By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.
Economists have joined the debate about the merits of requiring the downsizing of too big to fail (“TBTF”) financial firms. However, these debates have almost been devoid of theoretically based economic arguments.
Some economic analysts have argued that the TBTF institutions have captured and will manipulate the relevant regulatory and political structures to their advantage. This a political argument and economists as economists do not have any greater insight into the political dimension of issues than Joe and Mary Sixpack. Other economists have decried the TBTF institutions and their contribution to a further skewing of the distributions of income and wealth. Again, economists as economists have no greater insight in to issues of economic fairness than the next person.
With the exception of citing moral hazard incentives to greater risk taking, economists speaking as economists have been virtually silent about the fact that TBTF (and wanted-to-be-TBTF) firms were the center of a process of designing, underwriting, and issuing a variety of structured capital market products that contributed not only to redistributions of wealth in their favor, but (and more importantly to economists as economists) also contributed to the misallocation of resources on a massive scale. And the efficient allocation of resources is the sine qua non of economics.
This post outlines one line of economic reasoning that leads to the conclusion that TBTF financial firms should be dismantled on the grounds that the highly concentrated financial sector can give rise to informational asymmetries, the mispricing of risk and the misallocation of capital and other resources.
It is not a general theory of the recent crisis, but an argument suggesting that in financial markets dominated by a few large firms, those firms will be in a position to exploit informational asymmetries and enrich themselves even as their excess profits are dwarfed by the costs to society of the misallocated resources.
Informational Asymmetries
Economics indicates that markets and trading lead to an efficient allocation of resources. This result is predicated on a number of assumptions including the assumption that all parties to transactions make equally well-informed decisions. Implicit is an assumption that all the relevant information is free and is reflected in the decision-making processes of all parties. However, information is not free; the markets are unlikely to generate optimal levels of information given the “public good” dimension of information, and the information that is available is not uniformly distributed.
Economists have recognized that problems can arise when one party is intentionally misinformed or does not have access to some of the relevant information that other counterparties possess. If one of the less well-informed parties to the transaction would not have agreed to the trade or exchange had it had access to all the information, than the transaction was presumably inefficient and welfare reducing. To date, economists’ focus has been exclusively on information about the item (good or service or financial asset) being exchanged. The classic case in the economics literature is Akerlof’s, The Market for Lemons—i.e., the used car market where sellers have more information than buyers about the true condition of the cars.
Society has an interest in preventing inefficiency-producing, welfare-reducing transactions. Efficiency-enhancing disclosure standards should include all relevant information (but not all analyses). In addition to issuer and issuer-specific information, all non-issue non-issuer specific information (baring proprietary client information) should be disclosed to all of the counterparties. In the context of financial markets, relevant information is all information that bears on the expected return or the riskiness of the instrument. Currently, counterparties are implicitly assumed to have equal access to non-specific, relevant information, e.g., macroeconomic conditions and information regarding the relevant sector of the economy.
Informational asymmetries are particularly troublesome in markets for fixed income securities. For fixed income instruments, the expected return for a buy-and-hold investor is the current yield to maturity (re-investment risk of coupons aside). Significant informational asymmetries with regard to expected rate of return for such investors are limited. However, the risk dimension of the risk/return analysis is another story. The upside risk in fixed income securities is more limited than the downside risk as the coupon is fixed. On the other hand, credit events can degrade performance, but not enhance it. Tail risk is also often the most opaque.
When informational asymmetries contribute to mispricings in credit markets and resource misallocations in the economy, it will most likely be the result of buyers having less information then sellers about downside risks. Furthermore, firms involved in structuring products or underwriting issues that have more or better information about downside risks being higher than generally perceived will keep it private.
Financial product specific informational asymmetries can exist when the product is complex. For example, in 1994, a headline dominating financial scandal involved Banker’s Trust. If my memory is correct, BT had sold a non-vanilla interest rate swap product with embedded bells and whistles to P&G. Evidently unknown or unappreciated by P&G (when the deal was struck) was a provision by which P&G financed part of the deal (reduced the cost to themselves) by selling a currency option (on DEM/FrF). The ERM experienced a crisis and P&G found itself on the wrong side. It suffered losses and called foul. During the ensuing investigation, the regulators gained access to internal BT emails regarding the deal. One of the emails read something like: “They think that they know what they are doing, but they don’t. They are the perfect customer for us.”
Large financial firms may also possess non issue specific information of a kind unavailable to other market participants by virtue of the size of their activities in market making, underwriting, issuing structured products, advising, prime brokering, or via knowledge of their counterparties or some combination. For example, Goldman Sachs, by virtue of the scale of its activities relative to the CDS market may have had non-public knowledge about the vulnerability of AIGFP, AIG itself. It may have had insight to the stability of the CDO market and the balance sheets of firms which had purchased CDS protection from AIGFP as well the market for RMBS in general.
Attention has recently focused on GS’s role in creating CDOs that enable GS and one client to short the sub-prime market while GS sold the long side to other clients. GS has argued that it did nothing illegal and that it was acting on its own analysis and entirely properly. It may be that GS acted legally, but it was acting on the basis of an informational asymmetry as the clients that went long did not have access to all the information necessary to perform all the analyses that lead GS to take steps to short the market. The question of legality aside, it seems that GS knowingly exploited an informational asymmetry and encouraged the misallocation of capital.
GS has argued that it has outperformed its competitors because it was more knowledgeable, i.e., performed better analysis. However, GS may have been more knowledgeable, because it positioned itself to glean more information (from it counterparties and its numerous business lines), process it and act on that information before it was widely available to other market participants.
Chris Whalen recently stated publicly what many in the markets have believed for years: “In our experience, Buy Side investors today don’t do business with GS or the other major Sell Side firms because they trust them. They do business with firms like GS because they believe that the firm has better access to information than do the other dealers in the marketplace.”
GS uses information gained in the markets and from client contact to structure products and take proprietary positions To the extent that the trades and positions are based on informational asymmetries they represent a transfer from the “dumb” money to the “smart: money GS, and its high value clients.
With the number of large financial firms now three less than before the crisis, it is likrly that the remaining firms will reach a size relative to the markets that they will have access to information unavailable to other players, and hence be in a position to exploit informational asymmetries.
There are a number of questions which should concern economists and regulators.
1. Did the buyers of CDOs under invest in information and analyses because of the expense and the perception that disclosure and the rating agencies leveled the playing field?
2. What can and should be done to prevent firms from operating on non-instrument specific informational asymmetries gleaned through market activities?
3. What if anything can be done to insure that “sophisticated” investors are sophisticated enough to understand all the risks in new complex and unseasoned instruments and products.
Given the difficulties of determining whether one of the financial firms has or had relevant market non instrument specific information that the other counterparty(s) did not, regulators would have an impossible time enforcing compliance with a disclosure standard consistent with the efficient allocation of capital.
However, regulators could prevent firms from gaining informational asymmetries by preventing them from establishing large market shares in underwriting, issuance or trading of the relevant instruments. If each of the financial firms were constrained to be a small fraction of every market and activity they were engaged in, then it is less likely that any firm would be in possession of significantly more information about the market, counterparties, etc than any other participant in the market.
Furthermore, increasing the number of players with access to non-public information increases the likelihood that the information would become public.
Would limiting the size of a firms activities in a market/instrument be too costly to society, i.e., would downsizing the large financial firms be rightsizing them, or would it be inefficient? Defenders of the large firms argue that their size enables them to achieve economies of scale and that they are efficiency promoting.
While there are undoubtedly economies of scale in some financial market activities and while some subset of customers may find it advantageous to deal with a dominant provider of financial services, these considerations do not necessarily imply that large firms are more efficient or contribute to more efficient allocation of capital than small firms.
If the larger firms are larger because they are more efficient than smaller firms, it should be reflected in higher accurately measured returns on equity and risk-adjusted rates of return on capital. I believe that the readily available numbers (at least for commercial banks) would be inconsistent with the idea that the larger firms are more efficient. It seems much more likely that the existing large financial firms owe their size and success to the TBTF doctrine, their oligopolistic positions and their ability to profit from the informational advantage that they hold rather than to efficiencies arising from the scale of their operations
It is likely that TBTF firms have exploited informational asymmetries which contributed to the mis-pricing of risk and the misallocation of resources. The most straightforward way to prevent a repeat of the crisis in the future would be to limit the size of financial firms so what their activities are small relative to the markets in which they operate.
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Cronyism also creates information asymmetries. It isn’t just size but the connections which count. Unlike AIG, Citi, or JPM, it was not size that saved Goldman in the meltdown but having a former chairman and CEO being Tresury Secretary at the time.
I agree 100% that Goldman serves no useful societal function and that its activities result both in resource misallocation and wealth destruction. It quite simply has no reason to exist, and shouldn’t.
TBTF have implied government backstops which make their cost of doing business cheaper. This allows them to be more inefficient and risk taking. Their is also the effect that with size, a granular understanding of markets and communities is lost. This leads to further misallocations and indeed contributes largely, I think, to bubble formation. Afterall in securitizations and derivatives based on them, the information is controlled and generated by the orginator, the TBTF. And these instruments tend to be more profitable than investments in the real economy. They are also more unstable. So again misallocation and wealth destruction.
It is not likely that TBTF firms have exploited informational asymmetries, it’s certain and that’s the main cause of the financial crisis. Then exploitation of informational asymmetries stretches to cheating and fraud. Forget about efficient allocation of resources, that’s looting.
I had a series of posts on my blog about lemon banking market or lemon products (toxic assets).
Recently I started to suggest that again informational asymmetries are the cause of sovereign debt crisis. Look at the case of Greece. Sovereign debt is a market for lemons actually closer to a Ponzi scheme.
http://mgiannini.blogspot.com/2010/02/sovereign-debts-markets-for-lemons-and.html
Market structures and some TBTF helped overcome information asymmetries and sustained the development of Greece sovereign debt, under very peculiar conditions which range from cheating on statistics (remember ratings of sub-primes issue) to “too safe to fail” assets assumptions (lure more investors in sovereign bonds just to get back your money or Ponzi scheme).
http://mgiannini.blogspot.com/2010/03/money-creation-for-nothing-or-let.html
It is not economic inefficiencies arising from informational asymmetries that needs to be eliminated but rather criminal racketeering among political and financial elites that must be prosecuted.
The deliberate, controlled demolition of financial institutions including Bear Stearns, Lehman, Citi and AIG by individuals like Paulson, Rubin, et. al. , was a criminal act. These individuals intentionally torpedoed the US financial system and the global economy, thereby, creating a pretext for the implementation of a global financial regulatory regime administered by the IMF/BIS/FSB cabal under the auspices of the G20.
Any analysis of so-called informational asymmetries without addressing the objectives of the oligarchy that engineered the global financial crisis is at best pedantic.
You say that TBTF firms have “contributed to the misallocation of resources on a massive scale.” That would serve as a definition of parasitism.
At last, a Richard Alford post that I disagree with! In my opinion the biggest information gap is between spoilt retail investors and a complacent buy side, although the sell side are guilty of exploiting the fact that it is easy to part fools from their money. The best way to deal with it is, apart from a safety net to limit the worst outcomes, to stick retail with their losses, to uncompromisingly demand standardised performance information from fund managers, and to promote financial education for the public and professional qualifications for fund managers. For example, one of the biggest mistakes made in the financial crisis was to bail out money market mutual fund investors, who were looking for the capital certainly of short-term investments with a higher return than insured deposits. As I said in a comment on the Spitzer/Black post yesterday, it’s a cultural thing. We need to build up an investment culture that says “don’t buy what you don’t understand”. Get that, and the buy side will be forced to be more rigorous and careful, and then the sell side will take care of itself, because they will simply be unable to do business if they do not provide lots of information, and will find any reputation for cheating clients to be terminal.
In my view, the focus on “bankers”, derivatives, rating agencies etc is making matters worse, because it is allowing us to avoid looking at the real culprits for the financial crisis – ordinary people, ourselves.
“that the highly concentrated financial sector can give rise to informational asymmetries, the mispricing of risk and the misallocation of capital and other resources.”
This is certainly true…
An anthropological approach suggests that the foundational issue rests in the relationship of self-interest to the attenuating nature of biological altruism and its connection to natural human community size (Dunbar’s Number).
In other words, in scaled social structures the loss of physical and social proximity leads to a self-interested mis-perception of the whole by its component ‘communities’.
And this leads inevitably to the situation described in the quote above.
This has only been going on repeatedly for the last few thousand years. You’d think we’d catch on and begin to look at remedies.
Economics can never be a serious science until it begins to recognize how damaging and misleading it is to focus on a single flawed technology utilized by its true subject: the metabolism of a social organism.
It’s also interesting to consider civilizations as products of net ‘social energy’ (countless individual and group decisions interacting)…
And hence, the role of money as a store and allocator of ‘social energy’ (rather than as a store of value).
In this context, the excessive concentration of the ‘tokens’ of this social energy (money), and the role of inherent bias in credit-creation becomes a political catastrophe without remediation.
Maybe this sounds like gobbledy-gook, and maybe it is…
and I’ve bored myself with my own repetition. (I’d really like to move on to other aspects but feel I really need to get this root established.)
But I feel its important that both our political and economic experts, and more importantly regular people… begin to understand that it has real implications in policy and provides intellectual support and direction for needed remedies…
The Foundations of Authoritarianism
http://culturalengineer.blogspot.com/2009/05/foundations-of-authoritarianism.html
A thought:
Omitting the role of biological altruism and especially its attenuating nature from economic theory and policy consideration…
Makes as much sense as it would to ignore the role of self-interest.
Yeah, it makes things more complicated to measure and evaluate in economics.
But civilizations ARE complex/chaotic systems after all.
Who said planetary survival and progress were supposed to be easy!
Alford has come to bury Ceasar, not to praise him . . .
The Informational Asymmetries argument is exactly the one that TBTF institutions use to justify their size! And Alford’s proposed solution is a give-away to those firms. Limiting TBTF firms by market share begs the question: how do you define the market? Definitions based on global markets mean that TBTF firms have plenty of room to GROW, while still exerting their pernicious political influence here at home.
The commentors (especially Hugh) are much closer to the truth: We shouldn’t have size limits because TBTF firms EXPLOIT informational asymmetries, we should have size limits because they CREATE and WORSEN informational asymmetries that amount to market manipulation and fraud.
Yves, I am again dismayed at your providing a forum for Alford to state views that I would think are counter to your own thinking.
In Alford’s prior post of several weeks ago, he wrote that we should focus on the failings of the Fed as an institution and essentially ignore the backdoor bailout. This, at a time when you noted that there was an organized attempt at rehabilitating Geithner’s reputation. (Today we lean that SIGTARP is hinting at possible civil or criminal charges in relations to the AIG backdoor bailout.)
Alford’s arguments in his last two posts (I’m not familiar with his previous posts or other work) are written in an intellectual and academic fashion but the winding arguments simply finesse a point a view that is supportive of Geithner and TBTF. in a rather deceptive way. Let’s Hold the Fed Accountable! and *dismantle* TBTF! he proclaims loudly- while he then proceeds to undermine the efforts to accomplish those worthy objectives.
The notion of “efficiency” is one that seems far more foggy than is generally assumed.
If “efficient” markets depend on widely shared and accurate information about the future utility of purchased goods and services, then one immediately finds a distinction between markets for hard goods (such as cars, wheat and televisions) and financial products (stocks, bonds, CDOs etc.)
For the former, all relevant information about the product’s ability to provide the “utility” that a buyer expects can be known with adequate scrutinty before purchase (at least in theory). For the latter, because the “utility” produced by the product depends on future performance, which in turn depends on a wide variety of variables that the producer does not control and that occurr in the future (moves in interest rates, exchange rates, GDP, moves by competitors, etc.) all relevant information cannot be known, although buyers can know as much as possible, but it will be incomplete. Certainly in the extreme (the Bankers Trust derivatives) the hiding of information is clearly material and produces inefficiencies, but this is a separate point.
As a result, financial markets can never be efficient in the way that markets for hard goods are. The notion of efficient financial markets is a myth that collapses upon even superficial scrutiny, or, put another way, it is a notion that requires its own specific definition of “efficiency” that neuters it of much usefullness and clarity.
Moreover, the notion that the TBTFs can access information unavailable to others is a little odd in relation to the latest crisis. I’m just a Joe Six Pack, and I recall reading about NINJA loans, LIARS loans and general housing bubble madness in blogs and in the mainstream media as early as 2005. Why smaller financial institutions staffed with armies of PhD economists, sophisticated traders, bankers, portfolio managers etc. were somehow ‘duped’ is a mystery to me. The information seemed to be as prevalent as water in a thunderstorm. Why it was ignored is another issue entirely.
Nevertheless, there are many reasons to limit size in the financial industry, so all in all I quite agree with the premise of the post.
btw, I believe the bubble was ignored not because Wall Street didn’t see it, but because it was so enormously profitable to milk it that doing so was the most ‘rational’ behavior from the standpoint of immediate financial self interest. This is not an original thought and many who comment here share this view.