naked capitalism

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

Economists have joined the debate about the merits of requiring the downsizing of too big to fail (“TBTF”) financial firms. However, these debates have almost been devoid of theoretically based economic arguments.

Some economic analysts have argued that the TBTF institutions have captured and will manipulate the relevant regulatory and political structures to their advantage. This a political argument and economists as economists do not have any greater insight into the political dimension of issues than Joe and Mary Sixpack. Other economists have decried the TBTF institutions and their contribution to a further skewing of the distributions of income and wealth. Again, economists as economists have no greater insight in to issues of economic fairness than the next person.

With the exception of citing moral hazard incentives to greater risk taking, economists speaking as economists have been virtually silent about the fact that TBTF (and wanted-to-be-TBTF) firms were the center of a process of designing, underwriting, and issuing a variety of structured capital market products that contributed not only to redistributions of wealth in their favor, but (and more importantly to economists as economists) also contributed to the misallocation of resources on a massive scale. And the efficient allocation of resources is the sine qua non of economics.

This post outlines one line of economic reasoning that leads to the conclusion that TBTF financial firms should be dismantled on the grounds that the highly concentrated financial sector can give rise to informational asymmetries, the mispricing of risk and the misallocation of capital and other resources.
It is not a general theory of the recent crisis, but an argument suggesting that in financial markets dominated by a few large firms, those firms will be in a position to exploit informational asymmetries and enrich themselves even as their excess profits are dwarfed by the costs to society of the misallocated resources.

Informational Asymmetries

Economics indicates that markets and trading lead to an efficient allocation of resources. This result is predicated on a number of assumptions including the assumption that all parties to transactions make equally well-informed decisions. Implicit is an assumption that all the relevant information is free and is reflected in the decision-making processes of all parties. However, information is not free; the markets are unlikely to generate optimal levels of information given the “public good” dimension of information, and the information that is available is not uniformly distributed.

Economists have recognized that problems can arise when one party is intentionally misinformed or does not have access to some of the relevant information that other counterparties possess. If one of the less well-informed parties to the transaction would not have agreed to the trade or exchange had it had access to all the information, than the transaction was presumably inefficient and welfare reducing. To date, economists’ focus has been exclusively on information about the item (good or service or financial asset) being exchanged. The classic case in the economics literature is Akerlof’s, The Market for Lemons—i.e., the used car market where sellers have more information than buyers about the true condition of the cars.

Society has an interest in preventing inefficiency-producing, welfare-reducing transactions. Efficiency-enhancing disclosure standards should include all relevant information (but not all analyses). In addition to issuer and issuer-specific information, all non-issue non-issuer specific information (baring proprietary client information) should be disclosed to all of the counterparties. In the context of financial markets, relevant information is all information that bears on the expected return or the riskiness of the instrument. Currently, counterparties are implicitly assumed to have equal access to non-specific, relevant information, e.g., macroeconomic conditions and information regarding the relevant sector of the economy.

Informational asymmetries are particularly troublesome in markets for fixed income securities. For fixed income instruments, the expected return for a buy-and-hold investor is the current yield to maturity (re-investment risk of coupons aside). Significant informational asymmetries with regard to expected rate of return for such investors are limited. However, the risk dimension of the risk/return analysis is another story. The upside risk in fixed income securities is more limited than the downside risk as the coupon is fixed. On the other hand, credit events can degrade performance, but not enhance it. Tail risk is also often the most opaque.

When informational asymmetries contribute to mispricings in credit markets and resource misallocations in the economy, it will most likely be the result of buyers having less information then sellers about downside risks. Furthermore, firms involved in structuring products or underwriting issues that have more or better information about downside risks being higher than generally perceived will keep it private.

Financial product specific informational asymmetries can exist when the product is complex. For example, in 1994, a headline dominating financial scandal involved Banker’s Trust. If my memory is correct, BT had sold a non-vanilla interest rate swap product with embedded bells and whistles to P&G. Evidently unknown or unappreciated by P&G (when the deal was struck) was a provision by which P&G financed part of the deal (reduced the cost to themselves) by selling a currency option (on DEM/FrF). The ERM experienced a crisis and P&G found itself on the wrong side. It suffered losses and called foul. During the ensuing investigation, the regulators gained access to internal BT emails regarding the deal. One of the emails read something like: “They think that they know what they are doing, but they don’t. They are the perfect customer for us.”

Large financial firms may also possess non issue specific information of a kind unavailable to other market participants by virtue of the size of their activities in market making, underwriting, issuing structured products, advising, prime brokering, or via knowledge of their counterparties or some combination. For example, Goldman Sachs, by virtue of the scale of its activities relative to the CDS market may have had non-public knowledge about the vulnerability of AIGFP, AIG itself. It may have had insight to the stability of the CDO market and the balance sheets of firms which had purchased CDS protection from AIGFP as well the market for RMBS in general.

Attention has recently focused on GS’s role in creating CDOs that enable GS and one client to short the sub-prime market while GS sold the long side to other clients. GS has argued that it did nothing illegal and that it was acting on its own analysis and entirely properly. It may be that GS acted legally, but it was acting on the basis of an informational asymmetry as the clients that went long did not have access to all the information necessary to perform all the analyses that lead GS to take steps to short the market. The question of legality aside, it seems that GS knowingly exploited an informational asymmetry and encouraged the misallocation of capital.

GS has argued that it has outperformed its competitors because it was more knowledgeable, i.e., performed better analysis. However, GS may have been more knowledgeable, because it positioned itself to glean more information (from it counterparties and its numerous business lines), process it and act on that information before it was widely available to other market participants.

Chris Whalen recently stated publicly what many in the markets have believed for years: “In our experience, Buy Side investors today don’t do business with GS or the other major Sell Side firms because they trust them. They do business with firms like GS because they believe that the firm has better access to information than do the other dealers in the marketplace.”

GS uses information gained in the markets and from client contact to structure products and take proprietary positions To the extent that the trades and positions are based on informational asymmetries they represent a transfer from the “dumb” money to the “smart: money GS, and its high value clients.

With the number of large financial firms now three less than before the crisis, it is likrly that the remaining firms will reach a size relative to the markets that they will have access to information unavailable to other players, and hence be in a position to exploit informational asymmetries.
There are a number of questions which should concern economists and regulators.

1. Did the buyers of CDOs under invest in information and analyses because of the expense and the perception that disclosure and the rating agencies leveled the playing field?
2. What can and should be done to prevent firms from operating on non-instrument specific informational asymmetries gleaned through market activities?
3. What if anything can be done to insure that “sophisticated” investors are sophisticated enough to understand all the risks in new complex and unseasoned instruments and products.

Given the difficulties of determining whether one of the financial firms has or had relevant market non instrument specific information that the other counterparty(s) did not, regulators would have an impossible time enforcing compliance with a disclosure standard consistent with the efficient allocation of capital.

However, regulators could prevent firms from gaining informational asymmetries by preventing them from establishing large market shares in underwriting, issuance or trading of the relevant instruments. If each of the financial firms were constrained to be a small fraction of every market and activity they were engaged in, then it is less likely that any firm would be in possession of significantly more information about the market, counterparties, etc than any other participant in the market.

Furthermore, increasing the number of players with access to non-public information increases the likelihood that the information would become public.

Would limiting the size of a firms activities in a market/instrument be too costly to society, i.e., would downsizing the large financial firms be rightsizing them, or would it be inefficient? Defenders of the large firms argue that their size enables them to achieve economies of scale and that they are efficiency promoting.

While there are undoubtedly economies of scale in some financial market activities and while some subset of customers may find it advantageous to deal with a dominant provider of financial services, these considerations do not necessarily imply that large firms are more efficient or contribute to more efficient allocation of capital than small firms.

If the larger firms are larger because they are more efficient than smaller firms, it should be reflected in higher accurately measured returns on equity and risk-adjusted rates of return on capital. I believe that the readily available numbers (at least for commercial banks) would be inconsistent with the idea that the larger firms are more efficient. It seems much more likely that the existing large financial firms owe their size and success to the TBTF doctrine, their oligopolistic positions and their ability to profit from the informational advantage that they hold rather than to efficiencies arising from the scale of their operations

It is likely that TBTF firms have exploited informational asymmetries which contributed to the mis-pricing of risk and the misallocation of resources. The most straightforward way to prevent a repeat of the crisis in the future would be to limit the size of financial firms so what their activities are small relative to the markets in which they operate.