Category Archives: Risk and risk management

Amar Bhidé on the Role of Human Judgment

Rob Johnson of INET interviews Amar Bhide, an old McKinsey colleague and author of the book A Call for Judgment. From the introduction to this video:

The Professor of International Business at the Fletcher School of Law and Diplomacy criticizes the tendency in many quarters to rely on mathematical models to inform investment decisions. It’s that overreliance on models that tend to generalize and simplify that helped drive the world into the global financial crash of 2008 and the ensuing Great Recession. Bhidé makes a strong case that human actors need to immerse in the details of individual cases and weigh many different factors to come up with tailored decisions that more closely apply to the complexities of the real world. Bhide also argues that regulators need to take a similarly human-centered approach.

Quelle Surprise! Fed and Treasury Keen to Find As Few Systemically Risky Firms as Possible

We seem to be going back to the world before the crisis in number of respects. The first is that the Financial Times is again running rings around the Wall Street Journal on markets and financial services industry coverage. The crisis forced the Journal to throw a lot of resources on those beats, with the result that it became pretty competitive.

The second is that the authorities seem to be engaged in a weird form of cognitive dissonance. They clearly can’t pretend the crisis didn’t occur; if nothing else, all the extra new studies and rulemaking imposed by Dodd Frank make that impossible. Yet in every manner imaginable, they behave as if no financial markets near death event took place.

The object lesson of the evening is a story in the Financial Times on a battle between the FDIC, which is responsible for resolution of systemically important firms under Dodd Frank versus the Fed and Treasury. The struggle is over how many non-banks are to put on the systemically important watchlist as required by Dodd Frank. No one wants to be on that roster; it leads to the potential to be subject to all sorts of proctological examinations.

Quelle Surprise! Fed Lent Over $110 Billion Against Junk Collateral During Crisis

Former central banker Willem Buiter once remarked that the Federal Reserve’s “unusual and exigent circumstances” clause, which enables it to lend to “any individual, partnership or corporation” if it can’t get the dough from other banks, allows the Fed to lend against a dead dog if it so chooses.

It looks like the US central bank did precisely that.

Josh Rosner: Dodd Frank is a Farce on Too Big to Fail

Note: Josh Rosner, managing director of Graham Fisher & Co., submitted this written testimony for a March 30 panel for the House Oversight Committee that was cancelled. His testimony has been entered into the Congressional Record and will be available on the House Oversight Committee website in the near future. The text appears below..

Has Dodd-Frank Ended Too Big to Fail?

Almost three years have passed since the United States financial system shook, began to seize up, and threatened to bring the global economy crashing down. The seismic event followed a long period of neglect in bank supervision led by lobbyist-influenced legislators, “a chicken in every pot” administrations, and neutered bank examiners.

While the current cultural mythology suggests the underlying causes of the crisis were unobservable and unforeseeable, the reality is quite different. Structural changes in the mortgage finance system and the risks they posed were visible as early as 2001. Even as late as 2007 warnings of the misapplications of ratings in securitized assets such as collateralized debt obligations and the risks these errors posed to investors, to markets, and to the greater economy were either unseen or ignored by regulators who believed financial innovation meant that risk was “less concentrated in the banking system” and “made the economy less vulnerable to shocks that start in the financial system.” Borrowers, these regulators argued, had “a greater variety of credit sources and (had become) less vulnerable to the disruption of any one credit channel.”

In the wake of the crisis, and before either the Congressional Oversight Panel or the Financial Crisis Inquiry Commission delivered their final reports on the causes of the crisis, Congress passed the Dodd-Frank Act. The act claimed to end the era of “too-big-to-fail” institutions and sought to address the fundamental structural weaknesses and conflicts within the financial system. To falsely declare an end to Too Big to Fail without actually accomplishing that end is more damaging to the credibility of U.S. markets than a failure to act at all. The historic understanding that our markets were the most free to fair competition, most well regulated and transparent, has been the underlying basis of our ability to attract foreign capital. It is this view that, in turn, had supported our markets as the deepest, broadest, and most liquid.

In fact, Dodd-Frank reinforces the market perception that a small and elite group of large firms are different from the rest.

OMG, Greenspan Claims Financial Rent Seeking Promotes Prosperity!

I was already mundo unhappy with an Alan Greenspan op-ed in the Financial Times, which takes issue with Dodd Frank for ultimately one and only one disingenuous and boneheaded reason: interfering with the rent seeking of the financial sector is a Bad Idea. It might lead those wonderful financial firms to go overseas! US companies and investors might not be able to get their debt fix as regularly or in an many convenient colors and flavors as they’ve become accustomed to! But the Maestro managed to outdo himself in the category of tarting up the destructive behaviors of our new financial overlords.

What about those regulators? Never never can they keep up with those clever bankers. Greenspan airbrushes out the fact that he is the single person most responsible for the need for massive catch-up. Not only due was he actively hostile to supervision (and if you breed for incompetence, you are certain to get it), but he also gave banks a green light to go hog wild in derivatives land. And on top of that, he allowed banks to develop their own risk models and metrics, which also insured the regulators would not be able to oversee effectively (there would be a completely different attitude and level of understanding if the regulators had adopted the posture that they weren’t going to approve new products unless they understood them and could also model the exposures).

And the most important omission is that the we just had a global economic near-death experience thanks to the recklessness of the financial best and brightest.

Complexity and War or How Financial Firms Wreck Economies for Fun and Profit

There’s a great post up, “Human Complexity: The Strategic Game of ? and ?,” by Richard Bookstaber, former risk manager, author of the book A Demon of Our Own Design and currently an advisor to the Financial Stability Oversight Council. As insightful as it is, Bookstaber does not draw out some obvious implications, perhaps because they might not be well received by his current clients: that the current preferred profit path for the major capital markets firms is inherently destructive.

I suggest you read the post in its entirety. Bookstaber sets out to define what sort of complexity is relevant in financial markets:

The measurement of complexity in physics, engineering, and computer science falls into one of three camps: The amount of information content, the effect of non-linearity, and the connectedness of components.

Information theory takes the concept of “entropy” as a starting point…

Richard Alford: Fed Policy, Market Failures and Irony

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. “..there is always a well-known solution to every human problem — neat, plausible, and wrong.” H L Mencken One […]

Are Fannie and Freddie Giving Banks Yet Another Bailout by Not Pursuing PMI Claims?

The further you look at the banking mess, the more the same problems keeps staring back: too many losses, not anywhere enough equity or reserves, and a lot of tap dancing by the officialdom to pretend otherwise.

We wrote yesterday, thanks to some sleuthing by Chris Whalen, that Fannie and Freddie might be sitting on north of $100 billion of unreported losses. If they started realizing those losses, one of the first parties that would take a hit would be the private mortgage insurers, since on high loan to value loans (over 80% of appraised value), they were in the business of guaranteeing the loan balance in excess of 80%. So while the failure of the GSEs to act is no doubt part of the extend and pretend shell game, it serves to keep PMIs that would otherwise be as dead as certain notorious parrots alive.

Satyajit Das: Controlling Sovereign CDS Trading – The Dysfunctional Debate

By Satyajit Das, author of Extreme Money: The Masters of the Universe and the Cult of Risk (Forthcoming September 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

In an opinion piece entitled “Hedging bans risk pushing up debt costs” published on 9 March 2011 in the Financial Times, Conrad Voldstad, the chief executive of the International Swaps and Derivatives Association (“ISDA”) and formerly a senior derivatives banker with JP Morgan and Merrill Lynch, made the case against the EU ban on “naked” credit default swap (“CDS”) contracts on sovereigns.

Just as “patriotism is the last refuge of a scoundrel”, arguments citing market efficiency and the benefits of speculation seem to be the first resort of dealers.

Why is a Powerful Faux Liberal UK Think Tank Using a Tarnished Pol and Recycled US Republican Talking Points to Fight Breaking Up Banks?

By Richard Smith

The publication of a pamphlet from Demos, a British fauxgressive think-tank (unconnected with the American think-tank of the same name), is the latest visible move in a not-always-public epic battle between banks and regulators about bank reform. While Americans may assume that the time for regulatory intervention has passed, the preliminary findings of the Independent Banking Commission, a UK body whose output will put an important stake in the ground in the UK, is to be released on April 11th. Whatever mix of legislation, regulation and inaction is deemed appropriate by the politicians will follow the publication of the final IBC report in September.

Given the importance of this report, it should come as no surprise that the banks, or rather the bank that has most at stake, Barclays, is using every available channel to convey dire warnings about how terrible reining in the banks would be, particularly since the banks are really hardly at fault at all.

A curious centerpiece of this effort is this 100 page abortion of a pamphlet, penned by a fallen Labour MP (the usual expense account improprieties), Kitty Ussher.

Quelle Surprise! Geithner Gutting Dodd Frank via Intent to Exempt Foreign Exchange

I have mixed feelings about an article by Robert Kuttner, “Blowing a Hole in Dodd-Frank.” On the one hand, he’s found an important example of the Administration’s lack of interest in meaningful financial reforms, which is its intent to exempt foreign exchange derivatives from the implementation of Dodd-Frank. But his discussion of what this matters at critical junctures confuses foreign exchange cash market trading with derivatives and thus leaves the piece open to criticism.

Kuttner warns that Geithner has signaled strongly his preference to exempt foreign exchange from Dodd Frank implementation:

Treasury Secretary Timothy Geithner is close to a decision to exempt the $4 trillion-a-day foreign-currency market from key provisions of the Dodd-Frank Act requiring greater transparency in the trading of derivatives. In the horse-trading over the final conference version of that legislation last year, both Geithner and financial-industry executives lobbied extensively to give the Treasury secretary the right to create this loophole.

Is Nuclear Power Worth the Risk?

One of the interesting features during the Fukushima reactor crisis were the fistfights that broke out in comments between the defenders of nuclear power and the opponents. The boosters argued that the worst case scenario problems were overblown, both in terms of estimation of the odds of occurrence and the likely consequences. The critics contended that nuclear power was not economical ex massive subsidies, that there was no “safe” method of waste disposal, and that nuclear plants were always subject to corners-cutting, both in design and operation, so the ongoing hazards were greater than they appeared.

Reader Crocodile Chuck passed along a story from the Bulletin of Atomic Scientists, “The Lessons of Fukushima“, by anthropologist Hugh Gusterson. Here is the key section:

Do We Need Big Banks?

Yves here. I normally let VoxEU articles stand on their own, but this topic, of whether the bank PR that bigger banks are essential stands up to scrutiny, is near and dear to my heart.

Note that the authors point to a 1990s study that finds that a $25 billion in assets bank was the optimal size. There were a fair number of studies done then of bank size versus efficiency. I’m a bit surprised that this is the one that is most often cited, since it also came up with the biggest size threshold at which a negative cost curve kicked in (meaning the bank became more costly to run). One study found that the slightly negative cost curve started at $100 million in assets (!); more typical was somewhere between $1 and $5 billion. And remember, these studies were done in the days when banks returned checks, and check processing was believed to have strong scale economies (ie, if check processing was a bigger proportion of total costs then than now, it could arguably have increased scale economies).

Some academics were frustrated with these results. I recall reading a paper where the author argued that there were theoretical cost savings to being bigger (duh) and basically contended that the empirical data had to be wrong.

Why American Officials Have Been Criticizing the Japanese Nuclear Containment Efforts

Some bloggers as well as readers in comments have been very surprised at and unhappy with the spectacle of American officials taking issue with the Japanese response to the crisis at the Fukushima reactor. For instance, the US recommended evacuation for a 50 mile radius from the facility, as opposed to the 20 kilometers, or 12 miles, established by the Japanese.

The disparity in reporting appears to continue today.

Guest Post: Curbing the Credit Cycle

Credit booms sow the seeds of subsequent credit crunches. This column argues that these have their source in cross-bank externalities. To internalise these cross-sectional spillovers, policy should operate “across the system”. It adds that this is the essence of macro-prudential policy, which, for the first time is about to be undertaken internationally.