Survival of the Fittest: An Evolutionary Theory of Financial History Turin, December 14, 2007
Tony Ryan said it Just as some species become extinct in nature, some new financing techniques may prove to be less successful than others." (Assistant Secretary of the Treasury for Financial Markets Anthony W. Ryan before Congress in September 2007)
Goldman Sachs said it The Evolution of Excellence conference in London, November 2005
Thorstein Veblen tried it the economic life process [is] still in great measure awaiting theoretical formulation Why is Economics Not an Evolutionary Science? Quarterly Journal of Economics (1898)
Some economists have tried it Alchian, A.A. (1950) Uncertainty, evolution and economic theory. Journal of Political Economy 58: 211 222 Nelson, R.R. and Winter, S.G. (1982) An evolutionary theory of economic change. Harvard University Press, Cambridge, MA
But Hilferding still rules The legacy of Rudolf Hilferding s Finanzkapital (1910) Concentration and consolidation in financial services as an inexorable process of exploiting economies of scale and scope
An evolutionary process? Evolution as seen by Citigroup
A real evolutionary process Evolution as seen by Nature
The evolutionary analogy Genes institutional memory of business practices Potential for spontaneous mutation innovation Competition for finite resources customers, clients Mechanism for natural selection through the market allocation of capital and human resources and possibility of death in cases of under-performance (differential survival) Scope for speciation and hence sustained biodiversity Scope for extinction
The differences (part 1) When one organism ingests another in the natural world, it s just plain eating; in finance mergers and acquisitions can lead directly to mutation In finance, there s no counterpart to the role of sexual reproduction in the animal world mergers aren t sex In finance, most mutation is conscious innovation, rather than random change (so it s a Lamarckian not a Darwinian process)
Commercial banking 1900 1925 1950 1975 2000 2007 Internet/direct banks Telephone/direct banks Shareholder owned private banks High-end private and merchant banks Commercial banks Full service retail and commercial banks ` Bancassurance Monoline consumer finance and mortgage Subsidiaries of major conglomerates Shareholder owned savings and loans Not for profit savings and loans Government owned deposit takers
Investment banking 1900 1925 1950 1975 2000 2007 Boutique / specialist investment banks Universal bank divisions Shareholder owned investment banks Privately owned merchant banks Boutique investment managers Alternative investment managers Private equity houses Marketplace / exchange
A decade of financial innovation Instruments Mortgage-Backed Securities Other Asset-Backed Securities Collateralized Debt Obligations Collateralized Loan Obligations Derivatives Institutions Hedge funds Private equity Sovereign wealth funds Conduits Strategic Investment Vehicles (SIVs) Bond insurers
Asset backed securities 4,000 3,500 Mortgage-backed and asset-backed securities in the U.S. 3,000 2,500 2,000 1,500 1,000 500 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2,500 Ginnie Mae Fannie Mae Freddie Mac 2,000 1,500 1,000 500 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Auto Credit Card Equipment Home Equity Manufacturing Student Other
450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0 Derivatives Over-the-counter derivatives outstanding 2006 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Interest rate contracts Foreign exchange contracts Equity-linked contracts Commodity contracts CDS Other 1987 Notional Amount Outstanding($ BN)
80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 New entrants Number of financial institutions in selected developed countries 1908 1912 1916 1920 1924 1928 1932 1936 1940 1944 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 Commercial Banks Savings Banks Mutual & Cooperative Banks Mutual funds Hedge funds 1900 1904
The first hedge fund was set up in the 1940s to allow savvy investors to bet against stocks by taking socalled short positions. The Long Term Capital Management debacle didn t stem the rise
The environmental analogy Exogenous shocks can radically alter the evolutionary environment, rendering certain evolved traits disadvantageous where previously they had been advantageous, and vice versa Financial disruptions (like the Great Depression of the 1930s or the Great Inflation of the 1970s) are like the asteroid strikes and ice ages that periodically intervened in the evolutionary story of life on earth
200,000 180,000 160,000 Deposit insurance US$ 5,000 4,500 4,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 0 3,500 3,000 2,500 2,000 1,500 1,000 500 0 The last great dyings Bank failures in the United States 1929-33: The Great Depression 1980-95: Savings & Loans 1885 1890 1895 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Number of bank failures Deposit insurance limit 1875 1880 1865 1870 Bank failures
Is it happening again?
The American crisis $60bn of write-downs so far acknowledged by world s leading banks But total subprime-related losses could exceed $300bn Total risky debt losses could exceed $800bn* Collapse of issuance of ABS, CDOs Commercial paper outstanding declined $10.2bn last week; asset-backed CP declined $23bn Losses worst for US bond insurers (48% of paying resources), insurance cos. (2.4% of total assets) and US commercial banks (2.2%) *Subprime assets+other MBS+Leveraged loans+other ABS+Corporate liabilities (Bridgewater)
Survival of the fittest Estimated gross investments of the five largest funds amount to around $100bn Altogether, hedge funds now account for between one-third and a half of all trading in the US and UK equity and bond markets Example: Citadel buys E*Trade s $3.1bn ABS portfolio for 11-27 cents on the dollar
The differences (part 2) In the natural world, there are no regulators; in finance there is intelligent design (?) Regulators focus on consumer protection and systemic risk but may impede natural selection by their actions
A penultimate word from Joe This economic system cannot do without the ultima ratio of the complete destruction of those existences which are irretrievably associated with the hopelessly unadapted. Creative destruction means the disappearance of those firms which are unfit to live. (Joseph Schumpeter)
It really is Darwinian (or, rather, Lamarckian) out there The key to survival lies not just in being able to eat the weak, but in being prepared to mutate and even to speciate The possibility of extinction should not be removed by excessively precautionary regulation Conclusions