Knowing and Making

The FSA is expected over the next few days to publish published yesterday its new rules on bank bonuses, broadly in line with the guidelines announced by CEBS, the pan-European committee of regulators. It's likely that, f From 1 January, banks will only be allowed to pay a third  40% of bonuses in cash, with the rest paid as deferred claims of one kind or another - debt, preference shares or equity - which can be drawn down over three to five years. This is meant to reduce the incentive for bankers to take risks: with a high proportion of their wealth tied up in the company they work for, they will want to ensure its survival. However, there are two questions it leaves open, as I just managed to squeeze in on Radio 5 this afternoon  before they decided the 6 o'clock news was more important. The first question is: do banks - and bankers - actually know whether their actions are risky? It certainly didn't seem that way in 2008. Investments in property that they thought...

In an intriguing example of pricing an externality, Barack Obama has announced a plan to tax American banks based on their reliance on the wholesale finance markets. On a related subject, Nick Rowe has a neat analysis of finance as magic - the magic of borrowing short and lending long, sharing risk and creating liquidity. To make this magic work in a more stable fashion, it's understandable that governments would want to encourage banks to move from wholesale to deposit finance. Assuming it works, what are the effects of this move likely to be? The coordination game between multiple owners of capital will work better, for two reasons. First, because no individual will have as much power as they do now. Second, because the more finance is provided by millions of depositors (instead of a few hundred managers of wholesale capital) the more statistically predictable their behaviour is likely to be. Even when there are herd changes in depositor behaviour, the movement of a larger...

Robert Peston reports that Dunfermline Building Society is going to be taken over by Nationwide, and asks "why Dunfermline took such risks that ultimately cost the society its independence". Here's an article with a bit more detail about the story and what happened. I haven't been able to find out whether management were incentivised with highly leveraged short-term bonuses, but given that this is a Scottish building society, the obvious assumption is that they were not. So why would they take such huge risks? The answer surely is that they did not knowingly do so; but that they felt a pressure to chase profits and closed their eyes to the risk that usually goes with high returns. The pursuit of high profits is ingrained in the behaviour of managers even without financial incentives. This could be seen as a social pressure to keep up with the next guy; a psychological pressure to be the alpha male; or a boundedly rational economic decision based on an inaccurate est...

Robert Peston raises the interesting issue of whether European banks (and Goldman Sachs) were taking high risks in dealing with AIG. Goldman, Barclays, Society Generale and Deutsche Bank have each received between $8bn and $13bn since the US government's AIG bailout. Peston takes this as some indication that these banks were not being managed prudently - their reliance on AIG being a risky one. But the main complaint against AIG is that it was selling credit default swaps and other financial insurance products while not having enough capital to cover them, and underpricing the risk of default. If this is the case, then it might have been perfectly legitimate for these banks to buy the insurance, even factoring in the risk that AIG would default. A large proportion of the payments received by Goldman (Peston doesn't break down the payments to the other banks) are CDS-related - indicating that their insurance policy paid off. Even if it hadn't, they would not have "lost...

The FT's Market Insight column from a couple of days ago contained a reference which at first I skimmed over with barely a glance: "[bankers] feared that public sales would produce painfully low prices. That is a valid fear. After all, there are very few investors in the system right now with any appetite or capacity to take risk." A rather orthodox assertion and hardly worthy of note, thought I. And yet - a little thought shows that the riskiness of an investment is not only a characteristic of the underlying asset itself. Recall that, just a year or two ago, lots of not-very-risky assets with unexciting yields were being converted into riskier, high-return instruments by the simple trick of leverage. Borrow £200,000 at 4%, bung in £10,000 of equity, buy £210,000 of property or shares yielding 5%, and your £10,000 of cash magically earns a return of 25%, in return for a vast increase in risk. But the same trick is even easier to do in reverse. Let's say you are offe...

Brad DeLong has an impressively clear (although, or perhaps because, a bit technical) piece on risk appetite and fundamental values of assets . I feel I should respond to it, but it's such a tour de force of clear and explicit assumptions, rigorous logic and thunderous conclusions that I feel I barely can. I particularly loved this statement for pure bloody-minded literalism (that's a good thing, by the way): The fundamental values of asset prices are the money-metric values that the costate variables associated with the commodities would have in some reasonable utilitarian central-planning social-welfare-maximization exercise under reasonable utilitarian preferences. However, here is what comes to mind: Given that asset prices rarely approach the values Brad ascribes to them, could this be because there is competition for the limited amount of savings capital available in the world? If I, as a productively investing business, want to get access to some of it, I probably need t...