The confidence paper is up December 28, 2011 at 7:12 pm

Abstract:

The solvency/liquidity spiral was a major mode of large financial institution failure during the 2008 financial crisis. Many institutions began the crisis with significant funding liquidity risk. Initially unjustified investor doubts over an institution’s solvency caused a loss of confidence. This in turn caused the price and availability of funding to deteriorate, until in some cases this lead to failure. Thus a key factor in financial institution distress was loss of confidence caused by investor uncertainty over solvency.

As we show, the official accounts of the failures of Lehman Brothers and RBS provide substantial evidence for this failure mode. Our model has implications for confidence-enhancing regulatory and accounting policy, which we discuss. In particular, it suggests that minimum required capital is needed to keep investor confidence in a firm, and thus only capital above the minimum is available to absorb losses.

The full version is here.

Any comments would be much appreciated.

(Irritating geeky note: some folks have had some problems in the past with PDFs saved from Word 2010 not being readable on ipads. I think I have cured this problem here by saving an ISO 19005-1 compliant PDF, but please let me know if I haven’t.)

4 Responses to “The confidence paper is up”

  1. Congratulations.
    An excellent and timely paper. There appear to be no “faults” as your focus is on the financial system. However, I would suggest the subject also importantly relates to Private Non-Financial Companies who provide twice as much “credit” (through credit paymment terms extended to other PNFC’s) as banks & non-banks provide to PNFC’s (In the US, certainly) lubricating Real Economic activity. For example the withdrawal of trade credit insurance from PNFC’s in the UK & EU contributed significantly to the creeping loss of confidence (and the consequential withdrawal by banks of SME’s unsecured credit lines) and eventual 90% drop in global trade in Q4 2008. More restrictive payment terms for “uninsured” buyers reduced PNFC’s trading cashflow and initiated the “flight to quality” my former boss Hank Greenberg would often refer to at AIG as a competitive advantage.

    The paper helps pinpoint the failures of current financial and regulatory architecture. Reducing complexity (and therefore potential fault-lines) and re-tailoring funding solutions to fit clients needs (rather than the commercial needs of the financial communnity) is central to easing credit to the Real Economy. This involves reviewing all routes to risk-adjusted capital market funding which therefore includes regulated insurance as well as banking and shadow-banking (Solvency II & Basel III).

    In addition, the paper highlights the deep failure of the audit profession to show sufficient (if any) ‘professional skepticism’ in verifying valuation methodologies for PNFC’s Financial Reporting and Internal Controls. It also suggests that the fiduciary duty of publicly listed PNFC’s Boards should be held to the highest standard. The highest levels of corporate governance standards and risk management disclosure can provide retail investors with greater trust in the “public” system. These areas offer investors greater transparency and support systemic confidence as well as offering real economic value as a competitive business advantage. Until now, the popular “free market” narrative has been that “regulators” impose burdensome costs reducing short-term RoC that influence incentive-focused triggers. However, these have been conflated with longer-term investor-focused RaRoC often at the expense of the latter. This Principal/Agent problem can be far better addressed to re-establish confidence in financial markets in advanced economies.

    PS Yesterday, I posted a good piece on the audit subject of valuation methodologies by The Accounting Onion on twitter.

  2. Thank you for your comments: much appreciated.

  3. […] of risk in institutions that do not fund primarily through insured deposits that is the problem.  David Murphy has a new paper that looks at Lehman and RBS, and arrives at a similar conclusion.  This would imply that Glass-Steagall is utterly […]

  4. […] Maintaining Confidence: Understanding and preventing a major financial institution failure mode (Deus Ex Macchiato) [Investors] are aware that in a crisis: Investors will fail to roll debt if they are not confident in the health of an institution; and if sufficiently many investors fail to roll an institution’s debt, then that institution may fail. This means that the key question for a funder is not Is the institution I am considering funding solvent? but rather Will most other potential funders consider the institution solvent? […]