Wednesday, 18 March 2009

It’s FSA day

Not only do we have the Turner Review (PDF) to enjoy, but the regulator has also issued a consultation paper (PDF) on remuneration.

I’ll give the Turner Review a proper read over the next few days, but I have had a quick skim of the ‘what went wrong’ section. Not surprisingly I was drawn to the commentary on the rationality (or otherwise) of financial markets, which is explored as part of the discussion of whether the assumptions underlying the previous regulatory regime were sound. This bit is well worth a read, and it is not overly techie reading. Robert Shiller’s work on markets rightly gets a few plugs.

Here’s the core:
In the face of the worst financial crisis for a century, however, the assumptions of efficient market theory have been subject to increasingly effective criticism, drawing on both theoretical and empirical arguments. These criticisms include that:

• Market efficiency does not imply market rationality. There is nothing in empirical tests of market efficiency narrowly defined (i.e. tests of the non-existence of chartist patterns) which illustrates market rationality. The fact that prices move as random walks and cannot be predicted from prior movements in no way denies the possibility of self-reinforcing herd effects and of prices overshooting rational equilibrium levels.

• Individual rationality does not ensure collective rationality. There are good theoretical and mathematically modellable reasons for believing that, even if individuals are rationally self interested, their actions can, if determined in conditions of imperfect information and/or determined by particular relationships between end investors and their asset manager agents, result in market price movements characterised by self-reinforcing momentum.

• Individual behaviour is not entirely rational. There are moreover insights from behavioural economics, cognitive psychology and neuroscience, which reveal that people often do not make decisions in the rational front of brain way assumed in neoclassical economics, but make decisions which are rooted in the instinctive part of the brain, and which at the collective level are bound to produce herd effects and thus irrational momentum swings.

• Allocative efficiency benefits have limits. Beyond a certain degree of liquidity and market completion, the additional allocative efficiency benefits of further liquidity and market completion may be relatively slight, and therefore easily outweighed by additional instability risks which increasing liquidity or complexity might itself create. It is for instance arguable that the allocative efficiency benefits of the creation of markets for many complex structured credit securities (e.g. CDO-squareds) would have been at most trivial even if they had not played a role in creating financial instability.

• Empirical evidence illustrates large scale herd effects and market overshoots. Economists such as Robert Shiller have argued persuasively that empirical evidence proves that financial market prices can diverge substantially and for long periods of time from estimated economic values, with the calculated divergences at times so large that policymakers can reasonably conclude that market prices have become irrational.
Music to my ears, and no surprise that the FSA concludes that:
the acceptance that financial markets are inherently susceptible to irrational momentum effects does imply that regulatory approaches should be based on striking a balance between the benefits of market completion and market liquidity and the potential disadvantages which may arise from inherent instabilities in liquid markets.

And skipping forward a bit, there are some interesting comments about the failure of market discipline to sound the alarm about problem companies –
• Bank CDS prices before the crash of 2007 did not provide forewarning of the scale of problems ahead. They were moderately successful in indicating the relative riskiness of different institutions – e.g. suggesting that Northern Rock was more risky than other banks. But their overall sector wide level suggested that risks were at historically low not historically high levels.

• Bank share prices similarly failed to indicate that risks were increasing, but rather delivered strong market price reinforcement to management’s convictions that their aggressive growth strategies were value creative.

Obviously I’ve just focused on a couple of sections of the report that interested me. I may post up some further comments once I’ve had a proper look.

Turning to the remuneration consultation doc, early on the FSA (rightly in my view) makes clear that you can’t draw a causal link between rem policy and inappropriate risk-taking behaviour, but...:
there is widespread consensus that remuneration practices may have been a contributory factor to the market crisis. Practices in common use during the period leading up to the crisis, mainly but not exclusively in investment banking, tended to reward short-term revenue and profit targets. These gave staff incentives to pursue unduly risky practices, for example by undertaking higher risk investments or activities which provided higher income in the short run despite exposing the institution to higher potential losses in the longer run.

Again I went hunting for the section I'm most interested in, this time the role of shareholders. It turns out there is actually some discussion of the short-termism of shareholders, and how this can result in inappropriate remuneration arrangements being adopted. Get a load of this:
The interests of shareholders with a focus on short-term profits are not aligned with those of long-term shareholders. They are further not aligned with the interests of society as a whole, as they do not take into account the wider consequences of excessive risk-taking. Shareholders with a focus on short term profits can include employees of the firm who are participants in share incentive schemes, which often mature in a relatively short period of time. Pressure from shareholders with short-term perspectives is one factor why remuneration packages geared towards the short-term and leading to excessive risk-taking are offered to employees in the banking industry.

So they say:
Regulation of remuneration structures is a countervailing power to the influence of shareholders with a short-term focus and reduces the negative impacts of shareholder short-termism. It removes the power of shareholders with a short-term focus to impose remuneration structures which are in their interest, but not in the interest of long-term shareholders and society.

Again, I have to say I’m greatly encouraged by the direction in which things are turning. I’m almost feeling… optimistic.

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