IBM Thought Leadership: Transparency Makes the Invisible Hand Visible Again, And Inclusive

Paolo Sironi

Paolo Sironi

Paolo Sironi is the global research leader in Banking and Financial Markets at IBM, Institute of Business Value. IBV is the thought leadership centre of IBM.

Financial markets and economic systems are still exposed to periodic collapses, notwithstanding unprecedented institutional search for stability at all costs. Unorthodox central bank intervention and increasing regulatory action do not seem sufficient to save the macro-framework without a change in perspective. Kristalina Georgieva, chairperson of the IMF, reminded in a late 2019 CNN interview that “uncertainty is the new normal”. In 2020, the ECON Committee of the European Parliament identified that one of the top three challenges that central banks will be confronted with in the coming years is our lack of understanding of what a new “economic normal” looks like. As they observed in the turnkey paper “Challenges ahead for the ECB: navigating in the dark?”, some characterise this lack of knowledge of the new steady state, and therefore the lack of understanding of what the new equilibrium will be, as fundamental uncertainty. How can central banks decide on their policy response if they do not know where they are heading? It is in the nature of fundamental uncertainty that it is not measurable.

The Global Financial Crisis already revealed the weaknesses of the equilibrium assumptions, and that something was fundamentally broken in the main mechanisms that regulate or attempt to self-regulate financial services. During a public hearing in front of US Congress (after the default of Lehman Brothers) former FED Chairman Alan Greenspan declared that “I made a mistake in presuming that the self-interest of organisations, specifically banks, is such that they were best capable of protecting shareholders and equity in the firms … I discovered a flaw in the model that I perceived is the critical functioning structure that defines how the world works”. Greenspan’s radical candour might exonerate him from responsibility, but accountability cannot be reduced forever by normatively removing the theoretical problem. Instead, a positive theory is required, as identified in the theory and principles of Financial Market Transparency (FMT) published in 2019.

The rude awakening of 2008 forced the financial services industry to face a two-fold reaction, both inconclusive.

On the one hand, behavioural finance gained new academic thrust in the search for a response to the behavioural problem of intermediaries and investors, qualified as irrational. Notwithstanding the relevant insights, the approach has dealt only partially with the central issue that is essentially biological, having focused on the idea that apparent investor’s irrationality could be resumed to a rational state once cognitive biases had been exposed. From a neurological perspective, it would be like attempting to halve human brain in order to suppress its supposedly “emotional” side. Simple, right? Instead, FMT explains why humans tend to underestimate long tail probabilities as a reaction to uncertainty-based survival needs. Uncertainty is typically considered exogenous to investment decision-making: forgetting the Black Swan facilitates a more “reassuring” risk-taking appraisal. Same happens to most mathematical models, which are largely based on the assumption that available data is sufficient to calibrate the algorithms. Therefore, the FMT provides needed reasoning to keep financial models and algorithms open, instead of closing the reference framework towards another collapse, as the GFC demonstrated.

On the other hand, regulators had to confront with industry failure of self-regulating capacity. Signs of stress had already emerged in the ’90s, with a repetition of crises increasingly more systemic until the epilogue of the sub-prime mortgage bubble. The strengthening of regulatory safeguards generated an intense debate because of skyrocketing costs of compliance. Instead, the deep anchoring in the causality of the crisis to reference theory might not have been fully discussed and understood. The FMT makes that step, recognizing that we are indeed operating in an environment of fundamental uncertainty, which is the norm in finance. FMT is a positive and practical theory that investigates the evolution of bank business models facing digital disruption on regulated platform economies. It allows to make uncertainty endogenous to investment decision making, thus generate economic antifragility at micro and macro level.

How does it to that? FMT uses an Occams razor to identify scientifically new biological micro-foundations for economic action, and discloses the gap between homo sapiens and homo economicus. It provides a new starting point and a more reasonable understanding of financial markets functioning based on elements that make homo sapiens conscious. In doing so, it opens economic theory to redefine the meaning of money, investing, value, and performance by recognising the endogeneity of fundamental uncertainty on which they lay. Our relationship with money is largely emotional because homo sapiens biology faces fundamental uncertainty in all decision-making processes, over the irreversible time. Consequently, emotion cannot be excluded – also on digital – in a false claim of homo economicus’ rationality that can be true only ex-post.

A theoretical change paired by regulatory action is a needed step to de-anchor industry mindset from efficiently inefficient output-focused economies, thus allow for sustainable digital transformation towards outcome-oriented economies, which only win on digital. The FMT institutionalist approach is required to avoid the pitfalls of mainstream financial theory and anchor the current process of digital transformation of business models to investors’ biology, from which that of markets can be derived (responding to the adaptive market hypothesis of Professor Andrew Lo of the MIT Sloan School of Management). Therefore, FMT allows to understand how to remunerate shareholders by generating sustainable value for clients in a transparent regime. It is regulatory transparency – as in the European MiFID II – that is fostering deeper and holistic understanding of the biological micro-foundations of financial markets, letting a “more reasonable” and positive theory emerge that guides business model transformation on a disrupted social, economic, and digital landscape.

To generate value for clients and survive, the banking industry already had to face a bifurcation of strategies which led either towards a fast race-to-zero-price competition, or to the complex search for transparency-driven competitive advantages. On one side, some institutions entrenched in a last-ditch defence of prevailing relationship models, still centred on the assumption of rational agents’ behaviour, fully efficient information, and instantaneous price dynamics that are supposed independent. Instead, the latter are often influenced by herding and self-referential (i.e., opaque) generation of information. Therefore, the advent of full regulatory transparency (e.g., the reduction of opacity in the European MiFID II) and the impact of digital technology applied on distribution channels of products and their marketing to clients – still designed to conform with mainstream reference theory – has only accelerated the compression of business margins. This led to the search for an efficient scaling on low-cost volumes only (e.g., passive investing). On a larger scale, this trend can produce more endogenous instability because intermediaries become more concentrated in increasing complexity. On the other side, opening financial markets to a business vision that leverages on content (i.e., transparent information and communication) allows clients – real drivers of business value – to reclaim centre stage of any relationships based on trusted and “conscious banking” engagement. In fact, regulatory transparency reveals the fundamental uncertainty of the system stability, behind any attempts of arbitrage. Only dynamic management of financial relationships on a decision-making space mediated by time (irreversible element of human behaviour) allows making sense of investment goals and purpose. This is the target of new financial services platforms, cantered on the financial planning of clients’ lifestyles (e.g., Goal Based Investing). Only making platform participants aware of the generated value makes them also willing to pay for access, transforming the economic relationships of international banking asked to operate on platform economies.

The FMT understanding of how regulatory transparency can turn investment relationships into a competitive advantage, based on real value-generation for participants, re-sets the economic foundations of financial services on more sustainable revenue streams. These can be finally centred on human goals and purpose, improving ecosystem antifragility and benefitting the whole economy, revising the perspective on what the contribution of exponential technologies should be, such as fintech innovation and artificial intelligence, to unlock added value. Embracing transparency and forging a new theory of value for financial services can truly help to create positive economic impact that is aligned with the UN Development Goals.

Democracy is a platform, society is a platform, economies are platforms, and financial services are platforms. On platform economies, transparency is the core governance principle that generates trust. In a world facing growing uncertainty (deep environmental issues, strong digital shifts and concerning geopolitical tensions) transparency only can help humanity to unlock inclusive economic value, and turn change into progress. Ultimately, transparency is the new invisible hand made visible again. i

About the Author

Paolo Sironi is the Global Research Leader in Banking and Financial Markets at IBM, Institute for Business Value. He is senior advisor for selected global accounts, assisting service teams in C-level conversations to leverage IBM portfolio of exponential technologies. He is one of the most respected Fintech voices worldwide and co-hosts the European edition of Breaking Banks podcast. Paolo founded the German startup Capitects, then acquired by IBM, and directed the quantitative risk management department of Banca Intesa Sanpaolo. He is celebrated book author on digital transformation, quantitative finance and economics.

Paolo’s website:

FMT link to Amazon:

You may have an interest in also reading…

A Tunisian Transformation: BIAT is Driven by Civic Duty, Concern for the Planet, and Prudent Risk-Avoidance

Banque Internationale Arabe de Tunisie implements strategic projects and initiatives — and meets with enviable success BIAT’s financial performance attests

Government of India and World Bank Sign $500 Million Agreement to Improve Access to Finance for Micro, Small and Medium Enterprises

The Government of India and the World Bank today signed a $500 million loan agreement for the MSME Growth Innovation

Hans Peter Lankes, IFC: IFC’s Development Impact, One Market at a Time

Having worked in the international financial institutions for much of my career, I’m a big believer in the power that