I’ve been smitten with the Platypus Blues by Ms Luci Ellis, the erstwhile RBA Head of the Financial Stability Department. Her speech last week has received commentary on MB from H&H and Rumplestatskin but I think it needs some special detailed attention due to the extraordinary opinions expressed and how its left me feeling.
Critiquing Ms Ellis’s speech is certainly an appropriate follow up to my previous post outlining the power of practitioners to understand systems for risk management and gaming as opposed to the uselessness of market economists high level predictions. As background, I’d simply point out that Ms Ellis as with all RBA Heads of Departments, the Deputy Governor and Governor have never worked in the private sector in their professional lives. The Platypus speech would seem to highlight a number of policy misconceptions that this lack of experience causes.
The speech is long but I’ll do my best to point out important inconsistencies, inaccuracies and perhaps some bouquets. Ms Ellis:
Indeed, credit booms are very often part of the story in the lead-up to a period of financial instability. We published that assessment in the March and September Reviews. In the wake of that, we have sometimes been asked: how fast is too fast? Do we have a target for credit growth? Or for the ratio of credit to GDP? Or, perhaps, for housing and other asset prices? I can tell you quite plainly that we do not have numerical targets for any of these things. A target for credit growth, or any of these other variables, is not analogous to the RBA’s inflation target……….The distinction is simply that price stability is about inflation. So it can be defined as keeping inflation at an acceptably low rate. Financial stability is harder to define, but in essence it is about avoiding episodes when the financial system significantly harms the real economy.
My interpretation of this series of statements is that a fundamental flaw is at the heart of the RBA’s view of financial stability management. The RBA has specific targets for inflation and that is the single price (including assets) stability tool but has no targets or model parameters to govern financial stability. A big mistake not just of policy but market knowledge but lets move on. Ms Ellis:
At the Reserve Bank, and at most of our counterparts overseas, financial stability analysis includes looking at those macro ratios, but we don’t stop there. We look at the structure of balance sheets, both of financial institutions and the non-financial sectors that are their customers. Distributions matter a great deal as well. It is rarely the median borrower that causes the trouble. So we also analyse detailed micro data.
OK, a bouquet for this statement, detailed micro analysis is necessary but detailed frameworks with disclosed parameters can be built from micro systems to provide meaning to any analysis. If provided in the same way as the RBA Statistics, such would provide a framework for specialist and public debate and a discouragement for gaming. Is this what Ms Ellis meant? Let’s move on. Ms Ellis
Some people think that looking for risks to financial stability is about hunting out the ‘black swans’ that could blindside you…….It’s an important point about the limits of models, and about the need to make systems robust to unexpected events. But I don’t think that, taken literally, it’s a constructive way to conduct financial stability policy. The whole point about black swans is that you can’t look for them. You can’t imagine scenarios that are by definition unimaginable.
Hmmm, this is an overly simple summary of Mr Taleb’s book. My reading of the book’s theme is that black swan events are common despite popular opinion. It is the exact causes may be unforeseen and are rare, the occurrence of the event is not. But let’s see what is Ms Ellis’s alternative:
And the test I would apply is inspired by another member of Australia’s weird and wonderful fauna – the platypus. You see, when Europeans first saw a black swan, it would have been a surprise, but I doubt it rocked their world. There are plenty of other cases where the same species of animal is a different colour in different regions. But the platypus is strange. It is a mammal, but it has a duck’s bill; it is the only mammal with venomous spurs; it lays eggs; and it is a monotreme…………..It’s that sense of disbelief, of incredulity, that something is too ridiculous to be true, and yet it is true: that feeling is telling you something. When you have that feeling, you are having what I have come to describe as a Platypus Moment. And it is that moment, that feeling, we should be alert to.
This is inconsistent with an assertion that the RBA conducts micro analysis. As all Australians, I love the platypus but Ms Ellis’s analogy is unhelpful. The RBA’s test on identifying risks to financial stability is that when you see something so unusual, so unlike anything that you’ve seen before but if you have this funny feeling that it may be true, then that’s an event to take notice of. That may very well be the case but that’s not how systems are created which cause financial instability nor even the event that may be the tipping point. Platypus events are the symptoms not cause. Maybe the readers can understand why I have the Platypus Blues. Can Ms Ellis redeem herself?
To give a personal example, some years ago I experienced a Platypus Moment when I first read about vendor-financed down payment assistance charities in the United States………To give a personal example, some years ago I experienced a Platypus Moment when I first read about vendor-financed down payment assistance charities in the United States.Home-building companies would donate money to charities that in turn gave money to first-home buyers to fund their deposits. Usually these charities were quite local, so the builder that funded them often got the money back by inflating the sale price of the house. Unsurprisingly, US government housing agencies have found that borrowers who had received this kind of assistance were three times more likely to default on their mortgage as those who had not (Montgomery 2008).
Whilst I would strongly suggest that this Platypus was a symptom of lending processes which were supported by the US government, how is this different to the Australian FHOG especially the boost after 2008? If your looking at a financial stability risk or Platypus moment, how can the RBA go past the Australian government boosting FHOG, in concert with the RBA significantly lowering interest rates and the banks lending at those low interest rates to over stressed borrowers? It may be great sport to point out the failings in the US or other parts of the world, but its negligent of the RBA to not look into its own backyard. I’m singing the Platypus Blues! Ms Ellis:
…good example of rent-seeking. The textbooks define rent-seeking, roughly speaking, as manipulating the economic and social environment to benefit yourself without adding any real economic value to the world. In fact, because the act of rent-seeking absorbs time, energy and resources, it actually reduces human welfare. Often, but not always, rent-seekers try to persuade the government to bestow some favour on them……….Rent-seekers thrive in complex, opaque markets. A perfect example was the structured credit boom in the years before the crisis. In all the controversy about mark-to-model and the difficulties of pricing these securities, it is often forgotten that it matters whose model the security is being modelled with. Those kinds of informational advantages can be quite lucrative.
A bouquet for the first half of the above quote. Rent-seeking is my personal vendetta and is addressed often on MB. However, the gross irony of not drawing attention to the systemic risks of FHOG as I describe above makes me wonder what form of self justifying logic is going on here?
However, the second half demonstrates Ms Ellis’s lack of knowledge of the debt capital markets and credit rating opinions. Rent seekers do thrive on opaque markets. But how has that been able to thrive around the globe primarily in securitisation markets and more recently government backed bonds? In the full knowledge that credit ratings are opinions and by nature must be opaque, governments globally embedded in legislation for fund managers, banks and other financial institutions the use of these opinions in investment decisions and capital weighting. Can anyone think of a more structured environment for rent seeking to occur? BTW, not much has changed and the rent seeking continues. Ms Ellis:
The second key behaviour we watch for is risk-taking. In fact, the goal of financial stability policy is sometimes defined as reducing systemic risk: the risk of a disruptive financial crisis. I should emphasise that the objective here is not to eliminate all risk. Most social and economic progress comes from somebody being willing to take a risk – on a new idea, a new product, a new way of doing things.
This statement is a great narrative for the section on risk-taking, but what’s it backed up with? Ms Ellis:
Inappropriately relaxed perceptions about risk therefore led to inappropriately lax lending standards. Lenders didn’t worry if the borrower could afford the loan, or if that undocumented income really existed. Housing prices were rising rapidly. So lenders assumed that a borrower in trouble could always sell, or refinance with another lender.
I struggled to find much in this section worth commenting on but the above is worthy for what was not said or referred to. Ms Ellis again was referring to the US. Why not look in our own backyard? I am well aware that at the moment, reported arrears on Australian mortgages are low by international comparison but we are only now moving into a period of house price decline. A great many mortgagors in Australia are battling extreme adversity to pay mortgages. From personal experience in the finance industry, originating mortgages and managing risk as well as knowledge of many friends, I can state categorically that many borrowers are underqualified and over stressed in the mortgages they’ve been granted by banks. Rising prices is the only thing that has saved the mortgagors.
The issue for the RBA is that detailed borrower information (ie micro analysis) is available from banks if the regulators ensure that it is provided. But on Ms Ellis’ definition, the Platypus Moment for the RBA will be when it all blows up. Yet sadly, the information and indicators were there all the time. I just keep singing the Platypus Blues. Ms Ellis:
…in the face of rent-seeking, risk-taking and other challenges to financial stability, we need to be able to respond in the right way……….The right response, in fact, has several preconditions and from there can take several forms. The first precondition is the background of the macro policy framework. Avoidance of damaging credit cycles starts with management of the business cycle.
So Australian bank’s huge borrowings from offshore circa, $700Bn, when we maintain a current account deficit which the mining FutureBoom! cannot and never will repay is managing the credit cycle? In my view, the Australian housing market cannot sustain current pricing without continued support and growth from offshore lenders. Internal resources will not suffice. In the current global environment of deleveraging this is no Platypus it’s a duck and quacks exactly like one. Ms Ellis:
The second precondition is the regulatory and institutional framework. Regulators must have the powers, the mandate, the resources and – importantly – the culture to make them able and willing to respond appropriately to a threat to financial stability. Even more important, they must be able and willing to intervene early……….A good Australian example comes from the 2004–2005 period. A system-wide stress test revealed that mortgage insurers needed more capital to be resilient to a major downturn in the housing market, should one occur. So APRA raised these firms’ capital requirements. The stress test and the fallout from the early 2000s housing boom also revealed that some newer mortgage loan products were riskier than others. So APRA raised risk weights on those loans. It has retained that tougher treatment even after adopting the Basel II standard.
These statements are only partly true. Whilst there were changes in capital requirements for mortgage insurers and banks, it had more to do with the arbitrage which existed before the change. Prior to the significant changes in regulation, the bank’s received capital relief from a mortgage insured loan greater than the amount of capital the mortgage insurers were required to carry by regulation and by the credit rating agencies. This resulted in the mortgage boom of the first half of the last decade. With low capital requirements not being a break on credit growth for mortgages, the boom would have gone the Platypus.
However, since 2007 the major banks have been able to use advanced Basel II methodologies to calculate capital, very low capital requirements have been maintained for 80% of the market and the credit boom was reinvigorated. The major banks hold less than 2% capital against residential mortgages and the mortgage insurers about 0.75% against their risk. How and why is this is no Platypus? A final comment from Ms Ellis:
Focusing on risks and behaviours is the key to that communication, not numerical targets or forecasts. For if we succeed in preventing crises, whether through communication or some other response, then any prediction of a crisis will not occur. It would be a self-negating prophecy, one that would make it harder to repeat the success later on.
I agree but its rhetoric, a statement of the obvious conclusion that we need to manage people, organizations and risks and not just numbers. But its trite to ignore real and available information. Regulation is about creating an infrastructure in which business can operate without posing systemic risks and not a set of do and don’t rules and where businesses can succeed and fail. Allowing Australia’s major banks to be TBTF and rely on taxpayer supported does not fit this paradigm. Transparency of risks and information to the risk holders is key to maintaining systems which are difficult to game. Its not the RBA’s or APRA’s role to maintain a policy stance of identifying the Platypus. But maybe its mine to keep singing the Platypus Blues.