"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008

Monday, April 19, 2010

Really great links - Bank earnings - Banking crisis - Leverage and cost of bank equity

John Hussman - Bank earnings - "It seems equally unwise to celebrate "favorable" bank earnings reports that are exclusively driven by reduced loan loss provisions, particularly when the volume of impaired loans has not declined proportionately. Keep in mind that Enron and Worldcom were able to report outstanding earnings for a while by adjusting the manner by which revenues and expenses were accrued. I suspect that the U.S. banking system has become a similar breeding ground for innovative accounting."

Andrew Haldane - Banking crisis - "For the authorities, it poses a dilemma. Ex-ante, they may well say “never again”. But the ex-post costs of crisis mean such a statement lacks credibility. Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises. And the larger these costs, the lower the credibility of “never again” announcements. This is a doom loop.
        The “St Petersburg paradox” explains how a gambling strategy which starts small but then doubles-up in the event of a loss can yield positive (indeed, potentially infinite) expected returns. Provided, that is, the gambler has the resources to double-up in the face of a losing streak. The St Petersburg lottery has many similarities with the game played between the state and the banks over the past century or so. The banks have repeatedly doubled-up. And the state has underwritten any losing streak. Clearer practical examples of a policy time-consistency problem are unlikely to exist."

Andrew Haldane - Leverage and cost of bank capital - "It is possible to go one step further and argue that higher bank capital ratios could potentially lower banks’ cost of capital. The size of the premium demanded by holders of equity is a longstanding puzzle in finance – the equity premium puzzle. Robert Barro has suggested this puzzle can be explained by fears of extreme tail events. And what historically has been the single biggest cause of those tail events? Banking crises. Boosting banks’ capital would lessen the incidence of crises. If this lowered the equity premium, as Barro suggests, the cost of capital in the economy could actually fall.
        In the mid-1980s, an attempt on the world domino-toppling record – at that time, 8000 dominos - had to be abandoned when the pen from one of the TV film crew caused the majority of the dominos to cascade prematurely. Twenty years later a sparrow disturbed an attempt on the world domino-toppling record. Although the sparrow toppled 23,000 dominos, 750 built-in gaps averted systemic disaster and a new world record of over 4 million dominos was still set. No-one died, except the poor sparrow which (poetically if controversially) was shot by bow and arrow. So to banking. It has many of the same basic ingredients as other network industries, in particular the potential for viral spread and periodic systemic collapse. For financial firms holding asset portfolios, however, there is an additional dimension. This can be seen in the relationship between diversification on the one hand and diversity on the other. The two have quite different implications for resilience.
        In principle, size and scope increase the diversification benefits. Larger portfolios ought to make banks less prone to idiosyncratic risk to their asset portfolio. In the limit, banks can completely eradicate idiosyncratic risk by holding the market portfolio. The “only” risk they would face is aggregate or systematic risk.
        But if all banks are fully diversified and hold the market portfolio, that means they are all, in effect, holding the same portfolio. All are subject to the same systematic risk factors. In other words, the system as a whole lacks diversity. Other things equal, it is then prone to generalised, systemic collapse. Homogeneity breeds fragility. In Merton’s framework, the option to default selectively through modular holdings, rather than comprehensively through the market portfolio, has value to investors."

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