Tag: Systemic Risk

Must-Read: Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig, and Paul Pfleiderer (2013): Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive

Posted on by Brad DeLong

Must-Read: Very good. Mind you, I am not sure that it is right–while the risk premium ought to be linear in units of fundamental operating risk, and while requiring banks to maintain larger capital reserves ought to be irrelevant (save for the small financial-repression taxes involved) to costs of financing for Modigliani-Miller reasons, it is not clear to me that that is how things actually work in reality:

Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig, and Paul Pfleiderer (2013): Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive: “We examine the pervasive view that ‘equity is expensive’…

…which leads to claims that high capital requirements are costly for society and would affect credit markets adversely. We find that arguments made to support this view are fallacious, irrelevant to the policy debate by confusing private and social costs, or very weak. For example, the return on equity contains a risk premium that must go down if banks have more equity. It is thus incorrect to assume that the required return on equity remains fixed as capital requirements increase. It is also incorrect to translate higher taxes paid by banks to a social cost. Policies that subsidize debt and indirectly penalize equity through taxes and implicit guarantees are distortive. And while debt’s informational insensitivity may provide valuable liquidity, increased capital (and reduced leverage) can enhance this benefit. Finally, suggestions that high leverage serves a necessary disciplining role are based on inadequate theory lacking empirical support.

We conclude that bank equity is not socially expensive, and that high leverage at the levels allowed, for example, by the Basel III agreement is not necessary for banks to perform all their socially valuable functions and likely makes banking inefficient. Better capitalized banks suffer fewer distortions in lending decisions and would perform better. The fact that banks choose high leverage does not imply that this is socially optimal. Except for government subsidies and viewed from an ex ante perspective, high leverage may not even be privately optimal for banks.

Setting equity requirements significantly higher than the levels currently proposed would entail large social benefits and minimal, if any, social costs. Approaches based on equity dominate alternatives, including contingent capital. To achieve better capitalization quickly and efficiently and prevent disruption to lending, regulators must actively control equity payouts and issuance. If remaining challenges are addressed, capital regulation can be a powerful tool for enhancing the role of banks in the economy.

Must-read: James Kwak: “Profits in Finance”

Posted on by Brad DeLong

Must-Read: It used to be that we collectively paid Wall Street 1% per year of asset value–which was then some 3 years’ worth of GDP–to manage our investment and payments systems. Now we pay it more like 2% per year of asset value, which is now some 4 years’ worth of GDP. My guess is that, at a behavioral finance level, people “see” commissions but do not see either fees or price pressure effects.

Plus there is the cowboy-finance-creates-unmanageable-systemic-risk factor, plus the corporate-investment-banks-have-no-real-risk-managers factor. We are paying a very heavy price indeed for having disrupted our peculiarly regulated and oligopoly-ridden post-Great Depression New Deal financial system:

James Kwak: Profits in Finance: “Expense ratios on actively managed mutual funds have remained stubbornly high…

…Even though more people switch into index funds every year, their overall market share is still low—about $2 trillion out of a total of $18 trillion in U.S. mutual funds and ETFs. Actively managed stock mutual funds still have a weighted-average expense ratio of 86 basis points. Why do people pay 86 basis points for a product that is likely to trail the market, when they could pay 5 basis points for one that will track the market (with a $10,000 minimum investment)? It’s probably because they think the more expensive fund is better. This is a natural thing to believe. In most sectors of the economy, price does correlate with quality, albeit imperfectly…. And this is one area where I think marketing does have a major impact, both in the form of ordinary advertising and in the form of the propaganda you get with your 401(k) plan…. The persistence of high fees is partly due to the difficulty of convincing people that markets are nearly efficient and that most benchmark-beating returns are some product of (a) taking on more risk than the benchmark, (b) survivor bias, and (c) dumb luck.

Must-read: Olivier Blanchard and Joseph E. Gagnon: “Are US Stocks Overvalued?”

Posted on by Brad DeLong

Must-Read: I think that this is completely right: expected returns on U.S. stocks right now are lower than average, but the gap between expected returns on stocks and on other assets is significantly higher than average:

Olivier Blanchard and Joseph E. Gagnon: Are US Stocks Overvalued?: “Are stocks obviously overvalued?…

…The answer is no, and the reason is straightforward…. What matters for the valuation of stocks is the relation between future growth and future interest rates. Put another way, the equity premium… has if anything increased relative to where it was before the crisis…. The Shiller P/E ratio reached 26 late last year and is currently around 24, compared with a 60-year average of 20. This elevated Shiller P/E measure is commonly cited as an indicator that stocks may be overpriced, including by Shiller himself….

The deviations of the P/E from its historical average are in fact quite modest. But suppose that we see them as significant, that we believe they indicate the expected return on stocks is unusually low relative to history. Is it low with respect to the expected return on other assets?… [But] in all six cases, the equity premium is higher in 2015 than in 2005. Put another way, stock prices were more undervalued in 2015 than they were in 2005….

If you accept current forecasts, and you accept the notion that stocks were not overvalued in the mid-2000s, then you have to conclude that stocks are not overvalued today. If anything, the evidence from 150 years of data is that the equity premium tends to be high after a financial crisis, and then to slowly decline over the following decades, presumably as memories of the crisis gradually dissipate. If this is the case, then stocks look quite attractive for the long run…