Tuesday, February 24, 2009

Financial Crisis: Regulatory Arbitrage

I've been following the financial debacle pretty closely. I can explain a fair part of it, describing all the moving parts and how they interacted and why regulators and participants had a hard time seeing that their individual parts in it would lead to a calamity given what everyone else was doing. The main message is that it didn't start and end with the housing bubble and crash. The bubble had causes, (and the legislators behind it aren't backing off; they continue to think that more people should own houses whether they can afford them or not) and so did the crash.

But I've had a hard time summarizing the whole thing and naming a single root cause (other than vague "government interference in the markets") or a suggestion for what should be done differently that would lead to different outcomes next time. The whole thing seems so complex, and everyone in it merely responds to local incentives so it's hard to see what different incentives would lead to a a more stable outcome.

But I recently followed a pointer to an article by a group at NYU who gave a good summary and pointed to one of the parts of my story as the root cause, and I now think they're right. The root cause was regulatory arbitrage at the banks. Regulatory arbitrage describes actions someone takes in order to avoid the affects of some set of regulations that might apply to them if they ran their business differently. Rather than buying some asset in a jurisdiction where it is taxed, you have a subsidiary buy it, or you buy an option, or you buy a company that already owns it. If one kind of institution can't engage in a certain practice that looks like it'll make money, then people will invent a new kind of institution that's subject to different regulators which isn't so prohibited.

Part of my long riff on the crash has been that practically every financial institution that exists now is the result of regulatory arbitrage of some kind. Consumer banks accept deposits, but their activities are tightly regulated in order to qualify for deposit insurance, so commercial banks don't take deposits from consumers. Credit Unions have a different set of restrictions on their activities. Savings and Loans were restricted in the interest they could charge on loans, so when they had to compete on the interest they paid on deposits, they took excessive risks leading to the S&L crisis. Commercial bank investments are regulated and limited, so there are investment banks. Those have their own regulations, so we saw the rise of hedge funds which didn't have to report to anyone except their investors.

The regulatory arbitrage at the root of this crisis was that the consumer banks were restricted in what assets they can hold and what assets they can sell. So the mortgage-backed securities (MBS) they were selling stripped out the lucrative part of the loan repayment income stream and sold that for cash they could use to make more loans, while they ended up keeping the riskiest part on their books. Most of them found tools that appeared to insure against the remaining risks, but those were systemically flawed--all the banks relied on the same few institutions, and their back-up plans would only have worked if problems were isolated. When the crunch came it was general, and so all the back-up plans failed together.

As the NYU group said, "They were in effect equivalent to writing out-of-the-money put options on aggregate crises." In plain English, that means the insurers were selling assets that allowed their counter-parties to demand money from them if certain events took place. Initially, those seemed unlikely. Unfortunately, the events that would trigger the payout were defined so that when enough policies were written, only a general failure would suffice to pull the trigger. What wasn't obvious until later was that the combination of bank loan practices (required by regulators) and hedging strategies made that general failure more likely. An important thing to realize is that neither the regulators nor the banks realized when they introduced the instruments that this would be the outcome. They weren't knowingly making a heads-I-win,-tails-you-lose bet in the beginning. When you've only written the first few policies, the systemic risk is small. The risk grew as an ever-increasing number of institutions bought insurance against the same contingencies from the same counterparty. Normally, insurance companies reinsure to spread the risk to other companies, but AIG held all the credit default swaps itself.

Most of the recommendations from the NYU group make sense. More regulation, better regulation, or smarter regulators wouldn't have made anything better, and won't solve the problem next time either. Part of the dynamic with regulatory arbitrage includes regulatory capture: we have to assume that the regulations and the regulators will eventually be in the pockets of the regulated industry. The experienced people in any industry have the most information and interest in the details, so they're the natural experts to address any problems and to oversee any restrictions. The approach that can work is a set of regulations that requires visibility so that customers, clients, competitors, and counter-parties can see what their exposure is. These are the parties with a stake in the outcome who were stymied in the run-up to the debacle. Another principal is to change the nature of the compensation traders and bankers receive so that their incentives favor the long term stability of their institutions rather than short-term results. This is hard to set up, but possible: one idea is to pay bonuses in a long-term asset that vests slowly.

It's still a complex vexing subject, but understanding how regulatory arbitrage was an underlying cause at least provides a guideline to evaluating proposals to address the problem as we go forward. Bad solutions attempt to forbid certain kinds of actions or investments, since they provide an incentive to find a new kind of institution that can exploit the abandoned opportunity. It's better, when we detect a kind of transaction that is destabilizing in one way or another to find a way to allow it that makes its impact and extent visible and provides incentives to moderate the impact. That's not easy, and it's probably not the direction that regulators and legislators will want to go, but forbidding lucrative practices doesn't prevent them, it drives them underground and out of sight.

Monday, February 09, 2009

Iain Banks: Matter

Iain Banks' Matter is set in his Culture universe, and it's nearly as interesting as the best of the Culture novels. The high point of Matter is seeing people (and entities) at different technological levels interacting and moving back and forth between societies. The main focus is the Sarl, an industrializing society living on level 8 of Sursamen, an immense shellworld, and their war of conquest with one of their neighbors. The Sarl are getting help from a more advanced species, and being led to believe their own abilities are behind their successes. The royal family has a daughter Djan who was taken away and adopted by Special Circumstances, which gives a reason for them to have someone on the scene, even though Sursamen is outside their sphere of influence.

I think this is the first time we have directly seen that Banks' Culture universe includes competing civilizations at the level of the Culture. Previously we'd been led to believe that the Culture was an over-arching universal civilization that enforced a live-and-let-live stable peace among all species. Now we see that there are others at the level of the Culture, and the Morthenveld are powerful enough that the Culture mostly leaves their sectors and galaxies alone. When a Special Circumstances agent wants to visit a region under Morthenveld control she has to give up most of her powerful built-in weapons, skills, and communications devices.

Amid the local politics, and while following Djan's perigrinations as she attempts to return to Sursamen to find out what happened in the wake of her father's death, we discover that a deeper plot is afoot. Vast forces gather in darkness and secrecy, and Djan has to figure out what their goal is decide whether their plans are aligned with or opposed to those of the Culture before deciding what action to take.

The story has great descriptions of vast stellar constructions, many interacting civilizations, species and people. One of the things I like about the Culture novels is that even though we get to see grand conflicts in the foreground of the stories, it's clear that they are just the front page news of far bigger civilizations with vast abilities and gazillions of citizens, who mostly interact through peaceful commerce. We see a bit of that in a visit to a Morthenveld nestworld, which is huge beyond the scale of the entire Culture civilization.

While the book was nominated for this year's Prometheus award, I don't think it'll be a strong contender. It's perfectly sympathetic to libertarian goals and tastes, but the big conflicts don't directly apply to any hot-button issues. The book is very well written and a lot of fun to read, but this year there are books with a much tighter focus on out-of-control totalitarian governments to contend with, and Banks' Matter doesn't play in that arena.

Monday, February 02, 2009

Scott McCloud at TED

Scott McCloud, who understands comics better than anyone, gave a recent TED talk in which he explained comics while demonstrating how they work. It's a lot of fun.