Irrational Economist_ Making Decisions in a Dangerous World - Erwann Michel-Kerjan [93]
THREE LESSONS ON MARKET BEHAVIORS
What lessons can we draw regarding the current crisis from our experience with natural catastrophe reinsurance? First, when the intermediary sector’s capital is damaged, replacement capital does not arrive quickly. Instead, it is as though the intermediaries essentially try to self-heal: They charge a lot for access to their capital. Over time this helps them repair their balance sheets, along with capital inflows. But no cavalry bringing additional capital arrives to ensure that there is sufficient liquidity or capital to keep prices fair. Prices may be distorted for a period of time while intermediaries remain broken or weak. The system is sensitive—systemically sensitive—to shocks to the supply of intermediary capital.
The second lesson we can draw during the healing process is that this return toward fair pricing is going to be even more painful and slow in banking than it has been, repeatedly, in reinsurance. Why? Remember that the shocks to reinsurance capital are essentially flips of a coin: They are chance outcomes whose ex ante probabilities are unaffected by the ex post occurrence. In the financial crisis, the risk of lending was endogenous to the system. (In any crisis, lending is obviously going to be more risky.) Indeed, the worse the breakage of bond markets and the more bond underpricing we experience, the more stressed intermediary capital levels become. Markets that break therefore worsen the crisis and make the prospect of ongoing lending even more risky. So the sensitivity of intermediary capital to supply shocks affects, in turn, both the severity and the duration of the downturn.
The final lesson is that the concentrated risks of intermediary capital are both systemically dangerous and preventable. In reinsurance, traditional reinsurers are slowly being replaced by a diffuse set of agents who manage dedicated but reinsurance exposures for many investors—hedge funds, mutual funds, and so forth. Reinsurance can be, and increasingly is being, written in small pieces by many portfolio managers acting as agents for their beneficial investors. This allows for far wider sharing of reinsurance risk and less concern with “too big to fail.” The financial crisis has been made worse by the mistake of allowing intermediaries to accumulate large portfolios of securities whose markets the dealers were supposed to support. When those security values fell, intermediaries’ stressed capital levels made it impossible for them to support these markets. And when the intermediaries’ support of these markets waned, the public-good of liquidity declined, allowing for even less funding and even lower security vales.
This vicious cycle was an important but unnecessary magnifier of the current crisis. We have begun to make reinsurance markets more competitive by reducing intermediary concentration and by encouraging intermediaries to compete with investors directly. We need to do the same for bond markets—making them less reliant on exposed intermediary dealers, both by increasing the markets’ competitiveness and by using regulation to prohibit substantial dealer warehousing of risk. The cost and protracted nature of this crisis is a direct result of preventable problems that we allowed to emerge in the regulation and organization of bond markets.
RECOMMENDED READING
Ivashina, Victoria, and David S. Scharfstein. “Bank Lending During the Financial Crisis of 2008.” Harvard Business School Working Paper, July 2009.
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Economic Theory and the Financial Crisis
How Inefficient Incentives Can Lead to Catastrophes
KENNETH J. ARROW
One does not have to study deeply to find that the failure of markets for various kinds of derivative securities to perform properly is an essential element of the current financial crisis.1 Actually,