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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