Monday, 9 March 2009

Animal spirits, snake oil and big banks - what would you regulate?

Have banks become big by selling snake oil? If so, do we stop them selling snake oil or should we stop them becoming too big?

Robert Shiller wrote a column in Monday's Financial Times arguing that standard economic assumptions about the corrective behaviour of markets do not hold when set against recent findings by behavioural economists. In short: so-called rational agents demand things they want and their collective wants determine an equilibrium price; but there are also times when individuals demand things that they 'think' they want, based on what others are demanding. In such situations, individuals could even end up paying for snake oil if they were convinced enough that others also found snake oil valuable.

Shiller, a Yale professor, argues that, despite buyers not being able to fully evaluate the quality of financial assets, the market has managed to sell the financial equivalent of snake oil because of how the psychology of 'animal spirits' affects economic behaviour. Stories of people making money on, say, securitised mortgages led others to buy and sell these products without proper due diligence. The influence of 'animal spirits' on economic behaviour results in crises on a regular basis. (Shiller is the co-author of 'Animal Spirits' (Princeton University Press, 2009) along with George Akerlof, who won the Nobel Prize in 2001 for his seminal work on asymmetric information in the famous 1970 article, "The Market for 'Lemons'".)

If the above is correct, then the question for a policymaker or a regulator would be either to ensure that snake oil (a.k.a. dodgy assets) is not sold or that no financial institution becomes so big that it has to be bailed out when its own balance sheet is full of snake oil.

Last Friday, I had the opportunity to be a fly-on-the-wall in a closed-door meeting of central bankers, senior investment bankers and policymakers from around the world. They were discussing what had brought the world economy to its current state, what rules would be needed to prevent this in future, and what institutional reforms were needed to govern the new rules. I cannot mention what was discussed, but later I had a chance to pose three questions that I think are also relevant in light of Shiller's column:

1. As a central banker/regulator, is there a rule/principle/trigger that tells you that a bank or non-banking financial institution has become 'too big to fail'?

2. If not, what kind of boundaries would you put around different activities of financial institutions so that insurance companies, say, do not become hedge funds or put their fingers in so many pies that it is hard to distinguish between legitimate and dodgy transactions?

3. And how is the situation further complicated when institutions that previously operated as investment banks have now become deposit-taking institutions?

What do you think? Since many central bankers have previously been investment bankers, I'd especially like to hear from my banker friends. Information asymmetries are always going to hamper oversight by external agencies. So, if you had the responsibility of overseeing a healthy financial system, what would your answers be? Would you look out for animal spirits (individual behaviour), would you look out for snake oil (dodgy assets/transactions) or would you look out for financial institutions that had become 'too big' too soon?


Anonymous said...

Surely just three words are required to explain 95% of the current situation: "Fear and greed"?

Sharad Vohra said...

Having been in the center of the storm (yes I am a banker and yes I am a CDO Structuer and Marketer) there are a lot of lessons to be drawn from this financial crisis. The more I think about it and the more I see the markets drift to new lows, I conclude this crisis is a lot about the complete break-down of trust between the different market participants that made the financial system work for the last decade. We have seen the financial crisis take on a much greater force post-Lehman bankruptcy, when counterparties that normally traded on 10-15 year contracts with each other refused to face each other in overnight contracts!

I take the position that all the participants in the financial markets (regulators, central bankers, rating agencies, over-zealous bankers and investors) share some blame of where we are. It was a lack of financial oversight (on the part of regulators and central bankers), abundant liquidity and complete disregard for risk (on the part of banks, rating agencies and investors) that is the cause of this crisis. The so called 'toxic assets' that Geithner and Darling keep talking about do serve a purpose as does securitisation in general if done in a controlled manner.

Unfortunately, we are now in a situation which macro economists call 'over-shooting' and in these circumstances we now need the government to step in and restore some sort of equilibrium and stability in the markets. This of course is a slow and costly process (as we have seen with the bail-outs, fiscal stimulus and now the quantitative easing by the BOE and the ballooning deficits) but is much needed if we want the private sector to start participating. Notwithstanding the current crisis, I am still of the view that a capitalist system with more financial oversight, regulation and risk control is the way to go. This will foster innovation, which if done in the right manner makes the world economy more dynamic.

I will conclude by saying that I would look to monitor two aspects (individual behavior and dodgy assets) as we re-vamp the financial system and this would be achieved through pro-active industry regulation (both by an authority and self-regulation) that is forward looking and tries to accurately capture risk. If I can create a system that can achieve this then I feel I don't need to worry about 'too big to fail'.

srinidhi said...

I saw the first comment 'Fear and greed' and was tempted to say 'kaliyug'! Then I saw the comment by Sharad who says 'trust' is the main key. Which is also 'faith' in some ways or it could be 'values'!
It is not easy to get back to being smaller with all its extolled virtues, an assumption which in itself is questionable and the only way seems to be 'dharma' a global one as it were!

I suppose the real answer is that one hopes that a workable via media between communism and capitalism is rediscovered and is maintained or monitored and untill then it could be either 'hope' or being 'resigned' to our karma.

I am eaglerly looking forward to a dialogue amongst you in all seriouness. At my age all I want is to keep my 'hope' alive and I am tempted to say 'and kicking'
All the best.

Anonymous said...

Great blog Arunabha. On the post, am reading a lot of commentary on how economics is not a complete science - doesn't account for irrational human behaviour. That's the bigger question - policy and regulation cannot be based upon economic theories alone. Politics, sociology, law all have important lessons for policy.

Sunaina said...

Loved the post. By answer to your question is that none of those three options seem practically executable to me. You can't look out for animal spirits - your metrics would be fuzzy at best and I just don't know who would police individual behavior. You often don't know what is snake oil on an ex ante basis. In 2005, CDOs and securitization was innovative. The free market system was credited with spurring such financial "ingenuity". Hardly any one I know pointed out these structured derivatives as "dodgy assets" and those that did were ignored. Finally, too big too soon, though it seems the most feasible of the three, also is tricky to monitor. What are the cut-offs - is it market cap (it fluctuates with the market and assumes the market is rational), is it employees, is it balance sheet?

I would propose that central bankers consider targeting something other than inflation and employment/growth. How about targeting asset bubbles as much as inflation and growth. Second, I would suggest regulating the debt rate in overall economic and not allow an overburdened consumer, tightening lending standards etc. I hear talk of regulation but fear that no regulation will be able to prevent a hundred-year event created by an over-leveraged world. Asset bubbles and excess debt have been the causes of most depression-like events in history from tulips in Netherlands to Japan to the Swedish Banking Crisis to our current situation.

Nicholas Davis said...


First, I agree with Sunaina in that it's pretty hard to prove snake oil is snake oil, especially when the purveyors have massive resources and endless analysts with which to bamboozle. In the case of derivatives, having some form of x-ray vision to the composition of the underlying asset would be useful, though the problem is that wrapped and rated financial products don't really allow for that. But perhaps regulation can improve links to underlying assets by requiring originators to hold onto some of the downside.

Second, too-big-to-fail is such a nasty concept. We need to get away from the whole idea of managing such beasts and focus on designing financial institutions that can fail without bringing down the system, regardless of their size. This means standardizing and centralizing OTC markets, for example. The effort to pull down a failing bank might necessarily be proportional to its size, sure, but we should be taking the opportunity now to redesign the system so that no matter how big an institution gets, we can always carve it up and give bits to other, more efficient players without unleashing a Lehman-demon. Why maintain an environment in which Zombies thrive?

Third, people will always find clever ways to invest in dodgy things. We can definitely return to the days of clearly defined institutional functions in the financial system, and have laws to prevent firms stepping over the line. Heterogeneity has a lot going for it, not least as a good firewall in times of crisis. But we also need to confront the problem of risk management whereby people lever up on snake oil - whether that is helping people better understand what a snake look likes, or restricting their access to credit. Perhaps both.

Finally, the move to bank holding companies means that this has got easier - as I understand it, more regulation (reporting, capital requirements and supervision) applies to the banks as BHCs, and it is better that those funds and actions are under greater scrutiny. However I think you're right in suggesting that this move has implicitly meant the US has taken on a whole new heap of liabilities (to the tune of the client accounts held by the former Ibanks that are now guaranteed by the government). So let's hope the regulators are extra-incentivized to flush out any problems before the next demon arises.

A few of us over here in Geneva are working on this same issue, using Taleb's lovely novo-noun "robustification". You can read more about it on my blog - would love your comments there too!

Suvir Loomba said...

Is not the rampant "toxicity" of assets, in part, related to the inability
to value certain (complex) contracts that is more due to the breakdown of trust rather than inherent lack of value? These assets, including many ABS structures, are
reward and risk transfer mechanisms that play an important role. It is not
just the greed of banks, who acted more as salesmen than advisors, but also
the foolishness of "institutional" investors who bought these securities
without understanding the risks that caused the problem.

Banks are today being demonised when it is actually the regulators and
rating agencies, presumably guardians of public interest, that should have
questioned the pace at which these securities were absorbed by "unsuitable"
investor segments like pension, insurance etc. Not only that, the high
ratings given to securities backed by relatively "risky" assets means that
models used by the ratings agencies were highly questionable and not stress
tested for market failure scenarios.

Snake oil is useless, but all the securities currently under a freeze were not.
Animals eat within the laws of nature but investors hunted outside their
risk comfort zones. They were misled by rating agencies and relatively
niche investment banks rather than "big banks". Hence, it is not a ban on
snake oil, animal spirits or big banks that will help. We need market-savvy
regulators, solid rating models, better investor education and stronger
monitoring of institutional investor portfolios.

Anonymous said...

A (seemingly) virtuous cycle will most likely end in a vicious cycle. Aside fear, greed and "animal spirits", globalisation, performance benchmarking, peer comparisons, speed of information dissemination, mark-to-market accounting, innovation, behind-the-curve regulators and a financial system that's not restricted to just savings and loans will all help perpetuate this - whether its junk bonds, dot com stocks, housing/mortgage backed securities or (insert next bubble here... inflation?). You probably need to take away all of the above to eradicate boom and bust, which is impractical, maybe undesirable. But hopefully there's a way to avoid doing that, live with boom and bust but mitigate its effects...

I'm not smart enough to know what that may be, but believe strongly in something we should avoid when searching for it... and that's hindsight bias. Adding to those who've already mentioned it, we're all (rightly) hating snake oil for how its helped cripple a global financial system, but only with the benefit of hindsight. This doesn't by any means absolve the creaters and raters of snake oil of blame in terms of not forseeing what has happened or forsaking ethics in favour of meeting the bottom line. But what should also be highlighted here is that hindsight bias is crippling and may continue to be if we use it to regulate (maybe over-regulate?) the financial system. Just look at historical price distribution based risk management systems for an analogy... So whatever new regulations that come in, we may feel we've plugged the holes (repealing Glass Steagall, corporate governance checks post Enron, Worldcom)... but will they be relevant when the next bubble bursts?

Its time for bankers, regulators and politicians to (and i hate this phrase) "think outside the box" in that sense. How about tracking the runaway progress of any product (was it the result of a loophole being exploited or some regulation that's been arbitraged?), require that innovaters keep regulators in-step with what they're creating/selling rather than have it curbed or worse ignored. Create high barriers to entry for innovations so that if they transubstantiate into snake oil, scores of interconnected investors are not left holding the baby. How about central bankers applying their knowledge of the growth/inflation trade-off to the consumer level leverage/efficiency trade-off...

I guess this response hasn't followed the script, but hopefully it has generated some talking points and even better, some concrete ideas...

Prakash Kamath said...

With the collapse of the financial markets many 'Ponzi' schemes have surfaced which only goes to show that 'GREED' was indeed the driving force behind whichever financial schemes were being touted as the way to go forward be it 'derivatives', 'sub-prime' or whatever.

The end result is that whatever solution you may work out to resolve the situation and revive the financial institutions will require maximum outlay from all Governments - in other words the taxpayers. As a friend just jokingly mentioned recently that this is akin to an 'alcoholic' having a drink in a 'pub' without having to pay for it and end up having those who were teetotallers who have no connection to the 'alcoholic' having to settle the bill at a later date. The teetotallers would rather have abandoned their abstemious ways and at least had the satisfaction of having a few 'drinks' for which they are paying.

If Madoff, Stanford et al are being prosecuted why are so many heads of financial institutions being allowed not only to retire gracefully but shockingly are allowed generous 'golden' handshakes and pensions. Dont you think as a part of stabilising markets the first step is to prosecute all the people who have caused the crisis by venturing into 'exotic' financial instruments without considering the RISKS involved therein?

If nothing, in future all financial institutions will realise that they are not only accountable but the consequences of their dereliction of their duties could lead to a long spell behind bars. This is unlikely to happen so we will have a repeat of the current situation in another 20-30 years and the 'dialogue' will continue all over again.

C'est la vie!!

Gaurav Gujral said...

I’m probably not your target audience for this piece, but I found it extremely interesting to analyse from a policy perspective, and even though I’m not a banker, I’ll make some observations on where I think the gaps are and what we could do in the future to minimise the risk of such an event.

I agree with Nicholas that ‘too big to fail’ is somewhat a nasty concept. I would go a step further and say from a policy perspective, it is a very dangerous concept with an inherent moral hazard problem. It purports when a financial institution becomes systemically important (not be allowed to default on its credit obligations), it encourages excessive risk taking by its management (they are allowed to sell snake-oil and get rewarded for it, based on the current measures of performance), and are never really subject to the same levels of regulatory reprimand, as their smaller cousins.

I fear that with the recent policy measures of mutating a number of these investment banks to bank holding companies (BHCs), the problem is only exacerbated. These mega entities, beyond becoming national deposit-taking institutions are now doing everything from corporate and retail banking, capital market investments, over-the-counter, derivative’s trading, just stopping short of printing money!. An appropriate framework of financial regulation that emerges in the wake of these developments will now need to bring all of the activities of this mega-entity under much stricter oversight, disclosure and liquidity requirements, which would then have another casualty – Innovation.
In terms of principles/triggers, I think there is something to be said around monitoring the pace of balance sheet growth, broadening the purview of regulation to monitor off-balance sheet vehicles and also understanding counterparty risk.

I understand from my banker friends, that there is a further problem in prop-trading, where a financial institution’s assets are in bed with other private capital (e.g. private equity, hedge funds) and these are then packaged into loans, collateralised and sold to starry-eyed investors, transferring most of their credit risk. Suvir makes an important point about the role of Ratings Agencies, but here is another conflict of interest if you look at the incentive structures of how Ratings Agencies are compensated by their clients – the ‘too big to fail’ folks, selling the snake-oil. There are a number of these funds that themselves have become systemically important. So, when we talk of regulatory gap-filling, we need to think about how transactions like the one I mentioned above holds on to some degree to credit risk for the originator, penalises when Rating Agency puts a wrapper on a bottle of snake-oil with ‘lots of stars’ and finds a way to bring these shmancy systemically important private funds under stricter governance.

Now before I start sounding like a banker myself, I should stop.
I recently saw a fantastic, ballsy piece of journalism - John Stewart interviewing Cramer. Would'nt miss this one!