Duck and Cover: The Finance 'Arms Race'

10.08.2011
One clear lesson from the long Cold War era, with its nuclear gamesmanship between superpowers, was that stockpiling arms may not necessarily lead to enhanced security. As the U.S. and the Soviet Union feverishly spent money on an increasing number of increasingly deadly weapons, both sides found their populations saddled with greater fears for their own survival, evidenced by the building of bomb shelters, and drills that led kindergarteners like me to seek shelter under our desks.

Running a Wall Street financial firm sometimes resembles this kind of warfare, argue Vincent Glode from the University of Pennsylvania's Wharton School, Richard C. Green of Carnagie Mellon's Tepper School of Business, and Richard Lowery of the University of Texas' McCombs School. Their paper, "," will appear in a forthcoming .

Pointing out "incentives [that] financial firms have to over-invest in financial expertise," and arguing that these incentives "can have a destabilizing effect on financial markets," the professors develop a potentially dangerous model involving firm competition. In the model, the acquisition of expertise by financial firms, such as the hiring of Ph. D's to design and value financial instruments of ever-increasing complexity, "becomes an 'arms race.'"

When this happens, according to the authors:

* Investment in financial expertise confers an advantage on any one player (firm) when bargaining with counterparties in the trading process.

* This advantage is neutralized in equilibrium by offsetting investments made by competitors.