Tuesday, April 11, 2017

Mark Buchanan — Market complexity also makes for instability


Looks like another fallacy of composition is at work in finance to increase system instability by assuming that increasing the stability of individual institutions will increase the stability of the system as a whole. This post suggest that this is apparently not the case owing to network effects.

Physics Perspective
Market complexity also makes for instability
Mark Buchanan

11 comments:

Matthew Franko said...

" as well as perverse incentives for bankers to take on large risks."

Basel III on the regulation of the bank Leverage Ratio:

http://www.bis.org/publ/bcbs270.pdf

So if this ratio is regulated I dont see any "perverse incentives"...

What I do see is other govt policies perhaps wildly fluctuating the the denominator component of this ratio...


Tom Hickey said...

They still haven't figured out that the way to reduce risk in banking is to regulate the LHS of the balance sheet and not the RHS, as Warren Mosler has said, and to clean up the criminogenic environment, as Bill Black has said.

Detroit Dan said...

Tom, could please expand on your comment about reducing risk in banking via regulation of the LHS of the balance sheet? I would appreciate more specifics.

Thanks!

Tom Hickey said...

The LHS is the "asset" side" and the RHS is the "liability side," which includes liabilities and equity ("capital").

The problem with banks is that their assets are largely loans rather than real assets, which are accounts receivable and depending on the ability of the borrower to service the loan.

This involves two issues, the size of the loan and and the creditworthiness of the borrower.

One way to reduce risk is to regulate the collateral, e.g., how much banks can loan against property, which affects the value of the asset. If banks can lend without limitation, then the value of the collateral (real asset) will rise to the level against which banks are willing to lend. This can drive asset values way above prudent levels if the banks lend imprudently. Regulation can be used to prevent this happening.

A second way to reduce risk is to regulate credit standards for borrowing, e.g., down payment on RE, debt to income ratio, etc. to prevent banks from making dodgy loans, that is, acting imprudently.

History shows that financial crises often result from banks acting imprudently toward the peak of cycles. Government can modulate this by regulating the conditions of lending, that is, the asset side of the a bank's balance sheet instead of assuming that banks always act prudently when they have demonstrated that they do not.

Matthew Franko said...

Well if you read the BIS document in my link above, they do actually regulate the LHS they regulate the "Leverage Ratio" which is defined as:

"The Basel III leverage ratio is defined as the capital measure (the numerator) divided by the exposure measure (the denominator), with this ratio expressed as a percentage:

Leverage ratio = Capital measure/Exposure measure"

The denominator here ie "Exposure Measure" includes the LHS of the bank balance sheet...

Matthew Franko said...

And btw a ratio is not a very complex system....

Tom Hickey said...

Yes, but they are taking the LHS into account but not regulating it. The greater the leverage the higher the capital ratio (RHS) required. A capital requirement is regulating from the RHS

Tom Hickey said...

And btw a ratio is not a very complex system....

A ratio is very simple as a faction, but the factors influencing the numerator and denominator may be complicated or even complex.

Neil Wilson said...

Warren's regulation for the LHS 'asset' side is simple - a total ban on the bank generating any assets not specifically permitted.

So mortgages and credit lines for business and not a lot else.

Once you have that, then the RHS can be a central bank overdraft at whatever haircut the solvency regulation sees fit.

Detroit Dan said...

Thanks Tom (and Matt and Neil)!

Matt Franko said...

Checkmate:

https://www.americanbanker.com/opinion/raising-leverage-ratio-weakens-bank-liquidity

"One of the many problems with a high leverage ratio stems from the flight to safety during periods of stress, which causes bank deposits to soar. Since 2008, while the U.S. economy has struggled, deposits have risen by $2.6 trillion, often with pronounced temporary spikes that remain on a bank's balance sheet for just a few weeks. A recent example of this occurred during the politically charged debt-ceiling crisis. At that time, deposits jumped by $73 billion, according to Federal Deposit Insurance Corp. data.
Deposits provide crucial funding for all banks, but as deposits surge, bank leverage ratios drop. Worse, sudden changes in deposit flow make banks' leverage ratios volatile. Most banks simply manage this volatility by staying well above the current leverage ratio requirements. That is, they are generally over-capitalized."