Andrew Haldane of BoE once again making a riveting speech and once again on the financial sector.
First some insights from evolution of Elephant Seal:
Elephant seals have got too big for their beaches. A large specimen might weigh over 8000 lbs (3700 kg). Their size has a simple evolutionary explanation. Large males fight for the right to mate with a whole beach full of females. For elephant seals it is, quite literally, winner-takes-all. And the key to winning is simple – size. No-one is going to argue with a male swinging around his proboscis on the beach. In that way, size has become the dominant gene in the evolutionary trajectory of the elephant seal.
But size is not costless for the elephant seal. It makes them easy prey on land. At times in the past, this has threatened their very existence. In the 18th century, their main land predator – man – hunted elephant seals for their blubber and fur. In the 19th century, their numbers fell rapidly to below 100 and for a time they were believed to be extinct.2 Just in time, governments intervened to place restrictions on hunting, nationally and internationally. Today, elephant seal numbers have swelled to above 800,000. The hand of government has protected them from man – and from themselves.
So nature delivers an equilbrium which is sub-optimal:
So nature can deliver an evolutionary equilibrium which is sub-optimal for its participants, a market failure. The more intense the competitive race, the greater this market failure or co-ordination problem. Elephant seals would prefer to co-ordinate on a lower-blubber equilibrium, deer on a shorter-antler equilibrium, peacocks on a smaller-tail equilibrium. Competition prevents them from doing so. If there were a benign, enlightened zoological planner, able to compel less-conspicuous features, this would benefit not only each animal but the species as a whole. Unfortunately, there is not.
Reading these lines one clearly understands the need for the example. The Seals are being compared to the financial sector!!
He then says this sub-optimal behavior to out compete others leads to an arms race:
The tragedy of the commons is one example of an age-old problem of military arms races. The incentives of individual players, and outcomes for society, are much the same as in commons tragedies. Individual country incentives are to increase military might, to leapfrog opponents to improve national security. But this game of leapfrog is a Red Queen Race. The quest for national safety results in a steady rise in military spending and a steady fall in both societal and national security. The common good is jeopardised.
Finance is far from immune to these pressures.
He says three things lead to finance arms race:
Indeed, some structural features of the financial system make it particularly prone to arms-race behaviour.
One such structural feature is information asymmetry. Imperfections in information generate risk. Finance provides an information bridge between end-savers and investors, thereby prospectively reducing risk. Success in finance means forming that bridge at least cost and risk to those travelling across it. But judging how much risk is really being taken, and whether it is being managed well, is rarely easy for either end-savers or end-borrowers. Risk shows its true face perhaps only once in a generation. So as much as investors might wish to risk-adjust their returns, this is a daunting informational task. Facing this problem, many participants in the financial system (investors, managers, trustees, remuneration committees, pay consultants etc.) have resorted to simpler, indirect metrics to gauge skill in navigating risk.
A second structural feature of finance, which generates similar incentive effects, is maturity transformation. Banking involves borrowing short in a capital-certain instrument to lend long through a capital-uncertain instrument. When doubts creep in about this balance sheet structure, investors run on the bank knowing it is first-come, first-served. They are engaging in a liquidity arms race, penalising those behind them in the queue. These actions are individually rational but collectively self-defeating if the bank goes bust.
A third structural feature is that some markets for financial services are winner-takes-all tournaments, like elephant seals seeking mates on the beach. Whether it is making markets in financial instruments, lead underwriting a debt or equity issue or advising on a merger or takeover, there is typically only one winner. They take all. Tournaments like these lead to arms-race behaviour as firms seek to leapfrog one another in their competitive quest for top-dog status.
And moreover it is not a recent phenomenon. What is more important is to have a regulator who can slow the pace of the arms race..
He talks about three examples of arms race in financial sector:
In what follows, I discuss three examples of modern-day arms races in the financial sector: races in return, races in speed; and races for safety. These are examples from the past, present and future respectively. In each, a competitive battle for relative dominance results in an evolutionary equilibrium which is sub-optimal, individually and socially. They are latter-day tragedies of the financial commons.
Read the paper/speech for more details on each one. In typical Haldane style he once again takes the financial sector for a toss.
What lessons and solutions?Well like an arms race, we need multilateral disarmament:
What public policy lessons might be drawn from these financial arms races? First, because they generate sub-optimal outcomes, policy intervention can be justified. This policy intervention ought to act like a self-denying ordinance for financial firms, a protection against themselves. It ought not to be a tug-of-war between regulator and regulated. Rather, it aims to defuse a competitive tug-of-war among regulated firms.
Second, to be effective this intervention needs to constrain behaviour across the financial system as a whole; it requires multilateral disarmament. Acting to constrain only those at the top of the league (those bearing most risk, trading at greatest speed, seeking greatest safety) will do nothing to defuse competitive pressures lower down the pecking order. Indeed, it might even conceivably intensify the competitive scramble. In the language of financial regulation, policy needs to have a macro-prudential, as distinct from micro-prudential, perspective.
Third, what tools might such agencies bring to bear in tackling financial arms races in return, speed and safety? With hindsight, it is not difficult to identify instruments which might have slowed the pre-crisis race for excessive returns in banking. The most direct and effective would have been to place tighter constraints on banks’ leverage. This would have defused the return on equity race at source. The FPC has prioritised the leverage ratio as a macro-prudential instrument in its recommendations to date.
Systems, both social and natural, are characterised by a survival of the fittest. But for both, that competitive race can at times generate unhealthy outcomes for the system as a whole. In finance, these tragedies of the commons are, if anything, more likely than in other fields (seas, beaches and forests). The financial crisis attests to that. If there were a benign, enlightened regulatory planner, able to redirect competitive forces, this could potentially avert future tragedies of the financial commons. Fortunately, there is.
Fascinating as always..Way to go Dr Haldane..The way he links so many ideas is just amazing..