Category Archives: financial markets

Banking vs. Transparency

Posted on by

Tri Vi Dang, Gary Gorton, Bengt Holmstrom. and Guillermo Ordonez write,

banks produce private money because they can keep the information that they produce about backing assets secret. By being opaque, banks can produce bank money more efficiently. Opacity makes it prohibitively costly for an expert investor to find out information about the details of the bank’s balance sheet, eliminating the expert’s informational advantage. Opacity also mutes the effects that public information may have on the value of the bank’s assets. By keeping information symmetric among traders, opacity makes trading in bank money liquid.

All of this was explained in chapter 6 of From Poverty to Prosperity, the book that I wrote with Nick Schulz in 2009 (later re-issued as Hidden Wealth). On p. 224-225, we write

the assumption of complete transparency, in which any individual knows all of the risk being taken by everyone in the economy, is not merely unrealistic, it assumes away the reason for financial intermediation in the first place. . .a lack of complete transparency is built into the basic function of financial intermediation.

In my admittedly biased opinion, the narrative description in that chapter is much richer than the “model” that the four authors (including the most recent Nobel Prize winner) develop. Information about risks is not a binary phenomenon in which it is either public or not. People and the institutions that employ them have different access to information and different skills in processing it. That is what makes financial intermediation in the real complex–more complex than any model can capture.

Empirical Public Policy

Posted on by

James R. Barth and Stephen Matteo Miller write,

Testing whether it is good policy to increase bank capital requirements from 4 percent to 15 percent requires calculating and comparing the benefits and costs of such a change. Across all tested cases, it becomes clear that the benefits of increasing the capital ratio from 4 percent to 15 percent equal or exceed the costs.

This is an interesting example to discuss.

1. I am very confident that I could find problems with their methodology. This is an area in which empirical analysis is much less definitive than the authors suggest. I would say that their abstract is an example of lack of humility.

2. Nonetheless, I am very sympathetic to their conclusion.

3. In fact, many economists, left and right, are sympathetic to their conclusion. It would be hard to find a prestigious academic economist who is opposed to higher capital requirements for banks than what we have now. Unless these guys count.

4. But I bet that in fact capital requirements for banks will remain low, almost surely with obscure loopholes that make them even lower than the stated levels. It would not surprise me to find that capital requirements are so low that they are not binding, meaning that many banks will maintain capital ratios well above the minimum.

5. Speaking of my opinions, in Specialization and Trade I claim that government intervention in markets generally consists of subsidizing demand and restricting supply. This is inconsistent with any optimal intervention to address market failure.

6. Another presumption of mine is that housing policy will be dysfunctional. In addition to subsidizing demand and restricting supply, it will discourage saving and instead encourage indebtedness.

My claims in (4) -(6) might fall under the heading of “empirical public policy.” That is, what sorts of public policies can we expect? These questions are under-researched. On the other hand, economists over-research the topics of market failure and optimal policy solutions.

Implicit in this research imbalance is a very optimistic view of government intervention. It helps ingratiate economists with people in power. In effect, the economist says to the politician, “You are a wonderful public servant. I, the wise technocrat, am here to help you in your benevolent endeavors.”

Thus, the empirical policy economist is both obsequious and self-flattering. What gets lost is the opportunity to provide the public with a realistic comparison between the political process and the market process.

Finance: Practitioners vs. Economists

Posted on by

Pablo Fernandez writes,

If all investors had identical expectations,
A) Trading volume in financial markets would be very small. However, the trading volumes of many markets are
huge.
B) All valuations of the shares of a company should coincide. However, there are huge differences in stock
valuations (analysts, investment banks, consultants, financial companies …)
C) The return required for the shares of a company should be identical in all valuations.
D) The expected cash flows of the shares of a company should be identical every year in all valuations.

Since our world is not characterized by any of the four above characteristics, how can one even insinuate the
hypothesis of homogeneous expectations?

My thoughts:

1. I think that the models developed by financial economists have some value, unlike those of Keynesian macroeconomists.

2. However, the fiction of the “representative investor” is problematic for some of the reasons that the fiction of the “representative agent” is problematic in mainstream macro.

3. Economists tend to assume that the conflict between financial practitioners and financial economists should be resolved in favor of economists. To some extent, this has happened, as index funds and Black-Scholes option pricing became important in practice. But as Fernandez points out, financial practice still differs sharply from what models say that it ought to be, and the economists seem to be unwilling to explore why this is the case.

Reframing Financial Regulation

Posted on by

That is a new compendium from Mercatus. I wrote one of the essays, on risk-based capital.

The way I see it, the main purpose of central banking and financial regulation is to try to allocate credit to uses favored by political leaders. These leaders want credit to be cheap and available for government borrowing and for residential mortgages. So we should not be surprised that risk-based capital requirements are used to reward banks that put money into those assets.

In the essay, I explain why risk-based capital regulation has not served the intended purpose of reducing financial risk.

Did SarbOx concentrate wealth?

Posted on by

Marc Andreessen points out,

Microsoft went public in 1986, valued at $300m. It went to $300bn. Public shareholders got a thousand-time rise. When Google went public in 2004, it had about a $30bn valuation and went to about $300bn. Investors got about a 10-time rise. Facebook went public at about $100bn. It’s now $200bn, so public investors have had a two-time rise.

Pointer from Tyler Cowen.

Why is more value being captured in the pre-public phase than in the post-public phase? My guess is that Sarbanes-Oxley and the hostile environment to public corporations in general probably accounts for some of it. The consequence is that ordinary Americans capture a smaller share of wealth creation from growing companies than they used to.

Freddie, Fannie, and so-called Privatization

Posted on by

The WaPo reports,

Steven Mnuchin, President-elect Donald Trump’s nominee to lead the Treasury Department, said Wednesday that privatizing Fannie Mae and Freddie Mac is “right up there on the top-10 list of things we’re going to get done,” setting off a buying frenzy among investors.

I am very leery of this. My preferred approach for getting the government out of the mortgage market is the following:

1. Immediately stop any government support for cash-out refinances, second mortgages, and investor loans. Restrict support to owner-occupied purchase mortgages or refinances that lower the rate and term of the mortgage without the borrower taking out equity. Leave all the other mortgages to the private sector.

2. Gradually lower the maximum loan amounts for government support. As you do this, the private sector will have to fill in. If somebody steps up to issue mortgage-backed securities, fine. If instead what emerges is a model with banks holding the mortgages they originate while using long-term funding methods, then that is fine, too.

If you were to suddenly “privatize” Freddie and Fannie, you might end up restoring the status quo prior to 2008, with these institutions enjoying “too big to fail” status. They can use that status to borrow cheaply in credit markets and behave like hedge funds. I can remember when they were doing exotic things involving securities denominated in foreign currency that had nothing to do with their supposed “mission” of helping housing. These exotic transactions did not cause the firms to blow up then–because they blew up on credit risk instead.

I really detest the model of privatized profits and socialized risks. If you are going to privatize Freddie and Fannie, then you have to figure out a regulatory scheme to avoid socializing the risks. It’s not easy.

The Minnesota Plan for Big Banks

Posted on by

Neel Kashkari explains,

Today, banks can enjoy their explicit or implicit status as being TBTF potentially indefinitely. In contrast, the Minneapolis Plan puts a hard deadline on Treasury: Certify banks as no longer TBTF within five years, or else that bank will see dramatic increases in capital requirements. We believe the threat of these massive increases in capital will provide strong incentives for the largest banks to restructure themselves so that they are no longer systemically important.

Pointer from Mark Thoma. TBTF is, of course, too big to fail.

I endorse this approach. However, instead of the threat consisting of dramatic increases in capital requirements, I think that the threat ought to be to have the Treasury break up the banks. In effect, the government would be saying, “Either you break yourselves up, or we do the break-up for you.” I am confident that every large bank would come up with a divestment plan.

Keep in mind that the top financial institutions all grew through mergers and acquisitions. It is not as if any of them just naturally grew larger because of some unique ability to serve customers. As a result of these agglomerations, the largest institutions are too complex to be managed effectively. My guess is that breaking them into “smaller” units (I put smaller in quotes, because even after divestment these institutions would still be gigantic on a world historical scale) would not result in a large loss in total market value. It might very well result in an increase.

I should emphasize that smaller institutions are not necessarily less risky financially. But when they do fail, there are many feasible alternatives to bailouts. When a financial giant is about to fall, no Treasury Secretary can sleep at night unless there is a bailout.

Trust and Banks

Posted on by

Erika Vause writes,

No institution more clearly relies on trust than the bank. That is precisely what makes banks a lightning rod for suspicion. From the time modern banking emerged, it has been the subject of intense misgivings. Many of these suspicions are with us still.

This issue gets much more attention in Specialization and Trade than it does in standard economic textbooks, but reading Vause’s essay makes me think that there is even more involved. The role of materialism is one example. That is people, including most economists, want to see value reduced to tangible properties of things, such as capital and labor input. A prerequisite for understanding finance is a willingness to acknowledge the large intangible components of value, including the components that consist of trust and financial intermediation.

Greenspan and Financial Regulation

Posted on by

In his new biography of Alan Greenspan, Sebastian Mallaby says some things I agree with, but he also rides a number of hobby horses that I take issue with.

Where I agree:

1. I agree that it is hard to achieve financial soundness through regulation. Financial markets are too flexible and adaptive to prevent institutions from gaming the system. If you want to see that point made at greater length, read my essay The Chess Game of Financial Regulation.

2. From 1970 to 1990, we got rid of interest rate ceilings on deposits, restrictions on bank branches, and futile attempts to distinguish commercial banking from investment banking. The process was long and grueling, with lobbyists engaged in furious rent-seeking battles all along the way. What Mallaby points out, and that I hadn’t considered, is that when the dust settled, we had a more rational, integrated competitive financial sector, but we had the same archaic, fragmented regulatory structure. So we had a separate regulator for thrifts, even though institutions with thrift charters were doing things that the thrift regulator had never seen before. The same with commercial banks, insurance companies, and investment banks. It was a regulatory structure that was set up to fail.

Where I disagree:

1. Mallaby buys into the theory that Brooksley Born should have gotten her way and had all derivatives trading moved to exchanges. I disagree. It is possible to trade derivative contracts in Treasury bonds and bills on exchanges, because the underlying securities are generic and liquid. Traders can benchmark prices and cheaply engage in arbitrage transactions. What AIG and others were doing involved creating a separate credit default swap for each security. In effect, Born would have been asking the exchanges to set up hundreds of different markets, most of which would have been illiquid in terms of the underlying securities.

If Greenspan was reluctant to wade in with financial regulatory proposals, that may have been because he thought that the issues were over his head. In fact, that may be what I most respect about Greenspan. Regulators generally do not see their own limitations. Brooksley Born would be a prime example of a regulator willing to take on a task while lacking sufficient knowledge.

2. Although I agree with Mallaby on the challenges of reining in financial excesses using regulation, he takes the view that monetary policy can and should be used to prick bubbles. He writes as if a major lesson, perhaps even the main lesson, of the financial crisis is that central banks should raise interest rates to pop bubbles. He writes as if this is obvious, when in fact very few economists see it that way, even now. In fact, Timothy Taylor recently pointed to an IMF study saying that global debt is at an all-time high, and only on the extreme right are there economists suggesting that monetary policy needs to be tightened. The other day, I got to attend a talk by Mallaby and I posed this issue. He agreed that his views were not widely shared by the mainstream (the people who complain about low interest rates as a threat to financial stability tend to be on the far right), but he said that one of the perks of writing the book was putting his opinions out there. Fair enough.

3. Mallaby blames the crisis in part on inflation targeting. He sees this policy as the mindless result of Fed officials’ not-entirely-rational preference for low, stable inflation. He could have pointed out that it was the overwhelming consensus of academic economists of the 1980s and 1990s that low, stable inflation was exactly the right objective for monetary policy. They believed that demand-driven recessions were the result of the public’s errors in expectations about inflation. Get rid of those errors by stabilizing inflation, so the thinking went, and you would eliminate recessions. This was known as the so-called Divine Coincidence, because it meant that the Fed could just focus on keeping the rate of inflation steady and let full employment take care of itself.

4. Mallaby takes a cheap shot at the Basel II approach to risk-based capital requirements, in which regulators were to use a bank’s model of its risks to gauge the amount of capital it should have. He compares this to giving a teenager the keys to the Mercedes. (a) I think that Greenspan had retired before Basel II was widely implemented. Most banks, perhaps even all banks, were still on Basel I, which used risk buckets. (b) Rather than being silly, using models was a good idea. The Basel I approach treated a bank that hedged its risks and a bank that went unhedged as identical. Basel I had no coherent way of dealing with derivatives or securities with embedded options, such as mortgage-backed securities. You need to use a model to solve both of those problems. And because every bank codes its portfolio differently, it is impractical to try to input the data into any model other than the one that the bank itself uses. Since you cannot try other models on the data, the best you can do is audit the way the bank goes about its modeling process.

It’s not a perfect way to regulate, but there is no obviously better way. At his talk, Mallaby emphasized that he did not think that any regulatory policy could truly rein in risk-taking. This gets back to point 1 under “Where I agree.”

Grumpy About Stock Market Trading Volume

Posted on by

John Cochrane writes,

We know what this huge volume of trading is about. It’s about information, not preference shocks. Information seems to need trades to percolate into prices. We just don’t understand why.

…If you ask a high speed trader about signals about liquidating dividends, they will give you a blank stare. 99% of what they do is exactly inferring information from prices — not just the level of the price but its history, the history of quotes, volumes, and other data. This is the mechanism we need to understand.

I would be so desperate as to posit a taste for trading, aka Adam Smith’s “propensity to truck and barter.” I would actually want to examine what psychological mechanisms make investment managers decide that the portfolio mix that they held one second ago is not the right mix now.