Why Markets Need 'Naked' Credit Default Swaps. By Stuart M Turnbull and Lee M Wakeman
Anyone facing losses from a government default should be able to protect himself by hedging.WSJ, September 11, 2012, 7:22 p.m. ET
http://online.wsj.com/article/SB10000872396390443686004577639753399337204.html
Many regulators, politicians and academics consider credit default swaps to be insurance contracts. These folks then use the insurable-interest rule—which limits life-insurance claims to individuals adversely affected by the death of the insured—to recommend banning "naked" CDS purchases, that is, buying sovereign credit default swaps without holding the underlying sovereign bond. Financial Times columnist Wolfgang Munchau, for example, says that a naked CDS has "not one social or economic benefit."
The premise that only sovereign-debt holders suffer when a country defaults is false. Many other agents are adversely affected by a default, and they should be allowed to purchase sovereign CDS.
A 2006 Bank of England study found that the output losses for 45 sovereign defaults between 1970 and 2000 "appear to be very large—around 7% a year on the median measure—as well as long lasting." The haircut taken by investors after sovereign defaults ranges from 20%-70%. But many spectators to a sovereign-default drama also suffer significant losses of wealth and livelihood.
Domestic importers and foreign exporters suffer when the default is accompanied by a devaluation. Financial institutions and holders of domestic corporate debt suffer as their asset values fall. Domestic companies suffer as their credit risk increases, with smaller businesses being especially harmed as banks reduce loan availability. And of course all consumers suffer as the economy retrenches.
In Mexico after its 1982 default, new lending dried up, trade suffered, incomes dropped and economic growth stagnated. In Russia after its 1998 default, food prices doubled, input prices quadrupled and many banks collapsed. In Argentina after its 2002 default, inflation touched 80%, unemployment rose to 25%, the peso lost 70% of its value, bank credit was halved and many businesses closed.
Today, many participants in the Greek, Irish, Italian, Portuguese and Spanish economies suffer as their governments struggle to prevent bank runs and avoid default. Millions of Europeans will undoubtedly lose wealth and work if defaults are not avoided.
If one or more of these sovereigns do default, there will also be serious consequences for participants in other linked markets. Commercial banks will suffer losses on the defaulted debt, possibly triggering bank runs if investors fear they will be unable to honor their commitments.
Many other foreign participants will also suffer, as contagion concerns cause investors to downgrade many assets, including sovereign and corporate debt, and to demand increased collateral. This in turn may force the selling of distressed assets, pushing prices even lower.
While there are other ways of insuring against corporate defaults—shorting stocks or buying put options, for instance—credit default swaps provide the only cost-effective way of hedging against sovereign defaults.
Rather than restricting access to the sovereign debt CDS market, regulators should encourage the introduction of standardized, exchange-traded "mini" sovereign debt CDS contracts, which would allow small buyers to better protect themselves against default.
There is also little evidence to support the argument that access to the sovereign CDS market should be restricted because of excessive speculation. Although credit default swaps written on Greek government bonds paid out a relatively high 78.5 cents on the dollar in March 2012, the owners of these swaps only received $2.5 billion—a small fraction of the $140 billion losses suffered when Greece defaulted.
Rather than destabilizing the market for euro-zone sovereign debt, credit default swaps, by providing a mechanism to shift risk, grow the market and reduce government financing costs.
In addition, CDS prices are useful signals of sovereign credit worthiness—which may explain the hostility of some politicians toward them.
Mr. Turnbull is a business professor at the University of Houston. Mr. Wakeman is a consultant at Risk Analysis & Control.
Wednesday, September 12, 2012
As regulation has become more complex, it has also become less effective - Haldane and Madouros paper
Speech of the Year. WSJ Editorial
A regulator, of all people, shows how complex regulations contributed to the financial crisis.
WSJ, September 11, 2012, 7:13 p.m. ET
http://online.wsj.com/article/SB10000872396390444273704577637792879194380.html
While Americans were listening to the bloviators in Tampa and Charlotte, the speech of the year was delivered at the Federal Reserve's annual policy conference in Jackson Hole, Wyoming on August 31. And not by Fed Chairman Ben Bernanke. The orator of note was a regulator from the Bank of England, and his subject was "The dog and the frisbee."
In a presentation that deserves more attention, BoE Director of Financial Stability Andrew Haldane and colleague Vasileios Madouros point the way toward the real financial reform that Washington has never enacted. The authors marshal compelling evidence that as regulation has become more complex, it has also become less effective. They point out that much of the reason large banks are so difficult for regulators to comprehend is because regulators themselves have created complicated metrics that can't provide accurate measurements of a bank's health.
The paper's title refers to the fact that border collies can often catch frisbees better than people, because the dogs by necessity have to keep it simple. But the impulse of regulators, if asked to catch a frisbee, would be to encourage the construction of long equations related to wind speed and frisbee rotation that they likely wouldn't even understand.
Readers will recall how ineffective the Basel II international banking standards were at ensuring the health of investment banks like Bear Stearns. The inspector general of the Securities and Exchange Commission, which adopted the Basel standards in 2004, would report in 2008 that Bear remained compliant with these rules even as it was about to be rescued.
Messrs. Haldane and Madouros looked broadly at the pre-crisis financial industry, and specifically at a sample of 100 large global banks at the end of 2006. What they found was that a firm's leverage ratio—the amount of equity capital it held relative to its assets—was a fairly good predictor of which banks ended up sailing into the rocks in 2008. Banks with more capital tended to be sturdier.
But the definition of what constitutes capital was also critical, and here simpler is also better. Basel's "Tier 1" regulatory capital ratio was thought to be more precise because it assigned "risk weights" to each category of assets and required banks to perform millions of complex calculations. Yet it was hardly of any use in predicting disasters at too-big-to-fail banks.
We've argued that Basel II relied far too much on the judgments of government-anointed credit-rating agencies, plus a catastrophic bias in favor of mortgages as "safe." Instead of learning from that mistake, the gnomes have written into the new Basel III rules a dangerous bias in favor of sovereign debt. The growing complexity of the rules leaves more room for banks to pursue regulatory arbitrage, identifying assets that can be classified as safe, at least for compliance purposes.
Messrs. Haldane and Madouros also describe the larger problem: a belief among regulators that models can capture all necessary information and then accurately predict future risk. This belief is new, and not helpful. As the authors note, "Many of the dominant figures in 20th century economics—from Keynes to Hayek, from Simon to Friedman—placed imperfections in information and knowledge centre-stage. Uncertainty was for them the normal state of decision-making affairs."
A deadly flaw in financial regulation is the assumption that a few years or even a few decades of market data can allow models to accurately predict worst-case scenarios. The authors suggest that hundreds or even a thousand years of data might be needed before we could trust the Basel machinery.
Despite its failures, that machinery becomes larger and larger. As Messrs. Haldane and Madouros note, "Einstein wrote that: 'The problems that exist in the world today cannot be solved by the level of thinking that created them.' Yet the regulatory response to the crisis has largely been based on the level of thinking that created it. The Tower of Basel, like its near-namesake the Tower of Babel, continues to rise."
Exploding the myth that regulatory agencies are underfunded, they note that in both the U.K. and U.S. the number of regulators has for decades risen faster than the number of people employed in finance.
Complexity grows still faster. The authors report that in the 12 months after the passage of Dodd-Frank, rule-making that represents a mere 10% of the expected total will impose more than 2.2 million hours of annual compliance work on private business. Recent history suggests that if anything this will make another crisis more likely.
Here's a better idea: Raise genuine capital standards at banks and slash regulatory budgets in Washington. Abandon the Basel rules on "risk-weighting" and other fantasies of regulatory omniscience. In financial regulation, as in so many other areas of life, simpler is better.
Original paper: http://www.bankofengland.co.uk/publications/Pages/speeches/2012/596.aspx
A regulator, of all people, shows how complex regulations contributed to the financial crisis.
WSJ, September 11, 2012, 7:13 p.m. ET
http://online.wsj.com/article/SB10000872396390444273704577637792879194380.html
While Americans were listening to the bloviators in Tampa and Charlotte, the speech of the year was delivered at the Federal Reserve's annual policy conference in Jackson Hole, Wyoming on August 31. And not by Fed Chairman Ben Bernanke. The orator of note was a regulator from the Bank of England, and his subject was "The dog and the frisbee."
In a presentation that deserves more attention, BoE Director of Financial Stability Andrew Haldane and colleague Vasileios Madouros point the way toward the real financial reform that Washington has never enacted. The authors marshal compelling evidence that as regulation has become more complex, it has also become less effective. They point out that much of the reason large banks are so difficult for regulators to comprehend is because regulators themselves have created complicated metrics that can't provide accurate measurements of a bank's health.
The paper's title refers to the fact that border collies can often catch frisbees better than people, because the dogs by necessity have to keep it simple. But the impulse of regulators, if asked to catch a frisbee, would be to encourage the construction of long equations related to wind speed and frisbee rotation that they likely wouldn't even understand.
Readers will recall how ineffective the Basel II international banking standards were at ensuring the health of investment banks like Bear Stearns. The inspector general of the Securities and Exchange Commission, which adopted the Basel standards in 2004, would report in 2008 that Bear remained compliant with these rules even as it was about to be rescued.
Messrs. Haldane and Madouros looked broadly at the pre-crisis financial industry, and specifically at a sample of 100 large global banks at the end of 2006. What they found was that a firm's leverage ratio—the amount of equity capital it held relative to its assets—was a fairly good predictor of which banks ended up sailing into the rocks in 2008. Banks with more capital tended to be sturdier.
But the definition of what constitutes capital was also critical, and here simpler is also better. Basel's "Tier 1" regulatory capital ratio was thought to be more precise because it assigned "risk weights" to each category of assets and required banks to perform millions of complex calculations. Yet it was hardly of any use in predicting disasters at too-big-to-fail banks.
We've argued that Basel II relied far too much on the judgments of government-anointed credit-rating agencies, plus a catastrophic bias in favor of mortgages as "safe." Instead of learning from that mistake, the gnomes have written into the new Basel III rules a dangerous bias in favor of sovereign debt. The growing complexity of the rules leaves more room for banks to pursue regulatory arbitrage, identifying assets that can be classified as safe, at least for compliance purposes.
Messrs. Haldane and Madouros also describe the larger problem: a belief among regulators that models can capture all necessary information and then accurately predict future risk. This belief is new, and not helpful. As the authors note, "Many of the dominant figures in 20th century economics—from Keynes to Hayek, from Simon to Friedman—placed imperfections in information and knowledge centre-stage. Uncertainty was for them the normal state of decision-making affairs."
A deadly flaw in financial regulation is the assumption that a few years or even a few decades of market data can allow models to accurately predict worst-case scenarios. The authors suggest that hundreds or even a thousand years of data might be needed before we could trust the Basel machinery.
Despite its failures, that machinery becomes larger and larger. As Messrs. Haldane and Madouros note, "Einstein wrote that: 'The problems that exist in the world today cannot be solved by the level of thinking that created them.' Yet the regulatory response to the crisis has largely been based on the level of thinking that created it. The Tower of Basel, like its near-namesake the Tower of Babel, continues to rise."
Exploding the myth that regulatory agencies are underfunded, they note that in both the U.K. and U.S. the number of regulators has for decades risen faster than the number of people employed in finance.
Complexity grows still faster. The authors report that in the 12 months after the passage of Dodd-Frank, rule-making that represents a mere 10% of the expected total will impose more than 2.2 million hours of annual compliance work on private business. Recent history suggests that if anything this will make another crisis more likely.
Here's a better idea: Raise genuine capital standards at banks and slash regulatory budgets in Washington. Abandon the Basel rules on "risk-weighting" and other fantasies of regulatory omniscience. In financial regulation, as in so many other areas of life, simpler is better.
Original paper: http://www.bankofengland.co.uk/publications/Pages/speeches/2012/596.aspx
Tuesday, September 11, 2012
Estimating the Costs of Financial Regulation. By Andre Santos and Douglas Elliott
Estimating the Costs of Financial Regulation. By Andre Santos and Douglas Elliott
IMF Staff Discussion Notes No. 12/11
September 11, 2012
ISBN/ISSN: 978-1-61635-435-0 / 2221-030X
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26231.0
This study shows that financial reform will likely result in a modest increase in bank lending rates in the United States, Europe, and Japan in the long term. Higher safety margins in terms of capital and liquidity will lead to an increase in lenders’ operating costs, affecting bank customers, employees, and investors. Yet banks appear to have the ability to adapt to the regulatory changes without actions that would harm the wider economy. In response to the estimated rise in regulatory costs, average bank lending rates are likely to increase by 28 bps in the United States, 17 bps in Europe, and 8 bps in Japan in the long term. By comparison, the smallest increment by which major central banks adjust their short-term policy rates is 25 bps, which tends to have a small effect on economic growth.
A simple framework is used to estimate the likely increase in lending rates. These rates reflect the cost of allocated capital, other funding costs, credit losses, administrative costs, and several other factors. There is considerable uncertainty about these cost assumptions, but a sensitivity analysis shows that reasonable changes in assumptions do not dramatically alter the conclusions of this study. Cost estimates are based on several references, including academic theory, empirical analyses from industry and official sources, as well as financial disclosures by large banks.
The findings are based on methodologies that were used in previous studies by academics and the official sector. This study, however, estimates that lending rate increases will likely be significantly smaller, for the following reasons. First, the baseline scenario implies a smaller regulatory effect, with market forces accounting for some of the expected increases in safety margins. Second, banks are expected to absorb part of the higher costs by cutting expenses. Third, investors are expected to reduce their required rate of return on bank equity modestly as a result of the safety improvements. Debt investors are expected to follow suit, although to a much lesser extent.
There are important limitations to the analysis presented here. It does not address the potential transition costs as banks adjust to the new regulations. Nor does it assess the economic benefits of financial reforms. A number of regulatory reforms are not modeled; judgment has been required in making many of the estimates; and the modeling approach is relatively simple. Nevertheless, the results appear to be a balanced, albeit rough, assessment of the likely effects on bank lending. Further research would be useful to translate these credit impacts into effects on economic output.
IMF Staff Discussion Notes No. 12/11
September 11, 2012
ISBN/ISSN: 978-1-61635-435-0 / 2221-030X
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26231.0
This study shows that financial reform will likely result in a modest increase in bank lending rates in the United States, Europe, and Japan in the long term. Higher safety margins in terms of capital and liquidity will lead to an increase in lenders’ operating costs, affecting bank customers, employees, and investors. Yet banks appear to have the ability to adapt to the regulatory changes without actions that would harm the wider economy. In response to the estimated rise in regulatory costs, average bank lending rates are likely to increase by 28 bps in the United States, 17 bps in Europe, and 8 bps in Japan in the long term. By comparison, the smallest increment by which major central banks adjust their short-term policy rates is 25 bps, which tends to have a small effect on economic growth.
A simple framework is used to estimate the likely increase in lending rates. These rates reflect the cost of allocated capital, other funding costs, credit losses, administrative costs, and several other factors. There is considerable uncertainty about these cost assumptions, but a sensitivity analysis shows that reasonable changes in assumptions do not dramatically alter the conclusions of this study. Cost estimates are based on several references, including academic theory, empirical analyses from industry and official sources, as well as financial disclosures by large banks.
The findings are based on methodologies that were used in previous studies by academics and the official sector. This study, however, estimates that lending rate increases will likely be significantly smaller, for the following reasons. First, the baseline scenario implies a smaller regulatory effect, with market forces accounting for some of the expected increases in safety margins. Second, banks are expected to absorb part of the higher costs by cutting expenses. Third, investors are expected to reduce their required rate of return on bank equity modestly as a result of the safety improvements. Debt investors are expected to follow suit, although to a much lesser extent.
There are important limitations to the analysis presented here. It does not address the potential transition costs as banks adjust to the new regulations. Nor does it assess the economic benefits of financial reforms. A number of regulatory reforms are not modeled; judgment has been required in making many of the estimates; and the modeling approach is relatively simple. Nevertheless, the results appear to be a balanced, albeit rough, assessment of the likely effects on bank lending. Further research would be useful to translate these credit impacts into effects on economic output.
Wednesday, September 5, 2012
Our Future World: Global megatrends that will change the way we live
Our Future World: Global megatrends that will change the way we live (2012 update)
Sep 5, 2012
http://www.csiro.au/resources/Our-Future-World?goback=.gde_128402_member_159431416
The six interrelated megatrends identified in the report are:
Sep 5, 2012
http://www.csiro.au/resources/Our-Future-World?goback=.gde_128402_member_159431416
The six interrelated megatrends identified in the report are:
- More from less. The earth has limited supplies of natural mineral, energy, water and food resources essential for human survival and maintaining lifestyles.
- Going, going ... gone? Many of the world's natural habitats, plant species and animal species are in decline or at risk of extinction.
- The silk highway. Coming decades will see the world economy shift from west to east and north to south.
- Forever young. The ageing population is an asset. Australia and many other countries that make up the Organisation for Economic Cooperation and Development (OECD) have an ageing population.
- Virtually here. This megatrend explores what might happen in a world of increased connectivity where individuals, communities, governments and businesses are immersed into the virtual world to a much greater extent than ever before.
- Great expectations. This is a consumer, societal, demographic and cultural megatrend.It explores the rising demand demand for experiences over products and the rising importance of social relationships.
Friday, August 31, 2012
A New Heuristic Measure of Fragility and Tail Risks: Application to Stress Testing. By Nassim N Taleb et alii
A New Heuristic Measure of Fragility and Tail Risks: Application to Stress Testing. By Nassim N Taleb et alii
IMF Working Paper No. 12/216
Aug 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26222.0
Summary:This paper presents a simple heuristic measure of tail risk, which is applied to individual bank stress tests and to public debt. Stress testing can be seen as a first order test of the level of potential negative outcomes in response to tail shocks. However, the results of stress testing can be misleading in the presence of model error and the uncertainty attending parameters and their estimation. The heuristic can be seen as a second order stress test to detect nonlinearities in the tails that can lead to fragility, i.e., provide additional information on the robustness of stress tests. It also shows how the measure can be used to assess the robustness of public debt forecasts, an important issue in many countries. The heuristic measure outlined here can be used in a variety of situations to ascertain an ordinal ranking of fragility to tail risks.
IMF Working Paper No. 12/216
Aug 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26222.0
Summary:This paper presents a simple heuristic measure of tail risk, which is applied to individual bank stress tests and to public debt. Stress testing can be seen as a first order test of the level of potential negative outcomes in response to tail shocks. However, the results of stress testing can be misleading in the presence of model error and the uncertainty attending parameters and their estimation. The heuristic can be seen as a second order stress test to detect nonlinearities in the tails that can lead to fragility, i.e., provide additional information on the robustness of stress tests. It also shows how the measure can be used to assess the robustness of public debt forecasts, an important issue in many countries. The heuristic measure outlined here can be used in a variety of situations to ascertain an ordinal ranking of fragility to tail risks.
Global Housing Cycles. By Deniz Igan and Prakash Loungani
Global Housing Cycles. By Deniz Igan and Prakash Loungani
IMF Working Paper No. 12/217
Aug 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26229.0
Summary: Housing cycles and their impact on the financial system and the macroeconomy have become the center of attention following the global financial crisis. This paper documents thecharacteristics of housing cycles in a large set of countries, and examines the determinants of house price movements. Empirical analysis shows that house price dynamics are mostly driven by income and demographics but fluctuations in these fundamentals and credit conditions can create deviations from the implied equilibrium path. We conclude with a discussion of the macroeconomic implications of house price corrections.
IMF Working Paper No. 12/217
Aug 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26229.0
Summary: Housing cycles and their impact on the financial system and the macroeconomy have become the center of attention following the global financial crisis. This paper documents thecharacteristics of housing cycles in a large set of countries, and examines the determinants of house price movements. Empirical analysis shows that house price dynamics are mostly driven by income and demographics but fluctuations in these fundamentals and credit conditions can create deviations from the implied equilibrium path. We conclude with a discussion of the macroeconomic implications of house price corrections.
Tuesday, August 28, 2012
Effects of Culture on Firm Risk-Taking: A Cross-Country and Cross-Industry Analysis. By Roxana Mihet
Effects of Culture on Firm Risk-Taking: A Cross-Country and Cross-Industry Analysis. By Roxana Mihet
IMF Working Paper No. 12/210
Aug 2012
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012210
Summary: This paper investigates the effects of national culture on firm risk-taking, using a comprehensive dataset covering 50,000 firms in 400 industries in 51 countries. Risk-taking is found to be higher for domestic firms in countries with low uncertainty aversion, low tolerance for hierarchical relationships, and high individualism. Domestic firms in such countries tend to take substantially more risk in industries which are more informationally opaque (e.g. finance, mining, IT). Risk-taking by foreign firms is best explained by the cultural norms of their country of origin. These cultural norms do not proxy for legal constraints, insurance safety nets, or economic development.
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26204.0
Excerpts:
Introduction
Understanding whether national culture affects a society‟s likelihood to generate risk-seeking firms is important for effective policy-making and for improving corporate governance. It can enrich discussions on government policies that encourage entrepreneurship and innovation. A grasp of the impact of cultural influences on corporate risk-taking would allow policy-makers to better customize their policies for firms with different risk appetites, thus promoting more competitive business environments. Understanding the impact of culture on corporate risk-taking decisions is also important to the internal conduct of multinational firms. Internal decisions in multinational firms, such as the decision to pursue a risky R&D project, require well-orchestrated responses from executives with diverse cultural backgrounds. Even in firms with standardized operating procedures, the interpretation of various financial decisions can vary among executives from different societies as a result of their cultural differences (Tse et al. 1988). Accounting for the impact of cultural influences on decision-making allows the firms themselves to accommodate and adapt to such differences, hence diminishing “noisy” interactions among executives and errors in decision-making.
This study employs four dimensions of national culture identified by Hofstede (2001) and an international sample of 50,000 firms spread across 400 industries in 51 countries to analyze the effects of cultural differences on corporate risk-taking. More specifically, it tries to identify the channels through which cultural values can influence corporate risk-taking. Culture can affect the institutional and economic development at the macro level, the industrial diversification and industry concentration at the market structure level, as well as the corporate and individual decision-making at the micro level, all of which may in turn influence firm risk-taking decisions.
Previous literature has shown that national culture does in fact predict cross-country differences in the degree of institutional and economic development. Culture has been linked with creditor rights and investor protection (Stulz and Williamson 2003), with judicial efficiency (Radenbaugh et al. 2006), with corporate governance (Doidge et al. 2007), with bankruptcy protection and insolvency management (Beraho and Elisu 2010) and with overall levels of transparency and corruption (Husted 1999). Research has further established that national culture has an impact on the composition and leadership structure of boards of directors (Li and Harrison 2008) and also on individual decision-making at the micro level (Hilary and Hui 2009; Halek and Eisenhauer 2001; and Graham et al. 2009). On the other hand, attitudes towards risk are likely to be indirectly affected by culture through many of the factors listed above, as well as directly by national cultural norms, which may encourage or deter risk-taking.
This paper is not the first to study the impact of cultural values on corporate risk-taking. The extant literature has briefly studied the relation between culture and risk-taking, but has mostly focused on firms in the banking and the financial sectors (Houston et al. 2010; Kanagaretnam et al. 2011; Lehnert et al. 2011; Li and Zahra 2012). For example, Kanagaretnam et al. (2011) show that aggressive risk-taking activities by banks are more likely in societies with low uncertainty avoidance and high individualism. They show that cultural differences between societies have a profound influence on the level of bank risk-taking, and the ability to explain bank financial troubles during the recent financial crisis. On the other hand, Griffin et al. (2012) show that uncertainty avoidance is negatively and individualism is positively associated with firm-level riskiness in the non-financial sector (in the manufacturing sector).
This paper innovated in at least four ways. First, this paper takes a more holistic approach to the study of cultural influences on corporate risk-taking by studying not only the banking and the financial sectors, but all industries in a market economy. We take this approach in order to capture cross-industrial differences in risk-taking. The influence of cultural factors, such as national uncertainty aversion, may be of greater importance for firms in more informationally opaque industries such as information technologies, financial services, oil extraction, and chemicals, where information uncertainty is higher relative to manufacturing and industrial firms, because of the greater complexity of operations and the difficulty of assessing and managing risk. Thus, we test whether corporate risk-taking in informationally more opaque industries is more sensitive to a country‟s national cultural norms. Second, we differentiate between the direct and indirect effects of national culture on firm risk-taking. We specifically test whether cultural norms remain important in determining corporate risk-taking behaviors even after taking into account their impact on the institutional, economic and industrial environments. Third, unlike previous research which has used standard ordinary least squares analyses, we model both the direct and indirect effects of culture on risk-taking by employing a hierarchical linear mixed model. The hierarchical linear mixed model allows testing multi-level theories, simultaneously modeling variables at the firm, industry and country level without having to recourse to data aggregation or disaggregation as previous cultural economics studies have had to do. Fourth, by using a hierarchical linear model in explaining firm-level risk-taking, we can model not only the firm, industry and country-level influences on risk-taking, but also their cross-level interactions.
This paper finds that:
Culture impacts corporate risk-taking directly and not merely though indirect channels such as the legal and regulatory frameworks.
Corporate risk-taking is higher in societies with low uncertainty avoidance, low tolerance for hierarchical relationships and in societies which value individualism over collectivism, with these effects even more accentuated in societies with better formal institutions.
Additionally, firms in countries ranking high in uncertainty-aversion and low in individualism take significantly less risk in industrial sectors which are more informationally opaque (e.g. finance, IT, oil refinery and mining), compared to firms in countries lower in uncertainty-aversion and higher in individualism.
Risk-taking by foreign firms is best explained by the cultural norms of their country of origin.
These cultural dimensions are not proxying for legal constraints, economic development, bankruptcy costs, insurance safety nets, or many other factors.
The results of this study inform both theory and policy in several ways. First, these findings strengthen the argument that the same institutional rules can produce different economic outcomes in culturally-different societies. Second, they imply that policy-makers should take into account cross-cultural values and norms when drafting policies that promote competitive business environments. Third, they enrich governmental discussions on policies that address risk-taking in informationally opaque sectors.
Literature review
Several research studies in the financial, accounting, and management literatures have explored the importance of cultural values in decision-making. These studies find that culture can explain the institutional, legal and economic environments of a country at the macro level which can influence corporate risk-taking decisions, and offer evidence of the impact of culture on financial decision-making by individuals at the micro level beyond traditional economic arguments.
At the micro level, culture has (unsurprisingly) been shown to affect individual risk-taking behaviors. Breuer et al. (2011) find that individualism is linked to overconfidence and overoptimism and has a significantly positive effect on individual financial risk-taking and the decision to own stocks. Tse et al. (1988) show that home culture has predictable, significant effects on the decision-making of executives. Two decades later, Graham et al. (2010), using survey data in the U.S., also show that CEOs are not immune to the effects of culture. They find that CEOs‟ decision-making is strongly influenced by cultural values such as uncertainty-aversion.
At the macro level, cultural heritage has been linked to corporate governance, investor protection, creditor rights, bankruptcy protection, judicial efficiency, accounting transparency, and corruption. Doidge et al. (2007) find that cross-cultural differences explain much more of the variance in corporate governance than observable firm characteristics. Hope (2003a) shows evidence that both legal origin and culture (as proxied by Hofstede‟s cultural dimensions) are important in explaining firms‟ disclosure practices and investor protection. In fact, he finds that although legal origin is a key determinant of disclosure levels, its importance decreases with the richness of a firm‟s information environment, while culture still remains a significant determinant. Licht et al. (2005) find that social norms of governance correlate strongly and systematically with high individualism and low power distance. Stulz et al. (2003) find that cultural heritage, proxied by religion and language, predicts the cross-sectional variation in creditor rights better than a country‟s trade openness, economic development, legal origin, or language. Other studies find that culture predicts judicial efficiency and the transparency of accounting systems. Radenbaugh et al. (2006) find that countries in the Anglo cluster have an accounting system which is more transparent and less conservative than either the Germanic or the Latin accounting systems. Beraho et al. (2010) show that cross-cultural variables have a direct influence on the propensity to file for bankruptcy and on insolvency laws. Lastly, both Getz and Volkema (2001) and Robertson and Watson (2004) link cultural differences to corruption levels.
Furthermore, recent research has also linked cultural variables to economic and market development, although the evidence is mixed. Guiso et al. (2006) find that national culture impacts economic outcomes, by influencing national savings rates and income redistributions. Kwok and Tadesse (2006) find that culture explains cross-country variations in financial systems, with higher uncertainty-avoidance countries dominated by bank-based financial systems, rather than by stock-markets. Kirca et al. (2009) show that national culture impacts the implementation of market-oriented practices (i.e., generation, dissemination, and utilization of market intelligence) and the internalization of market-oriented values and norms (i.e., innovativeness, flexibility, openness of internal communication, speed, quality emphasis, competence emphasis, inter-functional cooperation, and responsibility). Lee and Peterson (2000) show that only countries with specific cultural tendencies (i.e., countries which emphasize individualism) tend to engender a strong entrepreneurial orientation, hence experiencing more entrepreneurship and global competitiveness. On the other hand, Pryor (2005) argues that cultural variables do not seem related to the level of economic development and are not useful in understanding economic growth or differences in levels of economic performance across countries. Additionally, Herger et al. (2008) also argue that cultural beliefs do not seem to support or impede financial development. This mixed evidence points to the idea that national culture might only indirectly influence economic and market development through its effects on the legal and institutional contexts.
The institutional and economic environments have been shown to affect corporate risk-taking decisions. There is a small strand of literature which has explored corporate risk-taking around the world which reflects countries‟ institutional and economic environments. For example, Laeven and Levine (2009) show that risk-taking by banks varies positively with the comparative power of shareholders within each bank. Moreover, they show that the relations between bank risk-taking and capital regulation, deposit insurance mechanisms, and bank activities restrictiveness, depend critically on the bank‟s ownership structure. Claessens et al. (2000) show that corporations in common law countries and market-based financial systems have less risky financing patterns, and that the stronger protection of equity and creditor rights is also associated with less financial risk. Overall, while the literature is relatively small, national culture has been indirectly linked with corporate risk-taking decisions in formal studies, although most of them only analyze the banking sector.
Culture has also been directly linked with corporate risk-taking, although again, most studies have focused on either the financial or the manufacturing sectors separately. Kanagaretnam et al. (2011) show that banks in high uncertainty avoidance societies tend to take less risk, whereas banks in high individualism societies take more risk. However, they do not control for institutional variables such as corporate governance, bankruptcy protection, judicial efficiency, transparency, and corruption, which have shown to be affected by national cultural norms and which could at their turn affect corporate risk-taking. Griffin et al. (2012) study the impact of culture on firms in the manufacturing sector in the period 1997-2006. To the best of our knowledge, they are the only ones who use a hierarchical linear mixed model to analyze the impact of culture on corporate risk-taking. They show that individualism has positive and significant direct effects, while uncertainty avoidance has negative and significant direct effects on corporate risk-taking.
This paper contributes to the literature on the impact of culture on firm risk-taking in several ways. While previous studies have studied either the direct or the indirect effects of culture on risk-taking, this paper tries to reconcile the two strands of literature and assess them simultaneously by using a hierarchical linear mixed model. This allow to test whether cultural norms remain important in determining corporate risk-taking behaviors even after taking into account their impact on the institutional, economic and industrial environments. Moreover, this paper extends the analyses of Griffin et al. (2012) and Kanagaretnam et al. (2011) to capture cross-industrial differences in risk-taking. Given the importance to national and global economies of the highly leveraged sector of finance, or the highly innovative sector of IT, or the highly risky commodity industries1, and given that firms in these industries are markedly different from manufacturing firms and have been more adversely affected by the recent global economic crisis, it is very important to understand the role of culture on cross-industrial variation in corporate risk-taking.
IMF Working Paper No. 12/210
Aug 2012
http://www.imfbookstore.org/ProdDetails.asp?ID=WPIEA2012210
Summary: This paper investigates the effects of national culture on firm risk-taking, using a comprehensive dataset covering 50,000 firms in 400 industries in 51 countries. Risk-taking is found to be higher for domestic firms in countries with low uncertainty aversion, low tolerance for hierarchical relationships, and high individualism. Domestic firms in such countries tend to take substantially more risk in industries which are more informationally opaque (e.g. finance, mining, IT). Risk-taking by foreign firms is best explained by the cultural norms of their country of origin. These cultural norms do not proxy for legal constraints, insurance safety nets, or economic development.
http://www.imf.org/external/pubs/cat/longres.aspx?sk=26204.0
Excerpts:
Introduction
Understanding whether national culture affects a society‟s likelihood to generate risk-seeking firms is important for effective policy-making and for improving corporate governance. It can enrich discussions on government policies that encourage entrepreneurship and innovation. A grasp of the impact of cultural influences on corporate risk-taking would allow policy-makers to better customize their policies for firms with different risk appetites, thus promoting more competitive business environments. Understanding the impact of culture on corporate risk-taking decisions is also important to the internal conduct of multinational firms. Internal decisions in multinational firms, such as the decision to pursue a risky R&D project, require well-orchestrated responses from executives with diverse cultural backgrounds. Even in firms with standardized operating procedures, the interpretation of various financial decisions can vary among executives from different societies as a result of their cultural differences (Tse et al. 1988). Accounting for the impact of cultural influences on decision-making allows the firms themselves to accommodate and adapt to such differences, hence diminishing “noisy” interactions among executives and errors in decision-making.
This study employs four dimensions of national culture identified by Hofstede (2001) and an international sample of 50,000 firms spread across 400 industries in 51 countries to analyze the effects of cultural differences on corporate risk-taking. More specifically, it tries to identify the channels through which cultural values can influence corporate risk-taking. Culture can affect the institutional and economic development at the macro level, the industrial diversification and industry concentration at the market structure level, as well as the corporate and individual decision-making at the micro level, all of which may in turn influence firm risk-taking decisions.
Previous literature has shown that national culture does in fact predict cross-country differences in the degree of institutional and economic development. Culture has been linked with creditor rights and investor protection (Stulz and Williamson 2003), with judicial efficiency (Radenbaugh et al. 2006), with corporate governance (Doidge et al. 2007), with bankruptcy protection and insolvency management (Beraho and Elisu 2010) and with overall levels of transparency and corruption (Husted 1999). Research has further established that national culture has an impact on the composition and leadership structure of boards of directors (Li and Harrison 2008) and also on individual decision-making at the micro level (Hilary and Hui 2009; Halek and Eisenhauer 2001; and Graham et al. 2009). On the other hand, attitudes towards risk are likely to be indirectly affected by culture through many of the factors listed above, as well as directly by national cultural norms, which may encourage or deter risk-taking.
This paper is not the first to study the impact of cultural values on corporate risk-taking. The extant literature has briefly studied the relation between culture and risk-taking, but has mostly focused on firms in the banking and the financial sectors (Houston et al. 2010; Kanagaretnam et al. 2011; Lehnert et al. 2011; Li and Zahra 2012). For example, Kanagaretnam et al. (2011) show that aggressive risk-taking activities by banks are more likely in societies with low uncertainty avoidance and high individualism. They show that cultural differences between societies have a profound influence on the level of bank risk-taking, and the ability to explain bank financial troubles during the recent financial crisis. On the other hand, Griffin et al. (2012) show that uncertainty avoidance is negatively and individualism is positively associated with firm-level riskiness in the non-financial sector (in the manufacturing sector).
This paper innovated in at least four ways. First, this paper takes a more holistic approach to the study of cultural influences on corporate risk-taking by studying not only the banking and the financial sectors, but all industries in a market economy. We take this approach in order to capture cross-industrial differences in risk-taking. The influence of cultural factors, such as national uncertainty aversion, may be of greater importance for firms in more informationally opaque industries such as information technologies, financial services, oil extraction, and chemicals, where information uncertainty is higher relative to manufacturing and industrial firms, because of the greater complexity of operations and the difficulty of assessing and managing risk. Thus, we test whether corporate risk-taking in informationally more opaque industries is more sensitive to a country‟s national cultural norms. Second, we differentiate between the direct and indirect effects of national culture on firm risk-taking. We specifically test whether cultural norms remain important in determining corporate risk-taking behaviors even after taking into account their impact on the institutional, economic and industrial environments. Third, unlike previous research which has used standard ordinary least squares analyses, we model both the direct and indirect effects of culture on risk-taking by employing a hierarchical linear mixed model. The hierarchical linear mixed model allows testing multi-level theories, simultaneously modeling variables at the firm, industry and country level without having to recourse to data aggregation or disaggregation as previous cultural economics studies have had to do. Fourth, by using a hierarchical linear model in explaining firm-level risk-taking, we can model not only the firm, industry and country-level influences on risk-taking, but also their cross-level interactions.
This paper finds that:
Culture impacts corporate risk-taking directly and not merely though indirect channels such as the legal and regulatory frameworks.
Corporate risk-taking is higher in societies with low uncertainty avoidance, low tolerance for hierarchical relationships and in societies which value individualism over collectivism, with these effects even more accentuated in societies with better formal institutions.
Additionally, firms in countries ranking high in uncertainty-aversion and low in individualism take significantly less risk in industrial sectors which are more informationally opaque (e.g. finance, IT, oil refinery and mining), compared to firms in countries lower in uncertainty-aversion and higher in individualism.
Risk-taking by foreign firms is best explained by the cultural norms of their country of origin.
These cultural dimensions are not proxying for legal constraints, economic development, bankruptcy costs, insurance safety nets, or many other factors.
The results of this study inform both theory and policy in several ways. First, these findings strengthen the argument that the same institutional rules can produce different economic outcomes in culturally-different societies. Second, they imply that policy-makers should take into account cross-cultural values and norms when drafting policies that promote competitive business environments. Third, they enrich governmental discussions on policies that address risk-taking in informationally opaque sectors.
Literature review
Several research studies in the financial, accounting, and management literatures have explored the importance of cultural values in decision-making. These studies find that culture can explain the institutional, legal and economic environments of a country at the macro level which can influence corporate risk-taking decisions, and offer evidence of the impact of culture on financial decision-making by individuals at the micro level beyond traditional economic arguments.
At the micro level, culture has (unsurprisingly) been shown to affect individual risk-taking behaviors. Breuer et al. (2011) find that individualism is linked to overconfidence and overoptimism and has a significantly positive effect on individual financial risk-taking and the decision to own stocks. Tse et al. (1988) show that home culture has predictable, significant effects on the decision-making of executives. Two decades later, Graham et al. (2010), using survey data in the U.S., also show that CEOs are not immune to the effects of culture. They find that CEOs‟ decision-making is strongly influenced by cultural values such as uncertainty-aversion.
At the macro level, cultural heritage has been linked to corporate governance, investor protection, creditor rights, bankruptcy protection, judicial efficiency, accounting transparency, and corruption. Doidge et al. (2007) find that cross-cultural differences explain much more of the variance in corporate governance than observable firm characteristics. Hope (2003a) shows evidence that both legal origin and culture (as proxied by Hofstede‟s cultural dimensions) are important in explaining firms‟ disclosure practices and investor protection. In fact, he finds that although legal origin is a key determinant of disclosure levels, its importance decreases with the richness of a firm‟s information environment, while culture still remains a significant determinant. Licht et al. (2005) find that social norms of governance correlate strongly and systematically with high individualism and low power distance. Stulz et al. (2003) find that cultural heritage, proxied by religion and language, predicts the cross-sectional variation in creditor rights better than a country‟s trade openness, economic development, legal origin, or language. Other studies find that culture predicts judicial efficiency and the transparency of accounting systems. Radenbaugh et al. (2006) find that countries in the Anglo cluster have an accounting system which is more transparent and less conservative than either the Germanic or the Latin accounting systems. Beraho et al. (2010) show that cross-cultural variables have a direct influence on the propensity to file for bankruptcy and on insolvency laws. Lastly, both Getz and Volkema (2001) and Robertson and Watson (2004) link cultural differences to corruption levels.
Furthermore, recent research has also linked cultural variables to economic and market development, although the evidence is mixed. Guiso et al. (2006) find that national culture impacts economic outcomes, by influencing national savings rates and income redistributions. Kwok and Tadesse (2006) find that culture explains cross-country variations in financial systems, with higher uncertainty-avoidance countries dominated by bank-based financial systems, rather than by stock-markets. Kirca et al. (2009) show that national culture impacts the implementation of market-oriented practices (i.e., generation, dissemination, and utilization of market intelligence) and the internalization of market-oriented values and norms (i.e., innovativeness, flexibility, openness of internal communication, speed, quality emphasis, competence emphasis, inter-functional cooperation, and responsibility). Lee and Peterson (2000) show that only countries with specific cultural tendencies (i.e., countries which emphasize individualism) tend to engender a strong entrepreneurial orientation, hence experiencing more entrepreneurship and global competitiveness. On the other hand, Pryor (2005) argues that cultural variables do not seem related to the level of economic development and are not useful in understanding economic growth or differences in levels of economic performance across countries. Additionally, Herger et al. (2008) also argue that cultural beliefs do not seem to support or impede financial development. This mixed evidence points to the idea that national culture might only indirectly influence economic and market development through its effects on the legal and institutional contexts.
The institutional and economic environments have been shown to affect corporate risk-taking decisions. There is a small strand of literature which has explored corporate risk-taking around the world which reflects countries‟ institutional and economic environments. For example, Laeven and Levine (2009) show that risk-taking by banks varies positively with the comparative power of shareholders within each bank. Moreover, they show that the relations between bank risk-taking and capital regulation, deposit insurance mechanisms, and bank activities restrictiveness, depend critically on the bank‟s ownership structure. Claessens et al. (2000) show that corporations in common law countries and market-based financial systems have less risky financing patterns, and that the stronger protection of equity and creditor rights is also associated with less financial risk. Overall, while the literature is relatively small, national culture has been indirectly linked with corporate risk-taking decisions in formal studies, although most of them only analyze the banking sector.
Culture has also been directly linked with corporate risk-taking, although again, most studies have focused on either the financial or the manufacturing sectors separately. Kanagaretnam et al. (2011) show that banks in high uncertainty avoidance societies tend to take less risk, whereas banks in high individualism societies take more risk. However, they do not control for institutional variables such as corporate governance, bankruptcy protection, judicial efficiency, transparency, and corruption, which have shown to be affected by national cultural norms and which could at their turn affect corporate risk-taking. Griffin et al. (2012) study the impact of culture on firms in the manufacturing sector in the period 1997-2006. To the best of our knowledge, they are the only ones who use a hierarchical linear mixed model to analyze the impact of culture on corporate risk-taking. They show that individualism has positive and significant direct effects, while uncertainty avoidance has negative and significant direct effects on corporate risk-taking.
This paper contributes to the literature on the impact of culture on firm risk-taking in several ways. While previous studies have studied either the direct or the indirect effects of culture on risk-taking, this paper tries to reconcile the two strands of literature and assess them simultaneously by using a hierarchical linear mixed model. This allow to test whether cultural norms remain important in determining corporate risk-taking behaviors even after taking into account their impact on the institutional, economic and industrial environments. Moreover, this paper extends the analyses of Griffin et al. (2012) and Kanagaretnam et al. (2011) to capture cross-industrial differences in risk-taking. Given the importance to national and global economies of the highly leveraged sector of finance, or the highly innovative sector of IT, or the highly risky commodity industries1, and given that firms in these industries are markedly different from manufacturing firms and have been more adversely affected by the recent global economic crisis, it is very important to understand the role of culture on cross-industrial variation in corporate risk-taking.
Monday, August 27, 2012
Incentivizing Calculated Risk-Taking: an Experiment with Commercial Bank Loan Officers. By Martin Kanz and Leora Klapper
Incentivizing Calculated Risk-Taking: an Experiment with Commercial Bank Loan Officers. By Martin Kanz and Leora Klapper
Mon, Aug 27, 2012 08:42am
http://blogs.worldbank.org/allaboutfinance/incentivizing-calculated-risk-taking-an-experiment-with-commercial-bank-loan-officers
In the aftermath of the global financial crisis, there has been much criticism of compensation practices at banks. Although much of this debate has focused on executive compensation (see the recent debate on this blog), there is a growing recognition that non-equity incentives for loan officers and other employees at the lower tiers of a bank’s corporate hierarchy may share some of the blame — volume incentives for mortgage brokers in the United States that rewarded high-risk lending at wildly unsustainable terms are a particularly striking case in point.
The view that excessive risk-taking in the run-up to the crisis had its roots in flawed incentives at all levels of financial institutions — not just at the top — has made inroads in policy circles, and has been reflected in efforts to regulate how banks can pay their loan officers. Well-intentioned as these efforts may be, they mask the fact that providing performance incentives in lending is, in fact, a very difficult problem. Assessing a borrower’s creditworthiness requires a complex tradeoff between risk and return; it contains an inherent element of deferred compensation and requires the interpretation of a noisy signal about an applicant’s actual creditworthiness. Whether and how performance incentives work in this setting is unclear: the limited evidence that exists about the impact of performance pay on employee behavior comes from the labor economics literature and suggests that — even in simple production tasks — the behavioral response to incentives tends to be much more complex than a simple mapping from stronger incentives to greater effort and performance.
So how does “pay-for-performance” affect the risk-appetite and lending decisions of loan officers? In a recent paper, coauthored with Shawn Cole of Harvard Business School we designed a field experiment with real-life loan officers to examine the impact of performance incentives on loan officer behavior. Working with a number of leading commercial banks in India, we recruited more than 200 loan officers with an average of more than ten years of experience in banking and brought them to a behavioral economics lab. In the lab, participants were asked to evaluate a set of loan applications under different, exogenously assigned incentives. This cross-over between an actual field experiment and a controlled lab setting allowed us to study risk-taking behavior using a real life population of highly experienced loan officers, while being able to get detailed measurements of risk-assessment and risk-taking behavior — the kind of data that would usually only be available from a lab experiment.
We deliberately set up our experiment in an informationally challenging emerging credit market — the Indian market for unsecured small enterprise loans. Borrowers in this market typically lack reliable credit scores and an established track record of formal sector borrowing. This generally rules out the use of predictive credit scoring and other advance loan approval technologies, making banks particularly reliant on the risk-assessment of their frontline employees. The credit files that our loan officers evaluated in the experiment consisted of actual loan applications from small enterprises applying for their first formal-sector loan. Each loan was matched with ten months of repayment history from the lender’s proprietary database (not surprisingly, more than 90% of defaults occur in the first three months of a loan’s tenure). This allowed us to compare the actual outcome of the loan with the loan officer’s decision and risk assessment in the experiment and to offer incentive payments based on the profitability of lending decisions loan officers took in the lab.
The reassuring news is that basic incentives seem to work quite well in lending. We find that pay for performance (incentives that reward profitable lending and penalize default) indeed induces loan officers to exert much greater effort in reviewing the information that is presented to them. This is all well, but the real question is whether this translates into improved lending decisions. One common concern with performance pay in lending is that stronger incentives may indeed make loan officers much more conscientious, so conscientious in fact that they may shy away from risks that would be profitable from the viewpoint of the bank and simply stop lending. In our experiment, we find this not to be the case: when loan officers faced high-powered incentives, the probability that they would approve a non-performing loan was reduced by 11% while overall lending went down by only 3.6%. In other words, more stringent incentive schemes actually made loan officers better at identifying and eliminating bad credits from the pool of loan applicants. Profits per loan increased by up to 4% over the median loan size and by more than 40% compared with the case when loan officers faced volume incentives.
These strong results highlighting the negative impact of volume incentives are in line with much recent evidence using observational data (Agarwal and Ben-David 2012; Berg, Puri, and Rocholl 2012). So is pay-for performance the solution to all of a bank’s internal agency problems? Unfortunately not. In an additional set of experiments, we varied the time horizon of the loan officer’s compensation contract — an important second dimension of the incentive scheme over which a bank typically has control. Interestingly, our results show that performance incentives quickly lose their bite as they are deferred even by a couple months. Given that in real life performance pay typically occurs in the form of a quarterly or annual bonus, this casts some doubt on the wisdom of trying to fix agency problems within financial institutions with monetary incentives alone. Interestingly, however, deferred compensation also makes permissive incentive schemes less tempting and can attenuate many of the negative effects of volume incentives. Some direct advice that comes out of this finding is that if a bank finds it necessary to provide volume incentives, it can limit the potential damage through deferred compensation.
Perhaps most interestingly, the results from our experiment also show that incentives affect not only actual lending decisions, they also distort loan officers’ subjective assessment of credit risk. Put simply, we find that when participants faced incentives that emphasize lending volume over loan quality, they started viewing their clients’ creditworthiness through rose-colored glasses. They inflated internal risk ratings — which were neither seen by any supervisor nor tied to incentives — by up to .3 standard deviations for the same loan. This finding resonates with the psychological concept of “cognitive dissonance” (Akerlof and Dickens 1982) and is in line with behavioral economics explanations that have tried to make sense of seemingly irrational behavior in sub-prime lending prior to the crisis, which are nicely summarized in a recent article by Nicholas Berberis (2012) from the Yale School of Management.
What are we to take away from these results? The question of how to better align private incentives with public interest is a major unresolved policy question that has arisen from the global financial crisis. Our experiments provide some of the first rigorous evidence on the link between performance pay and behavior among loan originators, which we hope will be a first step that can help tackle this important issue from the angle of corporate governance —– with the ultimate aim of making compensation policy a more effective component of a bank’s risk management mechanisms. Much work has recently gotten underway in this exciting research agenda, but it is clear that much more evidence is needed to translate these findings into meaningful policy prescriptions. To contribute to this agenda, we are currently working on a number of follow-up experiments to more fully understand the behavioral and psychological implications of the problem of incentives and individual risk-taking. Stay tuned.
References
Agarwal, Sumit, and Itzhak Ben-David. 2012. “Do Loan Officer Incentives Lead to Lax Lending Standards?” Ohio State University, Fisher College of Business. Working Paper WP-2012-7.
Agarwal, Sumit, and Faye H. Wang. 2009. “Perverse Incentives at the Banks? Evidence from a Natural Experiment.” Federal Reserve Bank of Chicago. Working Paper WP-09-08.
Akerlof, George A., and William T. Dickens. 1982. “The Economic Consequences of Cognitive Dissonance.” American Economic Review 72 (3):307–19.
Baker, George, Michael Jensen, and Kevin Murphy. 1988. “Compensation and Incentives: Practice vs. Theory.” Journal of Finance 43 (3):593–616.
Bandiera, Oriana, Iwan Barankay, and Imran Rasul. 2007. “Incentives for Managers and Inequality among Workers: Evidence from a Firm-Level Experiment.” Quarterly Journal of Economics 122 (2):729–73.
_____. 2009. “Social Connections and Incentives in the Workplace: Evidence from Personnel Data.” Econometrica 77 (4):1047–94.
_____ Team Incentives: Evidence from a Firm Level Experiment. Journal of the European Economic Association, forthcoming.
Barberis, Nicholas. 2012. “Psychology and the Financial Crisis of 2007-2008.” In Financial Innovation and the Crisis, edited by M. Haliassos. Cambridge, MA: MIT Press.
Berg, Tobias, Manju Puri, and Jorg Rocholl. 2012. “Loan Officer Incentives and the Limits of Hard Information.” Duke University Fuqua School of Business Working Paper.
Mon, Aug 27, 2012 08:42am
http://blogs.worldbank.org/allaboutfinance/incentivizing-calculated-risk-taking-an-experiment-with-commercial-bank-loan-officers
In the aftermath of the global financial crisis, there has been much criticism of compensation practices at banks. Although much of this debate has focused on executive compensation (see the recent debate on this blog), there is a growing recognition that non-equity incentives for loan officers and other employees at the lower tiers of a bank’s corporate hierarchy may share some of the blame — volume incentives for mortgage brokers in the United States that rewarded high-risk lending at wildly unsustainable terms are a particularly striking case in point.
The view that excessive risk-taking in the run-up to the crisis had its roots in flawed incentives at all levels of financial institutions — not just at the top — has made inroads in policy circles, and has been reflected in efforts to regulate how banks can pay their loan officers. Well-intentioned as these efforts may be, they mask the fact that providing performance incentives in lending is, in fact, a very difficult problem. Assessing a borrower’s creditworthiness requires a complex tradeoff between risk and return; it contains an inherent element of deferred compensation and requires the interpretation of a noisy signal about an applicant’s actual creditworthiness. Whether and how performance incentives work in this setting is unclear: the limited evidence that exists about the impact of performance pay on employee behavior comes from the labor economics literature and suggests that — even in simple production tasks — the behavioral response to incentives tends to be much more complex than a simple mapping from stronger incentives to greater effort and performance.
So how does “pay-for-performance” affect the risk-appetite and lending decisions of loan officers? In a recent paper, coauthored with Shawn Cole of Harvard Business School we designed a field experiment with real-life loan officers to examine the impact of performance incentives on loan officer behavior. Working with a number of leading commercial banks in India, we recruited more than 200 loan officers with an average of more than ten years of experience in banking and brought them to a behavioral economics lab. In the lab, participants were asked to evaluate a set of loan applications under different, exogenously assigned incentives. This cross-over between an actual field experiment and a controlled lab setting allowed us to study risk-taking behavior using a real life population of highly experienced loan officers, while being able to get detailed measurements of risk-assessment and risk-taking behavior — the kind of data that would usually only be available from a lab experiment.
We deliberately set up our experiment in an informationally challenging emerging credit market — the Indian market for unsecured small enterprise loans. Borrowers in this market typically lack reliable credit scores and an established track record of formal sector borrowing. This generally rules out the use of predictive credit scoring and other advance loan approval technologies, making banks particularly reliant on the risk-assessment of their frontline employees. The credit files that our loan officers evaluated in the experiment consisted of actual loan applications from small enterprises applying for their first formal-sector loan. Each loan was matched with ten months of repayment history from the lender’s proprietary database (not surprisingly, more than 90% of defaults occur in the first three months of a loan’s tenure). This allowed us to compare the actual outcome of the loan with the loan officer’s decision and risk assessment in the experiment and to offer incentive payments based on the profitability of lending decisions loan officers took in the lab.
The reassuring news is that basic incentives seem to work quite well in lending. We find that pay for performance (incentives that reward profitable lending and penalize default) indeed induces loan officers to exert much greater effort in reviewing the information that is presented to them. This is all well, but the real question is whether this translates into improved lending decisions. One common concern with performance pay in lending is that stronger incentives may indeed make loan officers much more conscientious, so conscientious in fact that they may shy away from risks that would be profitable from the viewpoint of the bank and simply stop lending. In our experiment, we find this not to be the case: when loan officers faced high-powered incentives, the probability that they would approve a non-performing loan was reduced by 11% while overall lending went down by only 3.6%. In other words, more stringent incentive schemes actually made loan officers better at identifying and eliminating bad credits from the pool of loan applicants. Profits per loan increased by up to 4% over the median loan size and by more than 40% compared with the case when loan officers faced volume incentives.
These strong results highlighting the negative impact of volume incentives are in line with much recent evidence using observational data (Agarwal and Ben-David 2012; Berg, Puri, and Rocholl 2012). So is pay-for performance the solution to all of a bank’s internal agency problems? Unfortunately not. In an additional set of experiments, we varied the time horizon of the loan officer’s compensation contract — an important second dimension of the incentive scheme over which a bank typically has control. Interestingly, our results show that performance incentives quickly lose their bite as they are deferred even by a couple months. Given that in real life performance pay typically occurs in the form of a quarterly or annual bonus, this casts some doubt on the wisdom of trying to fix agency problems within financial institutions with monetary incentives alone. Interestingly, however, deferred compensation also makes permissive incentive schemes less tempting and can attenuate many of the negative effects of volume incentives. Some direct advice that comes out of this finding is that if a bank finds it necessary to provide volume incentives, it can limit the potential damage through deferred compensation.
Perhaps most interestingly, the results from our experiment also show that incentives affect not only actual lending decisions, they also distort loan officers’ subjective assessment of credit risk. Put simply, we find that when participants faced incentives that emphasize lending volume over loan quality, they started viewing their clients’ creditworthiness through rose-colored glasses. They inflated internal risk ratings — which were neither seen by any supervisor nor tied to incentives — by up to .3 standard deviations for the same loan. This finding resonates with the psychological concept of “cognitive dissonance” (Akerlof and Dickens 1982) and is in line with behavioral economics explanations that have tried to make sense of seemingly irrational behavior in sub-prime lending prior to the crisis, which are nicely summarized in a recent article by Nicholas Berberis (2012) from the Yale School of Management.
What are we to take away from these results? The question of how to better align private incentives with public interest is a major unresolved policy question that has arisen from the global financial crisis. Our experiments provide some of the first rigorous evidence on the link between performance pay and behavior among loan originators, which we hope will be a first step that can help tackle this important issue from the angle of corporate governance —– with the ultimate aim of making compensation policy a more effective component of a bank’s risk management mechanisms. Much work has recently gotten underway in this exciting research agenda, but it is clear that much more evidence is needed to translate these findings into meaningful policy prescriptions. To contribute to this agenda, we are currently working on a number of follow-up experiments to more fully understand the behavioral and psychological implications of the problem of incentives and individual risk-taking. Stay tuned.
References
Agarwal, Sumit, and Itzhak Ben-David. 2012. “Do Loan Officer Incentives Lead to Lax Lending Standards?” Ohio State University, Fisher College of Business. Working Paper WP-2012-7.
Agarwal, Sumit, and Faye H. Wang. 2009. “Perverse Incentives at the Banks? Evidence from a Natural Experiment.” Federal Reserve Bank of Chicago. Working Paper WP-09-08.
Akerlof, George A., and William T. Dickens. 1982. “The Economic Consequences of Cognitive Dissonance.” American Economic Review 72 (3):307–19.
Baker, George, Michael Jensen, and Kevin Murphy. 1988. “Compensation and Incentives: Practice vs. Theory.” Journal of Finance 43 (3):593–616.
Bandiera, Oriana, Iwan Barankay, and Imran Rasul. 2007. “Incentives for Managers and Inequality among Workers: Evidence from a Firm-Level Experiment.” Quarterly Journal of Economics 122 (2):729–73.
_____. 2009. “Social Connections and Incentives in the Workplace: Evidence from Personnel Data.” Econometrica 77 (4):1047–94.
_____ Team Incentives: Evidence from a Firm Level Experiment. Journal of the European Economic Association, forthcoming.
Barberis, Nicholas. 2012. “Psychology and the Financial Crisis of 2007-2008.” In Financial Innovation and the Crisis, edited by M. Haliassos. Cambridge, MA: MIT Press.
Berg, Tobias, Manju Puri, and Jorg Rocholl. 2012. “Loan Officer Incentives and the Limits of Hard Information.” Duke University Fuqua School of Business Working Paper.
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