Andrew G Haldane: Financial arms races
Speech by Mr Andrew G Haldane, Executive Director, Financial Stability, Bank of England, at
the Institute for New Economic Thinking, Berlin, 14 April 2012.
All speeches are available online at www.bankofengland.co.uk/publications/speeches
* * *
Elephant seals have got too big for their beaches. A large specimen might weigh over
8000 lbs (3700 kg).1 Their size has a simple evolutionary explanation. Large males fight for
the right to mate with a whole beach full of females. For elephant seals it is, quite literally,
winner-takes-all. And the key to winning is simple - size. No-one is going to argue with a
male swinging around his proboscis on the beach. In that way, size has become the
dominant gene in the evolutionary trajectory of the elephant seal.
But size is not costless for the elephant seal. It makes them easy prey on land. At times in
the past, this has threatened their very existence. In the 18th century, their main land predator
- man - hunted elephant seals for their blubber and fur. In the 19th century, their numbers fell
rapidly to below 100 and for a time they were believed to be extinct.2 Just in time,
governments intervened to place restrictions on hunting, nationally and internationally.
Today, elephant seal numbers have swelled to above 800,000. The hand of government has
protected them from man - and from themselves.
The pattern is found throughout the animal world, in features as conspicuous as over-sized
antlers and over-elaborate plumage.3 In many cases, these physiological features have
evolved as a response to a competitive sexual race, a Darwinian tournament. Matthew
Ridley calls this the Red Queen Race from the Alice in Wonderland scene in which "however
fast they went, they never seemed to pass anything.4 As elephant seals, deer and peacocks
can attest, it is a race in which, in their quest to win, the species as a whole may end up as
loser.
So nature can deliver an evolutionary equilibrium which is sub-optimal for its participants, a
market failure. The more intense the competitive race, the greater this market failure or
co-ordination problem. Elephant seals would prefer to co-ordinate on a lower-blubber
equilibrium, deer on a shorter-antler equilibrium, peacocks on a smaller-tail equilibrium.
Competition prevents them from doing so. If there were a benign, enlightened zoological
planner, able to compel less-conspicuous features, this would benefit not only each animal
but the species as a whole. Unfortunately, there is not.
************
These inefficient Darwinian equilibria are as common in social as in natural systems. Garrett
Hardin's 1968 classic Tragedy of the Commons uses the metaphor of individual herdsmen
grazing their cattle on common land. "Each man is locked into a system that compels him to
increase his herd without limit - in a world that is limited. Ruin is the destination to which all
men rush, each pursuing his own best interest in a society that believes in the freedom of the
commons".5 Therein lies the tragedy, the market failure. This situation is made more, not
less, tragic by unbridled competition.
The tragedy of the commons is one example of an age-old problem of military arms races.
The incentives of individual players, and outcomes for society, are much the same as in
commons tragedies. Individual country incentives are to increase military might, to leapfrog
opponents to improve national security. But this game of leapfrog is a Red Queen Race. The
quest for national safety results in a steady rise in military spending and a steady fall in both
societal and national security. The common good is jeopardised.
These arms-race dynamics, and commons tragedies, have a history in economics too. It is
not just plumage that is conspicuous. As Thorstein Veblen set out at the end of the
19th century, so too is consumption.6 Some goods serve as a signal of social standing: they
are positional. Not everyone can have the apartment which is closest to the sea. As in other
arms races, the equilibrium is a sub-optimal one - a competitive shopping war in which
everyone conspicuously over-spends.
And so it is with economic behaviour more generally. Surveys indicate that relative income
and wealth are crucial to perceptions of happiness.7 Economic theories of wages, asset
prices, employment and consumption often embed concerns about relative standing.8 When
making many of life's choices, it appears to be important to "keep up with the Jones's", to
earn and spend with reference to one's neighbour. This concern with relative standing sows
the seeds of arms-race behaviour.
Finance is far from immune to these pressures. Indeed, some structural features of the
financial system make it particularly prone to arms-race behaviour. One such structural
feature is information asymmetry. Imperfections in information generate risk. Finance
provides an information bridge between end-savers and investors, thereby prospectively
reducing risk. Success in finance means forming that bridge at least cost and risk to those
travelling across it.
But judging how much risk is really being taken, and whether it is being managed well, is
rarely easy for either end-savers or end-borrowers. Risk shows its true face perhaps only
once in a generation. So as much as investors might wish to risk-adjust their returns, this is a
daunting informational task. Facing this problem, many participants in the financial system
(investors, managers, trustees, remuneration committees, pay consultants etc.) have
resorted to simpler, indirect metrics to gauge skill in navigating risk.
Ranking is one such performance metric. It provides a simple way of ordering the apples, the
oranges - and in particular the lemons. Indeed, in the face of acute uncertainty, ranking can
be the optimal inference strategy.9 This explains the ubiquity of league tables across the
financial sector when judging everything from investment performance to financial
deal-making. But ranking has an unfortunate side-effect. By hard-wiring relative standing, it
builds in arms-race behaviour among financial participants.
A second structural feature of finance, which generates similar incentive effects, is maturity
transformation. Banking involves borrowing short in a capital-certain instrument to lend long
through a capital-uncertain instrument. When doubts creep in about this balance sheet
structure, investors run on the bank knowing it is first-come, first-served. They are engaging
in a liquidity arms race, penalising those behind them in the queue. These actions are
individually rational but collectively self-defeating if the bank goes bust.10
A third structural feature is that some markets for financial services are winner-takes-all
tournaments, like elephant seals seeking mates on the beach. Whether it is making markets
in financial instruments, lead underwriting a debt or equity issue or advising on a merger or
takeover, there is typically only one winner. They take all. Tournaments like these lead to
arms-race behaviour as firms seek to leapfrog one another in their competitive quest for
top-dog status. In finance, this can lead to the winner being "cursed" and to everyone else
over-competing by under-pricing risk.
Financial arms races are scarcely a new phenomenon. How different history might have
been had Chuck Prince heeded JP Morgan's words from a century earlier: "I made a fortune
getting out too soon". Although not new, the liberalisation of financial services over the past
30 years, and the accompanying increase in financial scale, has probably increased
arms-race pressures. As banks have piled on the pounds, their fights on the beaches have
intensified. The stronger those competitive forces, the quicker an arms race escalates.
In what follows, I discuss three examples of modern-day arms races in the financial sector:
races in return, races in speed; and races for safety. These are examples from the past,
present and future respectively. In each, a competitive battle for relative dominance results in
an evolutionary equilibrium which is sub-optimal, individually and socially. They are latter-day
tragedies of the financial commons.
************
By any historical metric, the pre-crisis period was an extra-ordinary one for the financial
sector. This is no better illustrated than in the returns to financial sector labour and capital.
Between 1989 and 2007, the nominal gross value added of UK financial intermediaries rose
more than threefold, or by about 8% on average per year. Over the same period,
value-added of the non-financial corporate sector rose by about 51⁄2% per year.
More commonly-used performance measures in banking are returns on equity and executive
compensation. These rose even more dramatically over the period. Returns on equity for
UK banks rose from on average 1% in 1989 to 38% by 2007. This pattern was mirrored
among other major global banks where returns rose from 8% to 22% (Chart 1). The only
even broadly comparable period in banking history was in the early part of the 20th century
when UK banks' return on equity averaged 13% (Chart 2).
Measures of executive compensation rose even more dramatically. UK bank CEO
compensation rose by 13% per year on average between 1989 and 2007, from $0.5 million
to $4.3 million. US bank CEO compensation rose from $2.8 million to $26 million, also by
13% per year (Chart 3). Over the same period, compensation in the non-financial sector rose
by around 4% per year in the United States.
As Thomas Phillipon and Ariell Reschef have shown, that Himalayan rise in bank executive
salaries made the financial sector salary boom of even the 1920s look like a foothill.11 In
1980, a similarly-skilled individual earned about the same in investment banking as in the
non-financial sector. By 2005, that same person would be benefitting from a salary four times
that of their non-financial sector counterpart.
What explains this extra-ordinary period of high returns in finance? Arithmetically, the answer
is simple - leverage. The pre-crisis rise in returns on bank equity can be explained almost
fully by higher bank leverage.12 Equity returns inflated in line with bank balance sheets. So
too did bank CEO salaries. The increase in pre-crisis bank CEO salaries can be fully
explained, arithmetically, by high and rising returns on bank equity.13 Javier Gabaix and
Augustin Landier have shown that levels of CEO pay generally are well-explained by their
market capitalisation - the bigger the market cap, the bigger the bonus.14
But what drove those behaviours in the first place? It was a classic financial arms race, a
case not so much of "keeping up with the Jones's" as "keeping up with the Goldmans".15
From the early 1990s onwards, league-leading firms began posting high returns on equity.
Those firms with lower relative returns, who languished in the league, found themselves with
sand kicked in their face. They felt obliged not just to keep pace but to leapfrog, to shake
their tail feathers. The lower their rank, the greater these market pressures.16
Facing these competitive pressures, the best-response strategy for languishing banks was
simple - gear-up. They added to their waistlines to compete with the dominant male in the
pack. Like Hardin's cattle herdsmen, they multiplied their numbers. Leverage delivered an
instant leapfrog in returns on equity, a conspicous display of rich plumage.
High equity returns also added fuel to the parallel race in financial sector pay. With
equity-based remuneration contracts increasingly dominant, high equity returns added
directly to pay packets. And with remuneration committees and pay consultants using relative
pay as a reference, an arms race in remuneration took hold. As wages and equity returns
ascended, the races in pay and returns joined forces.
That spiral defined the pre-crisis arms race in financial returns. It generated an equilibrium of
synchronously high returns and pay, as banks unilaterally militarised as defence against their
competitors. But as in military arms races, the resulting outcome was a sub-optimally risky
one. High equity returns came through risky leverage. And high pay, especially in
equity-based forms, further encouraged risk-taking.17 The resulting high-leverage equilibrium
sowed the seeds of the financial crisis.
With hindsight, it was easy to spot this market failure, the co-ordination problem. Banks and
the financial system as a whole would have been better off had there been a benign,
enlightened regulatory planner, able to co-ordinate banks on a lower return equilibrium.
Unfortunately, there was not.
************
Over the past decade, trading in financial markets has undergone a technological
revolution.18 The frontier of this revolution is defined by speed. A decade ago, trade
execution times were measured in seconds. A few years ago, they were measured in
milliseconds. Today, they are measured in microseconds. Tomorrow, it will be nano-seconds
or pico-seconds. For technologists, this is a "race to zero" - the promised land of zero
latency where execution times converge on the speed of light.19 For social scientists, this is a
financial arms race, a sub-second game of leapfrog.
In their quest for speed, a number of firms are also engaged in a positional race. The shorter
the cable to the trading exchange, the faster a trade can be executed. This has encouraged
some firms to begin relocating their servers as close as physically possible to the trading
exchange - so-called "co-location". This is the financial equivalent of seeking the apartment
closest to the sea. It, too, fuels arms-race behaviour: "however fast they went, they never
seemed to pass anything".
Accompanying this shift in speed has been a dramatic change in the composition of trading
and market-making. During this decade, so-called High Frequency Trading (HFT) has come
to dominate. It now accounts for anywhere between a half and three-quarters of trading
volume on the world's major equity markets and a rising share of futures and other derivative
markets.20 In some markets, HFT firms have become the de-facto liquidity providers or
market-makers.21 Historically, designated market-makers were often granted privileges in
return for agreeing to ensure trade and price continuity. No longer: the sleek have inherited
the earth.
This emerging topology of trading has had some clear benefits. This is manifest in narrower,
sometimes dramatically narrower, bid-ask spreads for trading.22 For equity markets, these
have fallen by an order of magnitude since 2004. This is typically taken as evidence of
improved market liquidity and price efficiency.
But this dominant role for HFT, in their race to zero, has also had some potentially less
benign side-effects. Take order cancellations. All market participants cancel some of the
orders they place before they are executed. HFT firms have taken this to new levels,
submitting many (many) more order messages than they are willing to execute. A decade
ago, ten orders might be cancelled for every one executed. Today, that order cancellation
ratio can be closer to 60 (Chart 4).
There are some good reasons for order cancellation, including the arrival of price news after
an order has been placed. But there are, too, some potentially jarring side-effects. With HFT
firms serving as de-facto market-makers, but with the vast majority of their orders cancelled,
many on-screen quotes may not actually be executable. This creates a potentially misleading
picture of market resilience, a mirage of liquidity.
Second, because bandwidth is finite, submitting multiple quotes may slow down activity by
competitor traders. This practice of clogging competitors' screens is known, accurately if
inelegantly, as "quote stuffing".23 It is a classic congestion externality or commons tragedy.
These externalities are not hypothetical. They have already shown their face in the
extra-ordinary dynamics in market prices for an hour on 6 May 2010, the "Flash Crash".
Market dynamics during that period are yet to be given a fully-convincing explanation. But
some aspects are documented. One is the disappearance of liquidity and market-making by
HFT firms for a period during the Flash Crash. The mirage of liquidity proved just that. That
evaporation appears to have played a key role in propagating stress during the Flash
Crash.24
So too did message traffic congestion. One side-effect was to slow-down price discovery
across exchanges. Many traders firms found themselves observing stale prices. As a result,
identical stocks traded at different prices across exchanges (Chart 5). In principle, this
represented an arbitrage opportunity. In practice, arbitrage relies on costless trading and, at
that time, trades could not have been executed at any price.
The Flash Crash was short-lived. Some have argued the lessons have been learned. Yet it
appears to have been anything but a flash in the pan. In the period since, researchers have
identified a large number of "mini-Flash Crashes", with temporary dislocations in prices in
markets as varied as Japanese yen and cocoa futures.25 As with the Flash Crash, there
appears to be no convincing explanation for these gyrations.
The uncertainties and externalities associated with the race to zero are one candidate
explanation. Liquidity mirages and message traffic congestion are nibbling away at the
common good of market stability. The competitive quest for individual speed risks a fragile
evolutionary equilibrium. If there were a benign, enlightened regulatory planner, able to
co-ordinate the actions of traders on a lower-velocity equilibrium, the Flash Crash might have
been forestalled. Unfortunately, there was not.
************
The pre-crisis quest for return has, over the past few years, been replaced by a quest for
safety. Return on capital is no longer investors' priority. Return of capital is. That
risk-aversion is manifest in high risk premia on a wide range of risky assets and abnormally
low yields on a range of risk-free assets. It is also evident in investors' desire for financial
instruments which are secured on high-quality collateral. Investors are taking literally the
notion of a security.
That desire for security has had a particularly pronounced impact on banks, which are
refinancing large legacy asset portfolios. The cost of refinancing those portfolios has
increased dramatically since the crisis, particularly for instruments lower-down the creditor
hierarchy. The cost of unsecured borrowing by European banks has increased roughly
27-fold since 2007, while the cost of borrowing against high quality assets has risen "only"
16-fold.
These relative price effects have shaped importantly banks' financing choices. A large and
rising fraction of global banks' refinancing has taken place on secured terms. In 2007, the
majority of term refinancing of European banks' debt was on an unsecured basis. By 2011,
secured and unsecured refinancing were roughly balanced. In 2012, secured financing is
likely to take the lead (Chart 6).
For example, euro-area banks have roughly €1.1 trillion to refinance in 2012, 80% of which is
unsecured funding coming due. So far during 2012, only 20% has been rolled on unsecured
terms, with the lion's share on a secured basis (Chart 7). Central bank financing has played
its part in this shift. Of the €600 billion raised on secured terms by euro-area banks so far in
2012, 80% has been associated with the ECB's long-term refinancing operations.
Gauging levels of secured financing by commercial banks is difficult. Technically, the fraction
of banks' liabilities that are secured against their assets is often called encumbrance. But
data on banks' encumbrance levels are thin on the ground. Where data exist, they are rarely
on a consistent basis across banks. Some recent studies have suggested that the
encumbrance ratios of banking systems within Europe may lie anywhere between 3% and
40% of their liabilities.26
That is the arithmetic. But what explains this behaviour? This, too, appears to have an
arms-race element. Consider an unsecured creditor about to refinance. The larger the
existing fraction of secured financing, and the greater the uncertainty about this fraction, the
greater will be their incentive to seek security. Not to do so runs the risk of other creditors
leapfrogging ahead of them in the seniority queue. Creditors' incentives are very similar to
those during a bank run, except with investors now seeking security rather than immediacy.27
As with a bank run, this dynamic risks becoming self-fulfilling. The greater the level of, and
risk around, encumbrance levels, the higher the return unsecured creditors will demand
given the risks of subordination. And the higher this cost, the greater banks' incentives to
finance instead on secured terms. Both banks and their individual investors have incentives
to encumber the balance sheet by progressively - and self-fulfillingly - larger amounts. There
is an arms race spiral.
Yet the equilibrium of this seniority game is unlikely to be an optimal one, either for individual
investors or for the financial system as a whole. To queue-jump is ultimately futile for
creditors; it is another Red Queen Race. Not everyone can be at the front of the seniority
queue. Indeed, at high levels of encumbrance, the financial system as a whole may even be
riskier, as it is more susceptible to pro-cyclical swings in the underlying value of banks'
assets. The quest for individual security generates system-wide instability.
So under an arms race to safety, the like of which may be currently underway, the outcome
for the financial system could be both socially and individually inefficient. If there were a
benign, enlightened regulatory planner, able collectively to co-ordinate investors and banks
on a lower-encumbrance equilibrium, this race for safety could be forestalled. Unfortunately,
there is not.
************
What public policy lessons might be drawn from these financial arms races? First, because
they generate sub-optimal outcomes, policy intervention can be justified. This policy
intervention ought to act like a self-denying ordinance for financial firms, a protection against
themselves. It ought not to be a tug-of-war between regulator and regulated. Rather, it aims
to defuse a competitive tug-of-war among regulated firms.
Second, to be effective this intervention needs to constrain behaviour across the financial
system as a whole; it requires multilateral disarmament. Acting to constrain only those at the
top of the league (those bearing most risk, trading at greatest speed, seeking greatest safety)
will do nothing to defuse competitive pressures lower down the pecking order. Indeed, it
might even conceivably intensify the competitive scramble. In the language of financial
regulation, policy needs to have a macro-prudential, as distinct from micro-prudential,
perspective.28
The need for a system-wide perspective to preserve the public good of the commons was
recognised by Garret Hardin almost 50 years ago. It has been increasingly recognised by
financial regulators over the past five years. Over that period, we have seen the emergence
of explicitly macro-prudential agencies charged with safeguarding systemic risk in a number
of countries. In the United States we now have a multi-agency Financial Stability Oversight
Council (FSOC), in Europe the multi-country European Systemic Risk Board (ESRB) and in
the UK the Financial Policy Committee (FPC).
Third, what tools might such agencies bring to bear in tackling financial arms races in return,
speed and safety? With hindsight, it is not difficult to identify instruments which might have
slowed the pre-crisis race for excessive returns in banking. The most direct and effective
would have been to place tighter constraints on banks' leverage. This would have defused
the return on equity race at source. The FPC has prioritised the leverage ratio as a
macro-prudential instrument in its recommendations to date.29
A complementary approach would have been to require banks to adopt performance metrics
which did a better job of adjusting for risk. At the end of last year, the FPC raised concerns
about the use of return on equity metrics by banks which generate incentives to shrink equity
to hit return targets.30 Some institutional investors have raised similar concerns - and are
showing encouraging signs of acting on those concerns. After all, it is not difficult to devise
performance metrics which would do a better job of adjusting for risk, such as return on bank
assets.
There is some evidence recently of return on equity targets having become a less important
determinant of some banks' portfolio allocation and executive pay decisions. But equity
returns remain hardwired into both to some degree. Moreover, many global banks continue
to publish return on equity targets. This continuing attachment to counter-productive
performance metrics is a puzzle - and a worry. As long as it remains the case, it raises
questions about whether the lessons from the crisis have truly been learned.
Races in financial sector pay can also be tackled, albeit indirectly, by placing restrictions on
leverage and by avoiding linking remuneration to return on equity targets. Restrictions on
cash distributions by banks to shareholders and staff can also help. This has been a
favoured recommendation of the FPC over the past six months, as a means of bolstering
UK banks' capital defences against risks in the euro-area. In response, there is some
evidence of UK banks having modestly reduced cash distributions to staff in 2011.
A more direct approach to tackling pay races would be to set remuneration codes. This can
be justified as a regulatory means of leaning against excessive risk-taking incentives
- incentives which might be fanned by remunerating in equity.31 These have already been
developed by the Financial Stability Board internationally and by the FSA in the UK. They
specify, for example, maximum ratios of cash distribution and minimum periods of pay
deferral. Yet whether these codes go far enough in aligning pay and performance, in
equating risk and return, is an open question.
For example, consider the issue of pay horizons. Bonuses are typically set on an annual
cycle, with deferral or claw-back for maybe three or four years if guidelines are followed. But
this return cycle is materially shorter than the typical risk cycle. The risk cycle might last
perhaps 20 years. This duration mismatch means it is more likely than not that risk and
reward may get out of kilter in the financial sector. The current environment is evidence of
such a mismatch: while bank performance has fallen off a cliff, executive pay remains close
to pre-crisis Himalayan heights.
Lengthening deferral or claw-back periods, say to 10 years or more on an internationally
co-ordinated basis, would help close this gap in horizons, between risk and return. It would
elongate the period of liability bank managers face when they take on risk. This would better
align firm-level risk-taking incentives with the societal optimum. Avoiding relative benchmarks
in the setting of remuneration would also reduce the risk of an upwards-only pay escalator.
There is scope, too, for a reconsideration of the instruments used for remuneration. The
focus to date has been on non-cash distributions, often in equity. But paying in equity
appears in some pre-crisis cases to have exacerbated risk-taking incentives, acting as a
disincentive to raising new equity and encouraging gambles for resurrection. Remunerating
in long-maturity debt, or contingent capital instruments, may do a better job of aligning
risk-taking incentives with the public good than either cash or equity.32
Speed races in financial markets potentially generate societal sub-optimality, for example
due to message traffic congestion. As with road traffic congestion, one way to tackle that
would be to place direct restrictions on excessive message traffic - for example, by setting
maximum order cancellation ratios. The US Securities and Exchange Commission (SEC) are
considering this option. So too are the authorities in Europe under the draft proposals
contained in MiFID II. These are welcome moves.
New trading topologies also run the risk of turning the miracle of higher liquidity into a mirage
in situations of stress. One potential response would be to strengthen market-making
commitments. The past few years have seen a dilution of some of those commitments. For
example, in 2008 the New York Stock Exchange relaxed its market-making commitments on
maximum bid-ask spreads. One upshot was that, during the Flash Crash, the prices of some
stocks hit zero and others $9999.99 - so-called "stub quotes".
Following the Flash Crash, the SEC moved swiftly to ban stub quotes. This effectively
re-introduced a requirement for market-makers to ensure price continuity. It has also been
considering enhanced market-making obligations or incentives to improve the resilience of
market liquidity in situations of stress. In Europe, MiFID II is looking at the scope for
strengthening market-maker commitments for similar reasons. This would be a welcome
turning-back of the trading clock - a clock otherwise at risk of running too fast.
Strengthening circuit-breakers across exchanges can also help to restore market order in
situations of stress. They are means of automatically, if temporarily, halting the trading race if
it gets out of hand - a multilateral disarmament device. Following the Flash Crash, the
US authorities altered circuit-breaking rules so that they applied on an across-exchange
basis to prevent stress simply migrating between exchanges. It would be useful if the revised
trading proposals in Europe under MiFID II contained similar provisions.
Finally, safety races by bank investors are being explored by financial regulators. Over the
past six months, the FPC has paid increasing attention to the systemic risk posed by rising
levels of bank encumbrance. The FSA recently undertook a survey of UK banks' level of
encumbrance which the FPC will consider later this year.33 The issue is also being looked at
internationally.
There are a variety of policy options to forestall self-fulfilling safety races. One would be
greater transparency about levels of encumbrance. Lack of transparency creates an
uncertainty premium in unsecured borrowing rates, encourages further secured financing
and thereby speeds up the seniority race. Reducing that premium through greater
transparency would tend to slow the race, if not stall it. An option for stalling the race would
be to place maximum limits on levels of bank asset encumbrance. These would be similar in
principle to prudential limits on bank leverage and large exposures.
************
Systems, both social and natural, are characterised by a survival of the fittest. But for both,
that competitive race can at times generate unhealthy outcomes for the system as a whole.
In finance, these tragedies of the commons are, if anything, more likely than in other fields
(seas, beaches and forests). The financial crisis attests to that. If there were a benign,
enlightened regulatory planner, able to redirect competitive forces, this could potentially avert
future tragedies of the financial commons. Fortunately, there is.
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