Wednesday, November 11, 2009

Bookstaber goes to the SEC

I see that Richard Bookstaber is moving to the SEC. Good for him!

I hope that this is the start of some adult supervision by the regulatory authorities. Consider what Bookstaber had to say about the banking system in an older post on his blog:

The last thing a bank wants is a competitive, efficient market, because then it would not be able to extract economic rents. So the incentives are to create innovative products that reduce market efficiency, not enhance it.

How is this done? Well, I can quickly think of two ways. First, by creating informational asymmetries, by having products that are difficult for the users to understand and price. And, second, by designing innovative products, which, due to their non-standard nature, allow the banks to extract higher transaction costs.

There is a lot of asymmetries in the i-bank business, according to Bookstaber:

Innovative products are used to create return distributions that give a high likelihood of having positive returns at the expense of having a higher risk of catastrophic returns. Strategies that lead to a ‘make a little, make a little, make a little, …, lose a lot’ pattern of returns. If things go well for a while, the ‘lose a lot’ not yet being realized, the strategy gets levered up to become ‘make a lot, make a lot, make a lot,…, lose more than everything’, and viola, at some point the taxpayer is left holding the bag.

If we were to look at the sorts of strategies employed by large investment firms and banks, my bet is we would see a bias toward short volatility, short gamma, short credit and short liquidity. All facilitated with innovative products – you can’t really do the first two without derivatives – and all leading to these sorts of return characteristics.

Government support = regulation
If banks want to pursue these asymmetric strategies and get the government to backstop them, then they have to accept some form of regulation. David Merkel at Aleph Blog, has just put up a good post on the nuts and bolts of how to approach banking regulation.

Otherwise bring back the partnership i-bank
The other alternative is to bring back the partnership investment bank and eliminate government support. Having most of your own net worth tied up in your business will focus the partners on the risk side of the business a lot more. Isn’t it funny that partnership based entities like legal and accounting firms generally don’t have the same problems as investment banking? The last time we had a big blowup (Arthur Anderson), we didn’t see accountants running to the government for a bailout.

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