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After the Flood
How the Great Recession Changed Economic Thought
By Edward L. Glaeser, Tano Santos, E. Glen Weyl The University of Chicago Press
Copyright © 2017 The University of Chicago
All rights reserved.
ISBN: 978-0-226-44368-3
CHAPTER 1
Introduction
Edward L. Glaeser, Tano Santos, and E. Glen Weyl
The past three decades have been characterized by phenomenal upheavals in financial markets: the United States has witnessed two remarkable cycles both in the stock market during the late 1990s and in real estate during the first decade of the 21st century, followed by the Great Recession, the Japanese banking crisis that itself followed two equally impressive cycles in that country's stock and real estate markets, the larger Asian crisis of 1997, and the Eurozone banking crisis that still is ongoing at the time of this writing. These crises have occurred not in politically unstable countries without sound governance institutions and stable contractual environments, but at the heart of the developed world: the United States, Japan, and the Eurozone. The fact that all these events have led to a flurry of books, papers, journal special issues, and so on exploring the causes of, consequences of, and remedies for large systemic financial crises, which some had thought a thing of the past, is therefore not surprising. What are the origins of these speculative cycles? Are modern financial systems inherently prone to bubbles and instabilities? What are the effects on the real economy?
This volume follows in this tradition but takes a distinct perspective. The chapters in this book consist of papers presented at a conference held at the Columbia Business School in the spring of 2013 in honor of José Scheinkman's 65th birthday. These papers are centered on the lessons learned from the recent financial crisis, issues that have been high in José's agenda for some time now. They are all written by José's coauthors and former students during his remarkable and ongoing career as an economist. José's contributions span many different fields in economics, from growth to finance and pretty much everything in between. In this volume, we sought to use this diversity to bring new ideas to bear on the events of the past three decades. In doing so, we recruited José's closest colleagues from a variety of fields to speak to his most recent interests, in financial economics, which he has pursued for the past decade and a half.
We begin this introduction by focusing on the core financial contributions contained in the volume and gradually connect the papers outward from there, returning in our discussion of the final chapter to the core themes we take away from this collection.
1 Asset Pricing
Asset pricing not only lies at the core of finance, but also the core of José's intellectual interests. His first contribution to the field is an unpublished manuscript from 1977, Notes on Asset Pricing. Starting this volume with the contribution that fits squarely in this field is therefore only appropriate.
The law of one price implies prices can always be expressed as the inner product of the asset's payoff and another payoff that we term the stochastic discount factor. The stochastic discount factor is of interest to economists because, in the context of general equilibrium models, it encodes information about investors' intertemporal preferences as well as their attitudes toward risk. Information about these preferences is important because, for example, they determine the benefits of additional business-cycle smoothing through economic policy. A long literature in macroeconomics and finance derives specific models for the stochastic discount factors from first principles and tests the asset-pricing implications of these models. Since Hansen and Singleton's (1982) seminal paper that rejected the canonical consumption-based model, we have learned much about what is required from models that purport to explain asset prices. But our current models, such as those based on habits or long-run risks, have difficulty explaining the kind of cycles described in the opening lines of this introduction. Still, we have sound reasons to believe elements of those models have to eventually be part of "true" stochastic discount factor, because not even the most devoted behavioral finance researcher believes asset prices are completely delinked from macroeconomic magnitudes at all frequencies.
In sum, our current models for the stochastic discount factors are misspecified. Lars Hansen and José himself contribute the most recent product of their remarkable collaboration with a paper that explores a powerful representation of the stochastic discount factors, one outside standard parametric specifications. By a felicitous coincidence, Lars received the 2013 Nobel Prize, together with Eugene Fama and Robert Shiller, partially for his work on asset pricing. The inclusion of his work in this volume is thus doubly warranted.
In their paper, José and Lars explore the possibility that some components of that representation may be errors arising from an imperfectly specified model that may provide an accurate description of risk-return trade-offs at some frequencies but not others. This decomposition is important, because it will allow the econometrician to focus on particular frequencies of interest, say, business-cycle frequencies, while properly taking into account that the model may not be able to accommodate high-frequency events, such as fast-moving financial crises or even short-term deviations of prices from their fundamental values. This flexible representation of the stochastic discount factor thus captures our partial knowledge regarding its proper parameterization while maintaining our ability to conduct econometric analysis.
In addition, this approach opens the way for further specialization in the field of asset pricing. Some financial economists may focus on those components of the stochastic discount factor with strong mean-reverting components and explore interpretations of these components as liquidity and credit events or periods of missvaluation, for example. Others may focus on those business-cycle frequencies to uncover fundamental preference parameters that should be key in guiding the construction of macroeconomic models geared toward policy evaluation. What arises from the type of representations José and Lars advance in their work is a modular vision of asset pricing — one that emphasizes different economic forces determining risk-return trade-offs at different frequencies.
2 Financial Intermediation
Although the asset-pricing approach of this paper by José and Lars largely abstracts away from financial intermediation and financial institutions, José's research has always attended to the importance of financial institutions. The crises mentioned at the beginning of this introduction all feature financial intermediaries, such as banks, investment banks, or insurance companies, in starring roles. These entities hold vast portfolios of securities. Conflicts of interest within these intermediaries may affect their portfolio decisions and potentially, prices. The study of these agency problems, and of the compensation schemes designed to address them, may then be a critical component in our understanding of these crises. Many commentators have in fact placed the speculative activities of these large financial institutions (including AIG Financial Products and Lehman Brothers) at the center of the crisis and have argued that financial deregulation is to blame for these institutions drifting away from their traditional activities. This volume includes three papers specifically concerned with the issue of banking and what banks did before and during the present crisis.
Patrick Bolton's paper takes issue with the view that restricting what bankers can do is the appropriate regulatory response and instead places compensation inside banks at the heart of the current crisis. In particular, he emphasizes that compensation schemes typically focused on the wrong performance benchmarks, rewarding short-term revenue maximization at the expense of longer-term objectives. Bolton et al. (2006) show how, indeed, privately optimal compensation contracts may overweight (from a social perspective) short-term stock performance as an incentive to encourage managers to take risky actions that increase the speculative components of the stock price. Compensation issues and speculation thus go hand in hand and may offer clues as to why prices deviate from fundamentals. Patrick's paper argues the problem thus is not the broad bundling of tasks inside these new large financial institutions, but rather the adoption of compensation practices that encouraged inefficient risk-taking behavior precisely to induce speculation.
Bolton argues that a significant upside exists to providing clients with a wide range of financial services. Banks acquire information about their clients, and by pursuing many activities, they further expand their expertise. Restricting bankers' activities, in Bolton's view, would reduce the quality of services their clients receive and would hinder the ability of banks to direct resources efficiently throughout the real economy.
One standard argument is that the advantages of providing multiple services must be weighed against the potential conflict of interest that occurs if commercial banks attempt to raise money for firms in equity or bond markets in order to enable them to pay back existing loans. Bolton cites the Drucker and Puri (2007, 210) survey, noting that securities issued by "universal banks, who have a lending relationship with the issuer have lower yields (or less underpricing) and also lower fees." If these "conflicted" relationships were producing particularly risky loans, buttressed by the banks' reputations, fees and yields would presumably be higher, not lower.
Bolton also notes the banks that experienced the most difficulty during the downturn were not universal banks, but rather banks that specialized in investment banking, such as Bear Stearns and Lehman Brothers, or residential mortgages, such as New Century. Moreover, the troubles universal banks, such as Bank of America or JP Morgan Chase, experienced were often associated with their acquisitions of more specialized entities, such as Merrill Lynch, Bear Sterns, Countrywide, and Washington Mutual.
These empirical facts suggest to Bolton that restricting the range of banking services is unlikely to produce more "good bankers." Instead, he advocates better regulation of bankers' compensation. If banks reward their employees for taking on highly risky activities with large upside bonuses and limited downside punishment, those employees will push the bank to take on too much risk. Some studies, including Cheng et al. (2015), find those banks that provided the strongest incentives fared the worst during the crisis. Given the implicit insurance that governments provide to banks that are deemed "too big to fail," this risk-taking is likely to generally inflict larger social costs. In some cases, excess risk-taking by employees may not even be in the interests of the banks' own shareholders.
Bolton considers a number of possible schemes to regulate bankers' compensation, although he accepts that gaming almost any conceivable regulation will be possible. Attempts to ban bonuses altogether or to limit bankers' pay to some multiple of the lowest-paid employee at the bank seem like crude approaches. Surely, many bonuses deliver social value by inducing higher levels of effort. Restricting pay to a multiple of the least well-paid employee may induce banks to fire their least well-compensated workers and use subcontractors to provide their services.
Bolton finds subtler approaches to be more appealing, such as requiring employees whose compensation is tied to stock price to also pay a penalty when the bank's own credit default swap spread increases, essentially punishing the bankers for taking on more risk. Bolton also suggests changing corporate governance in ways that enhance the powers of the chief risk officer might be beneficial. Although outside regulators cannot perfectly enforce a new culture of more limited incentives, Bolton sees more upside in incentive reforms than he does is restricting the range of banking activities.
Albert Kyle's paper concerns a second tool for reducing the externalities from bank default — increased capital requirements. Regulations, especially those associated with the Basel Accords, have often required banks to hold minimum levels of risk-adjusted equity, which reduces the chances that a market fall will lead to a bank default, because the drop wipes out the value of equity before it reduces the value of more senior debt. In the wake of the crash, many economists have called for increasing the minimum capital requirements, perhaps from 8% to 20%.
Kyle's essay takes a somewhat stronger line than Bolton's — and one stronger than our instincts — by arguing that the primary externality stems from the government's inability to commit to refrain from bailing out insolvent banks. We have taken a more agnostic approach, arguing bank insolvency may create social costs whether or not the public sector bails them out. Moreover, whether the social costs come from failures or bailouts, a good case remains for regulatory actions that decrease the probability of bank failure, such as increased capital requirements.
Yet Kyle's remedy does not depend sensitively on the precise reasons for attempting to limit risk. Kyle supports those who want to raise equity requirements but favors a somewhat novel manner of increasing capital stability. Instead of merely issuing more equity, his proposal calls for an increase in the level of contingent capital, which represents debt that is converted into equity in the event of a crisis. This contingent capital offers the same capital cushion (20%) to protect debtholders and the public that an increase in equity capital creates, but Kyle's proposal creates stronger incentives, especially if the owners of contingent capital have difficulty colluding with the owners of equity.
Kyle echoes Kashyap et al. (2008), who argue that an excess of equity may insulate management from market pressures. Because abundant equity makes default less likely, bondholders are less likely to take steps to protect their investment from default. In principle, equity holders can monitor themselves, but in many historical examples, management appears to have subverted boards. Moreover, the equity holders also benefit from certain types of risk taking, because bondholders and the government bear the extreme downside risk. This fact makes equity holders poorly equipped to provide a strong counterweight to activities with large downside risks.
Therefore, like Kashyap et al. (2008), Kyle argues for contingent capital that increases only during downturns, but the structure of Kyle's proposal is radically different. Kashyap et al. (2008) suggest capital insurance, in which banks would pay a fee to an insurer who would provide extra capital in the event of a downturn. Kyle proposes the bank issue reverse preferred stock that naturally converts itself into equity in the event of a bust. Although the capital insurance structure has an attractive simplicity, Kyle's proposal also has advantages. Most notably, it eliminates the incentive to regulate the insurer, because bank insurers seem likely to pose significant downside risk themselves in the event of a market crash. Moreover, he argues that widespread owners of the preferred stock instruments seem likely to be better positioned than a single insurer to advocate for their interests. Obviously, this claim depends on the details of the political economy, because in some cases, more concentrated interests have greater influence, but his observation about the political implications of asset structures is provocative and interesting.
In its simplest formulation, banks would have a 20% capital cushion, but 10% of that cushion would come from equity and 10% would come from convertible preferred stock. During good times, the preferred stock would be treated like standard debt. During a conversion event, which would be declared by a regulator, banks would have the option of either converting the preferred stock to equity or buying back the preferred stock at par, using funds received from a recent issue of equity. Conversion events would have multiple possible triggers, including those created by external market events, such as a rapid decrease in the value of equity, or regulatory events, such as a low estimated value of the bank's capital.
In the event of a conversion, the preferred stock would become equity, and $1 of preferred stock, at par, would become $4 of equity. If the original capital structure were 10% equity and 10% preferred stock, then, after a complete conversion, the former owners of the preferred stock would hold 80% of the equity. In this way, the bank would suddenly get an infusion of capital without the difficulties of having to raise new equity in the middle of a crisis.
(Continues...)
Excerpted from After the Flood by Edward L. Glaeser, Tano Santos, E. Glen Weyl. Copyright © 2017 The University of Chicago. Excerpted by permission of The University of Chicago Press.
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