Dee Hock, the Father of Fintech

Marc Rubinstein writing in his “Net Interest” newsletter has a fascinating story about the history of Visa. The article is interesting on a number of levels.

It is partly a story of the battle currently being played out in the “payments” area of financial services but it also introduced me to the story of Dee Hock who convinced Bank of America to give up ownership of the credit card licensing business that it had built up around the BankAmericard it had launched in 1958. His efforts led to the formation of a new company, jointly owned by the banks participating in the credit card program, that was the foundation of Visa.

The interesting part was that Visa was designed from its inception to operate in a decentralised manner that balanced cooperation and competition. The tension between cooperation (aka “order”) and competition (sometimes leading to “disorder”) is pervasive in the world of money and finance. Rubinstein explores some of the lessons that the current crop of decentralised finance visionaries might take away from this earlier iteration of Fintech. Rubinstein’s post encouraged me to do a bit more digging on Hock himself (see this article from FastCompany for example) and I have also bought Hock’s book (“One from Many: VISA and the Rise of Chaordic Organization“) to read.

There is a much longer post to write on the issues discussed in Rubinstein’s post but that is for another day (i.e. when I think I understand them so I am not planning to do this any time soon). At this stage I will just call out one of the issues that I think need to be covered in any complete discussion of the potential for Fintech to replace banks – the role “elasticity of credit” plays in monetary systems.

“Elasticity of credit”

It seems pretty clear that the Fintech companies offer a viable (maybe compelling) alternative to banks in the payment part of the monetary system but economies also seem to need some “elasticity” in the supply of credit. It is not obvious how Fintech companies might meet this need so maybe there remains an area where properly regulated and supervised banks continue to have a role to play. That is my hypothesis at any rate which I freely admit might be wrong. This paper by Claudio Borio offers a good discussion of this issue (for the short version see here for a post I did on Borio’s paper).

Recommended

Tony – From the Outside

The potential for computer code to supplant the traditional operating framework of the economy and society

I am very far from expert on the issues discussed in the podcast this post links to, I am trying however to “up-skill”. The subject matter is a touch wonky so this is not a must listen recommendation. That said, the questions of DeFi and cryptocurrency are ones that I believe any serious student of banking and finance needs to understand.

In the podcast Demetri Kofinas (Host of the Hidden Forces podcast) is interviewed by two strong advocates of DeFi and crypto debating the potential of computer code to supplant legal structures as an operating framework for society. Demetri supports the idea that smart contracts can automate agreements but argues against the belief that self-executing software can or should supplant our legal systems. Computer code has huge potential in these applications but he maintains that you will still rely on some traditional legal and government framework to protect property rights and enforce property rights. He also argues that it is naïve and dangerous to synonymize open-source software with liberal democracy.

I am trying to keep an open mind on these questions but (thus far) broadly support the positions Demetri argues. There is a lot of ground to cover but Demetri is (based on my non-expert understanding of the topic) one of the better sources of insight I have come across.

Tony – From the Outside

What is the alternative to Friedman’s capitalism?

I have been digging into the debate about what Milton Friedman got right and wrong about the social responsibility of business. I am still in the process of organising my thoughts but this discussion on the “Capitalisn’t” podcast is, I think, worth listening to for anyone interested in the questions that Friedman’s 1970 essay raises.

You can find the podcast here

podcasts.apple.com/au/podcast/what-is-the-alternative-to-friedmans-capitalism/id1326698855

Tony – From the Outside

Corporate social responsibility – going back to the source

The 50th anniversary of Milton Friedman’s 1970 essay has triggered a deluge of commentary celebrating or critiquing the ideas it proposed. My bias probably swings to the “profit maximisation is not the entire answer” side of the debate but I recognised that I had not actually read the original essay. Time, I thought, to go back to the source and see what Friedman actually said.

I personally found this exercise useful because I realised that some of the commentary I had been reading was quoting him out of context or otherwise reading into his essay ideas that I am not sure he would have endorsed. I will leave my comment on the merits of his doctrine to another post.

Friedman’s doctrine of the limits of corporate social responsibility

Friedman’s famous (or infamous) conclusion is that in a “free” society…

there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception fraud.”

My more detailed notes on what Friedman wrote can be found here. That note includes lengthy extracts from the essay so that you can fact check my paraphrasing of what he said. My summary of his argument as I understand it runs as follows:

  • Friedman first seeks to establish that any meaningful discussion of social responsibility has to focus on the people who own or manage the business, not “the business” itself.
  • If we focus on the corporate executives who manage the business as agents of the shareholders, Friedman argues that these executive should only use the resources of a company to pursue the objectives set by their “employer” (i.e. the shareholders).
  • What do the shareholders want the business to do?
  • Friedman acknowledges that some may have different objectives but he assumes that profit maximisation constrained by the laws and ethical customs of the society in which they operate will be goal of most shareholders
  • The key point however is that corporate executives have no authority or right to pursue any objectives other than those defined by their employer (the shareholders) or which otherwise serve the interests of those people.
  • Friedman also argues that the expansion of social responsibilities introduces conflicts of interest into the management of the business without offering any guide or proper process for resolving them. Having multiple (possibly ill defined and conflicting) objectives is, Friedman argues, a recipe for giving executives an excuse to underperform.
  • Friedman acknowledges that corporate executives have the right to pursue whatever social responsibilities they choose in their private lives but, as corporate executives, their personal objectives must be subordinated to the responsibility to achieve the objectives of the shareholders, their ultimate employers.
  • It is important to understand how Friedman defined the idea of a corporate executive having a “social responsibility”. He argues that the concept is only meaningful if it creates a responsibility that is not consistent with the interests of their employer.
  • Friedman might be sceptical on the extent to which it is true, but my read of his essay is that he is not disputing the rights of a business to contribute to social and environmental goals that management believe are congruent with the long term profitability of the business.
  • Friedman argues that the use of company resources to pursue a social responsibility raises problematic political questions on two levels: principle and consequences.
  • On the level of POLITICAL PRINCIPLE, Friedman uses the rhetorical device of treating the exercise of social responsibility by a corporate executive as equivalent to the imposition of a tax
  • But it is intolerable for Friedman that this political power can be exercised by a corporate executive without the checks and balances that apply to government and government officials dealing with these fundamentally political choices.
  • On the grounds of CONSEQUENCES, Friedman questions whether the corporate executives have the knowledge and expertise to discharge the “social responsibilities” they have assumed on behalf of society. Poor consequences are acceptable if the executive is spending their own time and money but unacceptable as a point of principle when using someone else’s time and money.
  • Friedman cites a list of social challenges that he argues are likely to lay outside the domain of a corporate executive’s area of expertise
  • Private competitive enterprise is for Friedman the best way to make choices about how to allocate resources in society. This is because it forces people to be responsible for their own actions and makes it difficult for them to exploit other people for either selfish or unselfish purposes.
  • Friedman considers whether some social problems are too urgent to be left to the political process but dismisses this argument on two counts. Firstly because he is suspicious about how genuine the commitment to “social responsibility” really is but mostly because he is fundamentally committed to the principle that these kinds of social questions should be decided by the political process.
  • Friedman acknowledges that his doctrine makes it harder for good people to do good but that, he argues, is a “small price” to pay to avoid the greater evil of being forced to conform to an objective you as an individual do not agree with.
  • Friedman also considers the idea that shareholders can themselves choose to contribute to social causes but dismisses it. This is partly because he believes that these “choices” are forced on the majority by the shareholder activists but also because he believes that using the “cloak of social responsibility” to rationalise these choices undermines the foundations of a free society.
  • That is a big statement – how does he justify it?
  • He starts by citing a list of ways in which socially responsible actions can be argued (or rationalised) to be in the long-run interests of a corporation.
  • Friedman acknowledges that corporate executives are well within their rights to take “socially responsible” actions if they believe that their company can benefit from this “hypocritical window dressing”.
  • Friedman notes the irony of expecting business to exercise social responsibility by foregoing these short term benefits but argues that using the “cloak of social responsibility” in this way harms the foundations of a free society
  • Friedman cites the calls for wage and price controls (remember this was written in 1970) as one example of the way in which social responsibility can undermine a free society
  • But he also sees the trend for corporate executives to embrace social responsibility as part of a wider movement that paints the pursuit of profit as “wicked and immoral”. A free enterprise, market based, society is central to Friedman’s vision of a politically free society and must be defended to the fullest extent possible.
  • Here Friedman expands on the principles behind his commitment to the market mechanism as an instrument of freedom – in particular the principle of “unanimity” under which the market coordinates the needs and wants of individuals and no one is compelled to do something against their perceived interests.
  • He contrasts this with the principle of “conformity” that underpins the political mechanism.
  • In Friedman’s ideal world, all decisions would be based on the principle of unanimity but he acknowledges that this is not always possible.
  • He argues that the line needs to be drawn when the doctrine of “social responsibility” extends the political mechanisms of conformity and coercion into areas which can be addressed by the market mechanism.
Friedman concludes by labelling “social responsibility” a “fundamentally subversive doctrine”.

But the doctrine of “social responsibility” taken seriously would extend the scope of the political mechanism to every human activity. It does not differ in philosophy from the most explicitly collectivist doctrine. It differs only by professing to believe that collectivist ends can be attained without collectivist means.

That is why, in my book “Capitalism and Freedom,” I have called it a “fundamentally subversive doctrine” in a free society, and have said that in such a society, “there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception fraud.”

Hopefully what I have set out above offers a fair and unbiased account of what Friedman actually said. If not then tell me what I missed. I think he makes a number of good points but, as stated at the beginning of this post, I am not comfortable with the conclusions that he draws. I am working on a follow up post where I will attempt to deconstruct the essay and set out my perspective on the questions he sought to address.

Tony – From the Outside

A sceptical look at ESG

Anyone with more than a casual interest in business will be familiar with the increased focus on Environmental, Social and Governance (ESG) issues. There are sound arguments being made on both sides of the debate but I will admit upfront that I approach the topic with a somewhat ESG positive bias. Given my bias, it is all the more important to pay attention to what the sceptics are calling out rather than looking for affirmation amongst the true believers.

A post by Aswath Damodaran titled “Sounding good or Doing good? A Skeptical Look at ESG” is one of the better contributions to the ESG debate that I have encountered. I discussed one of his earlier contributions to the debate here and it is clear that he is not a fan of ESG. I am still working through his arguments but I like the analytical framework he employs and the way in which he supports his arguments with evidence.

I intend to do a couple of posts digging down into the ESG debate using Damodaran’s post and few other sources but want to start by laying out his arguments with some very limited comments.

Damodaran starts by framing ESG as part of a tradition of business ideas that have tended to prove to be more noise than substance, describing the ESG “sales pitch” as follows

“Companies that improve their social goodness standing will not only become more profitable and valuable over time, we are told, but they will also advance society’s best interests, thus resolving one of the fundamental conflicts of private enterprise, while also enriching investors”

There is no doubt that ESG, like many other business ideas, is prone to being over-hyped. There is room to take issue with the question of whether this is a fair description of the ESG movement as a whole. My gut feel is that presenting the “sales pitch” version is not representative of ESG advocates who genuinely believe that ESG can address problems in the ways the market currently operate, but it will be more productive to focus on the specific weaknesses that Damodaran discusses.

Damodaran starts with the problem of measurement

“Any attempts to measure environment and social goodness face two challenges. 

– The first is that much of social impact is qualitative, and developing a numerical value for that impact is difficult to do. 

– The second is even trickier, which is that there is little consensus on what social impacts to measure, and the weights to assign to them.”  

Assuming the measurement issues can be resolved, the second problem is identifying exactly how incorporating ESG factors into the business model or strategy contributes to improving the value of a company. Damodaran uses the following generic model of value drivers to explore this question

Figure 1: The Drivers of Value

Using this framework, Damodaran identifies two ways in which a company can derive benefits from incorporating ESG principles into its business strategy

  1. Goodness is rewarded – i.e. companies behave in a socially responsible way because it creates positive outcomes for their business
  2. Badness is punished – i.e. companies behave in a socially responsible way because bad behaviour is punished

Damodaran also identifies a third scenario in which “The bad guys win”

“In this scenario, bad companies mouth platitudes about social responsibility and environmental consciousness without taking any real action, but customers buy their products and services, either because they are cheaper or because of convenience, employees continue to work for them because they can earn more at these companies or have no options, and investors buy their shares because they deliver higher profits. As a result, bad companies may score low on corporate responsibility scales, but they will score high on profitability and stock price performance.”

Damodaran argues that the evidence supports the following conclusions:

  1. A weak link to profitability

“There are meta studies (summaries of all other studies) that  summarize hundreds of ESG research papers, and find a small positive link between ESG and profitability, but one that is very sensitive to how profits are measured and over what period, leading one of these studies to conclude that “citizens looking for solutions from any quarter to cure society’s pressing ills ought not appeal to financial returns alone to mobilize corporate involvement”. Breaking down ESG into its component parts, some studies find that environment (E) offered the strongest positive link to performance and social (S) the weakest, with governance (G) falling in the middle.”

2) A stronger link to funding costs

Studies of “sin” stocks, i.e., companies involved in businesses such as producing alcohol, tobacco, and gaming, find that these stocks are less commonly held by institutions, and that they face higher costs for funding, from equity and debt). The evidence for this is strongest in sectors like tobacco (starting in the 1990s) and fossil fuels (especially in the last decade), but these findings come with a troubling catch. While these companies face higher costs, and have lower value, investors in these companies will generate higher returns from holding these stocks.”

3) Some evidence that ESG focussed companies do reduce their risk of failure or exposure to disaster risk

“An alternate reason why companies would want to be “good” is that “bad” companies are exposed to disaster risks, where a combination of missteps by the company, luck, and a failure to build in enough protective controls (because they cost too much) can cause a disaster, either in human or financial terms. That disaster can not only cause substantial losses for the company, but the collateral reputation damage created can have long term consequences. One study created a value-weighted portfolio of controversial firms that had a history of violating ESG rules, and reported negative excess returns of 3.5% on this portfolio, even after controlling for risk, industry, and company characteristics. The conclusion in this study was that these lower excess returns are evidence that being socially irresponsible is costly for firms, and that markets do not fully incorporate the consequences of bad corporate behavior. The push back from skeptics is that not all firms that behave badly get embroiled in controversy, and it is possible that looking at just firms that are controversial creates a selection bias that explains the negative returns.”

Damodaran sums up his argument

“There is a weak link between ESG and operating performance (growth and profitability), and while some firms benefit from being good, many do not. Telling firms that being socially responsible will deliver higher growth, profits and value is false advertising. The evidence is stronger that bad firms get punished, either with higher funding costs or with a greater incidence of disasters and shocks. ESG advocates are on much stronger ground telling companies not to be bad, than telling companies to be good. In short, expensive gestures by publicly traded companies to make themselves look “good” are futile, both in terms of improving performance and delivering returns.”

There is a lot more to say on this topic. The evidence that certain types of companies do get punished for failing to be socially responsible is especially interesting. I see a fair degree of cynicism applied to the ESG stance adopted by the Australia banks but I suspect they are a good example of the type of company that will in fact benefit from making real investments in socially responsible business strategies.

Tony – From the Outside

Digital money – FT Alphaville

FT Alphaville is one of my go to sources for information and insight. The Alphaville post flagged below discusses the discussion paper recently released by the Bank of England on the pros and cons of a Central Bank Digital Currency. It is obviously a technical issue but worth at least scanning if you have any interest in banking and ways in which the concept of “money” may be evolving.

Read on ftalphaville.ft.com/2020/03/12/1584053069000/Digital-stimulus/

Banks may be asked to absorb more than their contractual share of the economic fallout of the Coronavirus

We have already seen signs that the Australian banks recognise that they need to absorb some of the fallout from the economic impact of the Coronavirus. This commentator writing out of the UK makes an interesting argument on how much extra cost banks and landlords should volunteer to absorb.

Richard Murphy on tax, accounting and political economy
— Read on www.taxresearch.org.uk/Blog/2020/03/04/banks-and-landlords-have-to-pick-up-the-costs-of-the-epidemic-to-come-if-the-the-economy-is-to-have-a-chance-of-surviving/

I am not saying banks should not do this but two themes to reflect on:

1) This can be seen as part of the price of rebuilding trust with the community

2) it reinforces the cyclicality of the risk that bank shareholders are required to absorb which then speaks to what is a fair “Through the Cycle” ROE for that risk

I have long struggled with the “banks are a simple utility ” argument and this reinforces my belief that you need a higher ROE to compensate for this risk

Tony

Company purpose

There has been a lot written on this topic recently, particularly in response to the recent announcement by the Business Roundtable of it decision that corporations should seek to serve all stakeholders rather than focusing on shareholders. I don’t propose to add anything new to the discussion in this post but simply to call out a couple of references I have found useful in trying to make sense of the issues.

This post by Aswath Damodaran offers a useful review of the issues associated with choosing what purpose a company should serve, and what might go wrong as the current debate plays out. Damodaran identifies 5 variations on how companies pursue their purpose

  1. Cut throat corporatism
  2. Crony corporatism
  3. Managerial corporatism
  4. Constrained corporatism
  5. Confused corporatism

“Confused corporatism” is the label Damodaran applies to the “stakeholder” approach. No surprises that he is not a fan. This extract from his post captures his core arguments.

“I know that this is a trying time to be a corporate CEO, with people demanding that you cure society’s ills and the economy’s problems, with the threat of punitive actions, if you don’t change. That said, I don’t believe that you can win this battle or even recoup some of your lost standing by giving up on the focus on shareholder wealth and replacing it with an ill-thought through and potentially destructive objective of advancing stakeholder interests. In my view, a much healthier discussion would be centered on creating more transparency about how corporations treat different stakeholder groups and linking that information with how they get valued in the market. I think that we are making strides on the first, with better information disclosure from companies and CSR measures, and I hope to help on the second front by connecting these disclosures to intrinsic value. As I noted earlier, if we want companies to behave better in their interactions with society, customers and employees, we have to make it in their financial best interests to do so, buying products and services from companies that treat other stakeholders better and paying higher prices for their shares.”

“From Shareholder wealth to Stakeholder interests: CEO Capitulation or Empty Doublespeak?”; Musings on Markets, 28 August 2019

The Economist also offers a perspective on what might go wrong with the “stakeholder” version of corporate purpose. The Economist uses the term “Collective Capitalism” to label this alternative formulation.

I am not convinced the answer proposed by The Economist is going to solve the problem but I still found it worth reading. Firstly, it reminds us that companies have been granted unique rights – in particular “limited liability”. We probably take this for granted but recognising that it is a privilege begs the question what does society get in return.

“Ever since businesses were granted limited liability in Britain and France in the 19th century, there have been arguments about what society can expect in return”

Like Damodaran, The Economist questions the ways in which companies might make the social choices not being addressed now.

“Consider accountability first. It is not clear how CEOs should know what “society” wants from their companies. The chances are that politicians, campaigning groups and the CEOs themselves will decide—and that ordinary people will not have a voice. Over the past 20 years industry and finance have become dominated by large firms, so a small number of unrepresentative business leaders will end up with immense power to set goals for society that range far beyond the immediate interests of their company.”

The Economist also reminds us that it is not clear how this kinder form of capitalism retains the creative destruction that has been part and parcel of the process of economic growth

The second problem is dynamism. Collective capitalism leans away from change. In a dynamic system firms have to forsake at least some stakeholders: a number need to shrink in order to reallocate capital and workers from obsolete industries to new ones. If, say, climate change is to be tackled, oil firms will face huge job cuts. Fans of the corporate giants of the managerial era in the 1960s often forget that AT&T ripped off consumers and that General Motors made out-of-date, unsafe cars. Both firms embodied social values that, even at the time, were uptight. They were sheltered partly because they performed broader social goals, whether jobs-for-life, world-class science or supporting the fabric of Detroit.

Lastly, this opinion piece by Barry Ritholz is also worth reading for a fairly blunt reminder of the parts of the system status quo that fall far short of the free market fairy tale. I have only scratched the surface of this topic but hopefully you will find the articles and blog posts referenced above useful.

Tony

Building applied critical thinking into the structure of an organisation

This article in Bloomberg caught my attention. It is a background piece on a team known as the “Applied Critical Thinking” unit that has been operating inside the New York Federal Reserve since 2016.

The general idea of contrarian thinking and recognising the limitations of what is and is not knowable are not huge innovations in themselves. What was interesting for me is the extent to which this unit can be thought of as a way of building that thought process into the structure of organisations that might otherwise tend towards consensus and groupthink built on simple certainties.

I have touched on this general topic in some previous posts. A review of Paul Wilmott and David Orrell’s book (The Money Formula), for example, discussed their use of the idea of a “Zone of Validity” to define the boundaries of what quantitative modelling could reveal about the financial system. Pixar (the digital animation company) also has some interesting examples of how a culture of candour and speaking truth to power can be built into the structure of an organisation rather than relying on slogans that people be brave or have courage.

I don’t have all the answers but this initiative by the NY Fed is I think worth watching. Something like this seem to me to have the potential to help address some of the culture problems that have undermined trust in large companies (it is not just the banks) and the financial system as a whole.

Tony

What is the value of information in the money market?

“Debt and institutions dealing with debt have two faces: a quiet one and a tumultuous one …. The shift from an information-insensitive state where liquidity and trust prevails because few questions need to be asked, to an information-sensitive state where there is a loss of confidence and a panic may break out is part of the overall system: the calamity is a consequence of the quiet. This does not mean that one should give up on improving the system. But in making changes, it is important not to let the recent crisis dominate the new designs. The quiet, liquid state is hugely valuable.”

Bengt Holmstrom (2015)

The quote above comes from an interesting paper by Bengt Holmstrom that explores the ways in which the role money markets play in the financial system is fundamentally different from that played by stock markets. That may seem like a statement of the obvious but Holmstrom argues that some reforms of credit markets which based on the importance of transparency and detailed disclosure are misconceived because they do not reflect these fundamental differences in function and mode of operation.

Holmstrom argues that the focus and purpose of stock markets is price discovery for the purpose of allocating risk efficiently. Money markets, in contrast are about obviating the need for price discovery in order to enhance the liquidity of the market. Over-collateralisation is one of the features of the money market that enable deep, liquid trading to occur without the need to understand the underlying risk of the assets that are being funded .

 “The design of money market policies and regulations should recognise that money markets are very different from stock markets. Lessons from the latter rarely apply to the former, because markets for risk-sharing and markets for funding have their own separate logic. The result is two coherent systems with practices that are in almost every respect polar opposites.”

From “Understanding the role of debt in the financial system” Bengt Holmstrom (BIS Working Papers No 479 – January 2015)

Holmstrom appears to have written the paper in response to what he believes are misconceived attempts to reform credit markets in the wake of the recent financial crisis. These reforms have often drawn on insights grounded in our understanding of stock markets where information and transparency are key requirements for efficient price discovery and risk management. His paper presents a perspective on the logic of credit markets and the structure of debt contracts that highlights the information insensitivity of debt. This perspective explains among other things why he believes that information insensitivity is the natural and desired state of the money markets.

Holmstrom notes that one of the puzzles of the GFC was how people traded so many opaque instruments with a seeming ignorance of their real risk. There is a tendency to see this as a conspiracy by bankers to confuse and defraud customers which in turn has prompted calls to make money market instruments more transparent. While transparency and disclosure is essential for risk pricing and allocation, Holmstrom argues that this is not the answer for money markets because they operate on different principles and serve a different function.

 “I will argue that a state of “no questions asked” is the hallmark of money market liquidity; that this is the way money markets are supposed to look when they are functioning well.”

“Among economists, the mistake is to apply to money markets the lessons and logic of stock markets.”

“The key point I want to communicate today is that these two markets are built on two entirely different, one could say diametrically opposite, logics. Ultimately, this is because they serve two very different purposes. Stock markets are in the first instance aimed at sharing and allocating aggregate risk. To do that effectively requires a market that is good at price discovery.

 “But the logic behind transparency in stock markets does not apply to money markets. The purpose of money markets is to provide liquidity for individuals and firms. The cheapest way to do so is by using over-collateralised debt that obviates the need for price discovery. Without the need for price discovery the need for public transparency is much less. Opacity is a natural feature of money markets and can in some instances enhance liquidity, as I will argue later.”

“Why does this matter? It matters because a wrong diagnosis of a problem is a bad starting point for remedies. We have learned quite a bit from this crisis and we will learn more. There are things that need to be fixed. But to minimise the chance of new, perhaps worse mistakes, we need to analyse remedies based on the purpose of liquidity provision. In particular, the very old logic of collateralised debt and the natural, but sometimes surprising implications this has for how information and risk are handled in money markets, need to be properly appreciated.”

There is a section of the paper titled “purposeful opacity” which, if I understood him correctly, seemed to extend his thesis on the value of being able to trade on an “information insensitive” basis to argue that “opacity” in the debt market is something to be embraced rather than eliminated. I struggled with embracing opacity in this way but that in no way diminishes the validity of the distinction he draws between debt and equity markets.

The other useful insight was the way in which over-collateralistion (whether explicit or implicit) anchors the liquidity of the money market. His discussion of why the sudden transition from a state in which the creditworthiness of a money market counter-party is taken for granted to one in which doubt emerges also rings true.

The remainder of this post mostly comprises extracts from the paper that offer more detail on the point I have summarised above. The paper is a technical one but worth the effort for anyone interested in the question of how banks should finance themselves and the role of debt in the financial system.

Money markets versus stock markets

Holmstrom argues that each system displays a coherent internal logic that reflects its purpose but these purposes are in many respects polar opposites.

Stock markets are primarily about risk sharing and price discovery. As a consequence, these markets are sensitive to information and value transparency. Traders are willing to make substantial investments to obtain this information. Liquidity is valuable but equity investors will tend to trade less often and in lower volumes than debt markets.

Money markets, in contrast, Holmstrom argues are primarily about liquidity provision and lending. The price discovery process is much simpler but trading is much higher volume and more urgent.

“The purpose of money markets is to provide liquidity. Money markets trade in debt claims that are backed, explicitly or implicitly, by collateral.

 “People often assume that liquidity requires transparency, but this is a misunderstanding. What is required for liquidity is symmetric information about the payoff of the security that is being traded so that adverse selection does not impair the market. Without symmetric information adverse selection may prevent trade from taking place or in other ways impair the market (Akerlof (1970)).”

“Trading in debt that is sufficiently over-collateralised is a cheap way to avoid adverse selection. When both parties know that there is enough collateral, more precise private information about the collateral becomes irrelevant and will not impair liquidity.”

The main purpose of stock markets is to share and allocate risk … Over time, stock markets have come to serve other objectives too, most notably governance objectives, but the pricing of shares is still firmly based on the cost of systemic risk (or a larger number of factors that cannot be diversified). Discovering the price of systemic risk requires markets to be transparent so that they can aggregate information efficiently.     

Purposeful opacity

“Because debt is information-insensitive … traders have muted incentives to invest in information about debt. This helps to explain why few questions were asked about highly rated debt: the likelihood of default was perceived to be low and the value of private information correspondingly small.”

 Panics: The ill consequences of debt and opacity

“Over-collateralised debt, short debt maturities, reference pricing, coarse ratings, opacity and “symmetric ignorance” all make sense in good times and contribute to the liquidity of money markets. But there is a downside. Everything that adds to liquidity in good times pushes risk into the tail. If the underlying collateral gets impaired and the prevailing trust is broken, the consequences may be cataclysmic”

“The occurrence of panics supports the informational thesis that is being put forward here. Panics always involve debt. Panics happen when information-insensitive debt (or banks) turns into information-sensitive debt … A regime shift occurs from a state where no one feels the need to ask detailed questions, to a state where there is enough uncertainty that some of the investors begin to ask questions about the underlying collateral and others get concerned about the possibility”

These events are cataclysmic precisely because the liquidity of debt rested on over-collateralisation and trust rather than a precise evaluation of values. Investors are suddenly in the position of equity holders looking for information, but without a market for price discovery. Private information becomes relevant, shattering the shared understanding and beliefs on which liquidity rested (see Morris and Shin (2012) for the general mechanism and Goldstein and Pauzner (2005) for an application to bank runs).

Would transparency have helped contain the contagion?

“A strong believer in the informational efficiency of markets would argue that, once trading in credit default swaps (CDS) and then the ABX index began, there was a liquid market in which bets could be made both ways. The market would find the price of systemic risk based on the best available evidence and that would serve as a warning of an imminent crisis. Pricing of specific default swaps might even impose market discipline on the issuers of the underlying debt instruments”

 Shadow banking

 “The rapid growth of shadow banking and the use of complex structured products have been seen as one of the main causes of the financial crisis. It is true that the problems started in the shadow banking system. But before we jump to the conclusion that shadow banking was based on unsound, even shady business practices, it is important to try to understand its remarkable expansion. Wall Street has a hard time surviving on products that provide little economic value. So what drove the demand for the new products?”

 “It is widely believed that the global savings glut played a key role. Money from less developed countries, especially Asia, flowed into the United States, because the US financial system was perceived to be safe … More importantly, the United States had a sophisticated securitisation technology that could activate and make better use of collateral … Unlike the traditional banking system, which kept mortgages on the banks’ books until maturity, funding them with deposits that grew slowly, the shadow banking system was highly scalable. It was designed to manufacture, aggregate and move large amounts of high-quality collateral long distances to reach distant, sizable pools of funds, including funds from abroad.”

“Looking at it in reverse, the shadow banking system had the means to create a lot of “parking space” for foreign money. Securitisation can manufacture large amounts of AAA-rated securities provided there is readily available raw material, that is, assets that one can pool and tranche”

“I am suggesting that it was an efficient transportation network for collateral that was instrumental in meeting the global demand for safe parking space.”

 “The distribution of debt tranches throughout the system, sliced and diced along the way, allowing contingent use of collateral”

“Collateral has been called the cash of shadow banking (European repo council (2014)). It is used to secure large deposits as well as a host of derivative transactions such as credit and interest rate swaps.”  

There is a relatively recent, but rapidly growing, body of theoretical research on financial markets where the role of collateral is explicitly modelled and where the distinction between local and global collateral is important

“Viewed through this theoretical lens, the rise of shadow banking makes perfectly good sense. It expanded in response to the global demand for safe assets. It improved on traditional banking by making collateral contingent on need and allowing it to circulate faster and attract more distant capital. In addition, securitisation created collateral of higher quality (until the crisis, that is) making it more widely acceptable. When the crisis hit, bailouts by the government, which many decry, were inevitable. But as just discussed, the theory supports the view that bailouts were efficient even as an ex ante policy (if one ignores potential moral hazard problems). Exchanging impaired collateral for high-quality government collateral, as has happened in the current crisis (as well as historically with clearing houses), can be rationalised on these grounds.”

 Some policy implications

 A crisis ends only when confidence returns. This requires getting back to the no-questions-asked state ….

Transparency would likely have made the situation worse

“By now, the methods out of a crisis appear relatively well understood. Government funds need to be committed in force (Geithner (2014)). Recapitalisation is the only sensible way out of a crisis. But it is much less clear how the banking system, and especially shadow banking, should be regulated to reduce the chance of crisis in the first place.  The evidence from the past panic suggests that greater transparency may not be that helpful.”

“The logic of over-capitalisation in money markets leads me to believe that higher capital requirements and regular stress tests is the best road for now.”

“Transparency can provide some market discipline and give early warning of trouble for individual banks. But it may also lead to strategic behaviour by management. The question of market discipline is thorny. In good times market discipline is likely to work well. The chance that a bank that is deemed risky would trigger a panic is non-existent and so the bank should pay the price for its imprudence. In bad times the situation is different. The failure of a bank could trigger a panic. In bad times it would seem prudent to be less transparent with the stress tests (for some evidence in support of this dichotomy, see Machiavelli (1532)).”