Tag Archives: Fat Tails

Bankers, Risk and the Rents of Slippery Skin

12 Monday Mar 2018

Posted by in Banking, rent seeking

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Risk taking is important to the economic success of a nation. Creative energy demands it, and it is critical to achieving economic growth and wealth creation. But it’s obviously possible to take too much risk or risks that are ill-considered, and that is all the more likely when risk-takers are absolved of the consequences of their actions. That is, healthy risk-taking and responsibility are inextricably linked. One can’t truly be said to take a risk if the cost of failure is borne by another party. It’s easy to understand why risk-taking becomes excessive or misdirected when that is the case.

Risk Shifting

There are various ways in which a party can parlay risky undertakings into easy gains by shifting the risks to others. For example, any piece of merchandise comes with the risk that it will not perform as advertised. Some traders might be tempted to sell unreliable merchandise and shift risk to the buyer without recourse. This is an area in which we must rely on a bulwark of private governance: caveat emptor. On the other hand, government tends to subsidize risk-taking in various ways: limited liability under the corporate form of business organization, bank deposit insurance, bankruptcy laws, the implicit government guarantee on mortgage assets, and the “too-big-to-fail” mentality of government bailouts.

Whose Skin In the Game?

These are examples of what Nassim Taleb bemoans as the failure to have “skin in the game”. The quoted expression happens to be the title of his new book. I have both praised and castigated Taleb’s work in the past. He made an interesting contribution about the nature and risk of extreme events in his book “Black Swan”, such as his application of so-called “fat tails” in probability distributions, though some have claimed the ideas were anything but original. I was highly critical of Taleb’s alarmist hyperbole on the effects of GMOs. In the present case, however, he considers “the asymmetry of risk bearing” to be a major social problem, and I’m generally in agreement with the point. The most interesting part of the brief discussion at the link is the following:

“In Taleb’s universe, the fieriest circle of hell is reserved for bankers and neoconservatives. ‘The best thing that could happen to society is the bankruptcy of Goldman Sachs,’ he tells me. ‘Banking is rent-seeking of industrial proportions.’ Taleb, who became rich as a derivatives trader, is not a foe of capitalism but of ‘cronyism’. ‘If you’re taking risks, God bless you. This is why I accept inequality. I’ve seen people go from trader to cab driver and back again.’“

Banks are a prominent example of the risk-shifting phenomenon. First of all, banking institutions are not required to hold much capital against their assets. In fact, recently banks have had average equity of less than 6% of assets. That’s much higher than during the financial crisis of ten years ago, but it is still rather thin and hardly represents much “skin in the game”.

Fractional Reserves

It should come as no surprise that a bank’s assets are funded largely by account balances held by depositors (liabilities), and not by equity capital. But your bank balance is not kept as cash in the vault. Instead, it is loaned out to the bank’s credit clients or used to purchase securities. This is facilitated by “fractional reserve banking”, whereby banks need only keep a fraction of their depositors’ money on hand as cash (or in their own reserve deposit accounts with the Federal Reserve). This generally works well on a day-to-day basis because depositors seldom ask to redeem more than a small fraction of their money on a given day.

Reserve requirements are set by the Federal Reserve and range from 0-10%, depending on the size of a banks’ deposit account balances. At the upper figure, a dollar of new cash deposits would allow a bank to extend new loans of up to $0.90. This legal practice divides many in the economics profession. Some believe it represents fraud rather than sound banking. This article by Frank Hollenbeck at the Mises Canada web site states that it is improper for a bank to lend a depositor’s money to others:

“Suppose you lived in the 18th century and had 100 ounces of gold. It’s heavy and you do not live in a safe neighborhood, so you decide to bring it to a goldsmith for safekeeping. In exchange for this gold, the goldsmith gives you ten tickets where eachis clearly marked as claims against 10 ounces. …

… Quickly the goldsmith realizes there is an easy, fraudulent, way to get rich: just lend out the gold to someone else by creating another 10 tickets. Since the tickets are rarelyredeemed, the goldsmith figures he can run this scam for a very long time. Of course, it is not his gold, but since it is in his vault, he can act as though it is his money to use. This is fractional reserve banking with a voluntary reserve requirement of 50%. Today, modern US banks have a reserve requirement of between 0% and 10%. This is also how the banking systemcan create money out of thin air, or basically counterfeit money, and steal the purchasing power from others without actually having to produce real goods and services.”

Another aspect of the argument against fractional reserves is that it creates economic instability, fueling booms and busts as the quantity of money in circulation sometimes exceeds or falls short of the needs of the public. Many authorities have taken a negative view of fractional reserve banking through the years: Irving Fisher, Milton Friedman, John Cochrane, Ralph Musgrave, and Laurence Kotlikoff, to name a few prominent economists (see this recent paper by Musgrave).

In Defense of Fractional Reserves

Others have defended fractional reserves as a practice that has and would again arise in a free market environment. According to this view, depositors would accept the logic of allowing banks to lend a portion of the funds in their accounts in order to generate income, rather than charging larger fees for “storage” and administration. If the depositing public is aware of the risk and has competing choices among banks, then the argument that banks expose depositors to excessive risk via fractional reserves is moot. Fractional reserves can exist in a private money economy in which competitive pressures reward banks (and their privately circulating notes) having sound lending practices. In fact, some would say that the very idea of a 100% reserve requirement is an unacceptable government intrusion into the private relationship between banks and their customers. All of that is true.

Some have compared fractional reserve banking to the sale of insurance. Consumers buy insurance to take advantage of pooled risk, but they have no expectation of a refund unless they incur the kind of insured loss in question. Bank depositors, on the other hand, expect a return of their funds in-full. Yes, low risk is an attribute they desire, and pooling across the withdrawal needs of many depositors is one reason why banks can invest and pass a part of the return on to depositors, both in interest and reduced fees. So, despite the differing needs and expectations of their customers, there is some validity to the comparison of insurers to fractional-reserve bankers.

Amplification of Shifted Risks

Do fractional reserves allow banks to take risks without having skin in the game? Absolutely! With as little as 6% equity at risk, banks have relatively little to lose relative to depositors. Yes, banks pay the FDIC to insure deposits, and premiums are higher for riskier banks. However, not all deposits are insured by the FDIC. More importantly, at the end of 2017, the entire FDIC deposit insurance fund was about 0.7% of commercial bank assets. One big bank failure would wipe it out, or a few hundred small ones. That’s well within the realm of possibility and historical experience. So, where does that leave depositors? Their skin is very much in the game, and the game is about the risks taken by banks in investing depositors’ funds.

We now live in the era of “too-big-to-fail” (TBTF), whereby large banks (and sometimes industrial firms) are viewed as so “systemically important” that they cannot be allowed to fail. Taxpayers must bail them out in the event they become insolvent. Thus, taxpayers have skin in the game. Banks collect rents to the extent that their returns exceed those commensurate with the risks for which they are actually “on the hook”.

Another avenue through which banks off-load risk is the extent to which Fannie Mae and Freddie Mac are still presumed to have the federal government’s implicit guarantee against default on the mortgage debt they purchase from banks. That is beyond the scope of the present discussion, however. And I have not discussed the role of large investment banks in the capital markets. That’s a whole other dimension of the story. This article by Guatam Mukunda in the Harvard Business Review provides a perspective on rent seeking in investment banking.

Conclusion

The combination of deposit insurance, TBTF and other risk-insulating subsidies, layered on top of a fractional reserve banking system, places banks into Taleb’s “fieriest circle of hell”. These factors blunt bank incentives to manage risk effectively as well as consumer incentives to conduct adequate due diligence in their banking relationships. It means that risk is not priced properly, because banks are likely to ignore risks from which they are shielded. Therefore, banks may allocate resources into excessively risky uses. The consequences for depositors and taxpayers can be dramatic.

Fractional reserves are not “fraud” in the sense that the system has unsuspecting victims. Anyone who has watched “It’s a Wonderful Life” knows that banks lend your deposits to others. But fractional reserves magnify the risk-mitigating privileges conferred upon the banking industry by government through various mechanisms. This “risk-cleansing” is converted to rents and collected by banks for their shareholders, but the risks are still borne by society. To the extent that fractional reserves create instability, deposit insurance is viewed as a necessity, but banks should pay a market premium to an insurer to cover the actual risk inherent in the system. Too-big-to-fail should end, as should the implicit subsidy collected by banks through the government-sponsored enterprises.

Taleb’s Crock Pot: Whip Statistical Theory and Rhetoric To a Fine Agitprop

29 Wednesday Oct 2014

Posted by in Uncategorized

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scary-crockpot

Nassim Taleb, a well-known statistical theorist, and two coauthors (a physicist and a philosopher) have written a working paper in which they purport to show that GMO’s should be banned worldwide lest we flirt with complete ruination, quite possibly the end of humanity. The paper may come to represent sacred writ to anti-GMO activists, as it seems to imply that their position is supported by statistical theory. Ultimately, the paper merely uses statistical theory in the service of rhetoric. It relies on a series of ill-defined dichotomies that the authors use to classify genetic plant engineering into the most “ruinous” category of processes. Among other things, GE is categorized by the authors as a “top-down” technology, it creates global risks and systemic risks, it involves interconnected factors, it is irreversible, its outcomes can be characterized by a probability distribution with “fat tails,” its true risks are “unknowable,” and (worst of all?) it is “human-made,” as opposed to a natural process devoid of human intervention. Perhaps the last condition is meant only to classify processes into the so-called “precautionary approach” to policy assessment, rather than “standard risk management,” but it may reveal something significant about the predisposition of the authors toward human technological endeavors.

The statistical theory presented by the authors is fine, as far as it goes. I have admired some of Taleb’s earlier work, such as Fooled By Randomness, which sought to demonstrate the irrationality of assigning likelihood or even meaning to chance events. Taleb achieved real stardom following the publication of The Black Swan, which warned of severe “outlier” events so rare that they cannot be predicted or even assigned probabilities by humans. The true risks are “unknowable.” Applied work involving “fat-tailed” distributions of possible outcomes, which characterize a wide range of phenomena, is typically supported by prior experience or data, but that is not possible with “ruinous” black swans. Perhaps “extremely long- and fat-tailed” is more descriptive of distributions giving rise to black swans, but of course the extreme outcomes might not be observable ex post.

Taleb, et al, contend that development and cultivation of GMOs carry risks of a black swan ecocide. “Significant” risks? Wait, that involves statistical precision… and data! “Excessive” risks? That implies measurability of one sort or another, not to mention a coherent tradeoff of some kind. “Any” risk of a certain qualitative nature (as defined by the “precautionary approach,” with possible ruin on any time scale)? Of course, the authors are not biologists, agronomists, or geneticists (neither am I), but they claim to have sufficient knowledge to make this judgment:

“Ecologically, in addition to intentional cultivation, GMOs have the propensity to spread uncontrollably, and thus their risks cannot be localized. The cross-breeding of wild-type plants with genetically modified ones prevents their disentangling, leading to irreversible system-wide effects with unknown downsides.” [emphasis added]

The article contains a comparison of GMOs to nuclear energy risks, which seems intended to defuse criticism that the authors are simply Luddites. They express guarded optimism that nuclear power-generating risks are “local” in nature, and that problems associated with long-term storage of nuclear wastes are manageable. Clearly, however, those risks are just as “unknowable” as those associated with GMOs. We might add to the list of dangerous human endeavors all research and development of artificial intelligence. After all, a complete ban on AI research would prevent the coming singularity, when we’ll otherwise be lorded over by ruthless, self-serving machines! On a less sarcastic note, I do not discount the possibility of a singularity, but we have the luxury of some time to develop AI in a cautious way, just as we have time to minimize risks in the continuing development and application of GE.

Here is a subset of the many assertions made by Taleb, et al in support of their view:

  • GMOs have the propensity to spread uncontrollably.
  • Healthwise, the modification of crops “impacts” everyone.
  • GMO risks are associated with “fragility” (essentially increasing costs).
  • GMOs imply monocultures.
  • GMOs are qualitatively dissimilar to selectively-bred crop varieties.
  • Selective breeding does not remove crops from their evolutionary context.
  • GMOs remove crops from their evolutionary context.
  • The ecological implications of releasing modified organisms into the wild are not tested empirically before release.
  • The health effects of GMOs have not been tested sufficiently.
  • Incremental varieties of GMOs cause the risk of ecocide to increase.

All of these points are debatable to one extent or another. For example, the common assertion that GMOs promote monocultures reflects a common confusion over GMOs versus adequate crop rotation in mechanized farming. The authors exploit this confusion by linking monocultures and GMOs to reduced genetic diversity (apparently within single crops) and assert that this makes crops more vulnerable to blight, though it is hard to see why this is a foregone conclusion regarding the effects of introducing desirable traits.

More fundamentally, Taleb, et al give short shrift to the idea that there is a risk-reward tradeoff in the use of GMOs, that there are potential benefits and risks of GMO alternatives, and the fact that GMOs do not, in fact, suspend evolutionary processes. If a mutation embodied in a GMO also confers an evolutionary advantage, chances are the mutation will be propagated. If not, the mutation will tend to vanish. This is a safety mechanism provided by nature. Of course, anti-GMO activists seek to conjure images of mad geneticists whipping up monster “Audrey” GMOs with evolutionary advantages, but that is not the character of biotechnology.

Taleb, et al, also wish to equate GMOs with Monsanto. The fact that they are so eager to invoke the company’s name in a negative context within an ostensibly academic paper is a giveaway that the paper is agenda-driven. Monsanto and GMOs are not synonymous, and it is highly misleading to conflate the technology with a single company.

The authors attempt to upstage critics with the choice of the adjective “non-naive” to describe their use of the precautionary principle to guide their policy prescription:

“… it is essential to distinguish the PP so that it is neither used naively to justify any act of caution, nor dismissed by those who wish to court risks for themselves or others. The PP is intended to make decisions that ensure survival when statistical evidence is limited—because it has not had time to show up —by focusing on the adverse effects of ‘absence of evidence.’”

So, they excuse themselves from bringing anything empirical to bear on the issue of GMO risks because, they contend, “unknowability” is the very nature of the risk/ruin problem, despite the fact that evidence supporting GMO safety does exist, in scads!

Here are a few other sources who have commented on the article:

This post on the NeuroLogica blog questions Taleb’s understanding of biology and genetic engineering. The author, Steven Novella, also notes that Taleb, et al, do not assess the risk of alternatives:

“Growing enough food for 7 billion people has consequences, in terms of land use, fertilizer, pesticides, and displacing natural ecosystems. GMO as a technology can potentially add to our efficiency. Banning GMO means relying more heavily on other technologies that may have even more risks.”

In addition, Novella says:

“… Taleb’s arguments to still come down to hyping the risk of unforeseen consequences due to the inherent limits of scientific knowledge. I don’t agree, however, that GMOs have the potential for global ruin. This is still largely based on a naive belief that transgenes are inherently risky, when there is no scientific reason to believe that they are. …  He failed to make a compelling argument that his principle of zero risk should apply to GMO.”

The Motley Fool, generally an admirer of Taleb’s previous work, also believes that he is off-base in the case of GMOs.

David Tribe at the GMO Pundit refutes a couple of assertions made by Taleb, et al. about natural variation and the “track record” of nature as an evaluator of risk.

And at DebunkingDenialism, Emil Karlsson is particularly galled, as he should be, by the comparison the paper makes of the risks of Russian Roulette to GMOs. He writes that Taleb and his coauthors fail to understand basic biology:

“In the end, the authors have clearly demonstrated that they do not care about biology, medicine or rational risk analysis. They have negligible knowledge of molecular biology, plant breeding and genetic engineering. It does not matter how much knowledge they have of statistics. If your model is based on flawed premises, then the application and conclusion of that model is going to be flawed. Garage in, garbage out.”

Taleb, et al have adorned their paper with statistical theory, and they are certainly correct that “unknowable” risks may be ruinous. But their case against GMOs ignores the substantial body of known evidence on GMO safety. They bring absolutely no evidence to bear to the contrary. Their arguments mislead by relying on false premises and arbitrary classifications. Unfortunately, that won’t stop reverent anti-GE crusaders from heralding Taleb’s “proof” that GMOs are ruinous and must be banned.