Conventional banks dont innovate or spread risk

Conventional banks neither innovate nor diversify risk

Robin Matthews

Issam Tlemsani


The paper challenges the idea that the conventional (non Islamic) financial sector either innovates or diversifies risk. Undoubtedly the growth of national financial sectors has been critical to national economic growth historically, but globalisation and the rise of the originate and distribute model of banking has changed the role of financial sectors utterly. Beyond a certain critical size, the contribution of financial sectors to society becomes like that of a public good. Their contribution depends on their existence rather than their size (in asset or income values): but beyond a certain critical size, conventional financial sectors become dysfunctional and make a negative contribution: estimates of the cost of the recent crisis range somewhere between $60 trillion and $200 trillion.

Criticality can be measured and predicted by (a) the size of financial sectors relative to the size of national economies and (b) the degree of interdependence between financial sectors internationally. That critical point has been reached and exceeded, making the next financial crisis originating in conventional financial sectors inevitable. Yet governments have backed away from measures that would alleviate the problem. We are faced with massive ignorance about what a financial sector actually does, both by those outside and those inside the financial sector.

Once the financial sectors have gone beyond a critical size, banks don’t really innovate or spread risks. Beyond that point, innovation means expanding the range of securities, mainly debt: leveraging financial assets against other financial assets. It is argued that diversified portfolios spread risk: beyond the critical point they don’t. If everyone holds the perfectly diversified portfolio; the portfolio that corresponds to the market portfolio, when the market fails, everyone fails, and once we incorporate feedbacks into financial networks it is inevitable that when one part of an innovative financial system (equivalently a heavily leveraged financial system) fails, the entire (global) financial system fails and failure percolates throughout other sectors in the global economy. Risk is a public good. One institution’s diversification of risk does not reduce risk, it merely spreads it more widely and disastrously.

To understand diversification of risk and to understand the true nature of innovation in finance, the paper distinguishes risk spreading and risk sharing. Risk spreading characterises conventional finance and innovation: risk sharing characterises Islamic finance. We argue that the case for Islamic type financing in the sense of risk sharing is overwhelming, for governments, regulators and for financial institutions that consider themselves innovators in an historic sense: contributors to society rather than greedy acquisitors of personal wealth.

We are describing a situation rather like that described by the story told to children about the emperor having no clothes. In the story an emperor, suffering from an excess of pride or insecurity, is manipulated by an exploitive tailor into believing he has been supplied with magnificent robes that only the privileged and enlightened can see. No one dares to believe their own eyes that tell them unequivocally that the emperor is naked: except a child, who blurts out; “why is the emperor naked?”

Why is there not a similar response to the nakedness of the financial sector, when its contribution, nationally and internationally has been so massively negative? We argue that one of the reasons is that we, meaning governments, regulators, bankers and the rest of us, are mostly divided into three groups; those who understand the mathematics of finance but not financial institutions, those who understand financial institutions but not the mathematics of finance and those who understand neither.

Effectively innovation according to the originate and distribution model of banking amounts to (a) a wealth transfer from the rest of the world to people in financial sectors, mostly in developed economies and/or (b) asset depreciation/default.

One purpose of the paper is to bridge the gap of understanding; another is to make a case for a risk sharing approach to marketing financial assets.



Supplied on request

Please leave your comments here.