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What's the Right Treatment for Trader Addiction in the Age of Bubbles?

On Friday, Paul Krugman dealt with financial market price bubbles, focusing specifically on emerging markets. He takes on the issue of bubble creation as a result of aggressive Fed loose money policy of the recent past. He correctly points out that the emerging markets situation is really one of a series of bubbles (commercial real estate, Asian securities, dot-com, residential real estate), referred to by George Soros as a “super bubble,” that has roiled through the economy since the 1980s.

Krugman makes the case that the evidence doesn’t support Fed policy causation of the current bubble, much less the others. He is spot on when he ascribes the bubble era to the deregulation of the financial sector. At the end of the article he says:

In short, the main lesson of this age of bubbles. . . is that when the financial industry is set loose to do its thing, it lurches from crisis to crisis.

This morning, on the same New York Times op-ed page, Professor Anat Admati of Stanford holds forth, offering up her oft-repeated panacea for the financial sector. She advocates de-leveraging of the banks, making them fund their activities with far more equity capital than debt. She should read Krugman's Friday article again.

There is absolutely nothing wrong with Admati’s advocacy of less leverage in banks. Low leverage is an attribute of a stable organization, able to absorb cash flow shocks. However she suggests that this is the key to solving our problems, ridding the economy of “too-big-to-fail” financial institutions. Simultaneously she argues that equity is really no more costly than debt and that lower leverage will address too-big-to-fail. That requires some more convoluted reasoning since if equity is no more costly it will not constrain raising capital.

Here’s Admati:

If banks could absorb much more of their losses, regulators would need to worry less about risk measurements, because banks would have better incentives to manage their risks and make appropriate investment decisions. [emphasis added]

This baffles me, but much worse than my confusion is that it is dangerous, far more dangerous than the antics of House Committees to eviscerate Dodd-Frank with various “technical correction” bills. Decision makers may actually take this reasoning to allow for an easy and simple solution to the problems. But, just how does the second italicized phrase flow from the first? I understand that standard corporate behavior as viewed by many is that businesses will behave rationally in accordance with rules that have been accepted for years. This formula has nothing to do with the modern financial services sector. Rearranging the capital structure will not foreclose risk taking; it may actually encourage it. If you are a trader, risk is proportionate to reward. A deleveraged capital structure may reduce the pressure on traders to manage their losses and their risk.

Remember the London Whale? The JP Morgan Chase trader initially changed the method of calculating risk on his positions as risk limits were breached. What did he do when this arithmetic trick created more headroom for him? He took on more risk. Risk expanded to occupy available space, the first rule of trader behavior.

Deleveraging, by itself, is like giving a heroin addict money for food and shelter and a job promising self-actualization. Those things will aid recovery, but only if you stop the addictive behavior. Otherwise, it all goes into the addict’s arm.

Far more important than deleveraging or any other capital adequacy approach to financial reform is stopping complex risk-taking activity. That activity will always grow to fill the space made available by the capital structure of the financial institution.

It is not as if investors in banks dislike the idea of risk taking and will impose discipline. A typical shareholder wants the bank to take risks and make commensurate rewards. For the short-term holder of bank shares, this is completely rational. Let the bank make massive profits and just be sure to be out of the position when the periodic crash occurs.

Again, it is not as if Admati’s ideas are wrong, they are simply insufficient and could be a distraction from the far more important work of reducing the complex risk in the financial system. It may well be that Admati has decided that the reduction of risk is too complicated to be sustained in the face of adversity by the bank lobby. If that is so, what a shame!

If only one side of the ledger is addressed—either Admati’s approach or the Basel approach of risk calculation to set capital adequacy—the result may well be to allow the other side of the ledger—risk taking—to become cumulatively worse. Provisions against a run on the banks may actually allow price bubbles to grow bigger and even more dangerous.

It is too bad that there is no simple way out of this. The problem is that the banks were able to reap super profits from complexity for decades. Predictably, financial markets became more and more complex. The system cannot be made safe until the traders can no longer profit, day-in and day-out, year after year, from complexity facing only the potential of a financial crisis sometime in the future as a curb on behavior. They will always opt to take it to the edge, no matter where that edge is.

The hard truth is that solving this is difficult and complicated and may even require another crash to complete.