Financial crises, financial innovation and financial engineering as a background for 21st century firms

This speech was given by Robert C. Merton, Nobel Prize of Economics and Professor at Harvard, during the Rencontres Economiques d’Aix-en-Provence 2008 “Firms, The New Frontiers” 

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Merton_cropThe theme of the conference, “firms”, revolves around the difficult challenges that companies are currently confronted with worldwide. As Dr. Lorenzi said, our macro economist organizers chose this traditionallymicro topic because they see firms at the heart of the current and forthcoming challenges and hopes of the world economy. My remarks, however, are not going to be about firms, at least not directly so. As you can see from the packed agenda of these next two days, our cups will run us over with the multifarious discussions of every facet of the firm. Instead, in this session, I’ll trymy hand at setting a framework for what is to follow by offering some observations on the external financial environment in which firms must function,namely the evolving character of the global financial system and the opportunities and challenges created by financial innovation. My remarks will make three points:

1. A well-functioning financial system, including its legal and accounting components, is a key driver for realizing the long-term growth and development potential of an economy.

2.Modern financial engineering permits the separation of risk exposure selection and management from physical and capital expenditure plans. Risk exposure can be radically changed without affecting capital, trade or income flows or the traditional balance sheet. Market-proven financial technology exists that makes it possible to do so on much larger scales and at much lower cost than had been true even in the not-too-distant past. Thus, as a practical matter: risk is now a separate dimension of management decisions for governments, for institutions and of course for firms.

3. Financial innovation creates enormous opportunities to improve risk sharing, lowering transaction costs and reducing information and agency costs, with significant gains, especially for small and developing countries. However, the same innovation creates daunting challenges of implementation. So I will offer some structural observations on financial crises, financial innovation and financial engineering.