February 6, 2008
Why it is so hard to keep the financial sector caged
By Martin Wolf
When will the next financial crisis come? We do not know. Yet of one thing we can be sure: unless we learn from this crisis, another one will put the world economy back on to the rocks in the not too distant future.
The FT has published a number of contributions on the lessons: Charles Goodhart of the London School of Economics and Avinash Persaud of Intelligence Capital offered “a proposal for how to avoid the next crash” (January 31); Francisco González of BBVA discussed “What banks can learn from this credit crisis” (February 4); and Daniel Heller of the Swiss National Bank argued for three ways to reform bank bonuses (February 4). The substance of Mr Heller’s argument was similar to a contribution of my own (“Regulators should intervene in bankers’ pay”, January 15), but without the regulatory coercion.
The big question, indeed, is whether lessons must be embedded in regulation. Optimistic opponents of regulation argue that the banks have learnt their lesson and will behave more responsibly in future. Pessimistic opponents fear that legislators might create a Sarbanes- Oxley squared. The Act passed by the US Congress in 2002, after Enron and other scandals, was bad enough, they say. The banks might now suffer something worse.
The remainder of this column can be read here. Debate from our panel of economists appears below.
Patrick Honohan: Yes, something needs to be done but what? For me the big questions are (i) ex ante or ex post controls; (ii) rules versus discretion and (iii) how to get better international coordination – especially in the eurozone.
The drive to modify the reward/incentive packages for bankers is of the ex post type: the banker gets his come-uppance after the failure. This provides good incentives, but only after the collateral damage has been done. Given the potential scale of these externalities, pre-emptive action by regulators must also remain part of the toolkit.
And such action should not be unduly rules-bound. Much of what has happened – not only in this wave but at the time of Enron – results from naïve reliance on mechanical rules (We’re OK if we buy AAA-rated securities; We always hedge our derivative exposures; Our internal ratings system has been approved by the regulator; company accounts mean what they say). But risk-seekers and fraudsters are in the business of circumventing mechanical rules. Regulators and risk-managers should not have to rely solely on such rules (whether or not adjusted to the business cycle).
International (as well as domestic) regulatory coordination has been shown up rather badly. This needs to be fixed, for crisis-management purposes even more than crisis prevention. The fragmented eurozone system of regulation is a conspicuous weakness. The co-operative arrangements that have been evolving do not look anything like robust enough to deal with a fast-breaking cross-border failure. I have long assumed that getting the political momentum to fix this might require a major failure; could the near-misses of recent months be enough of a trigger?
Posted by: Patrick Honohan | February 6th, 2008 at 12:22 pm | Report this commentDavid Williams (guest): Regulators should regard the payment of large short-term bonuses to bankers as a reward for creating long-term risk transactions as an indicator of enhanced risk. They should therefore place higher capital adequacy requirements upon such banks than upon those who tie the duration of rewards to the duration of risk and return. Thus banks who are myopic to cyclical risks will show weaker returns on capital than those who are prudent, and investors can make an informed decision.
David Williams is CEO of Avanti Communications and a former banker
Posted by: David Williams | February 6th, 2008 at 12:53 pm | Report this commentBernard Tyler FCA AIFP (guest): Martin demands that we play close attention to the structure of pay. This is the keystone of the solution because the sickness needing treatment is a commission based culture that inflates asset prices to reward participants but adds little value. Whether it’s bankers or estate agents receiving 75% of annual pay from commissions it warps their judgement.
Fifty years ago you were either an employee on a salary or you were a profit sharing partner. Now we have a third way and it is deeply unattractive. All of the reward and none of the unlimited personal risk.
There are three hands to the solution but the relevant one here is tackling pay structure through the taxation of bonuses.
In the UK the self employed partner has to account to the Revenue for 50% of his expected pay by the half year on 30th September (including bonus). The “comp pool bandit” who masquerades as an employee only pays tax on his bonus the month that he receives it.
Instead of loading control pressures onto the regulator, the taxation system can fix this mess. Assuming for illustration an increasing annual level of bonus: employees earning bonuses over 24% of salary would have to account for tax on half their (unreceived) bonus by 30th September the same as if they were self employed. Mirroring this the employer would be allowed to pay any bonus he chooses but bonuses over 24% would suffer an element of deferred recognition for corporation tax purposes.
Through tougher taxation you can make the partnership model attractive once more and the stick of personal liability will fairly match the carrot of profit participation.
Posted by: Bernard John Croxon Tyler FCA AIFP | February 7th, 2008 at 2:04 pm | Report this commentends.
Aseem Giri (guest): Government efforts at regulation always occur after the fact. Similar crises rarely repeat themselves; the only constant is eventual crisis. There is enough incentive within the financial markets to drive ingenuity that will lead to the next great pursuit of returns, precipitating a potential crisis. It would appear that it must be accepted as a given that such events will happen.
Aseem Giri is author of Imposters at the Gate, and former private equity professional and investment banker
Posted by: Aseem Giri | February 7th, 2008 at 4:31 pm | Report this commentPatrick Schotanus (guest): First, allow me a brief introduction, as it will explain some of the biases in my reasoning. I’ve been working in investment management for over 15 years, and currently I work as a quant strategist, with a primary focus on asset allocation, i.e. I look at things top-down. I also happen to be very interested by the phenomenon of consciousness.
In my opinion, one cannot separate the evolution of the financial sector from the bigger environment in which it operates, i.e. the capital markets. Let us put this in a broader context. There is a reason why the capital markets have become so dominant in modern society, and increasingly influence the “real” economy at a global scale, a clear example of the “tail wagging the dog”. As I like to say, capital markets are the Supreme Court in allocating resources: they determine the spreading of wealth, and ultimately influence our wellbeing. This is not a normative statement, but just an observation, or conclusion if you will. What makes capital markets so unique is the process of price discovery, and specifically the collective nature by which it takes place. It is at the heart of their efficiency, as well as survival. However, allow me first to refer to two other recent articles.
As you may be aware, recently there has been an exchange of views, via articles in the Financial Times and, respectively The Times, between George Soros and Anatole Kaletski. Whereas Soros, based on his hypothesis of Reflexivity, points to the inherent instability (overshooting tendencies) of the financial system, Kaletski on the other hand points to the “rational” correcting mechanisms by way of central banks, regulators and governments (let’s call them politicians.) I believe both are right and actually linked. There is a third alternative in looking at this: the psychological bias of overconfidence. This expresses itself both on the side of financiers (practitioners and academics), as well as on the side of politicians, whereby the latter provide the safety-net (e.g. “Greenspan-put”) for the former to sustain their overconfidence.
Let us look at what determines our thinking and behaviour as participants in the financial system: finance theory, also known as modern finance. Behavioural Finance (BF) has pointed out many anomalies in finance, in the process challenging the current dominant paradigm, the Efficient Market Hypothesis (EMH). One major driver of these anomalies is overconfidence. One of my former professors, Mark Rubinstein, wrote “Rational Markets: Yes or No? The Affirmative Case”. In my opinion, it is one of the best articles comparing BF with EMH, and points to this crucial psychological characteristic.
Under the current circumstances, its relevance is as follows. On the one hand, we have the overconfidence of financial engineers/quants in their (securitised) products, models, trading strategies, as well as, more importantly, in the theory that underpins these. Fellow strategist James Montier calls this the “illusion of knowledge”. On the other hand, we can also observe the overconfidence of politicians in their “right” and ability to interfere (what we may call the “illusion of control”), including their attempts to relieve the pain of “six-sigma” events. These illusions, and the way they are maintained, are among the root causes of the current problems. Specifically, I would argue that finance theory in its current format is largely maintained due to the historic bailouts, which have allowed it to “survive” the real world. If we agree that the current crisis, where we’ve seen locked-up markets, a run on a bank, and some of the most radical (coordinated) actions by central banks, is more serious than the internet-bubble (which in turn was more serious than the crises of 1998/1999 or 1987), there appears to be a pattern. In fact, I would argue that these problems are not only reflected in these, but also in other issues like corporate governance (e.g. fraud by SocGen’s “rogue” trader), and climate change (e.g. the historic mispricing of carbon).
Next, if we view the capital markets as a complex system, then we know from complexity theory that self-organising systems (at least those that contain some biological component) have one main priority: survival. In short, the financial system will attempt to self-correct any developments that threaten its survival. The problem is that in the case of the financial system the threats (i.e. “booms and busts”) originate with the masses, initially stimulated by unrealistic promises by their politicians (e.g. “You too can share in the American dream. . . Here’s your house”), as well as financial institutions (i.e. “We’ve created the perfect product for you”). In all cases, it leads to rampant speculation, the mass-psychology form of overconfidence if you will. (Consequently, the “herd” that is threatening the financial system has grown to such an extent, that the system’s own inclination to kill it has become a politically incorrect solution.)
Before you think I am a dangerous Ayn-Rand / Chicago-school extremist, allow me to expand on this. Although I do not suggest that econophysics is the correct alternative theory, one of its experts, Didier Sornette, analysed crashes and makes a fascinating observation:
“The concept that emerges here is that the organization of … financial markets leads intrinsically to ‘systemic instabilities’, that probably result in a very robust way from the fundamental nature of human beings, including our gregarious behavior, our greediness, our instinctive psychology during panics and crowd behavior and our risk aversion. The global behavior of the market, with its log-periodic structures that emerge as a result of [this] . . . is reminiscent of the process of the emergence of intelligent behavior at a macroscopic scale that individuals at the microscopic scale cannot perceive. This process has been discussed in biology . . . in connection with the emergence of consciousness.”
Although at first sight this sounds like EMH, the suggestion of a macroscopic consciousness implies there is more to this. The key point, in my view, is that capital markets form indeed a complex system, almost like a collective being. It is driven by the collective thinking and behaviour of its participants, and increasingly that means all of us in one form or another. The conscious part of this collective drive is framed by a paradigm, in other words a way of viewing and modelling the world. Although BF has shot holes in the ivory tower of EMH, it unfortunately cannot offer alternative housing (as Rubinstein correctly points out). Something is missing in modern finance, but consciously we collectively continue to use inadequate theories that lead to the failings in models, trades, and regulatory “patches”.
Einstein once said, “We can’t solve problems by using the same kind of thinking we used when we created them.” The shift from EMH to BF is important in that it underlines the fact that human cognition is more than rational judgement, but it does not make finance whole. Again, something is missing. Harvard’s Michael Jensen points in the right direction when he argues this from a corporate governance point-of-view:
“Finance theory and practice are incomplete without an integrated theory of integrity. . . . I define integrity without reference to morals, values, religion, or ethics. Something is in integrity if it is whole, complete and sound. Integrity is closely related to workability because an entity or system that is out of integrity will not be whole, complete and sound. Workability is the bridge to value. The farther out of integrity the less well any given entity will work.”
In my view, the implication of, in Jensen’s words, the required wholeness in finance is that we need to start to realise that the deeper-seated, and I believe ultimate, drivers in the process of price discovery are of a collective nature, unknown to each individual agent. They are archetypal, and therefore have remained largely unchanged over generations. Consequently, it is not surprising that capital markets have become evolution’s choice to express these in prices (i.e. numbers), aimed at creating order for our species to survive in an increasingly interconnected, economically driven, and environmentally challenged global society. As participants in the markets, directly or indirectly, we experience these in universal emotions, like trust and responsibility, but obviously also in the form of fear and greed.
In short, I argue that the financial system is our collective creation, which now (naturally) has outgrown us. Furthermore, compared to other systems (e.g. communism, democracy) it offers the most efficient way to allocate resources and determine priorities, particularly when viewed in a global economic context, i.e. people are more honest when they vote with their wallet than via the ballot. It is something politicians find difficult to comprehend, let alone accept. However, what is even more misunderstood is the true nature of speculation, in particular the deeper meaning of price discovery at such a massive scale for the human race. In any case, this realisation of “that what is beyond us” should bring humility, I’m almost tempted to state “a sense of awe”, instead of overconfidence. It should also make politicians think twice about their often-misguided attempts to control it, and make financiers question their belief that they have captured it in their models.
If, instead, politicians and financiers fail to grasp this and continue to live the aforementioned illusions, we will stumble on, but with growing negative consequences. Fortunately, there are indications that a new paradigm is emerging. Finance academics, like Andrew Lo (MIT) and George Loewenstein (Carnegie Mellon), are exploring hypotheses beyond those of modern finance. Personally, I believe we need to engage in the growing interdisciplinary debate on consciousness, with researchers like Roger Penrose (quantum physics), John Searle (philosophy), Fritjof Capra (physics/ecology), Michel Callon (sociology), and Antonio Damasio (neurobiology). In practical terms, the (albeit belated) recognition of the historic mispricing of carbon, and the initiatives taken for markets to re-price it, is an early sign that we are on the right track of long-term survival.
Patrick Schotanus is an investment strategist at Aegon Asset Management. These comments reflect his personal opinions
Posted by: Patrick Schotanus | February 8th, 2008 at 4:13 pm | Report this commentAndrew Smithers: Martin’s column calls, inter alia, for higher capital requirements but argues that this will not be enough. In addition we need to regulate bank remuneration.
I think it is helpful to distinguish between three different aims for bank regulation. (i) To reduce the risks on tax payers, (ii) to reduce the risks that imprudent banking will damage the real economy and possibly, though I will ignore it here (iii) to reduce the extent to which managers are able to exploit their position to derive excessive benefits at the expense of either shareholders or other employees.
(i) Can be improved and possibly solved by higher capital requirements. This is equitable as it represents the return for the subsidy given by the effective guarantees to depositors by tax-payers. Managements should be sacked if they allow banks to fall below high equity requirements, and replaced by government appointees whose first duty is not to shareholders but to the government and whose first job is to restore the capital ratios by raising new capital. The risks to tax-payers should then be minimal and the process should largely and perhaps completely obviate the need to have deposits switched to another bank.
(ii) In these circumstances shareholders would suffer rather than tax-payers, which should reduce the risks of imprudence, but I doubt whether this problem is really soluble at the management level. Banks behaved imprudently even when bonuses represented a nugatory proportion of managements’ remuneration. The tendency to extrapolate recent trends, rather than to assume their mean reversion, seems imbedded in human nature. Economies are prone to excess bouts of optimism and pessimism. People cannot be trusted to run financial organisations and no alternative management seems available. The resulting pro-cyclicality needs to be modified by central banks. But this will not happen while so much attention is given to the avoidance of recessions and too little to signs of excess in financial markets. High assets and unduly low prices for liquidity are among the key signs.
It is unlikely that recessions have been abolished. Mild and relatively frequent ones are probably the price we pay for avoiding deep ones or prolonged periods of weakness. (It is notable that the Japanese problems came at the end of the “Izanagi boom”, their longest recorded period of sustained growth.). The US currently risks a deep recession or a prolonged period of weakness, not just in the very short-term. Possibly the worst scenario is a short and mild downturn which fails to bring inflation below 2% p.a. In any subsequent recovery inflationary expectations would then be likely to rise, and will only be dampened by a much greater loss of output than would have been necessary had the Fed responded to the recklessness shown by the low price for liquidity and the high prices of financial assets, from which we have suffered over the past decade.
The Fed in recent years has pursued asymmetric policies by responding to asset price falls and not to rises. This may prove to have been justified and the fears that I and others have may have been groundless. One group is going to be proved wrong and denial must be avoided by whoever is in error.
Posted by: Andrew Smithers | February 11th, 2008 at 11:52 am | Report this commentMartin Wolf: I want to thank everybody for thoughtful comments. I respond as follows.
I think I disagree with Patrick Honohan. At the very least, rules have to be a big part of the regulatory structure. The difficulty in replacing rules with pure regulatory discretion is that regulators end up running the financial institutions. That is undesirable, to put it mildly. It is also surely impossible.
I agree there should be better co-ordination among regulators, but that is another Holy Grail. As we can see, there hasn’t been much co-ordination among regulators even within countries, certainly not within the US and UK. In the end, I do believe this must be more about incentives, on which more below.
I like David Williams’ suggestion that capital adequacy requirements be related to the structure of rewards, though I admit that would be inconsistent with what I have just said, since there would clearly be some regulatory discretion involved. I think there might be minimum standards for employment contracts in institutions eligible for government assistance (e.g. lender-of-last-resort help from the central bank).
Bernard Taylor recommends changing taxation, in order to go back to the partnership model of finance. I have no idea how effective the tax changes he recommends would be. But I fear it is impossible to go back to the partnership model given the capital requirements of the modern financial system. Indeed, as Andrew Smithers argues (and I agree), there is a need for much more capital, not less. So the challenge is how to align the incentives of employees with the interests of both shareholders and the wider public.
Aseem Giri suggests nothing can be done: this is how people are. My distinguished fellow-columnist, John Kay, makes much the same argument (February 13, http://www.ft.com/cms/s/0/7bc41300-d9d6-11dc-bd4d-0000779fd2ac.html). People get carried away in mad rushes of blood to the head or by herd behaviour. The question, I suppose, is whether the game is worth the candle. In the 1950s and 1960s – the era of repressed finance – such crises did not happen in the developed countries. Was that time so very dreadful? This Kay-like view is expounded at greater (and far more metaphysical) length by Patrick Schotanus. I do not think what he says is wrong. Finance is not just a machine, any more than the economy is just a machine to be tinkered with. But where his ideas leave us, in policy terms, is unclear.
Finally, let me respond briefly to Andrew Smithers. I agree that higher capital requirements make sense. My concerns with this proposal, however, are, first, the ability of shareholders to monitor management is poor and, second, the ability of management to appear to deliver high returns to shareholders, in the medium term, is far from poor. If so, the response to higher capital requirements could be still riskier behaviour. This might then generate even bigger crises that would threaten to wipe out even the larger capital base and so force the losses back onto the public sector. In other words, merely forcing banks to have more capital will not solve the problem if one does not also have some way of monitoring, or at least influencing, the degree of risk being taken on by the management and staff. At the very least, assets must be marked to market ruthlessly.
That is all a huge challenge. One idea I quite like is that banks be forced to take subordinated debt in large quantities from one another(i.e. debt that comes last in the queue, in the event of liquidation). The assumption is that banks are relatively well aware of the risks. Then, if the price of such subordinated debt falls (beyond that of similar debt in the economy), we would have a prima facie indication of a rise in the perceived riskiness of the banks.
Andrew also raises the question of the asymmetry of Fed behaviour – the so-called “Greenspan (now Bernanke) put”. I agree with him, up to a point. In particular, it does not make sense to respond to perceived bubbles only after they burst. That creates a dangerous asymmetry. But asset prices do not, so to speak, “crash upwards”. Human behaviour is itself asymmetric: on the whole, panics drive prices down more brutally than optimism pushes them upwards. Furthermore, big price falls are likely to be more disruptive for the economy than comparable rises. So the speed of response should, probably, be different to a rising or a falling market. But there should definitely be a response, in both directions. It is here that the Fed, in my judgement, has erred.
Posted by: Martin Wolf | February 13th, 2008 at 3:47 pm | Report this comment