Friday, 30 September 2016

Metadiscussion on "Are Big Banks Safer?"

Often More Dogmatic and Less Scientific

Natasha Sarin and Lawrence Summers of Harvard published a draft paper for the BPEA Conference in September titled “Have big banks gotten safer?
The authors use a market-based methodology to answer the question whether banks are safer now than they were before the Great Financial Crisis (or as AA prefers to call it The Almost a Second Great Depression) given global regulatory actions.
This post is not meant as an analysis or critique of their work.  Rather I’m using their paper to pose some larger questions about economics, particularly market-based economics. Think of this post as metadiscussion on themes in their paper. 
Before I begin a few disclosures. 
I think that economics is not a science per se, though a scientific approach is useful as a heuristic tool in approaching the topic, e.g., defining terms carefully and as precisely as possible and most importantly recognizing the limits of the endeavor.  The economy is a complex not a complicated system. Therefore, it cannot be successfully modeled.  All the mathematics in the world cannot change this fundamental fact.
Like many who toil in the financial world, I was raised on the prevailing standard economic theory that invests so-called “free markets” with magical wisdom and efficiency. That theory posits that markets are self-regulating, that is, if left to their own processes, they reach a stable full employment (as defined) equilibrium. Extraneous shocks not anything inherent in the market itself cause economic problems.  Vigorous competition keeps participants in the economy “honest” and largely results in maximizing social benefits. Government regulation and taxes distort these virtuous operations. Market prices represent the best available valuation of assets, if not always, then generally.      
As my language suggests, I am not a true believer.  It’s not that I think markets have no value.  It’s that I do not think they are omniscient.  Markets are also inherently unstable, that is, economic problems result from factors within the markets not just extraneous shocks.  Market outcomes do not always maximize social value.  Market valuations can stray from real value for prolonged periods.  Homo economicus is fiction.   That I suppose puts me in the Minskyite camp. 
To start things off, quotes from the abstract in the Sarin/Summers paper.  The quote is in italics.  I’ve boldfaced a few points that I want to use as springboards for my own comments.
“Since the financial crisis, there have been major changes in the regulation of large financial institutions directed at reducing their risk. Measures of regulatory capital have substantially increased; leverage ratios have been reduced; and stress testing has sought to further assure safety by raising levels of capital and reducing risk taking. Standard financial theories would predict that such changes would lead to substantial declines in financial market measures of risk. For major institutions in the United States and around the world and midsized institutions in the United States, we test this proposition using information on stock price volatility, option-based estimates of future volatility, beta, credit default swaps, earnings-price ratios, and preferred stock yields. To our surprise, we find that financial market information provides little support for the view that major institutions are significantly safer than they were before the crisis and some support for the notion that risks have actually increased. This does not make a case against the regulatory approaches that have been pursued, but does caution against complacency.

We examine a number of possible explanations for our surprising findings. We conclude that financial markets may have underestimated risk prior to the crisis and that there may have been significant distortions in measures of regulatory capital. While we cannot rule out these explanations, we believe that our findings are most consistent with a dramatic decline in the franchise value of major financial institutions, caused at least in part by new regulations. This decline in franchise value makes financial institutions more vulnerable to adverse shocks. We highlight that the ratio of the market value of common equity to assets on both a risk-adjusted and risk-unadjusted basis has declined significantly for most major institutions. Our findings, if validated by others, may have important implications for regulatory policy.

Now to some comments.

When Results Differ from Theory, Question Theory

When results differ from what theory predicts, one sensible approach is to question the theory itself, especially in this case as markets have a history of mis-valuing assets, e.g., the dotcom boom, real estate, etc.     

While the authors do not specifically raise this point, they seem to accept that the market is not always right.  We conclude that financial markets may have underestimated risk prior to the crisis”.   If markets were wrong then, why should we trust them now?  If markets were carried away by irrational exuberance then, perhaps they are being carried away by rational pessimism now.  

Beyond that how many times does the market have to be wrong before we conclude that standard financial theory on markets is wrong or deficient?  That is of course a dangerous step that could well undermine the bases for a lot of economic dogma and the politics that dogma supports.

If we assume that markets indeed can value assets with reasonable accuracy, it’s prudent to ask whether they can value some assets better than others.  Thus, is the market price for a Picasso as “good” (accurate) as the market price for a US Treasury bond? 

Financial institutions are black boxes of risk unlike a lot of other listed firms.  What gives the market the insight to value them?  

If you believe Mr. Dimon, and I sure hope you do, senior management at JPMorgan had no idea that the CIO was engaged in risky trading (instead of hedging), that risk control was ineffective, and that rogue whales were in London, even apparently when traders at other institutions publicly pointed out that one JPMC trader was significantly moving the CDS market. 

Mr. Stumpf has testified before the US Congress that he “knew nothing” about creation of bogus accounts, despite employees contacting the bank’s compliance and ethics department and some employees mentioning this is lawsuits filed for wrongful dismissal. 

Taking their statements at face value and AA knows no reason not to (I’m definitely senior management material), if the CEO with access to inside information doesn’t know, how does the market?

Regulators get to peer into these black boxes. In the case of large banks in the US they get "invited" (or more accurately invite themselves) to station personnel inside the box.  They get regular detailed reports on assets, trading positions, and can compel the FI to provide more information. If so motivated, regulators can meet with bank officers to raise questions.  Even with this access regulators appear to have trouble regulating banks.  What about the market gives it insights beyond regulators?  Or do regulators "see" but not "see" for other reasons?

The market doesn’t have the same level and detail of information as regulators nor can it force the FI to give it more.  On what basis does the market form an opinion?  If it is operating on less than complete information, is its market price more directional than locational?  That is, it identifies troubled institutions but may not have estimated their true value.  If so, then caution has to be used with results based on market values.

By contrast, it’s much easier, but not easy, to value a manufacturing firm.  These firms generate physical goods whose acceptance by customers can be tracked. Market share is going up or down.  Margins are increasing or decreasing.  Think of the saga of Blackberry.  But even in these cases, value is directional not locational.  That being said, there is always the counter case, e.g., Sunbeam, where “clever” practices can hide the rot in the underlying business. 

If Theory is Sound, Make Sure You Have Met the Conditions

Next are questions about the “market”. 

As I understand standard financial theory, there are some requirements for a market. 

Three guys trading among themselves infrequently is definitely not a market.  A market where participants have colluded (think LIBOR, think FX, think …) to “fix” prices in not a market.

To the extent that these markets’ prices are inputs into the valuation of securities, then one would have to question the accuracy of price determination of those other securities. 

Even where markets are not manipulated, they may not meet the test of a real market.  In which case their price “discovery” may be wildly inaccurate. It’s no secret that the only true bond market qua market is that for USG securities.  Other bonds trade infrequently and in too small numbers to meet the underlying requirement that the market price reflect the outcome of differing views among a multitude of participants.  CDS isn’t a real market.    

Don’t Push Theory Beyond Where It Functions

Related to this is pushing an assumed sound theory too far.  

Some years back, a client showed me an analysis he had received from a competitor.  It was a masterful piece of mathematics applying the Capital Asset Pricing Model etc. to various countries, showing individual country betas and cost of capital. I don’t remember all of the countries, but do remember that Finland and Bahrain were included. 

I noted that Nokia was roughly 70% of the value (market capitalization) of the Finnish market and so it seemed to me that the Finnish market was essentially Nokia idiosyncratic risk.  Since diversification of idiosyncratic risk is a key requirement for the CAPM etc, application of the theory was "dubious" at best.  I expressed doubts that the liquidity of the Bahrain market met the test for a "market".  What does a market price mean when there is no or almost no trading?

Look for Factors that Cause Theory to “Break Down”

But if we do have “real” markets that can generally estimate prices with reasonable accuracy, can there be factors that disrupt price discovery? 

After JFK was assassinated and after 9-11, the NYSE fell dramatically.  For 9-11 it was the largest one day fall since the Great Depression. And the market was closed until 17 September.  While horrific, these events did not wipe out billions in real value.   Liquidity preference, uncertainty, and outright bed wetting fear drove the market down. 

Similarly, there have been markets that imagined value creation e.g., the dotcom boom.   The authors recognize this with their conclusion that markets underestimated risk before the GFC. 

Given that admission, how do we know when to trust the market’s judgment?

It was an article of faith at the highest levels of at least one major country’s economic management apparatus that it is impossible to determine the occurrence of a bubble until after it pops.   I believe that maestro also held that markets self-regulate away excesses.  Views it is clear that worked very very well in theory, but less so in practice.

Are there any factors that could explain a similar pessimism and divergence from real value today?  While the NBER pronounced the GFC ended in 2009, there has not been the usual recovery.  Economic growth is anemic.  Central banks across the world are engaged in unprecedented intervention in financial markets that some fear is distorting markets and sowing the seeds for future busts.  Some are worried that conditions will remain so weak that unwinding intervention will not be possible without plunging the world back into GFC2.  Markets are jittery.    

As a sector, banks have been identified as the key culprits responsible for the GFC.  Thus, against the general worry about the economy, banks have pride of place as more risky than other firms.  If that weren’t enough to drive perceptions of bank risk higher, banks have also been repeatedly shown to be (a) apparently ethically challenged in the conduct of business--not just with respect to mortgage securities, but Libor rate setting, FX trading, and recently the creation of dummy customer accounts--and (b) lax or incapable of applying laws relating to sanctions, money laundering, etc.  Some institutions are serial offenders, “financial recidivists” as Ms. AA calls them.   Additionally note that the unprecedented central bank intervention is directly focused on the financial sector and thus on banks.  

In some cases, regulatory settlements have imposed onerous conditions on businesses and hefty fines while only deferring prosecution – leaving that risk “unsettled”.  In other cases, settlements have yet to be reached.  In one case regulators have opened what appears to be public haggling over the size of the fine –not something that is likely to calm market jitters. 

Compliance issues like trading losses appear all of a sudden.  One day everything is fine the next day the fur hits the fan. 

How does one quantify regulatory risk emanating from a "black box"?

In such an environment investors sensibly would demand higher risk premia.  Since the true risk is unknown and thus unquantifiable, that premium would be large to cover the unknown.  Perhaps larger than necessary?

Investors no doubt are also worried about the uncertain and potentially unfair results of civil suits, e.g., Arab Bank and the one against HSBC and several other major EU banks.   Something the government has little to no control over. And the results of which are left to the whims of judges and impartiality of juries.    

 Are You Conclusions Well Grounded?

Does this mean that bank franchise values have gone down?  

It depends. 

It depends on the accuracy of the two value points being compared. 

If the market underestimated risks before the GFC, then the market overestimated pre-GFC franchise values.  In this case, how can you make a comparison?

But it get worse.  Once you accept that the market made a single valuation "mistake", then you've accepted that it can make others.

So, why should one have more confidence in the current valuation? 

Particularly when economic conditions are not "normal":  a very anemic recovery and extraordinary central bank policies.  Conditions that have obtained for at least eight years despite the NBER's pronouncement. 

Nominal and Real Values

While one might compare nominal values, I think that “real” values (to the extent they might be known) would be more important for policy considerations.

But it has to be a challenge to untangle multiple factors affecting bank security prices to identify the main driver.  Well, at least, it’s hard for AA.

Wrapping Up

At this point, I’ve come back full circle to  where I began: skepticism about economics and market wisdom/valuations.

Don’t read the above as necessarily saying that market prices are “rubbish”, but rather that they are not infallible just as the market is not infallible.   A great deal of skepticism, caution, and humility has to be brought to bear when applying economic or financial theories to the real world.            

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