Complexity in Structured Finance and Difficulties Faced by Market Participants-A Critical Assessment of the Role of the Complexity in Financial Crisis

Abstract

The global financial crisis has been blamed on the part of the increasing complexity in the financial system which is one of the key developments in modern finance. Due to greater globalization and the integration of financial institutions and markets, they have become more interconnected and more fragile in the financial system. A significant proportion of the complex nature of the financial system results from the development of complex structured finance securities. The aim of this study is to investigate the remarkable rise and fall of structured finance by emphasizing the role of complexity. This study first examines the ways in which structured finance become more complicated over the last two decades. Complexity in structured finance arises from the pooling of assets, the detailed deal-specific structuring and documentations necessitated by tranching and the involvement of third parties. Besides, we have defined the term ‘complexity’ more narrowly to provide a better understanding of the essence of the complexity. Further, this study examines the motive for the financial institutions to issue more complex structured finance securities and finds that the increased complexity has been used as a mechanism to distract market participants. Finally, the complex structure of securities along with the perverse incentives and gluttonous behaviour of the market participants have undoubtedly impelled financial market towards more complex condition and ultimately thrust towards the collapse.