Friday, March 20, 2009

Nevertheless, this report is a milestone.

In case you want to read The Turner Review, here it is:

Here's a few good posts about it:

"Towards a rational exuberance

Lord Turner's report "A regulatory response to the banking crisis" was released yesterday.

However, Turner's recommendations barely address this problem. There are several valid recommendations about procyclical reserves and a hint at a power to intervene in momentum trading (such as short-selling which feeds on itself). But this only dances around the edges of the problem.

He also recommends technical training or qualifications for bank executives. But that's not where the irrationality is. Indeed, many bankers have been all too rational throughout this crisis - extracting rents for themselves at the expense of shareholders and creditors. Turner does recognise this principal-agent problem and some of his recommendations deal with it. However it is not a problem of irrationality; the irrationality that matters is that of borrowers and investors, not of banks.

The corollary of this is a more radical proposal.

Regulators - central banks or financial regulators such as the FSA - need to monitor aggregate irrationality. There are two ways to do this:
  • measures based on the behaviour of individuals, aggregated across a whole market
  • measures based on the aggregate risk taken and valuation implied by market asset prices
The second of these can be measured using (fairly) standard financial measures - projections of economic growth, share of output accruing to capital or to profits, discounted and compared with asset prices. The answers won't be exact, but measures that are wildly outside of economic rationality will be apparent.

There will certainly be challenges in measuring across different asset classes - typically a single regulator does not cover equity and debt markets, for example, and if there is an aggregate overvaluation, it will be very hard to gauge whether equity holders and debt holders are both expecting a too-high share of overall returns, and who is wrong. But with unified or at least coordinated regulation, it should be possible to determine that overall prices are too high.

The former requires insights from behavioural economics and particularly from behavioural finance. In many situations it is possible to measure objectively what the rational outcome or decision is. And it is possible to see where an individual investor diverges from this. Sometimes this does not matter for the system as a whole; and sometimes it does. But as Turner points out, markets are not always self-correcting and certainly not in the short term. Thus, it is likely that a dedicated regulator could identify substantial deviations from rationality in large populations.

On the border between these is the collective action problem: where individual rationality leads to an outcome which is not a rational one for the group. Turner does mention this but offers no solution. Again it is clearly measurable: at present, for example, we have an excess of desired savings leading to a reduction in overall output - clearly not a desirable outcome for the population as a whole, but perhaps rational for each individual saver. Somehow the interest rate mechanism is not resolving this problem (the zero bound is one reason; sticky prices, wages and investments are another).

So our hypothetical regulator has identified irrationality of some kind - irrational exuberance or irrational depression. What should it do?

Here we turn again to behavioural economics. There are clear ways in which irrational behaviour can be guided or corrected by specific stimuli. Specific examples:
  1. Framing of choices. The right kind of framing can influence people to take more or fewer risks, to consider the future more or less, and to put a higher or lower value on assets. Framing methods include choice of language, the range of pricing and risk choices available to buyers, subconscious signalling such as branding, and sensory cues such as colour and music. The mechanisms for regulators to communicate their decisions downward to the framing of commercial decisions do not yet exist, but could certainly be put in place. After all, they currently influence interest rates, so the argument for commercial freedom is not an absolute barrier to this.
  2. Visibility of irrationality. People tend to become more rational either if they have more time to reflect, or if their irrationality is made visible to them. A regulator could certainly have a role in making this happen. Simplistically, one could ask why not make people more rational all the time. But there are transaction costs and diminishing returns involved. It's not realistic for a regulator to step into all transactions everywhere; but if they are able to measure who is irrational, when and where, they can focus their efforts where they'll have an effect.
  3. Lengthened time horizons. Buyers generally make less rational decisions when they consider the consequences over a shorter time period. The longer a period that is considered, the better the decision will be. Interest rates are one way of influencing the time periods that investors consider; others include the credibility of inflation targets or the availability of externally anchored future events. For instance, subjects who are asked questions about their age and retirement dates will subsequently make a different kind of investment decision than those who are not.
  4. Increased scope of social contract. Buyers who act purely as individuals will make different choices to those who also consider the effects on their family, their social groups or their society. It is possible to measure the divergences between individual and group interest, and to influence the degree to which people consider the consequences for a group when making decisions.
This proposal undoubtedly needs further research: we don't yet know the most accurate measures of irrationality or the most effective influences on it. And there are obvious limits on rationality in all circumstances - predictions of the future are not perfect, information is not always available, and people cannot always know their own preferences with regard to time discounting.

But I am confident that direct methods to help people and groups to be more rational will have a more powerful, and more timely, effect than relying on banks' capital cushions to make the corrections for them. This isn't all about correcting for overconfidence; it will also work on the risk aversion and underconfidence we're seeing now. Exuberance can be rational, and growth will be more steady and reliable when it is.


"Wolf on Turner

Martin Wolf's article on Lord Turner's review is a good one (by which I mean, of course, that he agrees with me). He identifies irrationality as "the main analytical conclusion" of the report, but he doesn't take the next step of suggesting that it can be directly regulated.

But while Turner has diagnosed the right disease, he doesn't propose a workable cure. To combat irrationality, he suggests a set of tools that work through rational means. Counter-cyclical capital requirements, leverage ratios, remuneration and centralised CDS clearance are perfectly sensible measures, but - like interest rates, the main tool of existing counter-cyclical policy - they work by market participants responding rationally to incentives, with consistent discounts on time and risk.

As Turner points out, this criterion is unfulfilled often enough to matter. Investors and borrowers do not always act rationally, and if regulators want to combat that, they need to tackle it directly.

Fortunately, they are starting to gain the ability to do so. Behavioural economics research provides tools both to measure irrationality - on an individual or aggregate basis - and to influence it. If equity market participants take too much risk (as they, sometimes, objectively do), there are specific framing mechanisms which can increase risk aversion and have the effect of making investors more rational. If monetary and fiscal policy fail because of hyperbolic discounting, there are 'mental accounting' techniques which can correct for this.

Naturally such policies will require research and testing before being implemented; in particular, the methods for transmitting central policy decisions into the marketplace need work. Just as the mechanisms for transmitting central bank interest rate decisions into the money markets and the consumer debt markets have gradually developed over decades and are still not fully understood - quantitative easing, anyone? - rationality transmission will need time and experimentation to take root.

But if effective controls can be developed, we will be able to avoid restrictive controls on financial innovation by using a more targeted and direct toolkit to mitigate irrational exuberance or irrational fear. The economy - with help from the financial markets - will have room to grow, with a much lower chance of building up large internal imbalances.


Why the Turner report is a watershed for finance

By Martin Wolf

Published: March 19 2009 19:28 | Last updated: March 19 2009 19:28

Lord Turner is the UK’s man for all seasons. A few years ago, he fixed pensions. Today, it is finance. The report by the new chairman of the UK’s Financial Services Authority is a turning point.* The authorities of a country that used to boast of its light financial regulation have changed their minds: the UK has lost confidence in its financial sector.

“Over the last 18 months, and with increasing intensity over the last six, the world’s financial system has gone through its greatest crisis for at least half a century, indeed arguably the greatest crisis in the history of finance capitalism.” This is the report’s starting point. It advances two explanations for this disaster: exceptional macroeconomic conditions – particularly the emergence of excess savings in large parts of the world – and reliance on “the theory of efficient and rational markets”. As the report notes, “the predominant assumption behind financial market regulation – in the US, the UK and increasingly across the world – has been that financial markets are capable of being both efficient and rational”. So regulators were expected to stay out of the way. In the report’s new view, they should be in the way, instead. The financial sector no longer enjoys the benefit of the doubt: it may burn up the world.

The most important analytical points are that individual rationality does not ensure collective rationality, that individual behaviour is frequently less than rational and that, in consequence, markets can overshoot, in both directions. Above all, such failings create systemic risks: if everybody believes in the same (faulty) risk models, the system will become far more dangerous than any individual player appreciates; and if everybody relies on their ability to get out of the door before anybody else, many will die in the inferno.

To these points must be added the vulnerability inherent in borrowing “short and safe”, in order to lend “long and risky”. If we were not so familiar with banking, we would surely treat it as fraudulent. Moreover, far from reducing the frailty, securitisation enhanced it by spreading “toxic assets” everywhere.

The recommendations include: increased quality and quantity of capital, particularly against trading activities; a strongly countercyclical capital adequacy regime; a maximum gross leverage ratio; enhanced regulation and supervision of liquidity; coverage of all significant institutions; enhanced supervision of rating agencies; codes covering remuneration in systemically significant institutions; and centralised clearance of the majority of trades in credit defaults swaps.

Also recommended are enhanced “macro-prudential” analysis by the FSA, the Bank of England and global bodies; a big shift in regulation by the FSA towards high impact businesses, by focusing on business models, strategies, risks and outcomes in the supervised companies; greater international co-ordination of supervision; an independent European regulator; and an end to the “untenable present arrangements” for cross-border activities of European banks – the “Iceland problem”.

In short, the stable doors are to be locked tight, though only after a herd of horses has already bolted. Nevertheless, even Lord Turner’s radicalism is limited: the report rejects division of the financial system into utilities and a casino. The arguments against are that the casino would still need to be regulated, that such a distinction could not be introduced by one country on its own, particularly in the European Union, and that global companies need “large complex banking institutions providing financial risk management products”. So securities underwriting by banks is still needed, though “large-scale proprietary trading through in-house hedge funds is not”.

In all, this report offers radical tightening of regulation and supervision of a financial system that would remain broadly the same as today’s. The most regulated businesses would be less profitable and so would shrink. That would be no loss, suggests the report: the profits they reported were illusory, but the dangers they created all too real. This judgment is surely right.

Yet even this report leaves important questions unaddressed.

First, it does not explain why we can hope to contain the behaviour of companies too important to fail.

Second, it does not demonstrate that regulators can contain regulatory arbitrage by profit-seeking financiers.

Third, it does not deal with risks posed by institutions that may be too big to rescue by some host countries.

Fourth, it does not explore the room for charging heavily for guarantees.

Finally, it does not consider the incentives towards excessive leverage inherent in the tax system.

Nevertheless, this report is a milestone. It should help catalyse the needed global discussion of regulatory reform. Other countries – and, above all, the US – should commission comparable analyses of their own regulatory failures. I would also wish to see equally searching analysis of mistakes in monetary policy, both in the UK and elsewhere.

Humans learn far more from failure than success. The failures this time are big enough to make learning the lessons essential. The Turner report is a start. More learning must follow.

*Turner Review,"


The Turner review: some questions

The Turner review (pdf) of financial regulation (pdf) is intended to be the first words on the subject, not the last. It leaves open several questions. For me, the main ones are:
1) How do we get from here to there? Turner wants banks to have higher capital-asset ratios - even higher than Basel II ones. But banks are now under-capitalized; in my day job, I’ve estimated, from Bank of England data (table B1.2) that banks need over £80bn of capital just to return to 2006’s capital-assets ratio. How can banks raise their ratios so much? Turner says we need a “lengthy transition” period to ensure that his proposals don’t cause a halt to lending. But this period might be very long indeed. Not does he say how banks are to raise such capital, without further government help.
2) Turner wants banks to have counter-cyclical capital requirements, building up reserves in good times. But are these really enforceable?
Imagine the next boom, in which banks restrain lending. Young people will complain of being unable to get on the housing ladder. Firms will complain of being starved of finance to invest in profitable new equipment. Banks will resent the foregone profits. And everyone will downplay the probability of a recession - that’s what happens in booms. Can regulators or governments really resist these pressures to abandon counter-cyclical requirements?
3) Won’t regulatory arbitrage circumvent these problems, for example as offshore lenders step in to fill the gaps left by banks? Turner says that purely national regulation is “by far second best”, and calls for “internationally agreed” regulation. But isn’t this rather idealistic?
4) Far from accepting calls for a Glass-Steagall style separation of “utility” and investment banks, Turner seems to want a merger of the two. His call for very high capital requirements against banks’ trading books mean that stand-alone investment banks would face huge capital costs. This would encourage banks to take them over. Is this desireable?
5) If Turner gets his way, we’ll have slower, more stable economic growth. But what are the benefits of this over higher, more volatile growth? It’s easy to forget that booms can have lasting benefits - for example by bequeathing us a higher stock of physical capital or houses, or giving some of us nice capital gains as a result of irrational exuberance; I speak as one who sold a London flat for silly money a year ago.
6) Is Turner really wise to downplay the role of inadequate management structures in this crisis? He points out that managers’ big equity stakes did not stop Lehmans‘ collapsing. But he doesn’t point out that unrestrained hubristic chief executives (Dick Fuld, Fred Goodwin etc) played a role. And, aside from calling for banks to use some counter-conventional wisdom academic research, Turner doesn’t ask how to break up the deference to individual leaders or groupthink that led banks to so willingly take on high risks.
And herein lies the paradox of the report. The dominant theme of it is that banks are incapable of managing themselves. But to Turner, the solution is not a change of ownership (the N-word isn’t mentioned as far as I can see), nor or management structure, and certainly not the introduction of more market forces. Instead, it’s management at arm’s length, by regulators.

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