CFA Institute Journal Review 01 Feb 2013 Volume 43 Issue 1
Financial Expertise as an Arms Race (Digest Summary)
Journal of Finance
Financial firms attract and employ large numbers of extremely qualified workers compared with other sectors of the economy. Through the use of a simple bargaining model, the authors illustrate the incentives for firms to overinvest in financial expertise and liken the process to an “arms race.”
The authors explore the incentives for firms to invest in financial expertise by examining the role this expertise plays in trading a security. They show that by investing in financial expertise, firms protect themselves from opportunistic behavior and also secure more favorable terms in a trade. They also discuss how financial expertise, during times of high volatility, can cause a trade to break down.
How Is This Research Useful to Practitioners?
Financial expertise is defined by the authors as the ability to efficiently and accurately process information, under time pressure, in response to an offer to trade a security. Using their bargaining model, the authors show that the mere presence of financial expertise is sufficient to deter opportunistic behavior and secure more favorable terms in a trade. As other financial intermediaries invest in financial expertise, the advantages gained in a trade are neutralized, which triggers the incentive to acquire even more financial expertise. The result is what the authors call an “arms race.” Each firm will acquire more financial expertise until adverse selection caused by information asymmetry disrupts trades, which may also suggest that it is an interesting metric of both information asymmetry and the market cycle.
The authors show how this overinvestment in financial expertise can have a destabilizing effect. During times of high volatility, financial expertise causes more trades to break down as a result of adverse selection. This breakdown contracts demand for financial expertise, and somewhat counterintuitively, firms cut back on their expertise when there is the most uncertainty over asset value. The reason crises are frequently focused on newer sectors of the industry is that financial expertise is particularly important in those sectors; hence, those sectors are more susceptible to trade breakdowns when exposed to an exogenous shock.
In reality, the authors note, financial expertise also brings non-trade-related benefits to a firm, which further strengthens the incentive to invest in financial expertise. Of course, even firms with the most experts are surprised and mystified along with other firms when financial crises unfold.
How Did the Authors Conduct This Research?
The authors construct a bargaining model in which a buyer, when faced with a better-informed counterparty, will share some of the expected gain from trading a security to ensure that the trade takes place. The more financial expertise the seller has, the more expected gain will be offered by the buyer—up to a point.
During times of high volatility, the informational advantage of the seller becomes more valuable, thus increasing the price for the buyer until the trade is not viable for either buyer or seller. When the trade breaks down in such a manner, financial expertise becomes costly to the seller.
Firms invest in financial expertise to profit from trade in low-volatility regimes, despite the increased probability of trade breakdowns during periods of high volatility. It is up to the firm to balance the trade-off between the benefits of appearing informed and receiving a better price and the cost of the trade breaking down. Typically, firms will increase their investment in financial expertise and reach equilibrium just before the point when the trade breaks down. During periods of high volatility, firms adjust financial expertise downward in the form of layoffs as they attempt to combat the effect of adverse selection.
The authors have produced a framework for analyzing the incentives for investment in financial expertise by financial intermediary firms. Despite the apparent simplicity of the bargaining model, it manages to provide insight into the trade interaction between two parties—something that is very complicated. When they apply the framework in a wider context, the authors are able to offer new insight into how financial expertise contributes to financial crises. The model provides insight into how financial expertise can affect a trade; it would also be interesting to see how the model lends itself to an empirical study.