resilience, not stability

Archive for December, 2009

Regulatory Arbitrage and the Efficiency-Resilience Tradeoff

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On the subject of securitization and regulatory arbitrage, Daniel Tarullo notes:

“securitization appears to present a case in which efforts to plug gaps in regulatory coverage are quickly and repeatedly overtaken by innovative arbitraging measures.”

Arnold Kling noted the problem of adaptation of economic agents to changes in the regulatory regime in his paper on the financial crisis:

“The lesson is that financial regulation is not like a math problem, where once you solve it the problem stays solved. Instead, a regulatory regime elicits responses from firms in the private sector. As financial institutions adapt to regulations, they seek to maximize returns within the regulatory constraints. This takes the institutions in the direction of constantly seeking to reduce the regulatory “tax” by pushing to amend rules and by coming up with practices that are within the letter of the rules but contrary to their spirit. This natural process of seeking to maximize profits places any regulatory regime under continual assault, so that over time the regime’s ability to prevent crises degrades.”

Regulatory arbitrage follows from the application of Goodhart’s Law to financial regulation. One of Daniel Tarullo’s key recommendations to counter this arbitrage is the adoption of a “simple leverage ratio requirement” . Such blunt measures reduce efficiency – of course, we can make the system more resilient if we insist on blanket 25% bank capital ratios and ban all bonuses but this would be a grossly inefficient solution.

The tradeoff between efficiency and resilience is a constant theme in fields as diverse as corporate risk management, ecosystem management and in this case, financial regulation.

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Written by Ashwin Parameswaran

December 5th, 2009 at 7:19 am

Fix The System, Don’t Blame The Individuals

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Quoting from John Sterman’s authoritative book on system dynamics,

” A fundamental principle of system dynamics states that the structure of the system gives rise to its behavior. However, people have a strong tendency to attribute the behavior of others to dispositional rather than situational factors, that is, to character and especially character flaws rather than the system in which these people are acting. The tendency to blame the person rather than the system is so strong psychologists call it the “fundamental attribution error” (Ross 1977). In complex systems, different people placed in the same structure tend to behave in similar ways. When we attribute behavior to personality we lose sight of how the structure of the system shaped our choices. The attribution of behavior to individuals and special circumstances rather than system structure diverts our attention from the high leverage points where redesigning the system or government policy can have significant, sustained, beneficial effects on performance (Forrester 1969, chap.6; Meadows 1982). When we attribute behavior to people rather than system structure the focus of management becomes scapegoating and blame rather than the design of organizations in which ordinary people can achieve extraordinary results. ” (page 28-29)

Sterman’s comment is especially relevant to the current debate on reforming and regulating our financial system. It is misguided to focus on greedy bankers and incompetent or compromised regulators. Bankers and regulators are merely adapting to the incentives presented to them by our current economic and political system.

In fact, the real question is why so few economic actors indulge in fraud or milking taxpayer guarantees when they have every incentive to. After all, choosing not to play the game means accepting lower returns if one’s a shareholder and accepting lower bonuses and possibly even being fired for underperformance if one’s a manager or a trader.

The answer is that our ethics prevent us from exploiting the situation. But our ethical standards do not remain constant. They can and will erode if a perverse system is in place for too long. This gradual erosion of ethical standards is the real risk we face if we do not reform our system and fix the incentives. We may not realise this until it’s already too late and reversing this process and rebuilding ethical standards and trust in an economic system will be no easy task.

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Written by Ashwin Parameswaran

December 4th, 2009 at 3:19 pm

Negatively Skewed Bets and Fraud: Reconciling the “Control Fraud” and “Moral Hazard” explanations of the S&L crisis

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Commentators still disagree on the  role of fraud in the S&L crisis. Economists usually deny the importance of fraud and attribute the losses to “honest” risk-taking whereas criminologists such as William Black[i] highlight the role of systematic “control fraud”. But are these arguments incompatible with each other? I argue that the differences stem from an erroneous and incomplete understanding of the moral hazard issue.

According to the conventional moral hazard explanation [ii], S&Ls took on increasingly risky gambles and failed. However, it only makes sense to take on high risk 50-50 gambles if the owners of the S&L held diversified portfolios in which the individual S&L was not an outsized component. Else, the strategy of maximising the volatility of the asset portfolio is not optimal. Instead, the S&L owner’s optimal strategy is to maximise the probability of a positive outcome (i.e. maximise negative skewness). As increased leverage does not come at a commensurately increased cost due to deposit insurance, negative skewness can be maximised without compromising on the expected return [iii].

Akerlof and Romer [iv]pointed out that the evidence on the S&L crisis was consistent not with increased risk-taking but with “looting” i.e. fraud. In their words,

“many economists still seem not to understand that a combination of circumstances in the 1980s made it very easy to loot a financial institution with little risk of prosecution. Once this is clear, it becomes obvious that high-risk strategies that would pay off only in some states of the world were only for the timid. Why abuse the system to pursue a gamble that might pay off when you can exploit a sure thing with little risk of prosecution?”

Fraud represents a negatively skewed payoff provided that there is “little risk of prosecution”. Agents’ preference for negatively skewed payoffs makes fraud an attractive strategy. Any effective fraud-prevention strategy must increase the risk of prosecution to be successful i.e. the negative skewness must be reduced.

The moral hazard explanation also breaks down in cases where the S&L owner was also the CEO and manager of the firm. Quoting from Akerlof and Romer again,

“A crucial change in the regulations in the 1980s made it possible for a single person to own a thrift or for a parent company to own a thrift as a subsidiary. As one would expect, abusive strategies are easier to implement when ownership is concentrated and managers are tightly controlled by owners. In fact, this is why bank regulators had enforced rules prohibiting concentrated ownership until the 1980s. There were other thrifts with widely dispersed ownership and serious divergences between the interests of managers (who wanted to keep their jobs and reputations) and owners (who would have made much more money if the managers had looted their institutions).”

In this respect, S&L owners acted more like managers on high-powered incentive contracts than owners. Their equity investment in the S&L was usually minimal given the high leverage.  The dividend they could extract from the S&L before it went bankrupt could be equated to the bonuses paid to bankers in the current environment. One man ownership may have aligned managerial and owner interests in a normal firm but in an insolvent S&L with access to insured funds, it was an open invitation to engage in fraud.  As William Black noted,

“The leading law-and-economics text asserts that this is the ideal structure because it ensures managers’ fidelity to shareholders’ interests. This is one of  the areas where the field’s lack of knowledge of fraud has embarrassed it, for William Crawford had it exactly right: the best way to rob a bank is to own it. The person with the greatest incentives to engage in fraud is the CEO owner of a failing firm.”

To summarise, the control fraud theories favoured by William Black and Calavita, Pontell and Tillman[v] are not inconsistent with the moral hazard explanation.  S&L owners were incentivised to take on negatively skewed bets, fraud being one possibility if the possibility of prosecution is minimal. But the pervasiveness of the crisis still needed the fuel of deposit insurance. As Calavita, Pontell and Tillman put it, “selective application of the principles of free enterprise laid the foundation for risk-free fraud” and  “bad men and women took advantage of bad policies”[vi].

The key difference compared to the current crisis is that managers do not need to resort to fraud. More complete markets mean that there is an essentially unlimited supply of extremely negatively skewed bets.

[i] W. K Black, The best way to rob a bank is to own one: how corporate executives and politicians looted the S&L industry (Univ of Texas Pr, 2005).

[ii] R. C Merton, “An application of modern option pricing theory,” Journal of Banking and finance 1 (1977): 3–11.

[iii] subject to regulatory capital requirements.

[iv] G. A. Akerlof et al., “Looting: The economic underworld of bankruptcy for profit,” Brookings Papers on Economic Activity (1993): 1-73.

[v] K. Calavita, H. N Pontell, and R. Tillman, Big money crime: Fraud and politics in the savings and loan crisis (Univ of California Pr, 1999)

[vi] Ibid., p. 11,19

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Written by Ashwin Parameswaran

December 1st, 2009 at 4:56 pm