Welcome to European Tribune. It's gone a bit quiet around here these days, but it's still going.

Good bankers need not care about systemic risk

by Jerome a Paris Mon Apr 23rd, 2007 at 08:26:23 AM EST

I often say that a good banker is not a banker that makes the right analysis about the risks s/he takes, but one that makes the wrong analysis at the same time as other bankers. Well, the FT's Wolfgang Munchau, instead of telling us this week how France or Germany are messed up, agrees:

A risk shared may be more risky, not less

investors, eager to outperform the markets, take on two different types of risk during a boom. The first is a so-called “tail risk”, the kind of risk that caused the default of Long Term Capital Management almost 10 years ago. These are high risks with a very low probability of occurring, which offer high rewards. The second risk is herd behaviour, as investment managers do not want to underperform their competitors.

Mr Rajan says these two risks reinforce each other. During an asset price boom, investors are eager to take on the low probability tail risks, in the knowledge that others do the same. If the crash comes, they have at least not underperformed their competitors.

That's what we're seeing in financial markets right now: deals that are increasingly aggressive, because "that's where the market is": either you take these (unconsidered) risks, or you do no deals and your banks makes no income and you make no bonus.

Münchau even quotes Minsky: (see below)

The critical part of Minsky’s theory is that during an economic boom, an increasing number of investors gradually move from the first category [risk-averse who can meet their payment obligations out of current cash flows] to the second [speculative investors, who can do the same in the long run, but not necessarily in the short run] and third [Ponzi investors - someone who takes on new debt to meet current obligations, and hopes to finance the ever-rising debt through higher asset prices]. In a Minsky economy, instability is not due to some external shock, but is inherent in the system itself.

Minsky arrived at the pessimistic conclusion that the behaviour of financial markets is not self-correcting, and that this would justify heavy regulatory interference. While I do not agree with Minsky’s overall pessimism, I cannot fault the mechanism through which he derives internally-generated instability.

As Münchau rightly notes about Ponzi investors, "f you have an interest-only mortgage, then I am sorry to say you are in that category". And, as it were, an enormous chunk of mortages in the US in the past couple of years have precisely been in that category:

Similarly, in the banking world, you increasingly see interest-only loans, with principal repayments pushed back into the future and, worse, specific authorisations for investors to take money out of the assets (early dividends) early one, something that bankers usually frown upon - the whole point of lending is that you take less risk than owning the thing, because you have priority access to cash; if investors get their income before you, that deal kinda breaks down... But hey, "it's the market."

I don't want to go into too much detail of what my bank does, but one of the reasons I am working on offshore wind is that I consider it to be a safer bet in the current context: it's a new industrial sector, with little track record so far, something banks don't like too much because that means it's more risky, but it's not an unreasonable kind of risk to take: the long term outlook for renewable electricity is excellent, and any short term problems will have technical, real world, solutions not dependent on what "markets" think of your business or your asset.

We're getting closer and closer to the point where the herd realises that it's been doing crazy things, and when the stampede backwards starts. When it will happen, and what will trigger it is still unclear, but it is increasingly inevitable (one of the strangest things about the financial world today is that many banks seem aware of that risk, and have started hiring restructuring and distressed assets specialists - and yet everybody keeps on doing what "the market" is doing. The fact that a possible crisis is anticipated, and thus somehow discounted, will make the crash all the more unexpected, and thus brutal).

But as we know, once the true magnitude of the crisis hits, governments will be asked to - and they will need to, to avoid further damage to the real economy - step in and pick up the pieces. Systemic risk is still the grandest way for profits to be privatised while costs are socialised. So don't expect Münchau to push his logic to the point where he agrees that "heavy regulatory interference" is a good thing, because it would go against that.

"Look everyone, let's run this way!"

[Squeak, drop, splash]

Actually, it's not a bad strategy. If you know the government - those evil governments that waste money on welfare and other bad things - are going to step in and cover your arse if there's a major crisis, there's no incentive to be realistic about risk, and every incentive to be stupid about it.

What's missing is any element of personal responsibility.

Markets are an excellent mechanism for displacing the direct consequences of decisions from the decision makers to the powerless.

No wonder people like Munchau love them so much.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Mon Apr 23rd, 2007 at 08:35:35 AM EST
is that most bankers would tell you that there is actually a LOT of regulatory oversight. The whole Basle II framework to assess risk and allocate capital against it has created huge risk assessment bureaucracies in each bank; compliance requirements ("know your customer" checks to fight money laundering) are increasingly tough, etc...

And yet I have the feeling that banks will still be wrongfooted by the next big crisis. Either it's complacency because they think they're covered, or it's that bankers learnt the ropes and do deals that go around the guidelines while appearing to be within, or more likely that systemic risk is really, really hard to quantify and thus is ignored to a large extent (the low probability "inch wide, mile deep" fault).

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Mon Apr 23rd, 2007 at 08:42:25 AM EST
One of the biggest holes in capitalist theory is that decisions on investment are taken by employees within large organizations. Since their goal is to maximize their own revenue/social position/security, not the returns for the firm, the entire mechanism is skewed from what the theory predicts.

Furthermore, banking seems to me to be one of the most over-concentrated businesses where smaller deals that require expertise are no longer profitable on the scale that makes organizational sense and there is little  competition except for the biggest deals.

by citizen k (sansracine yahoo.fr) on Mon Apr 23rd, 2007 at 08:58:04 AM EST
[ Parent ]
Well, I guess in theory the enterprise will design the remuneration package in order to align the interests of the employees with those of the firm. The problem is that the people making those decisions are also employees ...
by Colman (colman at eurotrib.com) on Mon Apr 23rd, 2007 at 09:09:16 AM EST
[ Parent ]
This comes down to the structure of the "Corporation" and it's inherent "Principal/Agency" conflict between the owner shareholders and the management.

I believe that the solution to this problem lies in a corporate body which shares the revenues or production between Capital providers and Capital users: the "Capital Partnership" as I call it, is enabled by simple new legal forms like the US LLC and UK LLP.

In this model there are no "employees", merely managing and operating "partners".

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Mon Apr 23rd, 2007 at 12:11:52 PM EST
[ Parent ]
Once the organisation gets beyond a certain size you'll have the same problems. Someone is going to have to run the thing and the problems of agency come up immediately.
by Colman (colman at eurotrib.com) on Mon Apr 23rd, 2007 at 12:18:53 PM EST
[ Parent ]
The "Open Corporate" LLC/LLP I am developing and implementing is not an "organisation" but a framework within which individuals "self organise".

It's the "chaordic" approach envisaged by Dee Hock when setting up Visa.

Except I envisage (as did he, but the Banks would have none of it) that individuals - as well as intermediaries - would be members of the "chaordic" "partnership of partnerships" or "cooperative of cooperatives" that constitutes the enterprise model that results.

If a managing partner has a pre-agreed share of production or revenues then agency does not come into it.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Mon Apr 23rd, 2007 at 12:35:50 PM EST
[ Parent ]
Employees all the way down. And then note that the managers of the largest stockholdings are also employees and the entire structure looks quite peculiar.
by citizen k (sansracine yahoo.fr) on Mon Apr 23rd, 2007 at 02:45:50 PM EST
[ Parent ]
Not only that.
Just consider the US mortgage market. As I understand it (from reading on the Internet) one simplified way of getting a mortgage was:
  • go to a mortgage brokerage
  • they´ll get you a loan from a bank (and a commission for that)
  • the bank then will bundle x loans/mortgages together and sell them to investors.

Mortgage broker and bank both have their money. That´s actually both of the instances that deal directly with a customer. Any risks stay with the investor (not mentioning the clauses for an eventual buy-back).

And they handed out sub-prime and Alt-A mortgages to people with 0% down-payment, no documentation of income, teaser rates or negative amortization.
Why could they do it? Because they got rid of the risk.

So they looked only for market share and their commissions. Employees, mortgage brokerages and banks. Worked fine for a time in a booming housing market.
Now of course, several mortgage companies have declared bankruptcy. But for years, brokers got their bonuses and I suspect the owners of the bankrupt companies didn´t evolve into paupers either.

I suspect the theory didn´t include the possibility of transferring the risk to others. :)

by Detlef (Detlef1961_at_yahoo_dot_de) on Mon Apr 23rd, 2007 at 03:20:44 PM EST
[ Parent ]

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Mon Apr 23rd, 2007 at 08:58:14 AM EST
I'm waiting for the derivative market to experience a prolonged monetary contraction.  I haven't actually written and run a simulation, primarily because I don't care any more, but I think loses will be much greater than expected (possibly over 100%!) due to a thin secondary market and the fact the downside of a leveraged financial instrument is greater than the upside.  

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre
by ATinNM on Mon Apr 23rd, 2007 at 11:07:40 AM EST
What's the demographic breakdown of people who primarily play with derivatives?

Is it primarily pension fund managers, or primarily mavericks and hedge fund 'activists'?

I'm thinking if it's the latter - too bad.

The former might be more of a problem, of course.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Mon Apr 23rd, 2007 at 12:18:51 PM EST
[ Parent ]
I dunno what the money breakdown is, but all the big banks have huge derivative portfolios both for themselves and indirectly since they loan the money for traders.
by citizen k (sansracine yahoo.fr) on Mon Apr 23rd, 2007 at 03:35:24 PM EST
[ Parent ]
Pension funds, Money Market Banks, International Banks, hedge funds, arbitrage firms, the big stock market companies, buy-out firms, "privatization" companies, mutal fund companies, major international corporations, & etc & so on.

Even some goverments have gotten into the act.  

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Mon Apr 23rd, 2007 at 06:42:16 PM EST
[ Parent ]
From my perspective, it seems fragile. But maybe it is really doing what it is supposed to be doing and managing risk. The problem comes if the models are wrong and an assumption that A goes down only when B goes up runs into a situation in which they both drop like rocks.
by citizen k (sansracine yahoo.fr) on Mon Apr 23rd, 2007 at 10:44:27 PM EST
[ Parent ]
I agree that the principal risk - and it is truly systemic - is the "rush for the exit" liquidity risk.

But beyond this, I think that the increasingly consolidated clearing houses
have become - unrecognised by most commentators - entities which constitute "single points of failure" undercapitalised for the risks that they actually run (as opposed to those they THINK they run).

IMHO, in the energy and/or metals markets at least, a "fat-tailed" market "discontinuity" is inevitable in the near future.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Mon Apr 23rd, 2007 at 12:23:47 PM EST
[ Parent ]
Since my diary on Minsky, I realized that his term "Ponzi finance" refers to companies looking for money, while I was talking more about behaviour of the other side - investors. Basically, I argued that investing into markets became "the way" to earn life, people are not only encouraged but basically forced to participate (via pension funds), and the market is growing predominantly because of ever increasing money supply (=share demand).

How to characterise role of investors in the scary picture of financial collapse? What is "Ponzi" about what they do? Do investors become Ponzi monsters as well by chasing leverages?

One of casual explanations of financial "overheatings" is "too much money chasing to few assets". That certainly refers to investors. Can we say, that in this situations money gets pilled into pyramides one way or other?

Anyway, it must be good to understand the picture from both sides - companies and investors.

The big question: who is buying the shares now? Evaluations of markets go through the roof again, but the last week saw big increases in volume, especially on Friday. What is happening? Why? Was there a trigger? Who is buying the stuff?

by das monde on Tue Apr 24th, 2007 at 01:15:48 AM EST
brings other interesting perspectives and names:
The Financialization of Capitalism
by John Bellamy Foster

[The] monopoly capitalist economy, Baran and Sweezy suggested, is a vastly productive system that generates huge surpluses for the tiny minority of monopolists/oligopolists who are the primary owners and chief beneficiaries of the system. As capitalists they naturally seek to invest this surplus in a drive to ever greater accumulation. But the same conditions that give rise to these surpluses also introduce barriers that limit their profitable investment. [For] the owners of capital the dilemma is what to do with the immense surpluses at their disposal in the face of a dearth of investment opportunities. Their main solution from the 1970s on was to expand their demand for financial products as a means of maintaining and expanding their money capital. On the supply side of this process, financial institutions stepped forward with a vast array of new financial instruments: futures, options, derivatives, hedge funds, etc. The result was skyrocketing financial speculation that has persisted now for decades.

[In] 1984 James Tobin, a former member of Kennedy's Council of Economic Advisers and winner of the Nobel Prize in economics in 1981, [told]:

I confess to an uneasy Physiocratic suspicion... that we are throwing more and more of our resources...into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity. [...] I fear that, as Keynes saw even in his day, the advantages of the liquidity and negotiability of financial instruments come at the cost of facilitating nth-degree speculation which is short-sighted and inefficient... I suspect that Keynes was right to suggest that we should provide greater deterrents to transient holdings of financial instruments and larger rewards for long-term investors.

In sharp contrast to those like Tobin who suggested that the rapid growth of finance was having detrimental effects on the real economy, Magdoff and Sweezy [claimed] that financialization was functional for capitalism in the context of a tendency to stagnation.

(1) Financialization can be regarded as an ongoing process transcending particular financial bubbles. If we look at recent financial meltdowns beginning with the stock market crash of 1987, what is remarkable is how little effect they had in arresting or even slowing down the financialization trend. [...]

(3) Ownership of very substantial financial assets is clearly the main determinant of membership in the capitalist class. The gap between the top and the bottom of society in financial wealth and income has now reached astronomical proportions. [...]

(4) A central aspect of the stagnation-financialization dynamic has been speculation in housing. This has allowed homeowners to maintain their lifestyles to a considerable extent despite stagnant real wages by borrowing against growing home equity. As Pollin observed, Magdoff and Sweezy "recognized before almost anybody the increase in the reliance on debt by U.S. households [drawing on the expanding equity of their homes] as a means of maintaining their living standard as their wages started to stagnate or fall." But low interest rates since the last recession have encouraged true speculation in housing fueling a housing bubble. Today the pricking of the housing bubble has become a major source of instability in the U.S. economy. Consumer debt service ratios have been rising, while the soaring house values on which consumers have depended to service their debts have disappeared at present. The prices of single-family homes fell in more than half of the country's 149 largest metropolitan areas in the last quarter of 2006 (New York Times, February 16, 2007).

So crucial has the housing bubble been as a counter to stagnation and a basis for financialization, and so closely related is it to the basic well-being of U.S. households, that the current weakness in the housing market could precipitate both a sharp economic downturn and widespread financial disarray. Further rises in interest rates have the potential to generate a vicious circle of stagnant or even falling home values and burgeoning consumer debt service ratios leading to a flood of defaults. The fact that U.S. consumption is the core source of demand for the world economy raises the possibility that this could contribute to a more globalized crisis.

(7) The growing financialization of the world economy has resulted in greater imperial penetration into underdeveloped economies and increased financial dependence, marked by policies of neoliberal globalization. One concrete example is Brazil where the first priority of the economy during the last couple of decades under the domination of global monopoly-finance capital has been to attract foreign (primarily portfolio) investment and to pay off external debts to international capital, including the IMF. The result has been better "economic fundamentals" by financial criteria, but accompanied by high interest rates, deindustrialization, slow growth of the economy, and increased vulnerability to the often rapid movements of global finance.

Possibly, interests of super-rich "monopolists" may not not fuel "doom machine" much by itself, but their "exemplary" status may make a herd of wannabes blind.

by das monde on Tue Apr 24th, 2007 at 06:12:19 AM EST

Go to: [ European Tribune Homepage : Top of page : Top of comments ]

Top Diaries