Posted by Kenneth Anderson:
Soros on Principles of Financial Regulation and Efficient Market Hypothesis
http://volokh.com/archives/archive_2009_06_14-2009_06_20.shtml#1245258297
George Soros has a very interesting opinion piece in the Financial
Times, June 17, 2009 (might be behind subscriber wall at the FT, but I
received it by email from his office, so I'll quote some bits from
there). The essay outlines in short form his principles for reform of
financial regulation. I am still absorbing this, so I won't comment
here, but I put them out for your thoughts. I will try to post up some
other stuff on the financial regulation reform proposals coming from
the Obama administration over the next couple of days. (As ever,
however, I am always eager to read what co-blogger Zywicki has to say
about this stuff, and particularly the bankruptcy questions of
Chrysler, GM, and Delphi - I am no expert by any stretch on sale v
reorganization in bankruptcy. See Todd's earlier post comparing
Chrysler, GM and the secured creditor treatment in each.)
So, Soros starts out with a general comment on the comparative
disadvantages of un-regulation and government regulators:
I am not an advocate of too much regulation. Having gone too far in
deregulating - which contributed to the current crisis - we must
resist the temptation to go too far in the opposite direction.
While markets are imperfect, regulators are even more so. Not only
are they human, they are also bureaucratic and subject to political
influences, therefore regulations should be kept to a minimum.
He then goes on to propose three guiding principles for regulatory
reform. The first is that regulators must accept responsibility for
not allowing bubbles to get out of control. This is framed within the
inherent contradiction, Soros suggests, that regulators are no better
than markets at identifying what's a bubble and what's not.
[S]ince markets are bubble-prone, regulators must accept
responsibility for preventing bubbles from growing too big. Alan
Greenspan, the former chairman of the Federal Reserve, and others
have expressly refused that responsibility. If markets cannot
recognise bubbles, they argued, neither can regulators. They were
right and yet the authorities must accept the assignment, even
knowing that they are bound to be wrong. They will, however, have
the benefit of feedback from the markets so they can and must
continually re-calibrate to correct their mistakes.
The implicit assumption here - correct, in my view - is that we have a
problem of too-big-to-fail in these bubbles, systemic risk, and the
loss of the threat of moral hazard: the Greenspan and next the
Bernanke put. It is therefore not a sufficient answer for regulators
to refuse to take on the burden of bubble-popping. This seems to me
quite persuasive.
Second, Soros goes on, the problem is not merely the money supply,
though that is a factor, it is also the availability of credit and
then leverage off of it:
Second, to control asset bubbles it is not enough to control the
money supply; we must also control the availability of credit. This
cannot be done with monetary tools alone - we must also use credit
controls such as margin requirements and minimum capital
requirements. Currently these tend to be fixed irrespective of the
market's mood. Part of the authorities' job is to counteract these
moods. Margin and minimum capital requirements should be adjusted
to suit market conditions. Regulators should vary the loan-to-value
ratio on commercial and residential mortgages for risk-weighting
purposes to forestall real estate bubbles.
Again, I think this is broadly persuasive. I say this despite being a
big fan of John Taylor's new, short book from the Hoover Institution
Press, [1]Getting Off Track. The strong version of Taylor's argument,
Steve Krasner noted to me in conversation last week at Stanford, is
that if the Fed had simply followed the Taylor rule regarding the
money supply, then the bubble would not have developed. On the strong
version of Taylor's argument in the book, whatever the failures of
regulation or, responding to Greenspan's reply to Taylor, the global
savings glut, it doesn't matter - the money supply was the problem.
Soros is implicitly saying that money supply alone is not the issue;
credit and leverage matter on their own, and so does regulation
directly going to credit, e.g., margin and capital requirements.
Again, I am a big fan of Taylor's book - but I am content to read the
argument more weakly, so to understand that the crisis is
overdetermined, and that money supply, credit and leverage, political
temptations in regulation, etc., all play a role. I think most
financial commentators would go with the weaker position of
overdetermination of causes. And on the credit question - more
precisely, the leverage question - Soros is right, I think.
Soros finally - third - says that financial regulation must take up
the question of efficient market theory. On this, he is most
controversial. He has addressed much criticism toward the EMH over the
years - and the arguments are not always the same, nor of the same
level of breadth or generality. On the one hand, the latest edition of
Bratton's Corporate Finance textbook, which I am about to use in the
Fall semester for the first time in a couple of years and which begins
with a discussion of efficient markets, expresses much greater
caution, consistent with most academic commentators. Certainly that is
my feeling, particularly with regard to credit markets and
instruments. On the other hand, I was dismayed by how thoroughly my
law students last year dismissed market efficiency as having any value
at all and the very idea of quantitative valuation (of course, this
would save them the trouble of doing the present value arithmetic
...). So what is Soros's formulation of the critique of EMH and how
conceptually global is it in this iteration?
Third, we must reconceptualise the meaning of market risk. The
efficient market hypothesis postulates that markets tend towards
equilibrium and deviations occur in a random fashion; moreover,
markets are supposed to function without any discontinuity in the
sequence of prices. Under these conditions market risks can be
equated with the risks affecting individual market participants. As
long as they manage their risks properly, regulators ought to be
happy.
But the efficient market hypothesis is unrealistic. Markets are
subject to imbalances that individual participants may ignore if
they think they can liquidate their positions. Regulators cannot
ignore these imbalances. If too many participants are on the same
side, positions cannot be liquidated without causing a
discontinuity or, worse, a collapse. In that case the authorities
may have to come to the rescue. That means that there is systemic
risk in the market in addition to the risks most market
participants perceived prior to the crisis.
The securitisation of mortgages added a new dimension of systemic
risk. Financial engineers claimed they were reducing risks through
geographic diversification: in fact they were increasing them by
creating an agency problem. The agents were more interested in
maximising fee income than in protecting the interests of
bondholders. That is the verity that was ignored by regulators and
market participants alike.
The critique of efficient market theory here is agent-failure. No
argument there - the agency problems go deep into the heart of the
financial services institutions themselves, to include the fundamental
problem of what Steve Schwarcz has described as secondary agent
failures - misalignments of both duty of care and duty of loyalty. AT
bottom, Soros is pointing to information uncertainties in two
directions: one, as between managers and financial agents and, two,
between compensation in the present on uncertain future payoffs,
without an effective mechanism of clawback to correct results after
the fact or an effective discounting mechanism to address potential
future failure. But at bottom the critique in this piece of EMH is an
agent-principal critique. One can add other critiques; some stronger
and some weaker, but Soros has identified the one most amenable to
regulatory reform, I reckon.
Given the agent-centered critique, it is no surprise that Soros favors
a "skin in the game" approach - and he says that the 5% retention by
originators in securitizations is too small:
To avert a repetition, the agents must have "skin in the game" but
the five per cent proposed by the administration is more symbolic
than substantive. I would consider ten per cent as the minimum
requirement. To allow for possible discontinuities in markets
securities held by banks should carry a higher risk rating than
they do under the Basel Accords. Banks should pay for the implicit
guarantee they enjoy by using less leverage and accepting
restrictions on how they invest depositors' money; they should not
be allowed to speculate for their own account with other people's
money.
It is probably impractical to separate investment banking from
commercial banking as the US did with the Glass Steagull Act of
1933. But there has to be an internal firewall that separates
proprietary trading from commercial banking. Proprietary trading
ought to be financed out of a bank's own capital. If a bank is too
big to fail, regulators must go even further to protect its capital
from undue risk. They must regulate the compensation packages of
proprietary traders so that risks and rewards are properly aligned.
This may push proprietary trading out of banks into hedge funds.
That is where it properly belongs.
Again, little argument from me that proprietary trading conceptually
at least belongs in the hedge funds and private equity funds, whether
that is practical today or not. Proprietary trading is not the only
problem. I ordinarily teach a private equity course each year; it
covers the industry as a whole, including venture capital, buy out
funds of various kinds, etc., and I throw in little bit on hedge funds
as they aren't really covered elsewhere in our curriculum. But I was
troubled when last I taught the class in spring 2008 at a quote in a
Henry Kaufmann article in the WSJ - I always talked as an academic
about private equity serving to bring managerial efficiencies to
public companies via buyouts and all sorts of jolly stuff. Whereas
Kaufmann quoted a LBO fund manager as shrugging and saying, in
paraphrase, we're just part of the big mechanism that takes money from
the Fed and pours it into the housing markets and take a cut along the
way. Ouch, ouch, double ouch.
And finally ... derivatives. Do not fail to note Soros's blunt comment
on credit default swaps (italics added below). I am not sure I would
have focused on CDSs, once having put them onto public exchanges and
regularized and made public the counterparty relationships. Nor do I
think that the underlying securitizations are themselves the problem.
I grant the agency issues that Soros raises and of course there is a
huge, huge problem with insurance that turns out to be a license to
kill. The problem is more than just license to kill. It is also what
we might call a "license to be indifferent" - arising from what has
been talked about as the "phantom" creditor problem - formally holding
debt the risks of which have already, but non-publicly or
transparently, been counter-partied away, leaving one with an
incentive to indifference or something more toxic. Moreover, the mere
existence of an insurance market in CDSs does not, by itself alone,
solve the valuation problem of the underlying assets or the insurance.
Still, I think I probably would have instead focused on the
derivatives built to leverage the securitizations themselves as being
the most dangerous and toxic assets in all of this:
Finally, I have strong views on the regulation of derivatives. The
prevailing opinion is that they ought to be traded on regulated
exchanges. That is not enough. The issuance and trading of
derivatives ought to be as strictly regulated as stocks. Regulators
ought to insist that derivatives be homogenous, standardised and
transparent.
Custom made derivatives only serve to improve the profit margin of
the financial engineers designing them. In fact, some derivatives
ought not to be traded at all. I have in mind credit default swaps.
Consider the recent bankruptcy of AbitibiBowater and thatof General
Motors. In both cases, some bondholders owned CDS and stood to gain
more by bankruptcy than by reorganisation. It is like buying life
insurance on someone else's life and owning a licence to kill him.
CDS are instruments of destruction that ought to be outlawed.
Whether one agrees with Soros on each item, or the strength he assigns
each item, this is an outstanding short essay on reform agendas. As I
remarked in my note on the passing of Peter Bernstein, Soros on these
issues of finance and political finance is in a category of senior,
seasoned observer who is both at home with the analysis of risk but
also very clear as to its limits, and rooted in the practical world of
markets first and theory second. You can, as I do, think that Soros's
funding for things like Moveon.org and other bitterly partisan
political ventures a very bad thing - and I mean a very bad thing, and
a very bad thing including for the Democratic Party, but that's a
whole different discussion - while seeing the value in this kind of
informed intervention. The financial crisis is a matter, unlike a
range of others, that fits Soros's very considerable public talents
hand to glove.
References
1.
http://www.amazon.com/Getting-Off-Track-Interventions-Institution/dp/0817949712
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