How The Bailout Made The Overconfidence Problem Worse

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If Malcolm Gladwell is right—and I think he is—that overconfidence played an important role in creating our financial crisis, it’s time to start asking what we should be doing about this.

In the first place, we need to recognise the limits of policy. The search for technical fixes to behaviour embedded in the flawed characters of men and women in finance is doomed to failure. We’re not going to find some easy way to discount for overconfidence or even reign it in.

But we can adopt a policy of not making the problem worse. Unfortunately, much of what has gone on in what former Treasury Secretary Hank Paulson terms the “rescue” of the financial sector has been making the problem of overconfidence worse. In particular, the various guarantees—implicit and explicit—of assets and liabilities of financial firms tends to increase  overconfidence.

Everyone from Fed chair Ben Bernanke to Treasury Secretary Tim Geithner has officially announced that the policy of our government is that we will not allow another Lehman Brothers, which means that the government will do whatever it takes to prevent the collapse of a large, complex, systemically important financial institution.

Not many people seem to understand that this policy makes it almost impossible for banks to competently manage their risk. On the surface, the Wall Street banks benefit from lower borrowing costs thanks to the subsidies from both the explicitly guaranteed debt and the broader implicit guarantee against failure. But because this leaves the financial firms without a market check on their activities, it becomes impossible for them to gauge whether they are taking the appropriate risks and the appropriate level of risk.

So, for instance, we see that Goldman Sachs dramatically increased the amount of risk it takes from day to day last quarter. The market doesn’t seem to have penalised them for this additional risk. And why should investors care? They’ve got the government on their side.  Which means that Goldman has no market check on its risk, leaving the firm without outside guidance about the wisdom of its investments. In short, the market penalty on overconfidence is destroyed by the guarantees.

Artificially cheap capital also enables Goldman to speculate on trades that would normally be too risky. A kind of phony, government ‘Alpha’ is created by the guarantees—excess gains obtained without internally taking on commensurate levels of risk and its market costs. The folks at Goldman, to pick on them a bit more, are deceived into thinking they are better at this than they are. This is sure to encourage even more overconfidence.

Goldman still makes a show about caring about risk management, but the truth is that the firm is basically flying blind. That’s because while traditional risk management isn’t quite useless, but it is nearly so. Even somewhat sophisticated measures such as “Value at Risk” that banks employ don’t really work very well. Goldman itself admits this.

The only real test of risk management is provided by the financial Darwinism of the markets. By reading market signals about products—pricing of assets, pricing of insurance on those prices—banks develop models that can inform them about risk. By reading market signals about their own financial health—their cost of capital, their borrowing cost, the cost to insure their debt, the willingness of customers to enter into trades—risk managers get a view about the risks of their own portfolios and the strength of the business model. Guys and gals whose standard operating procedure is overconfidence, have this trait checked in the markets.

Now we’ve scrambled these signals, and encouraged overconfidence. Shareholders, bondholders, counterparties can become indifferent to risk. Business models can seem more effective than they actually are. In this situation, financial executives cannot appeal to the external market to determine whether they have the right business models, asset portfolios or capital structures. They just have to guessitimate.

This calculational chaos is far worse than simple ‘moral hazard.’ It doesn’t matter what regulations are in place, or how closely supervised a firm might be. After all, the regulators and supervisors suffer from the same blindness of the bank executives. The worst kind of overconfidence is encouraged across the broader markets.

It was this calculational chaos that brought down Fannie Mae and Freddie Mac. Even when closely supervised by regulators and with well-intentioned executives in place, the mortgage agencies were unable to properly evaluate the size of their balance sheets, the content and quality of their portfolios or the appropriateness of their business models. And now we’ve reduced Goldman Sachs to Goldie Mac, another flying blind, overconfident financial firm.

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