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Sunday, March 10, 2013

The Fed Whitewashes Citibank: Systemic Risk Understated

As reported by Reuters in March 2013, “The newest stress tests for U.S. banks produced scores that are at odds with other measures of lenders' safety, in another sign that some institutions may be too big for regulators to understand and executives to manage. For example, Citigroup Inc, which has been bailed out multiple times by the U.S. government, showed up on the score sheets posted by the Federal Reserve . . . as being clearly safer than JPMorgan Chase & Co. That conclusion is at odds with the views of investors, bond analysts and credit-rating agencies, as well as when measured by a yardstick regulators themselves want to use in the future.” Kathleen Shanley, a bond analyst at GimmeCredit, a research service for institutional investors, said "I wouldn't say that Citi is safer than JPMorgan, for a variety of reasons, including its track record.” Citigroup has lower credit ratings than JPMorgan, and prices for credit default swaps suggest that the market views JPMorgan as safer.
Analysis:
The matter was not simply whether the Federal Reserve had an accurate methodology for assessing the likely wherewithal of major banks to withstand financial stress. The more fundamental question is that which was put by Fred Cannon, director of U.S. research at Keefe, Bruyette & Woods. “At the end of the day, there is a legitimate question about the ability of regulators to fully evaluate $2 trillion institutions because of the complexity and exposures they have.” Given the systemic risk inherent in those institutions, the ability of regulators to know their underlying conditions translates into too much systemic risk. Put another way, flying blind is dangerous. The human race may have amassed such gigantic financial institutions that even the fall of one of those large trees could bring down the entire forest.
From a managerial standpoint, a $2 trillion financial institution is of such complexity that the CEO and even the senior management must take the word of subordinates that their complex products will not misfire to an extent that would bring down the firm. Rubbing against the declining economies of scale that go with a very large size is the arduous task of managing complexity on a large scale.
For example, the senior management of AIG was not aware of the extent of the company’s potential payouts on subprime-mortgage-based securities, and thus of the systemic risk of so many claims all at once on the insurance policies. A small unit at AIG constructed and sold the profitable “swaps” without any viable restraint or check on the unit by the upper management. The complexity of the swap instruments, combined with the human proclivity to dismiss low-probability catastrophic outcomes makes it virtually impossible for a senior executive to know what damage is being done at the department level.
Whereas economies of scale—the added synergy or efficiency from increased size—can be quantified, “unmanageable” is not a concept that is so easily put in monetary terms, especially by the managers themselves!  In other words, business management itself (and the managers themselves) may be of such a nature (and disposition) that the benefits of organizational “growth” are apt to be overstated while the fuzzy costs are conveniently discounted or even ignored outright.  It is rare indeed, if not unheard of, to read of an executive of a large multinational corporation admitting that the complexity at ground level is beyond his or her cognitive grasp. As a result, the systemic risk of gigantic financial institutions that sport an array of highly complex securities may be much higher than anyone realizes.

 

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