Arnold Kling  

Today's Financial Reading

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North, Wallis, and Weingast... Krugman's Baby-Sitting Analogy...

Two suggestions from Mark Thoma. First, Anne Sibert writes,


There is a substantial economics literature on the effect of gender on attitudes toward risk and most of it appears to support the idea that men are less risk averse than women in their financial decision making.1 There is also a sizable literature documenting that men tend to be more overconfident than women. Barber and Odean (2001) find that men are substantially more overconfident than women in financial markets. In general, overconfidence is not found to be related to ability (see Lundeberg et al (1994)) and that success is more likely to increase overconfidence in men than in women (see, for example, Beyer (1990)). Thus, if confidence helps produce successful outcomes, there is more likely to be strong feedback loop in confidence in men than in women.

As I've said before, if I were the regulatory czar and told to curb risk-taking at banks, the one factor I would like to control is the gender of the CEO.

Second, Gary B. Gorton writes,


bank charters were valuable because of subsidies, in the form of limited entry into banking, local deposit monopolies, interest-rate ceilings, and underpriced deposit insurance. In other words, bank regulation not only involved the "stick" of restrictions (reserve requirements, capital requirements, limitations on activities), but also the "carrot," that is, the subsidies.

His thesis is that banks take fewer risks when their charters are more valuable, and that their charters are more valuable when there are barriers to entry and other subsidies.

I would argue, for example, that the January 2002 revisions to bank capital regulations eroded the value of the Freddie and Fannie charters. This was somewhat intentional. Bank regulators wanted to make it easier for banks to fund mortgages, so the regulators made it possible for private-label mortgage securities with high ratings to enjoy the low capital requirements formerly restricted to GSE securities. As a result, over the next few years, private-label securitization soared and the market shares of Freddie and Fannie fell. Those firms then responded by taking more risks, by delving into sub-prime mortgages.

Gorton recommends


1. Senior tranches of securitizations of approved asset classes should be insured by the government.
2. The government must supervise and examine "banks," i.e., securitizations, rather than rely on ratings agencies. That is, the choices of asset class, portfolio, and tranching must be overseen be examiners.
3. Entry into securitization should be limited, and any firm that enters is deemed a "bank" and subject to supervision.

If the goal should be trying to restore the type of financial system we had five years ago, then Gorton may be right. However, I think that is the wrong goal. I think that the goal ought to be a smaller financial sector, with less overall leverage. I am willing to throw securitization under the bus. Gorton is not.

I think that for Gorton, the problem began with what he calls the "panic" of 2007 and 2008. For me, the problem began with the housing and debt bubbles, particularly in 2004-2006. In this instance, I agree with John Kenneth Galbraith, who in his Short History of Financial Euphoria sees the cause of financial crashes as being the euphoria that precedes them, not the events that trigger the collapse.


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COMMENTS (7 to date)
von Pepe writes:

What causes the euphoria/optimism?

Thomas DeMeo writes:

"In general, overconfidence is not found to be related to ability (see Lundeberg et al (1994)) and that success is more likely to increase overconfidence in men than in women (see, for example, Beyer (1990))."

Since success is proof of ability, the studies seem to produce conflicting results. If men are increasingly confident when successful, then overconfidence should be found to be related to ability.

Robert writes:

I thought that, per Tanta at calculated risk, FNM/FDM had no involvement in subprime due to their charter which prevented them from acquiring loans below a certain baseline.

That's not to say they didn't buy bad Alt-A loans and others of the sort.

Sorry, can't help but nitpick.

Vinnie writes:

If regulators were to implement incentives or mandates for hiring female CEOs, don't you think the incumbent players would filter out female candidates that fit the prevailing finance culture, i.e. those who are wired more "like men"? The difference in values across gender become largely irrelevant if the individual candidate does not exhibit them.

Rich Berger writes:

Robert-

Don't know where you got that impression. This article from the WaPo debunks that assertion.

http://www.washingtonpost.com/wp-dyn/content/article/2008/06/09/AR2008060902626.html

Snark writes:

As I've said before, if I were the regulatory czar and told to curb risk-taking at banks, the one factor I would like to control is the gender of the CEO.

And I question whether we can predict that controlling for this variable would measurably reduce risk when we take into account the following (as revealed by this study):

- Women leaders feel the sting of rejection but rapidly learn from adversity and develop an "I'll show you" attitude.

- Women leaders are more likely to ignore rules and take risks.

We could disregard these facts and assume that women CEOs are less prone to risk-taking than their male counterparts. If we are correct in our assumption, then from a risk-capital standpoint, wouldn’t the feminization of Corporate America portend sub-optimal performance?

Peter Findlen writes:

Is anyone willing to look at the fact that risk and returns are positively correlated in financial institutions, and the risk-management challenge is not to blow up the institution while obtaining good to excellent returns. Secondly, as all seasoned institutional players know, every once in a while the will be a "Minsky moment" for which the institution should be prepared to weather. Thirdly, regulatory arbitrage and exploiting central banking policies affords above average returns.

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