Archive for March, 2010
Alan Greenspan’s paper on the financial crisis calls for regulatory capital requirements on banks to be increased but also warns that there are limits to how much they can be increased. In his words: “Without adequate leverage, markets do not provide a rate of return on financial assets high enough to attract capital to that activity. Yet at too great a degree of leverage, bank solvency is at risk.” Greg Mankiw wonders whether the above assertion does not violate the Modigliani-Miller Theorem and is right to do so. Although Greenspan’s conclusion is correct, his argument is incomplete and misses out on the key reason why leverage matters for banks – the implicit and explicit creditor guarantee.
I explained the impact of creditor protection on banks’ optimal leverage in my first note. The conclusions which I summarised in a more concise form in this note are as follows: Even a small probability of a partial bailout will reduce the rate of return demanded by bank creditors and this reduction constitutes an increase in firm value. In a simple Modigliani-Miller world, the optimal leverage for a bank is therefore infinite. Even without invoking Modigliani-Miller, the argument for this is intuitive. If each incremental unit of debt is issued at less than its true economic cost due to deposit insurance or the TBTF doctrine, it “increases the size of the pie” and adds to firm value. In reality of course, there are many limits to leverage, the most important being regulatory capital requirements.
Indeed, the above is the main reason why we have any regulatory capital requirements at all. In the absence of regulation, a bank with blanket creditor protection will likely choose to operate with minimal equity capital especially when it has negligible franchise value or is insolvent. This is exactly what happened during the S&L crisis when bankrupt S&Ls with negligible franchise value bet the farm on the back of a capital structure almost completely funded by insured deposits.
One of the more predictable discoveries in Anton Valukas’ report on Lehman was the fate of the lone employee whistleblower and the reaction of the audit firm to the whistleblower’s allegations. Much ink has been spilt on improving the regulatory framework to avoid another Lehman (See for example TED). Improving the incentives for employee whistleblowers to come forward is an important regulatory imperative that has not received the attention that it deserves. All whistleblowers, not just employees, play a key role in uncovering fraud in corporations. The bulk of this post is derived from the excellent work done in this regard by Dyck, Morse and Zingales(henceforth DMZ) and Bowen, Call and Rajgopal.
Compared to other whistleblowers, employees have the best access to the information required to uncover fraud. They also possess the knowledge to analyse and parse the information for any signs of fraud. This is especially important in a field such as banking where outsiders rarely possess the knowledge to uncover fraud even when they possess the raw information – a key reason why the media is so ineffective in uncovering banking fraud compared to its role in other industries which DMZ highlight.
One might ask why auditors are so ineffective in uncovering fraud despite possessing the relevant information. One reason is the aforementioned lack of knowledge required to uncover fraud in complex situations. But a more crucial reason is that auditors are incentivised to ignore fraud. In DMZ’s words: “we find a clear cost for auditors who blow the whistle. The auditor of a company involved with fraud is more likely to lose the client if he blows the whistle than if he does not, while there is no significant evidence that bringing the fraud to light pays him off in terms of a greater number of accounts.”
So what prevents more employee whistleblowers from coming forward? As DMZ note, many whistleblowers prefer to remain anonymous because : “In spite of being selected cases (for which the expected benefit of revealing should exceed the expected cost), we find that in 82 percent of cases, the whistleblower was fired, quit under duress, or had significantly altered responsibilities. In addition, many employee whistleblowers report having to move to another industry and often to another town to escape personal harassment. The lawyer of James Bingham, a whistleblower in the Xerox case, sums up Jim’s situation as: “Jim had a great career, but he’ll never get a job in Corporate America again.”….. consequences to being the whistleblower include distancing and retaliation from fellow workers and friends, personal attacks on one’s character during the course of a protracted dispute, and the need to change one’s career. Not only is the honest behavior not rewarded by the market, but it is penalized.” i.e. employers prefer loyal employees to honest ones, just as they prefer loyal auditors to honest auditors.
Sarbanes–Oxley contained many provisions aimed at protecting whistleblowers. Quoting from Bowen, Call and Rajgopal: “In response to Enron, WorldCom and other scandals, Congress passed the Sarbanes–Oxley Act (SOX) in July 2002, which in part made it unlawful for companies to take negative action against employees who disclose “questionable accounting or auditing matters.” (See SOX section 806, codified as title 15 U.S.C., § 78f(m)(4).) Under the whistleblower provisions of SOX, employees who disclose improper financial practices receive greater protection from discrimination. (See title 18 U.S.C., § 1514A(a)(1).) SOX also ruled that every company quoted on a U.S. Stock Exchange must set up a hotline enabling whistle-blowers to report anonymously (Economist 2006).” DMZ offer many possible explanations for why these provisions have not succeeded: “One possible explanation is that rules which strengthen the protection of the whistleblowers’ current jobs offer only a small reward relative to the extensive ostracism whistleblowers face. Additionally, just because jobs are protected does not mean that career advancements in the firm are not impacted by whistle blowing. Another explanation could be that job protection is of no use if the firm goes bankrupt after the revelation of fraud.”
So what else can be done to encourage employees to come forward? Unsurprisingly, DMZ find that monetary incentives have a role to play and I agree. Employee whistleblowers play a more significant role in industries such as healthcare where “Qui tam” suits are available. I would assert that monetary incentives have an even stronger role to play in uncovering fraud in banking. The extremely high lifetime pay expected in the course of a banking career combined with the almost certainly career-ending implications of becoming a whistleblower means that any employee will think twice before pulling the trigger. Moreover, the extremely specialised nature of the industry means that many senior bankers have very few alternative industries to move to.
The focus of SOX on making it harder to fire whistleblowers is misguided as well as ineffective. The focus must be not to keep whistleblowers from losing their jobs but to compensate them sufficiently so that they never have to work again. As it happens, the scale of fraud in financial institutions means that this may even be achieved without spending taxpayer money. The whistleblower may be allowed to claim a small percentage of the monetary value of the fraud prevented from the institution itself, which should be more than sufficient for the purpose.
The obvious objection to my proposal is that this will lead to a surge in frivolous claims from disgruntled employees. For one, the monetary reward is dependent on fraud being proven in a court of law and the likely career-ending nature of becoming a whistleblower should be enough to prevent any frivolous allegations. Indeed, DMZ find that the percentage of frivolous lawsuits is lower in the healthcare industry where “qui tam” suits are available.
As DMZ point out, “the idea of extending the qui tam statue to corporate frauds (i.e. providing a financial award to those who bring forward information about a corporate fraud) is very much in the Hayekian spirit of sharpening the incentives of those who are endowed with information.” This is even more crucial in uncovering fraud in a complex industry such as banking where even qualified outsiders may struggle to put the pieces together and informed insiders face such steep deterrents that prevent them from rocking the boat.
In arguing the case for the moral hazard explanation of the financial crisis, I have frequently utilised evolutionary metaphors. This approach is not without controversy and this post is a partial justification as well as an explication of the conditions under which such an approach is valid. In particular, the simple story of selective forces maximising the moral hazard subsidy that I have outlined is dependent upon the specific circumstances and facts of our current financial system.
The “Natural Selection” Analogy
One point of dispute is whether selective forces are relevant in economic systems. The argument against selection usually invokes the possibility of firms or investors surviving for long periods of time despite losses i.e. bankruptcy is not strong enough as a selective force. My arguments rely not on firm survival as the selective force but the principal-agent relationship between investors and asset managers, between shareholders and CEOs etc. Selection kicks in much before the point of bankruptcy in the modern economy. In this respect, it is relevant to note the increased prevalence of shareholder activism in the last 25 years which has strengthened this argument. Moreover, the natural selection argument only serves as a more robust justification for the moral hazard story that does not depend upon explicit agent intentionality but is nevertheless strengthened by it.
The “Optimisation” Analogy
The argument that selective forces lead to optimisation is of course an old argument, most famously put by Milton Friedman and Armen Alchian. However, evolutionary economic processes only lead to optimisation if some key assumptions are satisfied. A brief summary of the key conditions under which an evolutionary process equates to neoclassical outcomes can be found on pages 26-27 of this paper by Nelson and Winter. Below is a partial analysis of these conditions with some examples relevant to the current crisis.
Genetic diversity is the raw material upon which Darwinian natural selection operates. Similarly, to achieve anything close to an “optimal” outcome, the strategies available to be chosen by economic agents must be sufficiently diverse. The “natural selection” explanation of the moral hazard problem which I had elaborated upon in my previous post, therefore depends upon the toolset of banks’ strategies being sufficiently varied. The toolset available to banks to exploit the moral hazard subsidy is primarily determined by two factors: technology/innovation and regulation. The development of new financial products via securitisation, tranching and most importantly synthetic issuances with a CDS rather than a bond as an underlying which I discussed here, has significantly expanded this toolset.
The story of one optimal strategy outcompeting all others is also dependent on environmental conditions being stable. Quoting from Nelson and Winter: “If the analysis concerns a hypothetical static economy, where the underlying economic problem is standing still, it is reasonable to ask whether the dynamics of an evolutionary selection process can solve it in the long run. But if the economy is undergoing continuing exogenous change, and particularly if it is changing in unanticipated ways, then there really is no “long run” in a substantive sense. Rather, the selection process is always in a transient phase, groping toward its temporary target. In that case, we should expect to find firm behavior always maladapted to its current environment and in characteristic ways—for example, out of date because of learning and adjustment lags, or “unstable” because of ongoing experimentation and trial-and-error learning.”
This follows logically from the ‘Law of Competitive Exclusion‘. In an environment free of disturbances, diversity of competing strategies must reduce dramatically as the optimal strategy will outcompete all others. In fact, disturbances are a key reason why competitive exclusion is rarely observed in ecosystems. When Evelyn Hutchinson examined the ‘Paradox of the Plankton’, one of the explanations he offered was the “permanent failure to achieve equilibrium” . Indeed, one of the most accepted explanations of the paradox is the ‘Intermediate Disturbance Hypothesis’ which concludes that ecosystem diversity may be low when the environment is free of disturbances.
Stability here is defined as “stability with respect to the criteria of selection”. In the principal-agent selective process, the analogous criteria to Darwinian “fitness” is profitability. Nelson and Winter’s objection is absolutely relevant when the strategy that maximises profitability is a moving target and there is significant uncertainty regarding the exact contours of this strategy. On the other hand, the kind of strategies that maximise profitability in a bank have not changed for a while, in no small part because of the size of the moral hazard free lunch available. A CEO who wants to maximise Return on Equity for his shareholders would maximise balance sheet leverage, as I explained in my first post. The stability of the parameters of the strategy that would maximise the moral hazard subsidy and accordingly profitability, ensures that this strategy outcompetes all others.
I have argued previously that the moral hazard explanation of the crisis fits the basic facts i.e. bank balance sheets were highly levered and invested in assets with severely negatively skewed payoffs. But this still leaves another objection to the moral hazard story unanswered – It was not only the banks with access to cheap leverage that were heavily invested in “safe” assets, but also asset managers, money market mutual funds and even ordinary investors. Why was this the case?
A partial explanation which I have discussed many times before relies on the preference of agents (in the principal-agent sense) for such bets. But this is an incomplete explanation. Apart from not being applicable to investors who are not agents, it neglects the principal’s option to walk away. A much better explanation that I mentioned here and here is the role of extended periods of stability in creating “moral hazard-like” outcomes. This is an altogether more profound and pervasive form of the moral hazard problem and lies at the heart of the Minsky-Holling thesis that stability breeds loss of resilience.
It is important to note that such an outcome can arise endogenously without any government intervention. Minsky argued that such an endogenous loss of resilience was inevitable but this is not obvious. As I noted here: “The assertion that an economy can move outside the corridor due to endogenous factors is difficult to reject. All it takes is a chance prolonged period of stability. However, this does not imply that the economy must move outside the corridor, which requires us to prove that prolonged periods of stability are the norm rather than the exception in a capitalist economy.”
But it can also arise as a result of macro-stabilising fiscal and monetary policies. Whether the current crisis was endogenous or not is essentially an empirical question. I have argued in previous posts that it was not and that the “Greenspan Put” monetary policy did as much damage as all the explicit bailouts did. The evidence behind such a view has been put forth well by David Merkel here and by Barry Ritholz in his book or in this excellent episode of Econtalk.