Enlist technology to cut financial risk

February 24, 2010|By Henry C. Lucas Jr.

As someone who has spent many years working with the application, management and impact of information technology, I have been relieved to see that the myriad of articles on the causes of the financial crisis of the last 18 months have so far not blamed the computer. As the crisis unfolded, my first thought was that someone will use technology as the excuse for it.

But if technology was not to blame for the crisis, what was the role of such things as computers, databases and telecommunications networks? Financial engineers developed sophisticated products and markets for them, especially derivatives that depended on underlying assets for their value. It is impossible to conceive of these products being created without the use of information technology - products like mortgage-backed securities, credit default swaps and auction-rate securities. Managers invented and then decided to market these products; the technology allowed them to do so successfully.

One of the great advantages of information technology is that it scales up quickly when the workload increases, unlike systems that depend on human workers who can only be hired so quickly and can only work a limited number of hours each week. It is relatively easy to add servers and associated devices; witness the rapid and smooth growth of Google, which has hundreds of thousands of servers in many different data centers. Technology can accommodate rapid growth, and these financial products became extremely popular; at one point the credit default swap market was estimated at $45 trillion. Technology helped create rapidly expanding markets that eventually achieved sizes that could threaten the solvency of the economy.

It is not clear if the companies investing in these products calculated these risks or simulated the impact of an event like a widespread decline in housing prices. It is doubtful that they had enough information to estimate the impact of low-probability events on the economy as a whole. Regulators largely ignored these rapidly expanding markets.

It is important for regulators to have adequate information technology of their own to monitor rapidly expanding as well as more stable markets. Regulators need to be able to simulate the impact on individual firms (especially those "too big to fail"), markets and the economy of events that might occur, like the decline in housing prices or the subprime mortgage crisis. Investment banks have billions of dollars of capital and billions in earnings, and they can afford all of the technology that is available. Regulators will need a system that collects information from databases at various agencies and combines it for analysis. Officials in different agencies should be connected through social networking and other technologies to coordinate their activities. Congress needs to see that regulators have adequate technology to do so.

It is not clear yet what new financial regulatory mechanisms Congress and the administration will put in place. It is unlikely to be a single agency, as existing agencies are all fighting to expand their jurisdictions. Absent a single regulator, coordination among agencies becomes of paramount importance.

The most important consideration is that someone needs to think about the entire economy and not just their regulatory domain. Technology can help with this task. It would make sense to have an overarching technology organization to collect intelligence from individual agencies and predict risks to different sectors and the economy as a whole.

Technology that enables new products and markets also enables great risk-taking. We must take advantage of the same technology to monitor and manage that risk.

Henry C. Lucas Jr. is Smith Professor of Information Systems and chairman of Decision, Operations and Information Technologies at the University of Maryland's Robert H. Smith School of Business. His e-mail is hlucas@rhsmith.umd.edu.

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