Saturday, 4 May 2013

We could have seen this coming. Or couldn't we?

A Black Swan in "Petra tou Romiou" in Cyprus. Photo by XristonPn
The handling of Cyprus's troubles will go down as one of the worst in economic history. Not only is one systemic bank forced to liquidation but the other has been treated as such (and will probably end up as such) since the infamous Eurogroup announcement on March 16th. Then, as the world was trying to accept the results, many began defending the handling of the situation, calling it necessary, moral and fair.

The basic premise of the "defense" is that people should have seen this coming and take the appropriate measures to counter it. Yet, what all of them fail to see is that nobody had ever warned about such things before. The most notable article on this was Peter Spiegel's one concerning a confidential memorandum on a haircut which would be "involving more foreign depositors and bond holders". Yet, this was not the outcome of some economic or political forecast of any kind. This was the result of a journalist doing his job (and doing it very well), at a time where nobody expected such decisions. There were some other articles which appeared in the press by the time the Eurogroup decision had been reached but these were the whole deal: a debate by Charles Goodhart of LSE arguing against bail-ins, an article in Bruegel which compared the similarities between a Cyprus and a Danish bail-in, a Reuters article presenting the possibilities for the Eurogroup meeting, another SSRN paper proposing measures to prevent such a bail-in, one on the NYT questioning whether such proposals might actually be feasible and one by yours truly explaining why a deposits haircut was a terrible idea. Note that the earliest of this articles (the NYT one) was just published on January 10th, with all the rest (except the SSRN paper which was again in late January) published a couple of days before the haircut.

Again, this was not the result of any economic analysis which predicted such an outcome. At most, it was an examination of what might happen, based on media reports which were more volatile than most speculative trades. Any person who calls himself an investor would not dare decide on such information, much less a depositor who has almost no idea what to do even if he understands this information, especially if most of his money are already tied up in time deposits. In all the aforementioned articles (other than the Peter Spiegel one), nothing specific on who would participate in such a haircut appeared. (Just notice the difference between the two Eurogroup decisions: the first was a levy on all depositors in all banks while the second was a levy on uninsured depositors in the two large banks). What happened next was what Nassim Nicolas Taleb would describe as a Black Swan
  1. The event is a surprise (to the observer).
  2. The event has a major effect.
  3. After the first recorded instance of the event, it is rationalized by hindsight, as if it could have been expected; that is, the relevant data were available but unaccounted for in risk mitigation programs. The same is true for the personal perception by individuals.
We cannot fully understand the effects of the decision on Cyprus yet, thus although point 2 may be out of our reach at the moment, yet, point 3 is what we should be focusing on. A notable example is Jean Pisani-Ferry who stated the following after the first Eurogroup decision was made:
The link provides a summary of the accounts a Russian bank was (is?) providing in Cyprus, with their respective interest rates. Yet, it appears that no earlier statements had been made on Cyprus, either warning about the eminent collapse or of the increasing interest rates, which by the way were always high even before Cyprus's entry in the EU or the Eurozone. As for the seriousness of the argument that savers should have deposited in Germany it appears that although there may be many pensioners with more than 100,000 in a bank (which may be nothing more than saving €100 per month for several years), the idea of sending their money abroad is almost incomprehensible if they never had a background in investments and especially if they use that money in their everyday lives, or they are tied in time deposits.

People have taken the chain of events in Cyprus even further as Barnejek now proposes that abolishing deposit insurance would be good for the bank health. Again, we have a failure to understand what we can forecast and what we cannot. In a discussion after my asking what we should do if a similar crisis occurred in the 2030's and we had no deposit insurance the argument was that we shouldn't worry about a future crisis. Abolishing deposit insurance would supposedly make banks stronger and people would be more careful on their choice of bank. Nevertheless, I would like to remind the reader that we tend to forget fast and the "this time it's different" motto will be heard again when the economy is booming. Who would be willing to go through 200+ pages of annual reports to understand whether a bank is good or not or even if one would be willing to do so how many of us have what it takes to really see through these? If we all could then Warren Buffett wouldn't be the only billionaire investor.

Then, the argument about making banks stronger would perhaps hold for some time after the recession, although it is the case that banks have very strong balance sheets when the economy shifts from recession to growth (Minksy had mentioned this back in the 1980's on what he called the financial instability hypothesis). Then as times are good, banks fund more loans of less and less quality, resulting in trouble again (again, Minsky is the originator of these theories). Then, when it hits the fan, and they lose money or are at the brink of doing so, people start paying attention to what their bank had been doing before and complain that we should have seen this before (just remember the Madoff scheme which lasted more than 40 years-in which case people could actually foresee trouble.). If we have no deposit insurance then as soon as news of financial distress hit the market (regardless of being justified or not) a bank run will occur destroying the bank through a huge outflow of liquidity. Thus, if (or after) trust is replaced by suspicion, any rumour that a bank is not financially well will in fact destroy it. A better alternative, the creation of a fund similar to the FDIC, has not promoted thus far. (Roger Lowenstein provides a short history of the Deposits Insurance Scheme in the US here).

In addition to the above, it has been suggested that the bail-in wasn't something new and if we kept our eyes open we could have seen it in a 2010 proposal. Well, first of all, a proposal for a directive is not the same as a directive. Just because 1 million Americans asked for the construction of a Death Star does not mean they are going to get it. If the documents which leaked 2-3 weeks before the event were classified as confidential then how was that public information? There was an outflow of deposits from the Cypriot banking system yet, this was more out of concern and reaction to rumours (which also proves the point made in the previous paragraph) than of predicting the outcome.

In retrospect everything appears to be easy, yet were where the voices of concern from Cypriot authorities when the Bank of Cyprus or Laiki Bank invested in Greek bonds? How about from Bundesbank officials when German banks did the same? (Yes, German banks got rid of much of those bonds later although it is doubtful whether this was done through BuBa pressure) As a former member of the BoC board states the decision to invest in them was considered good and profitable for the bank at the time. It would be unrealistic to believe that directors (and especially the CEO) of a bank would choose a terrible investment on purpose as this is not to their best personal interest: the bonuses they received were based on bank performance meaning that if the bank was doing bad then they received nothing. Nevertheless, it would also be unrealistic to assume that these choices were not terrible or that the directors used good risk management rules (as German banks did at the time). Yet, could they have seen the PSI before? Not a chance.

It is not just that there was no precedent in Europe. Those bonds were at their worst rated as A3, paid a significant amount of interest and were considered zero risk by everyone. Many (including yours truly) would like to see a post dated prior to 2009, stating that Greece, or any other country in the EU for that matter, would face so much trouble that a bond haircut would occur and that the risk premium was high. Yet, I have serious doubts on whether anyone was able to do it (and first of all, I admit that I could not see such a thing happen in a million years).

We should all be very careful in promoting policies which are based on "we could have seen this" arguments, since most of the times we wouldn't be in a bad situation if we could have really seen it coming. This is not providing an excuse for everything though: the Greek, Italian and Portuguese governments had been overspending for at least the past 10 years and Spain and Cyprus were in a housing bubble which was doomed to burst sooner or later. Nevertheless, the timing of such bursting, including its outcome are mostly unknown as I have argued before. Prevention should not be confused with vague forecasts of disasters. "This time it's different" has about the same validity as the "we could have seen this coming" premise and any policy based on our ability (or willingness) to see the future is doomed to fail.

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