Careful with the tail there February 6, 2012 at 7:19 pm

This guy is slick. Goodness me yes. Check this out:

One of the most pernicious effects, in my opinion, of the evolution of limited liability in the financial system, and the consequent transfer of more and more tail risk to society at large, has been the weakening of our understanding of the price of risk. Now don’t kid yourself: society always stands as the loss-absorber of last resort, under any capital, economic, or financial regime, because there are some losses which are too large for any system to absorb. (Think about a kilometer-wide asteroid hitting New York City or Los Angeles, for example.) After all, financial losses happen to a society. But the drawback of risk assumed by government and taxpayers is that it is not explicitly priced.

It is, of course, the Epicurean Dealmaker, and I think he is quite right on the essentials. There will always be a tail of financial risk that society must absorb, and the policy debate should be about how much there should be of it and what compensation society extracts from the financial system for taking it, not how to remove it (because that is impossible).

[As an aside, one could imagine trying to price it. For instance, suppose that banks have to be 100% deposit funded, and all deposits must be insured but there is limited insurance. Banks have to bid for the available insurance. That would at least establish a market clearing price for deposit insurance.]

TED puts the general argument nicely though:

But make no mistake, the decisions we make about how we allocate, limit, and distribute financial risk throughout society—including how much to put financial intermediaries on the hook—will reverberate broadly through the system and ultimately affect our very living standards and prospects.

Now, you may hate the following. I certainly do. But what if putting financial intermediaries less on the hook is better for society? What if it creates growth that more than pays for its extra costs? I’m not saying that is true – I don’t know – but the possibility must be acknowledged. Thinking about the problem as tail risk allocation at least saves us from knee-jerk responses which are unlikely to lie on the efficient frontier.

15 Responses to “Careful with the tail there”

  1. TED doesn’t udnerstand that slick doesn’t move prices on the bloomberg screen, or change the views of informed listeners. It just impresses the rubes in the cheap seats.

    If TED were serious, he’d try a rebuttal to Simon Johnson’s critique of Corrigan’s defense of size.

    http://baselinescenario.com/2009/12/08/gerry-corrigan%E2%80%99s-case-for-large-integrated-financial-groups/

  2. @vbounded — Why would I rebut Johnson’s argument? I agree with much of it.

    Informed readers can make up their own minds. If my writing helps them do that, that’s all I ask.

  3. well.. we have just tried your approach. they created artificial risk, sold it, placed bet on it, took the profits and showed finger to the rest. on top of that they took the pension funds for hostage, demanded ransom and left the mess to others to clean. would you like to have it again?

  4. This isn’t an argument about size: it is an argument about who bears tail risk and at what cost. If you break up the big banks, you have lots of little banks. (Or lots of little banks and other things, as some of the risk will move to other sectors.) Still someone is wearing the risk that the economy implodes and all of those mortgages aren’t worth anything. Sure, you might have moved some of it to bank equity holders, but it is still there and some tail is still with the taxpayer. My point is that you have to bear in mind that there are pros and cons to the decision of how much of this risk sits with the taxpayer, not just in terms of what happens when things go wrong, but also how much credit is available when things are going right.

  5. Regarding tail risk, I care about size because it brings political clout to distort the rules so as to subsidize the industry. I prefer spreading risk over a higher number of small entities that are heterogenous to reduce risks of them forming a bailout coalition as bad as the one for the big banks.

    Industry isn’t interested in an honest debate over tail risk like David presents.

  6. […] “There will always be a tail of financial risk that society must […]

  7. When you frame as TED did, makes you wonder why finance gets singled out. In the end, doesn’t society take the tail risk of all human activity? Who has the tail risk for industrial activity (Bopal?), medicine development, food industry, military industry, etc… All human ‘progress’ – or attempts thereof – contain a tail risk that is ultimately shared with society. Society is not just the backstop of finance, but for all human progress.

    In that sense, growing/improving/evolving as a society means accepting that risk. I think it is something we all implicitly acknowledge to be part of the ‘deal'; it just scared us a lot (and seems to surprise us) when it becomes explicit.

    So, in my humble opinion, growth is only possible because society acts as that final backstop, the absorber of tail-risk (including the ultimate tail-risk: wiping out all humans).

    Discussion should then turn to where the limit should be, i.e. what part of the tail still belongs to the industry, and what part to society.

  8. Most of the participants are trying to push the risk to the rest. As a result we had huge domain with semi-virtual contracts reshuffling the risk here and there and the supporting infrastructure /banks, hedge funds etc./ The thing is there are very few opportunities to invest in. There where massive underinvestment at the initial part of the process /R&D/, as a result there are not enough technology and processes to invest in. The existing capital is chasing it’s tail via speculation. This is not productive in any sense. I don’t see reason for society to bear the tail risk from this activity.

  9. Hans – I completely agree with you. The risk is there, like it or not, and as you say, “discussion should then turn to where the limit should be, i.e. what part of the tail still belongs to the industry, and what part to society”. I’d add too “and what price society charges the financial system for bearing that risk”.

    Comments such as the next one are utopian. Society can’t help but bear the risk at some point in the tail. The question is how far out and how to extract a reasonable premium for that risk bearing.

  10. Really? I find the abstraction of business failure as tail risk utopian. If business fails, it does not represent tail risk for the society as a whole except in the case for highly concentrated, monopolistic/oligopolistic cases /the huge pseudo-banks for example/. So they don’t really transfer or “manage” risk but allocate capital. At least this was the initial function of the banks. So how we ended up with trillions of fictitious capital in form financial instruments is up to the great moderator Greenspan to answer if he can.. So who lives in utopia?

  11. “Tail risk” is a general term from stochastics. What you are discussing is credit-extension risk specifically. The tail risk of our financial crisis wasn’t the occurrence of a surprise crash in the economy. It was an unsurprising crash of debtors provided credit on terms that would have been considered foolhardy thirty-five years ago. The lenders took their cut up front, an innovative practice, and thus were free to puff and sell (if not defraud and sell) the foolhardy risk to others, with the blessing of conflicted politicians. It isn’t something society should pay. It is something political society should prevent.

  12. A society that bears risk “at some point in the tail” has a right to regulate the nature of that tail before the risks are taken. When financial institutions model the profit expected over the life of a loan or deal, discount it to the present, and distribute all of it in the current period through bonuses and accruals-to-equity, the very notion of risk is laughed off. Such players should be limited to unlimited liability deals, in relation to the society. It is not ‘risk’ if you can cash out the estimated future gain and sell on the asset and its attendant risk.

  13. […] “There will always be a tail of financial risk that society must absorb”  – David Murphy […]

  14. quibble: The statement doesn’t make sense under ∀ economic regime. TED is presuming modern social cohesion and representedness.

    substantive problem: ∄ “the” price in a social sense. ∃ what happened. Maybe ∃ probability distributions of what will happen. Maybe ∃ O(100M) risk tolerance functions over potential outcomes. That ∃ (time-dependent) prices of transactions by particular players with capital structures and other idiosyncracies, says nothing about a social price.

    I’m not learned enough about the history of limited liability, but would love to read a thorough story from Parliamentary acts through American exploitation by … someone like you or tED.

  15. @vbounded SJ’s critique of GC is correct. But just because GC failed in arguing why large financial institutions are necessary / good / here to stay, doesn’t mean there aren’t other (correct) arguments proving his conclusion.