Macroeconomic Resilience

Richard Fisher of the Dallas Fed delivered a speech last week( h/t Zerohedge) on the topic of financial reform, which delivered some of the most brutally honest analysis of the problem at hand that I’ve seen from anyone at the Fed. It also made a few points that I felt deserved further analysis and elaboration.

The Dynamics of the TBTF Problem

In Fisher’s words: “Big banks that took on high risks and generated unsustainable losses received a public benefit: TBTF support. As a result, more conservative banks were denied the market share that would have been theirs if mismanaged big banks had been allowed to go out of business. In essence, conservative banks faced publicly backed competition…..It is my view that, by propping up deeply troubled big banks, authorities have eroded market discipline in the financial system.

The system has become slanted not only toward bigness but also high risk…..if the central bank and regulators view any losses to big bank creditors as systemically disruptive, big bank debt will effectively reign on high in the capital structure. Big banks would love leverage even more, making regulatory attempts to mandate lower leverage in boom times all the more difficult…..

It is not difficult to see where this dynamic leads—to more pronounced financial cycles and repeated crises.”

Fisher correctly notes that TBTF support damages system resilience not only by encouraging higher leverage amongst large banks, but by disadvantaging conservative banks that would otherwise have gained market share during the crisis. As I have noted many times on this blog, the dynamic, evolutionary view of moral hazard focuses not only on the protection provided to destabilising positive feedback forces, but on how stabilising negative feedback forces that might have flourished in the absence of the stabilising actions are selected against and progressively weeded out of the system.

Regulatory Discretion and the Time Consistency Problem

Fisher: “Language that includes a desire to minimize moral hazard—and directs the FDIC as receiver to consider “the potential for serious adverse effects”—provides wiggle room to perpetuate TBTF.” Fisher notes that it’s difficult to credibly commit ex-ante not to bail out TBTF creditors – as long as the regulator retains any amount of discretion with the purpose of maintaining systemic stability, they will be tempted to use it.

On the Ineffectiveness of Regulation Alone

Fisher: “While it is certainly true that ineffective regulation of systemically important institutions—like big commercial banking companies—contributed to the crisis, I find it highly unlikely that such institutions can be effectively regulated, even after reform…Simple regulatory changes in most cases represent a too-late attempt to catch up with the tricks of the regulated—the trickiest of whom tend to be large. In the U.S. financial system, what passed as “innovation” was in large part circumvention, as financial engineers invented ways to get around the rules of the road. There is little evidence that new regulations, involving capital and liquidity rules, could ever contain the circumvention instinct.”

This is a sentiment I don’t often hear expressed by a regulator – As I have opined before on this blog, regulations alone just don’t work. The history of banking is one of repeated circumvention of regulations by banks, a process that has only accelerated with the increased completeness of markets. The question is not whether deregulation accelerated the process of banks’ maximising the moral hazard subsidy – it almost certainly did and this was understood even by the Fed as early as 1983. As John Kareken noted, “Deregulation Is the Cart, Not the Horse”. The question is whether re-regulation has any chance of succeeding without fixing the incentives guiding the actors in the system – it does not.

Bailouts Come in Many Shapes and Sizes

Fisher: “Even if an effective resolution regime can be written down, chances are it might not be used. There are myriad ways for regulators to forbear. Accounting forbearance, for example, could artificially boost regulatory capital levels at troubled big banks. Special liquidity facilities could provide funding relief. In this and similar manners, crisis-related events that might trigger the need for resolution could be avoided, making resolution a moot issue.”

A watertight resolution regime may only encourage regulators to aggressively utilise other forbearance mechanisms. Fisher mentions accounting and liquidity relief but fails to mention the most important “alternative bailout mechanism” – the “Greenspan Put” variant of monetary policy.

Preventing Systemic Risk perpetuates the Too-Big-To-Fail Problem

Fisher: “Consider the idea of limiting any and all financial support strictly to the system as a whole, thus preventing any one firm from receiving individual assistance….If authorities wanted to support a big bank in trouble, they would need only institute a systemwide program. Big banks could then avail themselves of the program, even if nobody else needed it. Systemwide programs are unfortunately a perfect back door through which to channel big bank bailouts.”

“System-wide” programs by definition get activated only when big banks and non-banking financial institutions such as GE Capital are in trouble. Apart from perpetuating TBTF, they encourage smaller banks to mimic big banks and take on similar tail risk thus reducing system diversity.

Shrink the TBTF Banks?

Fisher clearly prefers that the big banks be shrunk as a “second-best” solution to the incentive problems that both regulators and banks face in our current system. Although I’m not convinced that shrinking the banks is a sufficient response, even a “free market” solution to the crisis will almost certainly imply a more dispersed banking sector, due to the removal of the TBTF subsidy. The gist of the problem is not size but insufficient diversity. Fisher argues “there is considerable diversity in strategy and performance among banks that are not TBTF.” This is the strongest and possibly even the only valid argument for breaking up the big banks. My concern is that even a more dispersed banking sector will evolve towards a tightly coupled and homogenous outcome due to the protection against systemic risk provided by the “alternative bailout mechanisms”, particularly the Greenspan Put.

The fact that Richard Fisher’s comments echo themes popular with both left-wing and right-wing commentators is not a coincidence. In the fitness landscape of our financial system, our current choice is not so much a local peak as a deep valley – tinkering will get us nowhere and a significant move either to the left or to the right is likely to be an improvement.

The Franken Amendment draws upon Richardson and White’s idea of a centralised clearing platform which I had criticised earlier. This proposal is based upon a flawed understanding of the structured products’ ratings process and the incentives guiding the agencies during this process and arises from a false extrapolation of the corporate and sovereign bond ratings process into the realm of structured products.

The fatal flaw in our ratings regime is not the issuer-pays model but the fact that ratings agencies only get paid if the bond is issued. In the structured products space, the difference between a potential AAA rating and a AA rating is not just that a higher spread is paid to the investor on the bond. The lower rating usually means that the bond will not be issued at all, which means that the ratings agency will not earn any fees. This problem cannot be solved even if we have a single monopolistic ratings agency paid by the SEC, so long as the fees are payable only upon issuance of the bond. As I have discussed earlier in more detail, ratings agencies are incentivised not only to expand market share but to expand the size of the market for rateable securities.

Let me explain the logic with a simple example. A pension fund approaches a bank for a bespoke AAA tranche on a portfolio of mortgage-backed securities. The bank constructs an appropriate tranche paying Libor + 100 bps and asks for a rating, upon which the clearing platform allocates it an agency. The agency comes back with a AA rating instead – so what does the bank do in this instance? It cannot change the tranching without damaging its own economics and the client will not accept a AA tranche paying the same coupon. So the deal just does not get done and the ratings agency is left without any fee for its opinion.

Let us go a little further along this chain of thought – all competing agencies are similarly stringent in their ratings and discover after six months that their earnings and dealflow have collapsed! At this point, they will of course gradually start easing their ratings requirements and sooner or later we will end up in the same position we were in before the crisis hit us. Its worth noting that this outcome does not change if someone other than the issuer pays the agency or even if we have a monopolistic ratings agency. Provided that the agency is a profit-maximising entity, the removal of direct competition may slow the process of easing of ratings criteria, but it will not change the end result.

In fact, the above example is too generous as it ignores the ease with which the centralised platform process can be gamed by banks. The central problem here is the fact that there are a multitude number of structured bonds that can fulfill a typical client request, such as the one above. For example, let us assume that the bank above constructs a tranche from a portfolio of MBS and applies to the platform which allocates it to Moody’s. If Moody’s comes back with an unsatisfactory rating, it cancels the issuance, makes a small modification to the portfolio and tranching and tries its luck again. The process can continue until the bank gets allocated to a more friendly ratings agency and the desired rating is achieved.

The fundamental issue here is that tinkering with the system in this manner is futile – the problems inherent in our current financial system are too fundamental and we have only two choices as I hinted at in an earlier post. We can either put in place blunt and almost certainly efficiency-reducing regulations or we can move towards a free-market system where the implicit and explicit protection provided to the banking sector is removed in a credible and time-consistent manner. To give you a simple example of a blunt regulation that will reduce the potential for ratings arbitrage, we could legislate that if a portfolio of sub investment-grade assets cannot be tranched to produce a AAA tranche. The price we pay for such regulations is that we eliminate a significant proportion of legitimate tranching, but this trade-off is unavoidable.

It was only a matter of time given the focus on the Goldman-SEC case before someone decided to apportion some of the blame onto the ratings agencies. And sure enough, the New York Times has a story out on how the ratings agencies were an integral part of the problem because they gave banks free access to their models and ratings methodology. But this is true of all banking regulations – banking regulators too make their rules, models and methodology freely available to banks who then proceed to arbitrage these rules, primarily to minimise the capital that they are required to hold. This is not surprising given that ratings agencies are essentially an outsourced function of the banking regulatory apparatus. And the problem of arbitrage is also well-known – I have referred to it as the Goodhart’s Law of financial regulation.

The NYT article implicitly suggests that increasing the opacity and ambiguity around the ratings methodology would have resulted in a better outcome. This is similar to how Google tries to discourage people from trying to arbitrage its search algorithm by keeping it opaque. Just keeping the algorithm private is not enough as search-engine optimisers soon figure out the key features of the algorithm by experimenting with what works and what does not, which means that Google needs to continuously modify the algorithm to stay one step ahead of the arbitrageurs.

Maintaining a continuously updated, opaque algorithm is not a suitable strategy for ratings agencies. Even if a banker does not know the exact ratings methodology, he can easily figure out the key features just by running a large number of sample portfolios through the ratings system and analysing the results. Moreover, ratings methodologies that are unpredictable by design can create unnecessary ratings volatility and friction in financial markets. And last but not least, ratings agencies have no incentive to engage in such an arms race with the banks given that they get paid by the bank only when a deal gets done.

The role of ratings agencies in exacerbating the financial crisis has been exaggerated. As David Merkel puts it, “Don’t blame the rating agencies for the failure of the regulators, because they ceded their statutory role to the rating agencies.” The mad rush to buy AAA bonds in the boom wasn’t as much a function of the irrational faith in ratings agencies as it was a function of the rational desire to obtain extra yield whilst not falling foul of internal and external rules and regulations. Even internal control functions in firms often limit the scope of investments by specifying minimum required ratings and then assume that this requirement makes all further supervision of the manager redundant. Unsurprisingly, the manager prefers even an expensive AAA to a cheap BBB bond.

It seems that Obama has come around to Paul Volcker’s position that “protected” financial institutions must not be allowed to take on proprietary risk. In this interview in Der Spiegel, Paul Volcker argues that banks must not be allowed to take on proprietary risk except for risk incidental to “client activities”. Quoting from the interview:

“SPIEGEL: Banking should become boring again?

Volcker: Banking will never be boring. Banking is a risky business. They are going to have plenty of activity. They can do underwriting. They can do securitization. They can do a lot of lending. They can do merger and acquisition advice. They can do investment management. These are all client activities. What I don’t want them doing is piling on top of that risky capital market business. That also leads to conflicts of interest.”

This is a more nuanced version of the argument that calls for the reinstatement of the Glass-Steagall Act. But it suffers from two fatal flaws:

Regulatory Arbitrage: Separation of “client risk” and “proprietary risk” sounds good in theory but it’s almost impossible to enforce in practise. As I’ve discussed previously, a detailed and fine-tuned regulatory policy will be easy to arbitrage and a blunt policy will result in a grossly inefficient financial system.

Losses on “Client Activities” were the major driver in the current crisis. My analysis of the UBS shareholder report highlighted how the accumulation of super-senior CDO tranches was justified primarily by their perceived importance in facilitating the sale of fee-generating junior tranches to clients. Quoting from the report: “within the CDO desk, the ability to retain these tranches was seen as a part of the overall CDO business, providing assistance to the structuring business more generally.” It is the losses on these tranches issued in the name of facilitating client business that were at the core of the crisis. It is these tranches that caused the majority of the losses on banks’ balance sheets. It is losses on insuring these tranches that brought down AIG. Segregated proprietary risk is monitored closely by almost all banks. The real villain of the piece was proprietary risk taken on under the cover of facilitating client business.

Implementation of the Ban

Clearly a simple ban on internal hedge funds and proprietary trading desks would not work. All banks trade the same product on their client’s behalf that they do on a proprietary basis and such a ban can be nullified simply by folding all proprietary operations into trading desks that also facilitate client business.

Another alternative would be to enforce market risk limits on banks, based on VaR for example. If VaR was the criteria in enforcing risk limits on banks in the previous crisis, the crisis would not have been averted. The super-senior CDO tranches at the heart of the crisis were low VaR assets on their own and “zero VaR” assets when merely delta hedged without any hedging of higher-order risks.

Again quoting from the UBS report: “MRC VaR methodologies relied on the AAA rating of the Super Senior positions. The AAA rating determined the relevant product-type time series to be used in calculating VaR. In turn, the product-type time series determined the volatility sensitivities to be applied to Super Senior positions. Until Q3 2007, the 5-year time series had demonstrated very low levels of volatility sensitivities. As a consequence, even unhedged Super Senior positions contributed little to VaR utilisation.” “Once hedged, either through NegBasis or AMPS trades, the Super Senior positions were VaR and Stress Testing neutral (i.e., because they were treated as fully hedged, the Super Senior positions were netted to zero and therefore did not utilize VaR and Stress limits). The CDO desk considered a Super Senior hedged with 2% or more of AMPS protection to be fully hedged. In several MRC reports, the long and short positions were netted, and the inventory of Super Seniors was not shown, or was unclear. For AMPS trades, the zero VaR assumption subsequently proved to be incorrect as only a portion of the exposure was hedged as described in section 4.2.3, although it was believed at the time that such protection was sufficient.”

To summarise, it is extremely unlikely that there exists a way to ban proprietary risk-taking that cannot be circumvented by the banks.

Much of the debate regarding the causes of the financial crisis ignores the fact that we live in a “second best” world. The “Theory of the Second Best” states that in a world that is far from a textbook “free market”, any move towards the theoretical free market optimum does not necessarily increase welfare.

Our current financial system is clearly far from a free market. The implicit and explicit guarantee to bank creditors via deposit insurance and the TBTF doctrine is a fundamental deviation from free market principles. On the other hand, derivatives markets are among the least regulated markets in any sector.

This second-best, hybrid nature of our financial system means that any discussion of the crisis must be strongly empirical in nature. Deductive logic is essential but a logical argument with incomplete facts can be made to fit almost any conclusion. So the Keynesians blame the free market and deregulation, the libertarians blame government action and the behavioural economists blame irrationality. But no one stops to consider any facts that don’t fit their preferred thesis.

The key conclusion of my work is that it is the combination of the moral hazard problem driven by bank creditor guarantees and the deregulated nature of key components of the financial system that caused the crisis. This is not a new argument. The argument for regulation itself rests on the need to protect the taxpayer in the presence of this creditor guarantee. The Fed recognised this argument as early as 1983. As John Kareken noted, “Deregulation Is the Cart, Not the Horse”. The growth of the CDS and other derivatives markets was not a problem by itself. It caused damage by enabling the banks to maximise the value of the free lunch derived from the taxpayer. The same could be said for bank compensation practices.

If re-regulation could work, then I’d be in favour of it. But I don’t think it can. As I’ve discussed before (1,2,3), almost any regulation will be arbitraged away by the banks. The only regulations that may be difficult to arbitrage are blunt and draconian regulations which will dramatically reduce the efficiency of the system. Even then, the odds of arbitrage are not low enough.

In an earlier note, I discussed how monitoring and incentive contracts can alleviate the asymmetric information problem in the principal-agent relationship. Perfect monitoring, apart from being impossible in many cases, is also too expensive. As a result, most principals will monitor to the extent that the expense is justified by the reduced incentive mismatch. In most industries, this approach is good enough. The menu of choices available to an agent is usually narrow and the principal only needs to monitor for the most egregious instances of abuse.

In fact, this was the case in banking as well until the advent of derivatives. Goodhart’s Law by itself does not guarantee arbitrage by the agent – the agent also needs a sufficiently wide menu of choices that the principal cannot completely monitor or contract for.

As discussed in an earlier note, agents in banking have a strong incentive to enter into bets with negatively skewed payoffs. The limiting factor was always the supply of such financial instruments. For example, supply of AAA corporate bonds has always been limited. Securitisation and tranching technology increased this limit substantially by using a diverse pool of credits with a lower rating to produce a substantial senior AAA tranche. But the supply was still limited by the number of mortgages or bonds that were available.

The innovation that effectively removed any limit on the agent’s ability to arbitrage was the growth of the CDS market and the development of the synthetic CDO. As the UBS shareholder report notes:

“Key to the growth of the CDO structuring business was the  development of the credit default swap (”CDS”) on ABS in June 2005 (when ISDA published  its CDS on ABS credit definitions). This permitted simple referencing of ABS through a CDS. Prior to this, cash ABS had to be sourced for inclusion in the CDO Warehouse.”

Steve Waldmann’s recent post explains why giving financial regulators discretion in choice of policy is almost always a bad idea. In his words:

“An enduring truth about financial regulation is this: Given the discretion to do so, financial regulators will always do the wrong thing.”

The reason of course is the time consistency problem . The temptation for the regulator and central bank to use their “discretion” to bail out the banks is overwhelming. The market will correctly equate a discretionary regulatory environment to be a bailout-prone one. As Lacker and Goodfriend observed in their paper on central bank lending policies in times of crisis:

“The problem with adding variability to central bank lending policy is that the central bank would have trouble sticking to it, for the same reason that central banks tend to overextend lending to begin with. An announced policy of constructive ambiguity does nothing to alter the ex post incentives that cause the central banks to lend in the first place.”

But what about the alternative? Would a regulatory environment that is written in stone perform any better? Most likely it would not – regulations that are written in stone suffer from Goodhart’s Law. The clearer and more detailed the regulation, the easier it is for market participants to arbitrage it.

Goodhart’s Law is the reason why algorithm-based technology services such as Google and Digg prefer to keep their algorithm private and opaque. However, as we’ve discussed above, discretion and opacity is not an option in financial regulation.

So how do we avoid arbitrage without having to resort to discretion and ambiguity in the regulatory framework? Goodhart’s Law is applicable only when we focus on intermediate targets that we presume are good proxies for our objective. The answer is to shift focus from intermediate proxy indicators of excessive risk, such as executive compensation or capital requirements, to the ultimate objective itself.

But is this even achievable? For example, Google and Digg have no option but to focus on a reasonable accurate proxy. The same may be true for financial regulation.

In his interview in Der Spiegel, Paul Volcker argues that banks must not be allowed to take on proprietary risk except for risk incidental to “client activities”. Quoting from the interview:

“SPIEGEL: Banking should become boring again?

Volcker: Banking will never be boring. Banking is a risky business. They are going to have plenty of activity. They can do underwriting. They can do securitization. They can do a lot of lending. They can do merger and acquisition advice. They can do investment management. These are all client activities. What I don’t want them doing is piling on top of that risky capital market business. That also leads to conflicts of interest.”

This is a more nuanced version of the argument that calls for the reinstatement of the Glass-Steagall Act. But it suffers from two fatal flaws:

• Regulatory Arbitrage: Separation of “client risk” and “proprietary risk” sounds good in theory but it’s almost impossible to enforce in practise. As I’ve discussed previously, a detailed and fine-tuned regulatory policy will be easy to arbitrage and a blunt policy will result in a grossly inefficient financial system.
  
• Losses on “Client Activities” were the major driver in the current crisis. My analysis of the UBS shareholder report highlighted how the accumulation of super-senior CDO tranches was justified primarily by their perceived importance in facilitating the sale of fee-generating junior tranches to clients. It is the losses on these tranches issued in the name of facilitating client business that were at the core of the crisis. It is these tranches that caused the majority of the losses on banks’ balance sheets. It is losses on insuring these tranches that brought down AIG. Segregated proprietary risk is monitored closely by almost all banks. The real villain of the piece was proprietary risk taken on under the cover of facilitating client business.

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.