Tuesday, December 21, 2010

Bank Leverage Limits

I've seen several posts riffing on Tyler Cowen's American Interest article stating banks tend to go 'short volatility'. I'm not too interested in it because I think it's a misleading way to put the problem.

Banking crises are correlated with business cycles, and business cycles are correlated with volatility. Thus, one could say they have too often gone 'short volatility'. But that is rather incidental, not an explicit strategy. The real question is why their portfolios tend to experience highly correlated declines that threaten their solvency every 15 years or so (just within the US: 1819, 1837, 1857, 1873, 1893, 1907, 1901,1929, 1966, 1970, 1975, 1981, 1990, 2008). My theory, based on Batesian mimicry, is here.

As to how to ameliorate if not eliminate these crises, Cowen supports Kevin Drum's argument:
The way to do it is with very simple, very blunt leverage restrictions that apply to all financial actors over a certain size: banks, insurance companies, hedge funds, private equity, you name it. If you have assets over, say, $10 billion, then the rules kick in. Strict leverage limits (say, 10:1 or maybe 15:1) based on conservative notions of both assets and capital would be a pretty effective bulwark against excessive risk taking but wouldn't seriously interfere with the basic asset allocation function of the financial industry.

I do like the way his solution actually makes sense, in that you know what he is saying. You can listen to some people talk for an hour and realize they are merely for more and better regulation, without any specifics. But, the reason why prominent people are vague is because then you aren't wrong, like Drum and Cowen are in this instance. The problem with this great idea is that if you make leverage the key point, regulators will focus on that, and so banks will just invest in riskier assets.

Crises are often compared to drinking binges, where excessive exuberance is followed by hangovers. Following that analogy, if you try to say, 'we don't want people drinking to excess, so we will stop everyone at 6 drinks', well then, they will switch from beer to wine, whiskey, or grain alcohol.

But the drinking problem is potentially soluble because you can measure alcohol, and say allow people one 12 ounce beer, one 5 ounce glass of wine, etc. Basically, the key unit is 'ethanol, which has measurable properties. In contrast, we don't know what 'risk' is. Beta? Volatility? Skew? Get back to me on that. You can't regulate what you can't define.

What about leverage as a proxy for this unmeasurable risk? As Proshares is showing with the Ultra (2x leverage), UltraPro (3x leverage), and short products, a security can have double or triple leverage behind it, have positive or negative exposure, and still be called a 'stock'. Similarly, a bank with 10:1 ratio but plenty of ninja loans had a lot more risk than a bank with 20:1 leverage but all their mortgages had 20% down (the bad old days per Alicia Munnell). Facility risk (eg, loan-to-value) is part of the problem, so too is obligor risk (eg, credit and bureau scores), and so the multiheaded beast grows, with risk hiding from any one metric that can be applied across any large financial institution. This, alas, brings forth many demographics, all who want unsecured lending, which has a populist appeal.

The key is that drinkers engage in moderation only when they realize hangovers are not worth any temporary high. Unless they believe that in their hearts, they will get around your regulations the same way college kids--who generally are below the 21 year old drinking age--tend to get around restrictions promoting their sobriety. Any top-down rule to prevent excess will simply waste time because you can hide the leverage at the other end, say be investing in assets that are leveraged a lot, or who have suppliers who implicitly leverage them (as in the dot-com bubble). Such rules might even make things worse by giving people a false sense of security if nothing bad happens for 10 years, as often is the case.

I used to be head of 'economic risk capital allocations' for a bank, and we had very low risk for mortgages. I left before the madness started, but I can see how it morphed because it would be easy for the business line managers pushing product to point to historical losses in mortgages and say they are basically riskless (eg, the Stiglitz and Orzag analysis). Now, some smart people (eg, Greg Lipmann, Andy Redleaf, Peter Schiff, among many others) saw the past data were not relevant once you start lending to people with no money down, or people with no documents, and that depending on collateral prices rising basically was a game of musical chairs. But within large organizations like banks and GSEs these people were demoted, as happened to David A. Andrukonis, the risk manager at Fannie Mae who was fired for getting in the way of Bill Syron's $38MM windfall. A big idea that is plausible and has many beneficiaries is very hard to resist in real time, and such ideas don't end via argument, but rather conspicuous failure.

So, define risk--not its correlates like leverage, but actual risk--first. Make sure it isn't backward-looking, looking at the past couple of crises, but by say anticipating the next bubble in muni debt or education. Unless you can convince people that such risks are real, any leverage rule will be made irrelevant via the creativity of people designing contracts taking into account the letter of the law. That's really hard, you might say, and we have to do something now. Doing something is not better, unless you think pandering to the mob is a primary objective. If risk management were merely following some simple asset-to-liabilities test, someone would have figured that out by now.

15 comments:

michael webster said...

When the tulip bubble ended, somewhat appropriately in smoke filled Dutch auction houses that happened also to be bars, there was a rush to the Courts to enforce both the promissory notes, and the delivery contracts.

The parliament in Amsterdam, after about 8 months, decided post facto that both the promissory notes - used to purchase the tulip futures, and the tulip futures themselves were gambling debts and so unenforceable in the Courts.

I very much like this approach as an anti-avoidance regulation. You don't have to know before hand what investment will turn out upon inspection to be a gambling vehicle, only that some investment will fit this bill.

David said...

Everything else you've said makes sense to me, but why not think that going 'short volatility' isn't also an explicit strategy? If it were an explicit strategy, it seems like it would be a pretty good one (especially given principal-agent stuff), as long as no one found out until later.

I haven't read Cowen's article, so I'm asking without really knowing anything of the evidence for this claim.

I'm enjoying your blog/book/videos. Thanks!

Jazzie Casas said...

Assuming that you have plenty of money to even get into a 15 year mortgage, then I am guessing that with your new 30 year payment, you should have plenty more to pay against principal to combat that extra .75% Remember that $ 50 extra a month cuts off 7 years off the life of the loan.

I am 30 right now and they is no way in hell that I am going to struggle and be stressed out until I am 45. Money is money. My life is more important to me so I would rather live easily and have a paid off house when I am 70.

Go for it. Get that BMW you always wanted too because with half the payment, you can afford it now!







home buyer

Jazzie Casas said...

Assuming that you have plenty of money to even get into a 15 year mortgage, then I am guessing that with your new 30 year payment, you should have plenty more to pay against principal to combat that extra .75% Remember that $ 50 extra a month cuts off 7 years off the life of the loan.

I am 30 right now and they is no way in hell that I am going to struggle and be stressed out until I am 45. Money is money. My life is more important to me so I would rather live easily and have a paid off house when I am 70.

Go for it. Get that BMW you always wanted too because with half the payment, you can afford it now!







home buyer

BlackRaven said...

I think the issue is that risk is very easy to define in an almost unusable way, ie. max dollar loss possible. I agree with your point that making things more specific merely change the rules which will shift the crisis point.

There is a point though that raising capital ratios drastically changes creditors belief in too big to fail if it changes the nature of risk taken. Instead of 1% risks being leveraged and then failing every 15yrs, leveraging 5% risks a lot less and failing every 3yrs would surely shift some risk out of the tail?

Mercury said...

You'll be pleased to know that Taleb has advocated for years that banks should be run/regulated essentially as public utilities with very low leverage while they quietly go about their boring, simple but critical business. Let the I-banks and BDs (capped in size) engage in more exciting and complex (and privately funded) financial schemes. Big and/or complex = higher risk.

I understand the problems you describe regarding the measurement of risk and leverage but I think you portray this issue as being more slippery than it really has to be (traders know how to "stuff the tails" to skew their VaR metrics and you still like VaR).

There are a bunch of banks (small community, Andy Beal, most of Canada...) which didn't get into things like sub-prime lending, stayed pretty conservative and didn't blow up. Even if explicit metrics fail to pin down risk and leverage in this regard I think it's safe to say (and this proves) that "you know it when you see it" as you also surely did when you managed a bank's risk and as most anyone else could have seen at the time when describing the profiles of the two groups of banks outlined above. I think explicit metrics, properly, yet simply defined, would work just fine most of the time but they don't have to be the only tool in the belt.

Many areas of the law rely on and are enforced on the basis of subjective judgements. If need be, (and it might not) I don't see why banking/finance regulations should have to be any different.

Anonymous said...

Let them fail and lose everything. Yes, America suffers a deep recession/depression. Then my hunch is you go decades without another banking crisis. Well worth the short-term pain. Simple solution.

Michael Meyers said...

Eric,

Nice article.... as they say: "life is messy."

Regards,
Michael

Anonymous said...

The blunt solution isn't 10:1 leverage, it's to completely abolish traditional banking. Wall off the "utility" parts of banking from the lending part. This is in one sense a radical suggestion, because it upsets powerful interest groups. But it's very conservative in the sense that it is almost guaranteed to be an improvement, unlike most regulation.

Dave said...

"Similarly, a bank with 10:1 ratio but plenty of ninja loans had a lot more risk than a bank with 20:1 leverage but all their mortgages had 20% down"

Fair enough, but isn't it still useful to regulate leverage, to limit how much the government will potentially be on the hook for? A 10:1 levered bank with plenty of ninja loans would still be less of a potential liability for the government than a similar sized bank, with a similar mix of loans, but 20:1 leverage.

Also, what about the merits of regulating leverage counter-cyclically?

Salem said...

"That's really hard, you might say, and we have to do something now. Doing something is not better, unless you pandering to the mob is a primary objective."

One of the best lines I've ever read on this blog - technical analysis meets public choice theory.

Eric Falkenstein said...

Dave: I just think it's a big waste of time. Look at the cross-sectional data on leverage average and default rates among banks, the relationship is pretty weak. Over time too, leverage is pretty unexplanatory.

Eben said...

"You can listen to some people talk for an hour and realize they are merely for more and better regulation, without any specifics."

Perhaps Mr. Falkenstein should take a look in the mirror? (I might be wrong that you are for more regulation, I suppose, but still...)

Eric Falkenstein said...

I'm for less regulation, more transparency (forced, which thus is regulation). Funds should have to provide their return data, which should be presented in a 'return to average investor', so that funds with high returns in incubation, but low subsequent returns are appropriately presented. Hedge funds should provide returns, as opposed to currently, where it is illegal to discuss returns. Banks should have to show the same risk reports seen by their CEO to outsiders: both are rather top-level, but it would be much better than what is in annual reports. Rating agency results should be tabulated by an independent body, noting the default rates by grade, industry, etc.

Bill said...

You are correct that any regulation with precise rules trying to define risk can be gamed. Here's my alternative proposal. Only the banks in the top quartile for being low risk should be permitted to pay dividends, buy back shares and/or pay bonuses in excess of $500,000 in cash. Regulators would be charged with evaluating riskiness. Riskiness will include all sources of risk (assets, leverage, duration mismatch) They will not do a perfect job of course. But here are some advantages of this system. The regulated will have some motivation to explain to the regulators how others are gaming the system so that their own banks have a better chance of being top quartile. Banks ranked in the 26th to 35th percentile will often make the top quartile shortly thereafter because they will have retained cash and banks who just made the top quartile will have paid out cash. The shareholders of banks will push them to be lower risk so they can get dividends. Yet those who are higher risk are only penalized if the regulators were right - a bank that pays no dividends for X years then goes bust is worthless. It's only by retaining capital and eventually being in the top quartile that those banks will get to disgorge some of the profits to its shareholders. Maybe after a decade or two, we can relax the top quartile rule to be the top 50%.