Tuesday, May 6, 2014

Are you SIFI?

"Financial crises are always and everywhere due to problems of short-term debt" quoth Doug Diamond, and wisely. Not so, according to the Office of Financial Research and the Financial Stability Council, which are, apparently, planning to "designate" as "systemically important" asset managers such as BlackRock and Fidelity.

The depths of this silliness are hard to fathom.

"Fail" means to fail to pay borrowed money. An equity mutual fund or asset manager pretty much literally cannot fail. They don't borrow money. If they do, you own the assets. You bear risks. You cannot run and demand your investment back. Vanguard -- which manages passive equity mutual funds -- is number two on the OFR's list (Figure 2 p.5.) Vanguard ought to be number one on the list of institutions forever exempt from "systemic risk" worries and poster child for how a run-free financial system works.

When the Treasury Office of Financial Research issued its "Asset Management and Financial Stability" report last year, I held back comment. I thought it was a joke. OK, seriously, I thought it was one of those pro-forma documents that poor government economists have to write occasionally when their bosses get really stupid ideas, a sort of Washington drunk-texting, that polite readers quietly dismiss and wait for a sheepish apology in the morning.
The Financial Stability Oversight Council (the Council) decided to study the activities of asset management firms to better inform its analysis of whether—and how—to consider such firms for enhanced prudential standards and supervision under Section 113 of the Dodd-Frank Act.1 The Council asked the Office of Financial Research (OFR), in collaboration with Council members, to provide data and analysis to inform this consideration...
You know, "the teacher made me do it."

OK, the report said a few sensible things like
asset managers may create funds that can be close substitutes for the money-like liabilities created by banks
May. But regulating short-term debt is easy, asset management companies are a drop in that bucket, and regulating short-term financing does not require that the whole institution be "designated" and subject to "enhanced supervision." (The phrase has a lot of Darth-Vader overtones.)

Just how can an equity fund manager cause any "systemic" problem according to the OFR?
An extended low interest rate investment climate, low market volatility, or competitive factors may lead some portfolio managers to “reach for yield,” that is, seek higher returns by purchasing relatively riskier assets than they would otherwise for a particular investment strategy. Some asset managers may also crowd or “herd” into popular asset classes or securities regardless of the size or liquidity of those asset classes or securities. These behaviors could contribute to increases in asset prices, as well as magnify market volatility and distress if the markets, or particular market segments, face a sudden shock.
Stop and think about this for a minute. People who pick stocks on your behalf, might make unwise purchases. The Federal Government is going to solve this problem by designating the institutions as  "systemically important," bringing forth an avalanche of regulatory oversight. A bunch of bureaucrats are, I guess, going to stop your manager from making unwise investments. This is the purpose of the Federal Government in the 21st century. Are any founding fathers not rolling over in their graves?

If the managers are such morons, why would people let managers screw around with their money anyway?
... potential information disparities between investment advisers and their clients could undermine those mitigants in the industry. Specifically, investors might not fully recognize or appreciate the nature of risks taken by their portfolio managers, despite required disclosures and investment mandate restrictions. In some cases, managers’ incentives (for example, some performance fees) may be structured so that managers share investors’ gains on the upside but do not share investors’ losses on the downside, a situation that creates incentives to invest in riskier assets
Caveat Emptor. This reads like an advertisement for Vanguard's passive funds. Sure. People give their money to morons, who squander it. What in the world does that have to do with stopping runs? And, really, direct federal regulation is going to sort this all out?

Name an ideal financial structure, one completely immune from runs. Answer: an exchange-traded-fund. The fund makes no promise at all. If the value of assets is in question, you can't go demand your money back. If you want out, you sell your shares to someone else. Yet even this is not above the OFR's scrutineering wishlist:
For example, exchange traded funds (ETFs) may transmit or amplify financial shocks originating elsewhere.
Why? well, they trade and trading might push up or down prices. (to be fair, there is a good paragraph on potential glitches in ETF plumbing, but nothing remotely justifying treating them as "systemic.")

And onwards
...data for separate accounts managed by U.S. asset managers are not reported publicly and their activities are less transparent than are those of registered fund
A "separately managed account" is just what you think it is. You own a bunch of stocks and hire some guy to buy them and sell them for you. If he goes under, you own the stocks. They're in your name! This guy is about to be designated "systemically important." 

Bottom line,  pretty much anyone, any institution, or any structure that ever buys or sells any security is now potentially "systemically important." Grandmas who meet in an investment club to trade tips on their  e-trade accounts? Well, they "herd," they "reach for yield," and they'll be "systemically important" soon.

The Dodd-Frank act never defined what "systemically important" or "danger to the US financial system" means. Therefore, it never defined what is not systemically important, hence safe,  hence protected from regulatory over-reach. Limitations on regulatory power turn out to be more important than grants of authority. 

I held off writing about this report originally because I figured something this silly would surely blow over. But I was wrong. The Wall Street Journal reports on Tuesday 5/5 that the FSOC is going forward with the plan. The Journal gets the point:
They're not banks. They don't lend out depositors' money with a promise to return it. Rather, they are agents that invest on behalf of clients, who bear the risk of loss. The firms don't even hold the clients' money—custodians do that—and the asset managers have no claim on client funds.... 
They don't carry much debt. They don't rely on short-term funding. As far as we can tell, no one in the market is betting on their success or failure via credit-default swaps. So where's the systemic risk? 
...if BlackRock and Fidelity were to go bankrupt, the investors in their funds should not suffer any losses.... 
But as taxpayers have sadly learned since the financial crisis, concepts like "systemic risk" have never been precisely defined and remain in the eye of the regulator.



20 comments:

  1. I think that the discussion of systemic risk and SIFIs should start with a more basic question: why do we pay people to trade securities on our behalf, when we don't have a particular investment philosophy our outlook that we want them to implement? All that most people want is to have their savings grow with the growth of the economy.

    It would be enough for the financial system to implement a suitable ledger that keeps track of our savings as they grow in that way (or our debt, in the case of borrowers). What we have now is a ledger denominated in dollars, with a few unfortunate side-effects of that unit of account: 1. fragile banks 2. a need to choose asset managers 3. occasional panics where we re-evaluate that choice - in your words: "If you want out, you sell your shares to someone else."

    Most people should be holding a form of money, and financial news should not require a herd-like reaction from people managing our savings. The solution to runs is monetary innovation; the work of Gary Gorton shows that a system with a shortage of money cannot be a run-free financial system.

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  2. I agree with Dr. Cochran's sentiments regarding this sentence:

    "An extended low interest rate investment climate, low market volatility, or competitive factors may lead some portfolio managers to “reach for yield,” that is, seek higher returns by purchasing relatively riskier assets than they would otherwise for a particular investment strategy."

    Perhaps Hyman Minsky in that, but I agree mostly with Eugee Fama, who says ain't no such thing as a bubble (though I might except gold, bit coins and art prices).

    But, let's be fair: There has been a lot of preaching that the Fed's regime of low interest rates is "financially destabilizing" and has encouraged bubbles in the past (pre-2008 in real estate) or will again.

    I will agree with anybody who says regulations should first not exist, but if they do, simplicity and clarity are prerequisites. By this standard, Cochrane's proposal for banks that pay a (we hope simple) tax based on the flightiness of their deposits is interesting.

    And perhaps we should all say the obvious: If you are a saver, you are not only entitled to returns, but losses on your savings.

    In era of excess capital formation, your returns should be expected (as a group) to fall below zero,



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    1. Ben,

      "Perhaps Hyman Minsky in that, but I agree mostly with Eugee Fama, who says ain't no such thing as a bubble"

      Fama subscribes to the marginal theory of value:

      https://en.wikipedia.org/wiki/Marginalism

      There are other theories of value. See:

      https://en.wikipedia.org/wiki/Theory_of_Value

      One that is missing is the legal theory of value. A system of laws can arbitrarily give something value - absent any market forces. For instance, MMT theory would say that one reason that the currency of a country has value is because the legal authority (government) demands payment of taxes in that currency.

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    2. Frank-

      Thanks for your comment.

      I guess my feeling is that "bubbles" are not bubbles unless there is a change in underlying fundamentals, and that could happen to any asset class (set aside gold, art, and bitcoin).

      One exception might have been the dot.com bubble, in which Wall Street brokerages with solid brand names flogged e-stocks they knew were crap, as we know from e-mails that surfaced. So unsophisticated investors might have bought into it. There was a VC-brokerage house-retail investor daisy-dumping chain going on. Pump and dump.

      But in general, no. For example, leading up to 2008 we had sophisticated institutional investors buying commercial trophy properties in most major cities. The fundamentals looked good, they made their spreadsheets work. The 50 percent correction in commercial properties seems like a bubble popping, or was it a change in the direction of anticipated rents?

      More to the point, why do we hear that low interest rates cause bubbles? That suggests professional investors lose their marbles and take too much risk in low interest rate environments. That also suggests we have no choice but to suffocate growth and keep interest rates artificially high.

      Now to be fair, we have left-wing regulators and right-wing tight-money hysterics both braying that low interest rates make professional investors go crazy.

      Here is how Putin undermines the West: Throw capital at it, and lower interest rates.

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    3. Ben,

      "I guess my feeling is that bubbles are not bubbles unless there is a change in underlying fundamentals..."

      I see it a slightly different way. You can value an asset a number of different ways (not sure which is "fundamental"):

      1. Cost-of-production theory of value - for housing, how much money would it cost to build a replacement house
      2. Time theory of value - for housing, how long would it take to build a replacement house
      3. Veblen goods - for housing, how does this house make me feel better as a person (pride in ownership, personal independence, etc.)
      4. Utilitarian theory of value - for housing, how do this house perform as a roof over my head, a place to rest in secure confines, etc.
      5. Market theory of value - for housing, how much has the last similar house sold for

      The inflating and bursting of a bubble is simply the market value moving from one valuation technique to another.

      "That also suggests we have no choice but to suffocate growth and keep interest rates artificially high."

      Except that nominal growth and nominal interest rates tend to be positively correlated.

      Here is a chart comparing a nominal long term interest rate (Moody's AAA) and growth in nominal GDP:

      http://research.stlouisfed.org/fred2/graph/fredgraph.png?g=AbM

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    4. Good points.

      But, interest rates and growth were higher in the 1960s...but we also had 90 percent top MTR, a unionized workforce, and very little international trade, and transportation, finance and telecommunications where heavily, heavily regulated.

      Hard to believe, no?

      I think what happened is since then (well starting in the 1980s) central banks and the Fed have been suffocating US growth,....

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  3. John,

    I believe that companies like Black Rock, Vanguard, and Fidelity buy short term debt (on behalf of their clients) through their money market funds yes?

    "Financial crises are always and everywhere due to problems of short-term debt"

    Is the problem with the buyer or with the seller?

    "Just how can an equity fund manager cause any systemic problem according to the OFR?"

    You do realize that companies such as BlackRock, Vanguard, and Fidelity manage both stock and bond funds.

    Question: Now that these companies have been designated as systemically important, can they engage in short term lending through their money market funds or must they divest (sell off) their money market funds?

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  4. It’s good to see Doug Diamond saying that financial crises are due to short term debt. Why then is he so keen to maintain a banking system where long term loans and investments are funded by “short-term debt”? At least he and Phillip Dybvig were keen to maintain the latter system in this 1986 paper:

    https://notendur.hi.is/~ajonsson/kennsla2006/dybvig&diamond1986.pdf

    Have they changed their minds? If not, have they published anything on that topic recently?

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  5. "Stop and think about this for a minute. People who pick stocks on your behalf, might make unwise purchases. The Federal Government is going to solve this problem by designating the institutions as "systemically important," bringing forth an avalanche of regulatory oversight. A bunch of bureaucrats are, I guess, going to stop your manager from making unwise investments."

    You are actually understating your case. Mutual funds managed by Vanguard, Blackrock, etc. don't have carte blanche as to which stocks are picked. The individual investor initially chooses which fund to invest in and these funds are limited by their prospectus as to which stocks (bonds, etc) to invest in. Within the limited universe described by the funds prospectus, most funds are highly diversified. Grandma and her investment club have much more discretion as to "stock picking" than do mutual fund managers.

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  6. I second Frank Restly's point. The desire to put mutual funds under the "enhanced supervision" does not come from concerns about the liability side of their balance sheet (although the gov't did see fit to guarantee investors' shares in the crisis...), but from where they invest it. As you're saying, there's no question that this is silly for large asset managers investing only in equity.

    But that really does not apply to the majority of MMFs, who are also very active in repo markets, buying short-term debt, etc. Gary Gorton (among others) has shown this very nicely - since the end of the crisis, more than half of repo funding comes from MMFs. So a failure of a large MMF would immediately have adverse effects on the funding liquidity in the banking system...

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    1. If MMFs can promise fixed value and fail, and if banks are dependent on such MMFs for short term funding, that is why MMFs not invested in treasuries must have floating values -- so they cant fail -- and banks should be banned from relying on run-prone short-term funding! That's a whole lot simpler than making all of finance SIFI.

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    2. MMFs could have Grumpy’s “fixed value” rather than “floating value” and still buy government debt if MMFs were only allowed to buy SHORT TERM government debt, and part of the agreement between MMFs and depositors said that in the event of an MMF having problems, it could restrict repayment of deposits to the speed at which their government debt matured.

      MMFs would then be able to pay a little interest and still be near 100% safe. The above “restrict repayment of deposits” condition used to be common in the small print of agreements between normal retail banks and depositors. Not sure if it still is.

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    3. Agree that banning or at least restricting banks' over-reliance on short-term funding would be a significantly easier and more efficient way of dealing with all of these concerns, but I'm afraid for all kinds of political economy reasons [aka regulatory capture] it wouldn't be a 'whole lot simpler' to actually implement such a system...

      And in the absence of considerably stricter equity financing of banks, floating MMF share values alone would not solve the problem. In a fire sale scenario with rapidly falling share values MMFs would still cut back on short-term lending. Which again is not to say that SIFI designation etc are a first best, but given the constraints I can see where this is coming from.

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    4. John,

      "and banks should be banned from relying on run-prone short-term funding!"

      Then all that you would need to do is define what is a bank. Is GE capital a bank? Was AIG a bank? How about Mutual of Omaha or Nationwide - are they banks?

      Simpler would eliminating the need for money market funds entirely. Which means no one (including the federal government) borrows short term.

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    5. Insisting on floating values for MMFs does prevent them from failing, but it's not clear that this improves the system as a whole. There is the fire-sale externality that js4 notes above. Likewise, a ban on short-term funding seems to result in a monetary contraction. You note elsewhere that Treasury securities are already being re-used multiple times as collateral. I don't think we can regulate the system effectively if we don't understand that it is trying to produce information-insensitive securities to facilitate lending transactions, because there is a shortage of government securities that are usable as money.

      Your proposed reform of government debt is a good one, but it doesn't increase the aggregate amount of Treasury securities - only their form. Without an increase in the amount of money, we will inevitably see private efforts to produce approximations.

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    6. Frank,

      There’s no need to define the word “bank”. As you rightly say, there is no sharp distinction between banks and non-banks. The important point is to have a rule which says something like: “Any entity which accepts or attracts funds and lends on or invests those funds can only obtain those funds from shareholders rather than from depositors or bondholders.”

      How many of the traditional functions performed by a bank those “entities” carry out (e.g. issue check books and credit cards) doesn’t matter.

      Of course the above rule needn’t be applied to EVERY lending/investing institution. E.g. chasing around after every back street loan shark and other small scale lenders would not be necessary.

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    7. Ralph,

      "chasing around...other small scale lenders would not be necessary."

      Countrywide Financial was what you would call a small scale lender. With the housing boom and bust, it became a large scale lender. You get into trying to define what constitutes small scale / not small scale.

      A company can start off small scale and grow into large scale - what happens to the loans a company makes when it crosses the small scale / large scale threshold?

      "The important point is to have a rule which says something like: Any entity which accepts or attracts funds and lends on or invests those funds can only obtain those funds from shareholders rather than from depositors or bondholders”

      The problem you get into is for a large conglomerate company (for instance General Electric), how do you (as a regulator) identify the source of funding for a particular enterprise? Money is fungible.

      For instance - General Electric in a month

      Borrows $75 million in short term money on the open market
      Obtains $50 million in profits on goods that it sells
      Sells $25 million in new stock
      Loans $75 million in long term money
      Builds a $75 million dollar new manufacturing facility

      Prove that GE borrowed $75 million in short term money to lend $75 million in long term money.

      This is why you need to define the word "bank". Does a "bank" in your world engage in the production of any sellable good?

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  7. A fund complex like Vanguard or Fidelity is comprised of a number of independently managed funds. They don't act like a single large investor. That should be enough to sink this idea, without even getting into economics.

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  8. Aside from how nonsensical the idea of insuring mutual funds is, the implict argument that: (1) asset managers buy securities that are "too risky", (2) investors who hire these asset managers are too naive/ignorant/poorly informed to correct this and (3) a group of regulators can define what excessive risk taking is and identify it the moment it occurs just boggles my mind. It requires a large amount of arrogance on the part of legislators to suggest that this might be in any way beneficial to society at large.

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  9. What about MF Global? They allegedly owned none of the positions in client accounts, but somehow spent all their clients' money. They were never prosecuted for fraud. Is the new government thinking via-a-vis companies like Vanguard, "We want to be able to regulate firms into and out of the market place according to regulator whims and crony capitalism rather than enforce the criminal code on those who commit fraud."?

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