Wednesday, December 17, 2008

Future of the financial industry and market capitalism

One of the earliest and best speculations that I came across was the following which suggested that we are now on the verge of rolling back the market economy ("The Commanding Heights"):

... we’re now moving from the realm of rhetoric into the realm of practical action – and everything seems to be pointing to a sea-change in government attitudes to market intervention. The UK (which has pushed some aspects of financial market liberalization further than the US) is now seriously considering partially nationalizing its banking industry. European business leaders are now complaining that the EU isn’t regulating enough – that is, it isn’t engaging in coordinated action to stop its own financial markets from tanking. The reasons for EU inaction lie in the lack of any structures that would militate towards concerted action to address problems of market confidence, in large part because European financial markets are even less regulated than their US equivalents (as I’ve noted before the EU is typically more interested in liberalizing markets than restraining them, contrary to the general impression in the US). The lack of EU level institutions means that states like Ireland and Germany are taking individual actions that are intended to shore up their own banking structures, but may have beggar-my-neighbour implications for their neighbours.

Still, if I had to lay bets on what will happen in the next 2-4 years, they would be on the following outcomes.
(1) Continued high level involvement of the US government in shaping financial markets, not only through regulation, but through manipulation of antitrust law, selective granting and withholding of government support, and substantial ownership stakes in major enterprises over the next several years. I imagine that these stakes will be wound down eventually – but the ever-present possibility that the US will do this again will fundamentally reshape the incentives of market actors in difficult-to-predict ways.
(2) A much tighter regulatory structure emerging at the EU level, hastening the kinds of processes that my former colleague Elliot Posner has
examined in his academic work. The hostility of the UK to EU level structures is already much less surely grounded than it was, and is likely to become less grounded still over time. More speculatively, I might predict a UK-German consensus emerging on financial market regulation that would be intended to stave off French efforts to re-open the questions of EU constraints on fiscal policy. If such an implicit agreement emerges, Ireland and other smaller states will find it difficult to resist.
(3) The creation of formal – but weak – international structures, intended to ensure greater explicit coordination of regulatory policy and consultation over state actions that may potentially have international ramifications. ...

(4) The effective abandonment of international efforts to try to limit state involvement in the economy through tighter international rules on procurement etc, and the weakening or collapse of internal EU rules on permissible state aid.
These aren’t the only possibilities of course – another, perfectly plausible outcome might involve the collapse of international efforts at coordination, and the adoption by major states of beggar-thy-neighbour policies in a more systematic way. Nor do these possibilities necessarily imply the resurgence of social democracy – equally possible are various forms of managerial capitalism, of a return to economic nationalism, or even of a mild or less-than-mild resurgence of fascism.

Others have focused more on near term effects:
1. Reinhard Selten: ...the market does not value new types of complex securities correctly. For this reason, it is necessary to establish rules for the registration of new types of securities. Securities, not unlike food, should be given risk-related labels. (Unfortunately, this was the role of ratings agencies which failed in this task.)

2. Worthwhile Canadian Initiative: Regulate safe levels of leverage and duration-mismatch. If mortgages had been restricted to 75% of the house price, a 25% fall in house prices would not cause mortgage defaults. But a 26% fall would. The only truly safe level of leverage is zero. But people want leverage, and an efficient financial system ought to let them have it. Without leverage, we would have to pay cash for our homes, or else use equity-finance, and with equity-finance the bank, as part-landlord, would want to stop us painting the walls orange. Similarly, a restriction on duration-mismatch would prevent runs, yet the only truly safe level is zero. But people want duration-mismatch, and an efficient financial system ought to let them have it. We might suddenly find ourselves with an emergency need for immediate cash. In any case, regulations limiting leverage and mismatch have been tried in the past and have failed. People want leverage and mismatch, and will always figure out new ways to get around those regulations.

Government guarantees of solvency and liquidity. These can be explicit or implicit (ad hoc bailouts). Government guarantees imply regulation to try to reduce moral hazard. With the government effectively a part-owner of financial institutions, it needs to exercise surveillance, which is complex and costly. If the government were good at distinguishing good loans from bad, why would we need a capitalist financial system in the first place? Let’s have one big government bank for all savings and loans. But history tells us this won’t work any better. And governments too can become insolvent and illiquid (they can’t print foreign currency), so the guarantee becomes worthless.

3. Michael Spence: ... segregate a sector of financial services through regulation, restricting its lines of business and setting capital requirements to ensure that the likelihood of an inability to function in processing transactions and channeling short-term capital is minimal. This would be a sector that is in effect a regulated public utility.

4. Mark Thoma: ... we need to be more active in regulating market structure. Firm size is a good place to start (but not the only front that needs action). If economies of scale are so important that we must tolerate firms that are large parts of financial or goods markets, large enough to threaten the broader economy if they fail, then these firms are natural monopolies and need to be treated as such. The market will not provide the proper regulation of behavior in these cases, and they certainly won't regulate themselves. And if they aren't natural monopolies, and I'm not convinced that, for example, investment banks fit this category, then break them up. We'll still have to worry about systemic risk, having 1,000 small banking firms go bankrupt at the same time is no easier than if a single firm a thousand times larger goes under (and it may even be harder to intervene when there are a thousand failures rather than just one), but the chances of this happening are smaller when the industry is competitive, and more active regulation on other fronts can reduce the exposure to systemic risk factors.

The other problem is forgetting how markets correct themselves when they do manage to do so. The costs of self-correction are often not considered when thinking about market adjustment. Correction of resource allocations can be costly, but it's institutional flaws that are the most problematic. To the extent that there is an automatic institutional correction mechanism built into the system's design, it often only happens after a large motivating event. ... But sometimes we can see problems developing, or we can find them if we take the time and effort to look in the right places, and in such cases we should step in and prevent the accident from occurring in the first place.

5. Paul Samuelson: ... I believe that there is no satisfactory alternative to market systems as a way of organizing both economically poor and economically rich populations. ... However, using markets is not the same thing as unregulated capitalism so beloved by libertarians. Such systems cannot regulate themselves, either micro-economically or macro-economically. Wherever tried they systematically breed intolerable inequalities.

6. Stumbling and Mumbling: Regulate banker's pay - Banks lost money on mortgage derivatives because of principal-agent failings. Principals - banks’ bosses - didn’t understand what agents (traders) were doing, and traders had incentives to take on excessive risk, because the gains from doing so - a life-changing bonus - exceeded the benefits of prudence. ... Banks are under-capitalized because chief executives have traditionally had incentives to maximize earnings by using leverage. Pressure upon them to be more prudent has been absent partly because when shareholding is dispersed, no individual shareholder has much incentive to rein in management.

Banning "Bad" Financial Innovations:
Interfluidity: ... consider common stocks. No rational regulator concerned with substantive transparency would approve of common stock, if it were a novel investment vehicle. It guarantees no cashflows whatever, its "control rights" are so weak for most purchasers that representations thereof should be viewed as fraudulent. Empirically common stock behavior is very weakly coupled to the performance and health of the firms that stocks fund. The only instrument in wide use more substantatively opaque than common stock is fiat money.

I think common stock is a deeply imperfect instrument, one that we should work to improve upon and eventually replace. But, there's little question that over the several hundred years between the invention of joint stock companies and the advent of information-technology that might make more fine-grained claims practicable, common stock served a useful purpose, both in terms of pooling capital and risk, and promoting information discovery and revelation.

Still, much of our current catastrophe was caused by investors investing overeagerly in securities whose structures were clear enough, but the economic substance of which they were entirely incapable of evaluating. Rather than banning such securities, we should turn our attention to understanding why they did this. A lot of very opaque securities (both substantively and structurally) were invented, sure. But how did they vault from idiosyncratic experimentation to widespread implementation? This had to do with the structure of financial intermediation, and it is there that I believe that regulatory energy should be focused, rather than on evaluating the terms of contracts.

Flawed financial instruments only become policy issues when people responsible for investment on a significant scale decide that what they don't know won't hurt them. This can happen by virtue of fads and fashion, the madness of crowds: consider internet stocks, or blind faith in diversification and "stocks for the long run". But most poor investment, in dollar-weighted terms, is not taken by foolish individuals placing their own money. Bankers and institutional investors are on the one hand granted the power to control investment on a very large scale, and on the other hand make consistently awful choices. Delegated money, rather than trading off return and safety, often trades return for safe-harbor. Absurd contracts that appear to offer high returns are very attractive to money managers of all stripes, if they offer a veneer of safety and "prudence", or better yet, if they become conventional.

Getting regulators in the habit of banning some classes of contracts (or worse, requiring them to approve novel contracts) would have the perverse effect of certifying the instruments that are permitted. A better approach would be to eliminate safe-harbor for intermediaries by insisting that they be substantially invested in the funds they manage, and on the hook — financially, not just reputationally — for losses as well as gains. (Obviously, we should eliminate safe-harbor that derives from rating agency certifications or statistical risk models. But that won't be sufficient — professionals will always manufacture "best practices" and find safety in numbers, or hide behind consultations with experts and representations by prestigious sources.)

Stumbling and Mumbling: Good financial innovation - of the sort advocated by Robert Shiller - has been lacking because it’s very difficult for anyone to own its beneficial effects; it’s a public good. By contrast, the gains from “bad” financial innovation - overly complex mortgage derivatives - are more appropriable. So we get more of it.

Or Improving Information:
Interfluidity: A contract is "structurally" transparent if, conditional on any set of observable real economic outcomes, it is clear what cash flows are compelled of all parties. A contract is "substantively" transparent if the economic outcomes that determine the cash flows are themselves susceptible to analysis. A mortgage-backed security, for example, might be structurally transparent but substantively opaque: Knowing the performance of the bundled mortgages, it might be easy to calculate the cash flows payable to all tranches. But as a practical matter, it might be impossible to estimate the performance of a thousands of heterogeneous loans in a volatile housing market. Common stock is arguably both structurally and substantively opaque: Even if one knows with certainty the long-term performance of a firm, the cash flows due a stockholder can be difficult to predict. And the future performance of a firm is itself very hard to estimate.

I think a strong case can be made for regulatory promotion of structural transparency. ... That said, I don't think the best approach would be to forbid nonstandard contracts. Instead, regulators could "bless" certain contractual forms as well-defined, while creating penalties for those who offer contracts that are structurally opaque or that serve to hide embedded leverage. Parties who have good reason to deviate from very standard contracts would have the ability to do so, but would risk of being punished if those instruments are deemed to have violated standards of clarity. In other words, instead of eliminating "bad" contracts, regulators should take on the role of organizations like
ISDA and proactively define "good" contracts that meet needs they identify by monitoring "exotics" that gain prominence in the market. Unlike ISDA, however, regulators' primary mandate would be to ensure that the contracts they bless are well thought out from the public's perspective: that "catastrophic success" of those contracts would not create fragile networks of counterparties or other hazards. "Blessed" contracts might well include obligations to periodically report contract valuations notional and net, and collateralization to a public registrar. They would rely upon collateral much more than counterparty for security (to restrict embedded leverage), and provide for standardized means of termination or novation, to prevent the emergence of economically useless but systemically hazardous multilaterally offset positions. They might work proactively to encourage the formation of centrally cleared exchanges, to permit counterparty neutrality with less collateral or risk of early termination, as new forms of contract grow popular.

Mark Thoma: ... investors can no longer trust what ratings agencies tell them. A crucial piece of information, information designed to break informational asymmetries between firms and investors, turned out to be unreliable. In addition, investors can no longer believe the numbers they see on bank books. The numbers might say the bank is solvent, but how reliable are those numbers? And even if the numbers are meaningful today, will they be meaningful tomorrow? Is there any way to actually value the assets a lot of these banks have on their books when there is essentially no market for them, no way to engage in price discovery?

... it's going to be difficult to convince people they can trust this information again, people won't easily believe a ratings agency, real estate agent, risk assessment model, etc. just because someone announces that the problems are all fixed now, models can't be repaired overnight, so on some fronts time may be the only real solution.

Big shocks don't necessarily shake the informational foundations of markets. There can be an event that occurs in the tail of the distribution of possible events that is viewed as just that, an unusual, costly event, but not one that fundamentally upsets our understanding of how the world works while at the same time undercutting the informational flows we use to understand these markets. I don't think the crash, for example, caused us to question the reliability of the information we receive the way this episode has. After the crash, we still thought we understood how to use models to process reliable information. But this crisis has destroyed confidence in the information and the models we use, and it won't be easy to bring this back.

Michael Spence: ... anticipate that emergency channels will occasionally be needed when there is widespread distress in the rest of the financial sector, and set up such channels in advance. Then deployment would be automatic and not a source of risk to the real economy. Of these two options, the first is likely to be perceived as preferable.

British Prime Minister Gordon Brown recently said the global financial system needs an early warning system – continuous oversight and monitoring to anticipate and head off crises. The idea appeared to gain traction among world leaders at the G-20 meetings in Washington. This is a good idea, but acting on it will require a nontrivial extension of our current knowledge and capabilities. We have been operating with indicators that, while relevant, do not add up to a complete picture of systemic risk – they set off alarm bells but lack authority.

Systemic risk escalates in the financial system when formerly uncorrelated risks shift and become highly correlated. When that happens, then insurance and diversification models fail. There are two striking aspects of the current crisis and its origins. One is that systemic risk built steadily in the system. The second is that this buildup went either unnoticed or was not acted upon. That means that it was not perceived by the majority of participants until it was too late. Financial innovation, intended to redistribute and reduce risk, appears mainly to have hidden it from view. An important challenge going forward is to better understand these dynamics as the analytical underpinning of an early warning system with respect to financial instability.

One approach is to bet on information and the market participants’ learning. The focus would be a major regulatory overhaul to fix or dramatically improve transparency problems, with the hope or expectation that market participants armed with much better information would detect and manage risk better, especially with the benefit of applying lessons learned from experience. To be honest, I wouldn’t want to bet global financial stability on this pillar alone. We are dealing with fat-tailed risks where the endogenous dynamics are causing the correlated risks to rise over time. While that happens, the system throws out very little data about the rising risk until the system becomes unstable. Absent very accurate and sophisticated models of the dynamics, expectations and beliefs about risk will lag behind the shifting reality (as they clearly did in this case) and the natural circuit breakers associated with risk avoidance by market participants and regulators won’t work.

What else we can do to prevent future crisis:
1. Worthwhile Canadian Initiative: Prevent bubbles. If central banks had raised interest rates sufficiently high, they could have burst the housing bubble before it got too big. But not all assets were over-priced, and high interest rates would have done harm in the rest of the economy. And this cure also relies on the policymakers keeping their heads while all around them are (in hindsight) losing theirs. Policymakers are people too. And in any case, a real shock could have had a similar effect on average house prices. A financial system ought to be robust to real shocks, as well as to bursting bubbles.

Trying to prevent crises by trying to prevent default hasn’t worked in the past, and I think it could never work. The overarching reason is this: if the financial system seems safe, people will take bigger risks, which makes the financial system unsafe. If the government is protecting us, we don’t need to look at the risks, and will leverage up to the hilt in illiquid assets at bubble prices. Wearing seat belts makes us drive faster.
Instead of trying to prevent default, we should focus on trying to prevent default from having real costs. Reducing real costs should also reduce contagion. Enforcing contracts is legitimate government business.

2. Mark Thoma: We have been too worried, I think, about making a mistake when we do this (What if we are wrong about a bubble and pop a real boom?). Yes, the government won't always get it right - even the private sector undertakes activities that look foolish in hindsight and the government is no different - but we need to think in terms of whether we are doing good on balance and not be so worried about that the one case when we might get it wrong (though we do want to minimize such cases). The balance is currently off, fear of one mistake is causing us to forego lots of useful actions, and it's time for that to change.

What mistakes were made?
Brad DeLong: The failure to contain the crisis will ultimately be traced, I think, to excessive concern with the first two subsidiary objectives: reining in Wall Street princes and keeping economic decision-making private. ... The desire to prevent the princes of Wall Street from profiting from the crisis was reflected in the Fed-Treasury decision to let Lehman Brothers collapse in an uncontrolled bankruptcy without oversight, supervision, or guarantees. ... allowing some bank to fail, and persuading some debt holders and counterparties that the government guarantee of support to institutions that were too big to fail was not certain.

In retrospect, this was a major mistake. The extended web of finance as it existed in the summer of 2008 was the result of millions of calculations that the US government did, in fact, guarantee the unsecured debt of every very large bank and bank-like entity in America. With that guarantee broken by Lehman Brothers' collapse, every financial institution immediately sought to acquire a much greater capital cushion in order to avoid the need to draw on government support, but found it impossible to do so. The Lehman Brothers bankruptcy created an extraordinary and immediate demand for additional bank capital, which the private sector could not supply.

It was at this point that the Treasury made the second mistake. Because it tried to keep the private sector private, it sought to avoid partial or full nationalization of the components of the banking system deemed too big to fail. In retrospect, the Treasury should have identified all such entities and started buying common stock in them - whether they liked it or not - until the crisis passed.

Finally, let's not forget that securitization was in response to increased regulation and changes in capital requirements. See here and here.

No comments: