisor and issuers of ratings. But the spectrum of potential conflict areas could be broader, and thus more efforts must be devoted to understanding in detail the operation and linkages of this industry. Final comments The subprime crisis has opened a debate on the risks of financial innovation. It reminds us that higher levels of sophistication do not guarantee the normal operation of the financial system. A reasonable level of regulation, control and monitoring is required. I think we should move forward in innovation processes, as they are positive, but we must move forward with caution. It is important to implement policy changes gradually to provide an adequate level of information and transparency that will ensure an adequate assessment of the risks involved. It is also crucial to review in detail the incentives and potential conflicts of interest arising from the new tools and processes.