Can you stop banks acting like lemmings?

By Felix Salmon
April 14, 2009

The great Larry Lessig emails me to point to a Newsweek article he wrote back in October, which I missed at the time. It’s entitled “Why The Banks All Fell Down”, and Lessig asks whether there’s a connection between his theory there, on the one hand (properly Lessig ascribes it to Avinash Persaud), and my story about the Gaussian copula function, on the other.

Here’s Lessig:

The models governing our financial system were developed in the 1950s. They were built, as Persaud explains, upon the assumption that “each user is the only person using them.” That assumption may have made sense when only the Rand Corporation (which developed the models) had the data to act upon them. But as Persaud wrote in the Financial Times in March, in “today’s flat world, [where] market participants from Argentina to New Zealand have the same data,” the assumption is nothing short of nuts. As the market shifts, the models used by all the major investment banks “throw up the same portfolios to be favored and those not to be.” This is the Heisenberg uncertainty principle for financial markets: by being observed, the observed gets changed. The global, simultaneous and practically instantaneous “adjustments” lead “the herd” (a.k.a. our financial system) right off the cliff.

The financial system is indeed full of models which make sense if only one person uses them, but which become extremely dangerous if everybody starts to use them. Here’s the relevant bit of my Wired story:

The real danger was created not because any given trader adopted it but because every trader did. In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust.

The financial markets were reminded of this in the summer of 2007, when simultaneously all the formerly-very-successful quant and stat-arb hedge funds all blew up at the same time. Bryant Urstadt wrote the definitive article on the blow-up for the MIT Technology Review, which is hidden behind a registration firewall here; the gist is that all the funds were following much the same strategy (something called “pairs trading” is mentioned), and that as a result asset classes become highly correlated which were never correlated in the past.

In 2007, the damage was limited: there was a lot of fallout in the world of hedge funds, but the stock market continued to rise, and the systemic implications seemed to be contained. But the adoption of the Gaussian copula function was much more widespread than a bunch of hedge funds: it was embraced at pretty much every CDO origination and trading desk on Wall Street. And when the entire financial system starts using essentially the same model, the systemic devastation which can result is enormous.

So yes, when Persaud talks about “the market-sensitive risk models used by thousands of market participants”, he’s very much referring to things like the Gaussian copula function, which proved to be one of the best ways ever invented of shunting risk off into the tails. He’s probably also talking about the near-universal adoption of Value-at-Risk, which as Joe Nocera explains does a great job of allowing managers to ignore the tails, no matter how much risk is in them.

Persaud says that there are important implications for regulatory policy:

This brings us to the philosophical problem of the reliance of supervisors on bank risk models. The reason we regulate markets over and above normal corporate law is that from time to time markets fail and these failings have devastating consequences. If the purpose of regulation is to avoid market failures, we cannot use, as the instruments of financial regulation, risk-models that rely on market prices, or any other instrument derived from market prices such as mark-to-market accounting. Market prices cannot save us from market failures. Yet, this is the thrust of modern financial regulation, which calls for more transparency on prices, more price-sensitive risk models and more price-sensitive prudential controls. These tools are like seat belts that stop working whenever you press hard on the accelerator.

The problem is that it’s very unclear what the alternative is. The lesson of the failure of Basel II is, indeed, that you can’t trust banks to judge their own internal risks very well. But the whole reason why Basel II was created in the first place is that financial instruments are so complicated these days that it’s very easy to do an end-run around simpler regulations.

My feeling is that the best way to go is to set some very clear and simple rules, much as the Spanish central bank did, and refuse to allow banks to build enormous businesses doing things that the regulators don’t understand. And secondly to place a cap on banks’ balance sheets — I think something around $300 billion is reasonable, and that there’s no reason why any bank should be bigger than that. Alternatively, if you are bigger than that, then you have to become much more constrained in what kind of activities you’re involved in: you should basically just be doing plain-vanilla deposit-taking, borrowing, and lending.

That wouldn’t prevent future financial crises outright. But it would probably stop them from causing a major global recession.

More From Felix Salmon
Post Felix
The Piketty pessimist
The most expensive lottery ticket in the world
The problems of HFT, Joe Stiglitz edition
Private equity math, Nuveen edition
Five explanations for Greece’s bond yield
Comments
13 comments so far

“This is the Heisenberg uncertainty principle for financial markets: by being observed, the observed gets changed”

NO, NO, NO. The uncertainty principle states that there is an irreducible minimum uncertainty in certain pairs of observables, and applies to all wave based systems, not just the teensy ones Heisenberg was intersted in. The “observability problem” relates to quantum systems and states that it is only the act of interacting with other particles (or “making an observation”) which causes a system to be thrown into an eigenstate.

The two are unerelated. Stick to what you know, if anything.

Posted by Ian Kemmish | Report as abusive

I think that this is basically the way to go:

http://www.voxeu.org/index.php?q=node/32 32

“Regulating the new financial sector

Willem Buiter
9 March 2009″

“Narrow banking vs. investment banking

The distinction between public utility banking/narrow banking vs. investment banking; (the rest) has to be re-introduced. I advocate a form of Glass-Steagall on steroids, with a heavily regulated and closely supervised narrow banking sector, engaged in commercial banking (taking deposits and making loans) and benefiting from lender of last resort and market maker of last resort support. The investment bank sector will also be regulated and supervised, but more lightly, and according to the same principles as other systemically important highly leveraged non-narrow bank institutions.

Universal banking has few if any efficiency advantages and many disadvantages. Economies of scale and scope in banking are soon exhausted. They tend to be fat to fail, have a lack of focus, and suffer from span-of-control negative synergies etc. Universal banks or financial supermarkets use their size to exploit market power and try to shelter their risky, non-narrow banking activities under the LLR and MMLR umbrella of the narrow bank that’s hiding somewhere inside the universal bank.
Penalise bank size

Splitting banks into public utility or narrow banks does not solve the problems of banks (narrow or investment) becoming too big or too interconnected to fail. It is therefore necessary to penalise bank size per se, to stop banks from becoming too large to fail (if they are interconnected but small, they are still not systemically important). I would penalise size through capital requirements that are progressive in size (as well as leverage).”

And:

http://www.rgemonitor.com/us-monitor/255 279/limited_purpose_banking_putting_an_e nd_to_financial_crises

“This limited purpose banking is a modern version of narrow banking proposed by Frank Knight, Henry Simons, and Irving Fisher. Banks would hold deposits, cash checks, wire money, originate loans, and market mutual funds, including money market funds with no guarantee of par value redemption.

With limited purpose banking, financial crises would largely disappear. Banks would never fail, never stop originating loans, never expose the public to massive liabilities, and never see their stock values evaporate. Banks would be stable, boring economic cogs – like gas stations.

The Fed would also gain full control of the money supply. To expand the money supply, the Fed would continue buying Treasuries from the public and supplying cash. But banks wouldn’t be multiplying and contracting M1 (cash plus demand deposits) based on their ever changing decisions about lending deposited funds.

Milton Friedman, who also advocated narrow banking, blamed the Depression on the Fed’s failure to offset the M1 money multiplier’s collapse. In the past year the M1 multiplier has contracted by over 40 percent, forcing the Fed to double base money. If the multiplier shoots back up, we could see the money supply and prices explode.

What about investment banks, brokerage firms, hedge funds, and insurance companies? What’s their right financial order?

Again, regulate to purpose.”

Banks will cease to act like lemmings once they are no longer run by people — who will always act like lemmings. “Extraordinary Popular Delusions and the Madness of Crowds” was a big long book of examples almost a century and a half before “portfolio insurance”, which I think is still the single best example of a financial idea that falls on its face if everyone is trying to do it at the same time.

Large groups of people make very good aggregated decisions, far better than the individuals would make on their own, provided they aren’t able to look over each other’s shoulder at the other guys’ guesses. The market fails on this last point — indeed, most traders will refuse to trade in a new situation in which there is no established “price”, which is exactly the situation, on a macro level, when they’re most likely to set the price correctly.

Felix-

One can generalize from your idea that similarity/congruency in practice (i.e. the gaussian copula model) leads to convergence of correlations across firms. One, somewhat ignored, facet of this is the impact that identical regulatory structures (Basel II) have upon financial firms. If there is a shock to the system, then (in order to maintain capital requirements) all firms must liquidate similar assets at similar times, leading to the proverbial “rush to the exit”. Given that we want to regulate financial firms similarly (if not identically), and that we want to keep the information produced by “mark-to-market” accounting, the only solution is the one that you propose, limiting the size of financial firms. This will not eliminate the problems, merely dampen their impact. I would go one step further and prohibit the public listing of all financial institutions. This would help to keep the size of the balance sheet down, as well as shield management from quarterly earnings goals.

Posted by Chris | Report as abusive

First, not all the banks fell down. So look at the banks that did not.

The problem with the fallen banks can only be fixed when their goals are changed from maximizing profits, and pointed toward doing a good ong term job for the share holders and the banks customers. Also, the idea of measuring success by Wall Street expectations also has to be scrapped.

The problem is also present in other businesses, and always has been there. Take the auto manufacturers: They are all geared up for high production and maximizing profits. Wrong focus. They have been building throw away cars for a long time, rather than building cars to last at least 30 years and travel 500,00 miles with just routine maintenance. No focus on saving the resources.

Same as peoples lives. When our personal focus is based on getting as high as one can, and earning as much as one can with no regard as to how much good one is doing for other people the crash will most certainly come.

Need to refocus the country.

Posted by F Belz | Report as abusive

Felix — Face it, human beings feel safer moving in herds:

http://epicureandealmaker.blogspot.com/2 007/04/talking-of-michelangelo.html

I made this point way back in the dark ages of April 2007, before Larry Lessig was a glimmer in his parents’ eyes. Oh, for a wider and more alert audience.

Finally, I am not sure your idea to limit every bank to less than $300 billion in assets will necessarily fix the problem. You could just end up with a larger herd of smaller lemmings plunging over the same damn cliff as before (or, what is more likely, a different cliff). Human nature is a bitch.

We shouldn’t have to place any caps on banks’ balance sheets, we just need to limit how much money they are allowed to borrow from the Federal Reserve and how much coverage they get from the FDIC. We should also make sure that anyone selling insurance on debt has enough reserves to cover their bets, so the government doesn’t have to do that again.

Posted by KenG | Report as abusive

The following is an incredibly insightful lecture by Avinash Persaud (November 24, 2008):

“How Well-Meaning Principles Caused the Financial Crisis”

http://fora.tv/2008/11/24/How_Well-Meani ng_Principles_Caused_the_Financial_Crisi s#chapter_01

KEY POINTS
The regulators’ mantra of risk-sensitivity has meant in effect that regulatory capital was more sensitive to the market price of risks, which inevitably led to systemic crisis. Mark-to-market accounting was one, but not the only source of increased sensitivity to market risks. The legal principle that we must preserve equality of treatment of financial institutions also contributed to the systemic fragility of the banking system. There is natural diversity in a financial system and it is a key source of liquidity that should not be destroyed.

Journal of International Banking and Finance Law, January 2009 3

Posted by Mikey10011 | Report as abusive

You will remember that there was a massive failure by the banking regulators in this regard. I am a former senior bank regulator and I spent many years in the investment banking world involved in risk management, risk reporting and risk technology. There appears to be a failure to recognize that the regulatory process can only work if there are good regulatory people looking at the matters every day. If I may let me offer the following comments:

1. The bank regulators had the authority to examine any aspect of a bank’s activities. They had the authority to figure out what was going on at the banks and to limit it. The regulators did nothing. So all the new regulations on paper will mean nothing if the regulators cannot or will not do their jobs.

2. Consolidating regulators or setting up an international cooperative coalition will not likely achieve the desired goals. Creating new risk models will not likely do the job. Sending a regulator who makes $50,000 dollars a year to examine the activities of sophisticated financial traders who make millions of dollars a year is not a fair battle. And if you have ever worked in a government agency, as I did, you will be intimately familiar with the viciousness of the turf battles among the senior officials. There is a lot of deadwood at the top of the agencies and it needs to be cleaned out. A Herculean task if there ever was one.

Posted by S. Hellinger | Report as abusive

You realize, of course, that lots of things are OK if a few people do them, but undermine society if a large group adopts them.

For a classic example, take innoculations against disease. They’re a great idea, preventing the pandemics that have caused the fall of many civilizations. But, since there is –say –a 1 in 10,000 chance of an adverse reaction –what is even better for a single individual is not to take the innoulation, while evrybody else does.

Naturally, if very many people do it, pandemics return.

Many of the practices of our fearless financial leadership class fall into exactly this category.

Scumbags.

Posted by Tim Connor | Report as abusive

Isaac Asimov was clever enough when he wrote “Foundation”, (where the great mathematician Hari Seldon develop the mathematics of “psycho history”), to include the detail that the predictions produced by the model would be invalid if the group who was the object for the prediction was familiar with psycho history. It is interesting that a sci-fi writer fifty years ago had a hunch about the role of feedback that it took us a severe crisis to realize in full.

Posted by Gaute | Report as abusive

Ian, man, chill. If you don’t like it, don’t read it. I like physics too, but I’m not going to dump on Felix for using a famous but widely misunderstood principle to communicate with the majority of his audience a bit better. I thought it was clever. Felix, I don’t mind seeing this point made again and again (and I’ve seen similar discussions before.) It’s valid and pertinent to the Global Crisis.

Posted by AmericanFool | Report as abusive
Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/