Moral Hazard and Conventional Wisdom

Was moral hazard, in the form of expectations of a bailout, responsible for the reckless behavior that led to the banking crisis? James Surowiecki argues, quite convincingly I think, that the moral hazard argument is overrated:

In order to believe that the banks engaged in reckless behavior because they assumed that if they got into trouble, the government would bail them out, you have to believe not only that financial institutions thought it would be fine if their share prices were driven down to near-zero as long as they were rescued in the end. You also have to believe that the banks knew that what they were doing was reckless, and that there was a meaningful chance that it would wreck their companies, but decided that it was still worth doing because if everything went south, the government would step in. And that, even before Dimon’s comment yesterday, always seemed improbable, because all of the accounts of the banks’ behavior in the years leading up to the crisis suggest that most of them were swept up in housing-market hysteria like everyone else.

In a way, the moral-hazard argument ascribes far too much foresight, intelligence, and rationality to the banks. It assumes they were coldly calculating the chances and consequences of failure and forging ahead nonetheless, when the reality seems to be that for the most part they were blissfully ignorant and arrogant about the flaws in their lending and investment strategies.

I think Surowiecki is correct as far as he goes, but he doesn’t go far enough. To me the interesting question is, just why were bankers so ‘blissfully ignorant and arrogant’? The Epicurean Dealmaker provides an eloquent answer:

I also explained that the fast pace and high pressure of the business tend to attract individuals who do not attach great importance to deep, theoretical, or introspective thought. Rather, quickness of intellect, nice interpersonal judgment, and a certain calculating capacity akin to the ability of practiced chess players to think several moves ahead are the most valuable and prized attributes in my industry. What I did not explain was the natural corollary to these observations; namely, that due to their vocational preoccupations and intellectual predispositions, investment bankers tend to be extremely adept and quick at sussing out and acting on what is commonly known as the conventional wisdom.

This should not be surprising, either. After all, investment bankers spend all their waking hours figuring out and relaying to clients what "the market thinks" about deals, securities, and prices. Investment banks are gatekeepers to the markets, whether underwriting securities, trading financial instruments, or structuring and executing mergers and acquisitions. And what is the market itself but a gigantic, multi-tentacled, complexly interlinked engine for the real-time calculation of conventional wisdom? Figuring out, anticipating, and shaping conventional wisdom is what investment bankers do. It is the ocean in which we swim.

(More words of wisdom from TED can be found here).

The Regulator's Dilemma

If there’s one idea that has achieved consensus over the past few months, it is that regulators were asleep at the switch as the credit bubble inflated. A better regulatory system would have preempted the bubble, precluded the need for bank bailouts, and saved the world much misery.

If only it were that easy!

Imagine that you are the regulator in charge of the banking industry. What are your aims?

Well, on the one hand you want to prevent ‘unwarranted’ bank runs. An unwarranted bank run is one in which the bank did nothing wrong, and is actually well-capitalized, but due to ‘irrational’ investor panic faces a potentially life-threatening short-term funding gap. Preventing unwarranted bank runs is what lies behind well-known CB catchphrases such as “contagion”, “systemic risks”, “lender of last resort”, and “too big to fail”.

On the other hand, you as the regulator are (moderately) in favor of ‘warranted’ bank runs. If a bank does something stupid, it should pay. Depositors should withdraw their money from badly-run banks, and you don't want to stand in their way. You don't want to bail out the incompetent; that’s deeply unfair to the competent, and it messes up incentives all through the system. (To quote one famous investor, “Bailouts are bad morality as well as bad economics”).

Unfortunately, these two aims are fundamentally incompatible. Because smart bankers will simply pile into precisely those trades which pose systemic risks!

Why should a banker take the trouble to build a unique portfolio, thus exposing himself to all sorts of idiosyncratic risk factors? If these idiosyncratic factors go against him, he will appear (uniquely) stupid, and will probably not be bailed out. It’s much better for him to pile into the same trade as everyone else¹. Then if things go sour, it will be a systemic crisis and so everyone will be bailed out, including the banker in question.

(This insight is nothing new; it is merely the compensation dynamic for 1 trader on a desk of 10 traders, applied to 1 bank in an economy of 10 banks, with bailouts substituting for bonuses.)

In fact the situation is even more perverse than it appears. A standard measure of trade quality is the risk-reward ratio: the lower this ratio, the better the trade. But if systemic crises and consequently bailouts are in play, then the reasoning becomes inverted. Losses from low-risk trades are, by definition, small; hence low-risk traders are unlikely to be bailed out. Conversely, losses from high-risk trades are, by definition, large and potentially life-threatening; hence high-risk traders will often be backstopped by the government. This is moral hazard at its most pernicious.

It gets worse. The more enthusiastically people herd into one (systemically risky) trade, the higher the odds of a bailout; the higher the odds of a bailout for a particular trade, the more people will want to enter that trade. Yes, it’s our old friend, positive feedback!

So what’s a well-meaning regulator to do? There are only two coherent choices, really: put an end to bailouts, or put an end to bank proprietary trading.

Sadly, I don’t see either of these happening.

Footnotes

# ¹ Throughout this post I use ‘trades’ as a convenient short-hand for ‘institutional strategic decisions’.

Bubbles and the Rational Trader

A few weeks ago, Paul Krugman wrote a lengthy essay on the history of macroeconomic thought for the New York Times Magazine. His article prompted a flood of commentary both pro and con; I do not propose to add to this deluge.

I do however want to take issue with one particular assumption that runs through both the original article, and through many of the responses to it (from both left and right). This assumption has to do with the relationship between rationality and bubbles.

One group of economists argues that traders are rational and markets are efficient; hence bubbles (if they do arise) are likely to be short-lived and self-correcting. Since markets are largely self-regulating, the role of government is to intervene as little as possible¹.

Another group argues that traders are often irrational and markets are often inefficient; hence bubbles may last a long time before eventually (and painfully) bursting. Since markets cannot be trusted 100%, the role of government is to intervene whenever necessary.

Some members of the interventionist crowd go further: they take the (to them, self-evident) existence of bubbles as proof that traders are not rational.

Meanwhile, some members of the non-interventionist crowd invert this logic: they assume the rationality of traders to argue that bubbles cannot in fact exist (“the price is always right”).

Running through all these arguments is the assumption that rational traders will not foster bubbles; indeed, that they will trade against any bubbles that they encounter.

This assumption is wrong. Ask any experienced macro hand what he would do when confronted with an incipient or actual bubble, and the answer comes pat: ride the trend. Contribute to the bubble’s expansion, don’t counter it.

Why is it rational to ride bubbles?

The first reason is the simplest: it is exceedingly difficult – bordering on the impossible – to predict when a given bubble will burst. The canonical financial bubble follows an exponential growth path; such a path is scale-invariant and self-similar, hence there is no way to tell, just from looking at a chart, whether one is closer to its beginning or its end.

Second, the pattern of gains and losses during a bubble’s expansion and subsequent collapse is typically asymmetric. Expansions tend to play out over a scale of years, while collapses often occur within a matter of weeks or months. Expansions involve steady gains gradually accumulating (and eventually exponentiating), while collapses involve sudden massive drops and large amounts of wealth wiped out in very short time spans. From a portfolio point of view, the overall effect is a wash (as indeed it should be, given that bubbles, by definition, do not involve true wealth creation). Hence a portfolio should be agnostic towards bubbles.

But for an individual trader the incentives are quite different. Most professional traders make an annual performance-linked bonus if they’re successful, and face firing if they’re not. Clearly, for a trader it is better to bet on a continuing expansion (and be right 9 years out of 10) than it is to bet on a crash. The payoff matrix is straightforward:

When the crash comes (as eventually it must) the trader’s portfolio will lose far more money than it would have gained in the event of no crash, but the cost to the trader is no more severe than if he had bet against the bubble and been proven wrong.

It’s not just short-term risk-reward considerations that make bubbles more likely; there’s also a long-term selection effect at work. A trader who stays contrarian throughout an expansion is likely to be out of a job by the time the crash finally comes. Rational contrarians recognize that “you have to be in it to win it”; hence they swallow their skepticism and become (or act like) true believers. Bubbles thus tend to create their own boosters, while forcing out all the naysayers. This is selection at its most insidious.

Finally, consider the case of the prescient trader who stays in the game long enough to counter-trade the bubble just before it pops. Does he profit from his acuity? In many cases, the answer is no. Trader bonuses are paid out of firm-wide compensation pools; if the rest of the firm has lost money (and remember, the rest of the firm is full of herd-followers who were riding the bubble, for all the reasons detailed above) then our hypothetical trader would not get paid. One more reason not to counter-trade the bubble (or rather, not to counter-trade your colleagues, which is much the same thing).

Notice that these arguments depend to a large extent on endogenous or even circular reasoning. Bubbles grow exponentially because everyone rides them; but one reason why people ride bubbles is because the growth is exponential. Similarly, traders conform because they fear that contrarianism, even if successful, will go unrewarded; but one reason why contrarianism goes unrewarded is because all the traders are conformists².

This should be no surprise. The defining characteristic of a bubble is positive feedback. Without positive feedback, incipient divergences from ‘fundamental value’ will always be counter-traded, causing reversion to the mean. And what is endogeneity (or circularity) but a positive feedback loop? The triggers may be various and even insignificant, but once a bubble gets under way, it’s very hard to pop. And despite the conventional wisdom, no rational trader would even try.

Addendum: bubbles have many progenitors. This article focuses on the incentives governing one group thereof, namely professional traders. Not everyone has exactly the same payoff profile, or is exposed to exactly the same group dynamics, as traders. Nonetheless it turns out that analogous factors are at play for almost everyone concerned in inflating a bubble. I will return to this topic – how different actors face similar structures leading to similar outcomes – in future posts.

Footnotes:

# ¹ This view, incidentally, provided much of the intellectual ballast for the deregulation policy followed by the Greenspan-era Fed-Treasury-SEC.

# ² This applies to the specific case of multiple traders within a particular firm during a bubble. There are other situations in which being contrarian is profitable and also not inconsistent with trend-following; I will address such situations in future posts.

Why Is Regulatory Arbitrage So Attractive?

When the histories of today’s very interesting times are finally written, I suspect that the phrase ‘regulatory arbitrage’ will feature prominently. One may point to the housing bubble or the bubble in finance as proximate causes; or to unsustainable global macro imbalances as a more distant cause. But the grease that lubricated the wheels of the runaway train was regulatory arbitrage.

Why was regulatory arbitrage so prevalent during the boom? There are several reasons.

First, regulatory arbitrage is easy. It’s certainly easier than trying to beat the market in ‘legitimate’ ways, as many retired traders can testify. What’s more, this state of affairs is likely to persist. Regulatory agencies in the USA are notoriously understaffed; their few workers are notoriously underpaid. Anyone competent enough to understand the complexities of modern financial instruments (which, incidentally, are often designed specifically to avoid or evade regulatory scrutiny) would waste little time in quitting and joining the very Wall Street firms he is supposed to be monitoring. Add in the phalanxes of lawyers and compliance officers whose job it is to ensure that the shenanigans stay on the right side of the letter of the law, and it’s an unequal battle. The investment banks will always win.

Perversely, this outcome is often reinforced by legislative action. Consider the practice of jurisdiction-shopping, wherein firms migrate their corporate entities to domiciles where the regulators are friendlier, or set up multiple entities in various jurisdictions such that key issues ‘fall through the cracks’. Confronted with this reality, the dominant response on the part of legislators has been to ease regulatory burdens, so as to stanch the corporate exodus. Unchecked, this merely leads to a race-to-the-bottom as countries compete to offer the most lax regimes. The long-term consequences of such a race can be devastating, as recent events make clear.

Second, regulatory arbitrage, unlike say interest rate arbitrage or index arbitrage or cross-border arbitrage, is true arbitrage: the arbitrageur takes no market risk at all. In all other real-world arbitrages, the arbitrageur takes some sort of liquidity or timing or event risk. Even if the final outcome is a guaranteed profit, there may be some path along which the arbitrageur goes bankrupt before he can realize that profit. This is not the case with a ‘pure’ regulatory arbitrage.

It gets even better: the diminished market risk means that the arbitrageur can take much larger positions, and presumably make much larger profits. (Consider the case of SIVs designed to stockpile risky assets off bank balance-sheets. If the assets do well, the bankers get paid. If the assets do badly, well, nothing happens – they weren’t on the bank’s balance sheet, so who cares?) Regulatory arbitrage is thus not only easier than other forms or arbitrage, it is also more lucrative.

But what about non-market risk? Clearly, if regulatory arbitrage is sufficiently widespread, the system as a whole can come crashing down. (Think of the role played by credit ratings abuse in inflating the housing bubble.) Unfortunately, risks to ‘the system as a whole’ are not borne by individual bankers. This brings us to our third contributory factor: incentives. Thanks to the quarterly-earnings / annual-bonus culture on Wall Street, practitioners have almost no incentive to play for the long term. Indeed, anyone who chooses to do so would be quickly forced out or passed over in favor of his more aggressive colleagues. Poorly-structured incentive schemes reinforce the attractiveness of regulatory arbitrage, and ensure that traders will take full advantage of any loopholes they can find.

Will things change? It’s unlikely. The talent mismatch between regulators and Wall Street is not going to diminish. Nor are traders going to be held accountable for non-market risks; indeed, if anything the bailouts have firmed the Street’s expectation that systemic risks will always be backstopped by the government (moral hazard, anyone?). And regulatory arbitrage will continue to be easier as well as more lucrative than other forms of speculation.

The only way to prevent regulator arbitrage is to eliminate the incentive structures that support it. But even if the government took advantage of its post-bailout leverage to impose drastic salary caps or other behavioral restrictions (a scenario improbable in the extreme, given the current condition of de facto state capture), bankers would simply work their way around them. The example of Barclays makes this eminently clear:

Two former Barclays execs are starting a fund called Protium Finance. Protium has two equity investors who are putting in $450 million. Barclays is lending Protium $12.6 billion. Protium is using the cash to buy $12.3 billion in what we used to call toxic assets from Barclays. Protium’s 45 staff members get a management fee of $40 million per year.

Although Barclays is recognizing its exposure to Protium, Protium is a different company, and it’s not a bank. That’s important these days, and this is Tett’s main point. In particular, because it’s not a bank, British regulators can’t do anything to it. In particular, they can’t prevent Protium from paying its managers whatever they want to pay it, and they probably can’t force Protium to even tell them what its managers are making.

So here we have the ultimate form of regulatory arbitrage. If you’re a bank exec worried about public exposure or, even worse, regulation of your compensation, go create a new special-purpose vehicle to manage bank assets, entice the equity investors in with a sweetheart deal, and pay yourself whatever you want.

Brilliant, devious, lucrative, and almost impossible to police. That, I’m afraid, is regulatory arbitrage in a nutshell.