Showing posts with label Free Market Fallacies. Show all posts
Showing posts with label Free Market Fallacies. Show all posts

Saturday 3 June 2017

Global FX Code of Ethics: If You Have to State the Obvious, You Obviously Have a Real Problem

Annual Manifestation of the Free Market God at the AEA

Regular readers of this blog will have noticed that AA has little faith in the myth of the “self-regulating free market”.  Just last week  AA’s scant faith was confirmed yet again.

On 25 May the central bank-led Foreign Exchange Working Group (FXWG) in partnership with the private sector Market Participants Group (MPG) released a global code of conduct for the wholesale foreign exchange (FX) market.
The first principle of six in the Code is Ethics.  
This section of the Code calls on market participants to inter alia “strive for the highest ethical standards”, “the highest professional standards”, as well as “identify and address conflicts of interest”.

But let's let the Code "speak" for itself with AA using boldface to highlight key ideas
“Market Participants should:
  • Act honestly in dealings with Clients and other Market Participants;
  • Act fairly, dealing with Clients and other Market Participants in a consistent and appropriately transparent manner; and
  • Act with integrity, particularly in avoiding and confronting questionable practices and behaviours.”
What this means in fewer words is that market participants should be honest and capable.

Two observations:

First, with reference to the “highest ethical standards” AA is at a loss to understand how being honest is an exemplar of “highest ethical standards”.  Are there ethical standards that allow one to be dishonest or act unfairly?  AA holds that being honest and acting fairly is like being pregnant.  One either is or is not.

Second, the six principles are not listed in alphabetical order.  Does the fact that ethics is placed first reflect an assessment by the FXWG and MPG (though perhaps the latter’s assessment is not as strong as the former’s) that there is a particular problem with ethics or more precisely a lack of ethics? If one has to make a point about what is self-evident, that seems to be an indication implication that practice is lacking.    

Does the need for promulgation of ethical standards refute the dogma of the self-regulating market?  If the market regulates itself, then such problems would be transitory and quickly remedied   

AA's parents and then AA himself spent a not inconsiderable sum on education, a good portion of which funded AA’s direct and indirect studies of economic dogma. 

It is an article of the Free Market faith that market forces driven by intense free market competition, act to indirectly compel ethical behavior among market participants.  Those who are unethical and act unfairly are displaced because customers flock to virtuous participants who act fairly and with high ethical standards.  This occurs even though the latter's salutary behaviour is motivated solely by the pursuit of profit not of virtue.  

That's the theory but this press release seems to confirm not the practice.

Friday 21 October 2016

SEC to Rely on FINRA to Monitor Brokerages

"Daddy, read me the story of the self-regulating market again"
If your daddy didn't read you this fairy tale when you were young, maybe your "Uncle" Milton told it to you at university.  Or a kindly professor relayed the Uncle's wisdom to you. 

If this didn't happen, here's a quick recap. 

Even if each businessman single-mindedly pursues his or her own profit to the exclusion of all other concerns, where there is intense competition of the "free" market (note that requirement) salutary outcomes result:
  1. individual or overall market excesses are magically curbed 
  2. firms offer the best service and prices, eventually competing profits away to zero unless, of course, they make improvements to products.  [Because profits never go to zero (except in bankruptcy) this no doubt proves the creative power of free markets to constantly improve products.]
  3. those firms that do not lower their prices or improve their products are forced out of business
Since by definition, the market in the USA is not only "free" but "intensely" competitive, then with such miraculous powers there is little if any need for government regulation.  In fact by interfering with the market, governments are liable to do more harm then good as this quote attributed to Mitt Romney demonstrates. 

The invisible hand of the market always moves faster and better than the heavy hand of government.

This theory seems to be the rationale for this recent SEC decision reported this Monday by Reuters.

The Securities and Exchange Commission is leaning more heavily on partner regulator the Financial Industry Regulatory Authority to monitor brokerages as it devotes extra staff to oversee the rapid growth of independent financial advisers, a top regulator said Monday
What could possibly be a reasonable objection to FINRA taking over SEC duties?

Simply put, FINRA is an industry group and therefore has an inherent conflict of interest. 

Does this mean that it is certain that they will fail to do a proper job or that they have failed in the past?  No.  What it does mean is that a conflict could cause them to fail.

What are some of the potential trouble "spots"?

  1. Setting professional qualification standards too low.  FINRA doesn't report the pass rates on its qualification exams (Series 7, etc).  The pass rates for the CFA, CFP, FRM are all reported and suggest these certifications are difficult to obtain.  Why is that?   
  2. Restricting information on actions against brokers.  If you'll recall a while back, FINRA was criticized for failing to provide enough information in its Broker Check (BC) tool to allow investors to determine whether to work with a particular broker.  FINRA announced some improvements but just recently the  Public Investors Arbitration Bar Association found those improvements lacking and criticized FINRA because BC doesn't include reasons for a broker's termination by a firm, information about bankruptcies, tax liens and scores on relevant industry examinations.  PIABA noted that some of this information is provided by state security regulators (government agencies) which suggests (but does not prove) that legal liability issues did not motivate these omissions.  
  3. Applying a light touch on penalties when perhaps a heavier one is justified.  In the past the maximum fine was $15,000 per "offense" in the NASD days. (FINRA is the combination of the "old" NASD and NYSE separate self-regulatory bodies).   This has changed. Fee levels have increased.   In 2016 FINRA is set for a record year of estimated fines of some $160 million due to some "supersized" fines.  ("Supersized" is defined as a fine $1 million or more).  The estimated 2016 total fines is less than the fines levied against Wells Fargo by government regulators for the "fake accounts" scandal. The last time I looked FINRA's largest 2016 fine was some $25 million against Met Life (2015 revenues $70 billion net income $5 billion).  See the analysis of these "ginormous" fines by Sutherland Asbill and Brennan here.  And here for K&L Gates' analysis of 2015 fines in which it's noted that most FINRA actions are resolved for less than $50,000.  It should be noted that FINRA fines individuals as well as firms and that many of the firms in the industry are minnows alongside the major brokerage firms so $50,000 could be a firm threatening fee. 
Just to be clear, I am not accusing FINRA of improper behavior.  I am merely pointing out a conflict of interest.

During his illustrious career, AA has seen a lot of conflicts of interest turn into conflicts of action. 

Here's one "sweet" story - not witnessed by AA.


Early warning signals of the coronary heart disease (CHD) risk of sugar (sucrose) emerged in the 1950s. We examined Sugar Research Foundation (SRF) internal documents, historical reports, and statements relevant to early debates about the dietary causes of CHD and assembled findings chronologically into a narrative case study. The SRF sponsored its first CHD research project in 1965, a literature review published in the New England Journal of Medicine, which singled out fat and cholesterol as the dietary causes of CHD and downplayed evidence that sucrose consumption was also a risk factor. The SRF set the review’s objective, contributed articles for inclusion, and received drafts. The SRF’s funding and role was not disclosed. Together with other recent analyses of sugar industry documents, our findings suggest the industry sponsored a research program in the 1960s and 1970s that successfully cast doubt about the hazards of sucrose while promoting fat as the dietary culprit in CHD. Policymaking committees should consider giving less weight to food industry–funded studies and include mechanistic and animal studies as well as studies appraising the effect of added sugars on multiple CHD biomarkers and disease development


Why take a risk with this conflict of interest? 

FINRA has a role to play.  

But should the SEC cede what is properly a government responsibility?


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.