Friday, January 30, 2009

A proposal to prevent wholesale financial failure: A critique

Yesterday, Drs. Roubini and Pederson of the NYU Stern School of Business published "A proposal to prevent wholesale financial failure" in the Financial Times. This post would like to examine their thoughts in detail. Their core proposal "is to impose a new systemic capital requirement and systemic insurance programme".

They go on to make the following points.

The root of the problem is that banks have little incentive to take into account the costs they impose on the wider economy if their failure prompts a systemic liquidity spiral. This is akin to when a company pollutes as part of its production without incurring the full costs of this pollution. To prevent this, pollution is regulated and taxed.

DoctoRx here. The core assertion here is questionable on the following grounds:
1. Any systemically important institution does in fact take into account the systemic ramifications of its actions. After all, if its error can bring down its house, it won't smoke in bed (to mix metaphors).
2. There is fuzzy thinking in comparing an error or bad luck caused by decisions a financial company makes with pollution. Pollution is a "bad thing" on its face. Financial companies may simply take too much risk, such as loading up on mortgages to the exclusion of, say, lending to AAA corporations. If in fact a financial company is producing pollution, that product should be banned. So the analogy fails.

There are two challenges associated with reducing the risk of a liquidity crisis. Systemic risk must be first measured and then managed. We propose to define a bank’s systemic risk as the extent to which it is likely to contribute to a general financial crisis. This measure can be estimated using standard risk-management techniques already used inside banks – but not across banks, as we propose – to weigh how much each trading desk or division contributes to the overall risk of a bank.

DoctoRx here. The questionable assertion here is the term "standard risk-management techniques already used". This is scary. Dr. Nassim Nicholas Taleb ("Black Swan" author and philosopher; prior options trader) correctly predicted the demise of Fannie Mae and the horror in the financial markets because he saw that the risk model, such as "Value at Risk", was fatally flawed.

With this measure of systemic risk in hand, a regulator can manage it. We propose two ways to manage systemic risk. First, the regulator would assess each bank’s systemic risk. The higher it is, the more capital the bank should hold.

DoctoRx here. Several objections:
1. Dr. Taleb teaches that is really impossible to "measure" risk, no matter what it is.
2. Even if risk could somehow be even approximated, trusting a regulator to correctly assess both a bank's inherent risk and its importance to the riskiness of the system as a whole represents a leap of faith that this blogger, for one, is unwilling to make.
3. Of course, the greater the risk, the greater the capital requirement. But there will always be the issue of whether the capital set aside for damage to the system is sufficient.

Second, each institution would be required to buy insurance against its systemic risk – that is, against its own losses in a scenario in which the whole financial sector is doing poorly. In the event of a pay-off on the insurance, the payment should not go to the company, but to the regulator in charge of stabilising the financial sector.

DoctoRx here. Again, some points regarding this proposal.
1. Who reinsures the insurer? What if the insurer fails? What if the reinsurer fails?
2. Who sets the insurance rate?
3. This situation sets up a perverse incentive in which the regulator brings in funds if the bank does poorly. Perhaps what would be better would be for the regulator to be compensated if the bank does well. Well . . .wouldn't that be similar to the current situation in which insiders were compensated if their institution reported good numbers for the short term, no matter the intermediate or long-term results?

DoctoRx: Summary

In interviews at Davos and pre-Davos, Dr. Taleb called for banks to be treated as regulated utilities, perhaps owned by governments. This point of view has been propounded in this blog, as well ("What Does Reform of the Banking System Have to do with the Internet?") That post also discussed the NYU Stern white paper, "Restoring Financial Stability: How to Repair a Failed System"). In that post I argued against the very existence of what the white paper called "large complex financial institutions" if they were systemically threatening. I also stated that private money could do what it wants, with appropriate regulation, with the understanding that it would not be bailed out and could not threaten the system; e.g., no more Long Term Credit messes, no more Lehman Brothers, etc. Dr. Taleb expressed the same thought, as well.

Dr. Roubini has been prescient as a prognosticator. However, as a physician, I am aware that a genius diagnostician may yet not come up with the optimal treatment plan for a patient. In this case, Dr. Roubini has entered what might be called the statist quo. In this situation, systemic risk would exist but allegedly, better regulation (read, government) would alleviate the problem.

In the Taleb (and DoctoRx) model, systemic risk from banks that are depository institutions would not be allowed to exist, period.

In this view, the functioning of basic banking is akin to a utility. Just as the lights must stay on, toilets must flush, etc., so must basic banking functions go on and on and on. In this model, Glass-Steagall would come back into being with appropriate updates, nationwide banking could occur, but the banks would be small and competitive, and financial gamblers could gamble and use leverage if they could obtain it, but they could not threaten the utility-like banking system.

Copyright (C) Long Lake LLC 2009

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