An Accident Waiting to Happen
shameless ‘I told you so’ polemic’ -- but with an optimistic
What Was Really Wrong?
The 2008 financial
crisis is rooted in seriously flawed theories and regulatory structures.
economic theory assumes that all risks can be reduced to known probability
distributions that are common knowledge – everyone knows what the true
probability distribution is. The
assumption is crucial for building mathematical models; but it bears little
resemblance to reality and sustains the dangerous belief that diversification
eliminates risk and thus the need for case-by-case judgments.
In a 1994
article ("Return to Judgment," Journal of Portfolio Management)
I challenged a 1974 claim (in the same journal) by Paul Samuelson that
investors should construct passive market portfolios and “throw away the
the use of models based on the same flawed assumption continued to expand and
lots and lots of keys got thrown away.
Valuing securities taking into account the vagaries of specific
circumstances – trying to get a handle on “unsystematic” risk
– finance professors taught, was a wasted effort.
2002 someone who was writing a survey for the Economist about the future of
capitalism asked me to offer a prognostication.
Capitalism, I emailed him, was in great shape – except in the
financial sector because of the pervasive belief that diversification was a
substitute for due diligence.
“I think the financial system faces a much
sharper change from the trajectory its been on since the early 1980s -- much more so than in the other elements of
the modern capitalist system (e.g low taxes, deregulation, cost conscious
managers, privatization, cross-border trade and investment) that I think are
here to stay. Of course if the
financial sub-system really starts unraveling, the other elements may also be
“One reason for expecting a sharp change is
simply that trees don't go to the sky.
The growth in the value of financial assets (and in the incomes of
bankers) has far outstripped the rate of growth of the real economy (and of
other working stiffs). The inevitable mean-reversion is already in place
witness NASDAQ and VC returns. Heck one
of these days, we might even see the S&P trade at a reasonable P/E.”
“But that's not the main dimension of the system
that's out of whack. In fact, I think the absurd valuations themselves may be a
symptom of flawed assumptions about agency problems. To simplify: when a
"principal" provides capital to an "agent" he faces two
kinds of problems -- that the agent is a crook and that the agent has bad
judgment. I don't see too much of a
direct problem on the crookedness side--the rules of the game haven't made
outright stealing any easier over the last few decades. The systemic problem lies in the lax control
over errors of judgment. This has arisen because of the mistaken belief that
diversification (and well aligned incentives) can substitute for the control of
bad judgment through due-diligence and oversight. Everyone has bought into the belief —
investors, intermediaries and implicitly (through the promotion of market
liquidity) regulators — that diversified portfolios make the problem of
bad judgment disappear. Actually,
diversification complements due-diligence and oversight; relying on diversification
as a substitute exacerbates the problem of bad judgment. Incentives to cheat also may increase -- many
fraudulent schemes start out as cover-ups for mistakes.
¶ A regulatory apparatus, first established in the Great Depression, has
underpinned the breadth and depth of U.S. stock markets. But, it has also have severely impaired
corporate governance. For instance,
rules prohibiting insider trading and requiring disclosure encourage trading by
keeping the casino honest; but, placing special burdens on insiders,
discourages stockholders from accumulating control positions or even serving on
the boards of directors. Inevitably boards comprise individuals who don’t
have a significant economic stake in the company.
Takeover threats may deter flagrant abuses but aren’t a substitute
for informed oversight by insiders. In
banks and other financial service firms, even that threat is absent because
regulations (and highly leveraged capital structures) make hostile takeovers
(I had discussed the trade-off stock market
liquidity and governance in a 1993 article in the Journal of Financial
and then in several more popular pieces in the Harvard Business Review, the
and the New York Times
and in a Royal Society of Arts lecture. My 1988 doctoral dissertation
had shown that the much feared corporate raiders curbed only the extreme cases
of mis-governance, and that too, just the problem of over diversification).
¶ The unintended consequences of Depression Era rules on banking have inflicted
even more damage than did the stock market rules.
In principle the case for bank regulation was strong. The rules protected depositors from imprudent
bankers — and bankers from jittery depositors. Before this, the fear of bank runs made depositors
and lenders inordinately cautious: Mortgage loans, for instance, rarely
exceeded half of the value of the property.
The creation of the FDIC both ensured the safety of deposits and also
freed bankers from the challenge of earning the confidence of depositors. Bank examiners became the main restraint.
The switch initially produced good side effects. Banks lowered down payments on mortgages,
making home ownership more affordable.
Regulators also provided the cover needed to pursue innovative risk management
strategies. In the ‘70s for
instance, banks started using futures to hedge the risks of making long term
loans with short term deposits. Without
deposit insurance -- and the reassurance of state supervision -- even
sophisticated depositors would shun banks that traded futures. Paltry passbook
rates simply wouldn't compensate for the risks.
Eventually however, more complex and dangerous innovations flourished
under the regulatory canopy. Regulators apparently succumbed to the idea that
if a little financial innovation was good, a lot must be great. Banks directly or indirectly enabled
instruments that were far outside the regulators’ capacity to
Banks’ CEOs weren’t on top of things either. Freed of both
stockholder and depositor restraints, banks (and their financial next of kin)
became sprawling, unmanageable enterprises whose balance sheets and trading
books are but wishful guesses. CEOs famously frolicked on golf courses
and at bridge tournaments while their businesses imploded because they didn't
know any better.
¶ President Clinton says the
collapse was triggered by the absence of good investment opportunities outside
housing. In my view the system was an
accident waiting to happen and anything could have triggered it. If we want to identify a particular trigger,
I would vote for the knock-on effects of the rapid advances of the Chinese
economy: As Ned Phelps and I wrote in 2005, China
increased its capacity to produce modern goods for international markets more
quickly than it increased its capacity to consume such goods. This created a “savings
glut’. But if the Chinese saved,
someone had to borrow. And the borrowing
had to be channeled through a financial system that could screen for
creditworthiness and guarantee repayment.
financial system offered the illusion of such a capacity but in fact buckled
under the amounts that passed through it.
¶ Besides the financial costs to
taxpayers and the global economic slowdown, the dysfunctions of the financial
system have exacted a serious toll on the legitimacy of providing great rewards
for great contributions. Finance certainly contributes to prosperity, but
the vast wealth secured in recent years by a small number of financiers does
not map into a commensurate increase in their economic productivity: they
haven't created or financed new industries or turned around failing companies.
Rather they have used subsidized borrowing to leverage the returns of
questionable schemes, secure in the knowledge that if things go wrong the
authorities will step in, trying to shore up asset prices or prop up failing
counterparties. The sharp rise in income inequality at the top of the
scale owes much more to reverse Robin Hood regulation than to a small decline
in personal income tax rates.
¶ The haste with which Congress is
being railroaded into passing a $700 billion bailout is disquieting. The establishment tells us that unless we act
immediately, catastrophe awaits.
But on what theory or evidence?
And consider the source – the very same crowd that didn’t
see it coming.
And what’s the worst case consequence of no bailout?
The Dow falls, 1000, 2000, 3000 points? So what – financial markets
fluctuate? (After word: The Dow in fact did
fall precipitiously after the bailout was passed. Would the Dow in fact have
fallen more if there had been a more measured and thoughtful response? Did
shouting “fire-marshals!” in a crowded theatre really help? )
We enter a deep recession?
That’s more serious – but take a deep breath. The US did endure a very serious
recession in the early 1980s.
Unemployment and interest rates were in double digits. But that was, most would consider, a
necessary cost of wringing out inflation and restructuring the old economy. There was no quick fix.
As against this possible
downside, we have the near certainty that that a hasty $700 billion bailout
will be mismanaged or worse. For some people, is this an opportunity to
rake it in or what?
¶ Neither presidential candidate
has offered a plausible long term fix.
McCain rails against greed – but that’s not a strategy.
Obama, like many others, favors bringing the regulatory system into the
21st Century because "old institutions cannot adequately
oversee new practices."
Sounds great, but which agency has the capacity to spare? Bank examiners
continue to struggle with traditional lending, and the Fed hasn’t yet
mastered the problem of central banking in a globalized economy. And, adding capable regulatory staff to
oversee fiendishly complex innovations and institutions – and then
keeping them from going over to make the big bucks on Wall Street –
isn’t like recruiting baggage screeners at airports.
¶ Rather than trying to keep up
with the never ending proliferation of innovations, it is time regulators
pulled commercial banks back into traditional lending. Let's instead revive the radical idea of
narrow banking and tightly limit what banks (and any other entities that raise
short term deposits from the public) can do: nothing besides making loans and
simple hedging transactions that examiners who don't have PhDs in finance can
monitor. And, certainly, no willy-nilly diversification or Rube Goldberg
¶ Anyone else: investment banks,
hedge funds, trusts and the like can innovate and speculate to the utmost, free
of any additional oversight. But, they would not be allowed to trade with or
secure credit from regulated banks, except through prudent, well secured loans.
This simple, “retro” approach would protect depositors, limit the
risks of financial contagion, allow the FDIC and Fed to focus on their primary
responsibilities, and not require new agencies or more regulators. Less, would
in fact, be more.
¶ Unfortunately the panicky
response to the crisis is moving us even further away from narrow banking
– witness the conversion of Morgan Stanley and Goldman Sachs into
bank-holding companies to be regulated by the Fed. This is wrong-headed – if the Fed
couldn’t control the tangled mess at Citicorp how is it going to cope
with more Too Big Fail and Too Complex to Manage mega-banks?
(I made the old argument
for narrow banking in a presentation
at a conference held at the council on
Foreign Relations in November 2007 and then in a New York Times op-ed
(forthcoming). My critique of mega-banks is in a
Some Good News
¶ Until very recently many scholars and
financiers claimed that the “sophistication” of the US financial system was a prime cause of US
prosperity. If this was really true
– and the system is shorn of its refinements –
we would have much to worry about.
But is it?
¶ Certainly a modern economy needs sound
financial basics – stock markets, banks, insurance companies, venture
capitalists, commodities exchanges etc. But there is no evidence, that all the
bells whistles that have been developed over the last couple of decades are
have created value.
¶ In fact the claims in favor of increased
sophistication are implausible on their face.
Can we really believe that a financial sector that accounted for more than a fifth of the profits of the
S&P 500 (and that does not include the profits of the hedge funds) have
produced improvements in mobilizing or allocating capital of that magnitude?
¶ More likely,
innovators and entrepreneurs in the real economy prospered in spite of the talent and funds that were taken up by the
expansion of the financial sector. So if the financial sector shrinks back to
the “basics” so much the better for long run prosperity.
¶ Also encouraging, even if there is a
recession: Our Venturesome
Economy (TM !) has demonstrated a
capacity to develop and deploy innovations that sustain our long run prosperity
in good times and in bad. Personal
computers recall took off in the dark days of the early 1980s. But we mustn’t let the ill-will
generated by bad financial innovations lead to policies that harm innovators in
the good economy! Clean out the stable, but please keep the horse.
(This was written on September 30th 2008 (before the bailout).
I believe its all still valid.)
. Back to Home Page
As I said to a friend who was contemplating
investment in a dodgy “emerging” market: “Giving your money to twenty thieves is
no better than giving it to just one.”
 "Return to Judgment," Journal of
Portfolio Management, V 20, N 2: pp. 19-25, Winter 1994.
 "The Hidden Costs of Stock Market
Liquidity," Journal of Financial Economics, V 34, 1993: pp. 31-51.
 High cost of liquidity, Financial Times,
December 13, 1994
 Fair Stock Markets: The Hidden Cost, The New
York Times, January 22, 1995.
 The hidden costs of investor protection: lessons from
Royal Society of Arts Journal, V CXLII, N 5452, July 1994: pp. 27-34.
(from lecture delivered to the Royal Society of Arts, London April 13, 1994)
 Published in
"The Causes and Consequences of Hostile Takeovers," Journal of
Applied Corporate Finance, V 2, N 2: pp. 36-59, Summer 1989.
 See for
instance Robert Litan’s Ph.D. Dissertation: An Economic Inquiry Into the Expansion
of Bank Powers.