With the benefit of hindsight, two of the most foretelling indicators of a crisis looming in the financial sector were the strong increase in leverage and managers’ appetite for risk due to compensation schemes based on incentives to boost performance (Panetta et al., 2009). In this column, we discuss below how the evidence on recent developments in capital regulation, leverage, and managers’ compensation may have contributed to the current crisis.
A new financial accelerator approach
The idea that the financial sector can amplify the business cycle dates back at least to Fisher (1933). In this original view, however, financial factors have an asymmetric role; financial frictions limit the availability of external finance to firms and households, worsening downturns; however, they do not have a symmetric positive role during upturns. The so called financial accelerator theory works mainly through the value of collateral. In its modern reformulation (Bernanke and Gertler, 1989), it predicts that a rise in asset prices makes it easier for households and firms to obtain loans, while a decline makes it more difficult. This mechanism is pro-cyclical because the value of collateral tends to be positively correlated with the business cycle and because credit availability feeds back into investment and consumption, and hence into economic growth. Within the financial accelerator, the focus is on the way in which financial markets influence the business cycle indirectly, via their impact on the non-financial sector (firms and households).
Much less work has been devoted to the direct role of the financial system in amplifying shocks to the real economy.1 Analyses prompted by the ongoing crisis point out that a financial accelerator-type mechanism may also be at work for financial firms, particularly banks. We call this mechanism the New Financial Accelerator (NFA), although its functioning has been well known at least since Kindleberger (1978).
The NFA mechanism has been clearly illustrated by Adrian and Shin (2008) – a negative shock to asset prices depletes banks’ capital and increases leverage. Since raising new capital is difficult in a downturn, banks tend to react by liquidating assets. Disposals feed back into asset prices, propagating the initial shock. This may have a strong impact on economic activity, especially when shocks hit several banks simultaneously, as is typical of systemic events. In this framework the propagating factor is leverage – when banks are highly leveraged, the initial negative shock and the ensuing reduction in asset prices may induce massive asset liquidations, accentuating the price fall and possibly triggering a vicious circle, especially if banks want to restore a target leverage level. In principle, the mechanism is symmetric. A positive shock increases capital and reduces leverage, inducing banks to expand assets.
For the NFA mechanism to generate pro-cyclical amplification, at least two conditions are necessary. The first, widely acknowledged condition is that the shock to the prices of the assets used as collateral must be pro-cyclical. The second condition is that banks do not fully accommodate shocks into leverage; clearly, the empirical strength of the NFA depends on whether this assumption holds in practice.
Did banks target an optimal leverage?
Adrian and Shin (2008) show that commercial banks do appear to target leverage levels and that the leverage of US security brokers and dealers (which used to include investment banks) increases when asset prices also increase, denoting in this sense a pro-cyclical leverage. However, the graphical evidence in Adrian and Shin (2008) does not seem to hold for all countries. While monetary and financial institutions in the US and the UK do indeed display a positive correlation between asset prices and leverage, in Germany, France, Italy, and Japan the correlation is negative (Figure 1).
Figure 1. Financial assets and leverage of monetary financial institutions
Sources: Calculations based on national financial accounts (Federal Reserve System, Office for National Statistics, Bundesbank, Banque de France, Banca d'Italia and Bank of Japan); see Panetta et al. (2009).
Note: Leverage is defined as the ratio between financial assets and the difference between financial assets and liabilities. Data refer to commercial banks, monetary authority and money market mutual funds for the US, to banks for Japan and to monetary financial institutions (banks, central banks and money market mutual funds), for European countries.
Further insights into the pro-cyclicality of the financial system can be gained from analysis of the direct relationship between leverage and the business cycle, to see whether financial institutions do indeed expand leverage in periods of high GDP growth. In this case as well, the evidence of the NFA effect seems to be limited (see Figure 1.2 in Panetta et al., 2009).
We also separated the two key determinants of leverage: (a) investors’ portfolio decisions (exposure to each market/asset class) and (b) price changes, largely exogenous to the individual investor. Genuine pro-cyclical behaviour should directly affect the former. US evidence suggests that the banks’ reaction to capital gains seems to contradict the prediction of the NFA (see Figure 1.3 in Panetta et al., 2009). One possible interpretation is that banks smooth changes in the size of their balance sheet by offsetting larger gains with more prudent asset acquisition policies (e.g. moderating lending; and vice-versa).
Another essential element in assessing the empirical relevance of the NFA is the actual level of leverage of financial institutions. In the years 2000-2006 the leverage of commercial banks rose significantly in all major European countries (Figure 2). The increase was sharpest in the UK and Switzerland. The low level of leverage of US commercial banks (see Figure 1.4 in Panetta et al., 2009), and its flat trend, contrasts sharply with the much higher and growing leverage observed among US investment banks. These differences partly reflect regulatory provisions.
Figure 2. Leverage of large international banks, 2000-2008
Source: Fitch-Ibca. Leverage is defined as total assets over capital; see Panetta et al., (2009). The data points linked by a continuous line represent the weighted average of the leverage of the sample of banks in turn considered; the top of the vertical segments correspond to the maximum value of leverage of the sample of banks considered. Continental Europe: ten major commercial banks; Switzerland: three major banks; UK: five major commercial banks; US investment banks: five major banks.
Did compensation schemes increase the appetite for risk?
Several indications suggest a positive answer. Incentive schemes based on a set of readily observable performance measures lead to excessive short-termism and appetite for risk; both end up boosting risk and leverage. In the financial sector the pay-for-performance system has thus accentuated the degree of pro-cyclicality of the economy.
Remuneration schemes are usually based on mechanisms that are inherently sensitive to short-run indicators of firm performance. Therefore such schemes may prompt executives to underweight long-term underperformance in order to boost immediate results. In good times, bank managers may opt for lax lending standards in order to inflate short-term profits, despite the potential drawbacks for future credit quality. This contributes to the onset of boom-bust cycles (see e.g. the case of non-recourse mortgage loans in Dell’Ariccia et al., 2008).
As the financial crisis revealed, managers’ incentives are often paid based on deals that entail large immediate gains but also large risks. These risks were largely overlooked, as managers generated abnormal returns that appeared to stem from their superior abilities, but were actually just a market risk premium for compensating their exposure to hidden risk (fake alpha). Evidence confirms that it is difficult to generate abnormal returns due to investment skills: for example, Gibson and Wang (2008) argue that the positive risk-adjusted returns of hedge funds reflect mainly liquidity risk premia.
In most cases, true ex ante risk of financial intermediaries is hard to disentangle from “true alpha” (superior investment skills), so an accurate assessment often doesn’t come until after the risks have materialised as actual losses. This is especially true for tail risk – risk related to events that are rare or hard to foresee. As a result, excessive risk-taking behaviour has contributed to increase pro-cyclicality, since risks tend to build up undetected during expansions and then to materialise in downturns (Borio et al., 2001). Indeed, as the recent crisis has shown, many investment strategies generated returns that were only apparently abnormal, and turned into losses as soon as the risks materialised. The limited empirical evidence appears to suggest that incentive fees are positively related to risk (Elton et al., 2003). In fact, over the last eighteen years the group of hedge funds with higher incentive fees also exhibited higher volatility (Figure 3).
Figure 3. Incentive fees and risk taking of hedge funds, 1991-2008
Source: Calculations based on Hund Fund Research, Inc data. Annualised monthly standard deviation of returns over a 12 months period, for a sample of around 6.900 hedge funds, grouped based on the level of their incentive fees.
New financial accelerator-type mechanisms are at work in the current crisis, and the general increase of leverage over the past years amplified their effect. The excessive focus on short-term performance characterising managers’ compensation schemes increased appetite for risk in the financial sector and contributed to the increase in leverage. These two pieces of evidence point to the relevance of policy proposals aimed at tackling the effects of excessive leverage and risk-taking on financial sector pro-cyclicality (see our next column).
Disclaimer: The opinions expressed are those of the authors and do not necessarily reflect those of the Bank of Italy.
1 A notable exception is the research activity carried out in the current decade at the Bank for International Settlements on the inherent pro-cyclicality of post Bretton Woods financial arrangements (see Borio et al., 2001).
Adrian, T. and H. S. Shin (2008), “Liquidity and Leverage”, Federal Reserve Bank of New York, Staff Report No. 328.
Bernanke, B. S. and M. Gertler (1989) “Agency Costs, Net Worth, and Business Fluctuations”, American Economic Review, 1989, Vol. 79, No. 1, pp. 14–31.
Borio, C., C. Furfine, and P. Lowe (2001), “Pro-cyclicality of the Financial System and Financial Stability: Issues and Policy Options”, BIS Papers, No. 1.
Dell’Ariccia, G., D. Igan and L. Laeven (2008), “Credit Booms and Lending Standards: Evidence from the Subprime Mortgage Market”, IMF Working Paper, WP/08/106.
Elton, E., M. Gruber and C. Blake (2003), “Incentive Fees and Mutual Funds”, The Journal of Finance, Vol. 58, No. 2, pp. 779–804.
Fisher, I. (1933), “The Debt–Deflation Theory of Great Depressions”, Econometrica, 1 pp. 337–357.
Gibson, R. and S. Wang (2008), “Hedge Fund Alphas: Do They Reflect Managerial Skills or Mere Compensation for Liquidity Risk Bearing?”, Swiss Finance Institute Research Paper Series, No. 08–37.
Kindleberger, C. (1978), Manias, Panics, and Crashes: a History of Financial Crises, Basic Books.
Panetta F., Angelini P., Albertazzi U.., Columba F., Cornacchia W., Di Cesare A., Pilati A., Salleo C. and Santini G. (2009), “Financial Sector Pro-Cyclicality: Lessons from the Crisis”, Bank of Italy Occasional Papers No. 44 .