Swiss coco

Financial and economic wealth are largely a function of expectations. A factory is valuable because I expect that it will help produce something that people want; a house is valuable because I expect that it will be a place people want to live. If people suddenly stop wanting to buy what the factory produces — or if they stop wanting to live in that house — then the factory or house loses its value, even if it is physically unchanged.

The size of a bank's liabilities to depositors is pretty clear in dollar terms, at least in principle; the bank owes a precise amount of dollars to depositors, and it owes it to them now. In a practical sense the liability is somewhat lower; the depositors won't all ask for their money right away, even if the bank charges fees. If the bank pays a low enough interest rate and charges fees, then, even with the costs of maintaining the bank accounts, the deposits provide the bank with a cheap source of funding that, in a true economic sense, reduces the size of the liability. Even in that sense, though, the true economic size of the deposits owed to customers is probably not a lot lower than the nominal size.

The asset side of the bank is murkier. If the bank has made a ten-year loan, the value of being entitled to that money depends on how things go over the next ten years; it depends on the ability of the bank to fund itself more cheaply than the interest rate on the loan,[1] and it depends on the ability (and sometimes willingness) of the borrower to actually pay it. The bank may even have investments in companies or real estate, and their value depends on the ability of those assets to provide things people want in the future. There are accounting rules about how we're supposed to guess at the value of these things, but these are merely conventional guesses.

These accounting guesses have some real force insofar as banking regulators impose solvency requirements on banks; the regulators want the bank's assets to be worth more than the liabilities, and use accounting guesses for at least some of those requirements.[2] The regulator's primary purpose is to protect the payment system, and particularly to protect the depositors' ability to get and use their deposits. The solvency requirements serve this in two ways: in the short run, if a bank is low on actual cash but has a lot of assets, it can sell assets or put assets up as collateral to borrow money to give to depositors. To the extent that this is our primary concern, the value of the assets should be reckoned based on the amount of money that could be acquired somewhat quickly by selling or borrowing against them. The primary purpose of the solvency requirement, however, is long-run: if the cash flows from the assets are anticipated to be reliably lower than the cash flows being paid on the liabilities, then eventually the bank will run out of cash, even if the depositors don't do anything weird. A regulation that is only worried about this concern is only worried about cash flows, not how much the asset could be sold for today.

There is an important sense in which, if the market value of your assets is lower than your liabilities, the market is saying that its best guess is that your cash flows in will not ultimately keep up with your cash flows out, but there is a fair amount of wiggle-room here. Market prices of assets bounce around a bit, and if the assets of a bank have gone down in the past three months, the bankers could well say, well, perhaps they will go back up in the next three months. Within certain constraints, the ability of the bank to hold onto cheap deposits does become important; even if the markets imply that funding costs over the life of the asset will eat up cash flows, if the bank can effectively borrow from depositors more cheaply, it may be able to survive. There are accounting rules that codify in certain ways how banks can get away with this; in particular, they can declare that they don't intend to sell certain assets, and if the market price changes they can ignore that change.[3] To some degree this feels like wishful thinking to me, but there's an element of wishful thinking in a well-capitalized bank as well; in one case you're hoping that the market is right, and that the cash flows in will be larger than the cash flows out, while in the other case you're hoping that the market is wrong. Even if we made banks use the market value for all of their assets,[4] the difference between a bank that is solvent and one that is insolvent is not a crisp one; there is a continuum, which is just one reason that the requirement is not just that assets exceed liabilities, but that they do so by some margin.

One new way to evade insolvency was introduced after the 2007–2009 financial crisis: the contingent convertible bond. "Bond" here is something of a misnomer, but they look like bonds in that they typically pay out a fixed interest rate and can be called in after a period of time, much like paying off a bond. Their key feature, though, is that they don't pay out if the bank's assets don't exceed the bank's liabilities by more than a certain specified margin. These "cocos" are designed to be liabilities as long as the bank can afford them, but to go away if liabilities are too large as a fraction of assets; if assets lose value, the cocos take the hit, and the depositors and other claimants on the bank are protected.

Different cocos work in different ways, perhaps in part with different purposes in mind. Most notably, some of them convert into stock or something similar when the asset-to-liability ratio gets too low. (These are the ones that are best called "contingent convertible bonds", though the term "coco" includes other securities that work rather differently.) Some of them convert into ... nothing. They go away. In each of these cases, though, they cease being liabilities, and thereby help restore the asset-to-liability ratio. If their purpose is to deal with long-term sustainability, rather than short-term sustainability (which is the purpose of liquidity regulations rather than capital regulations), then what matters about these things is their cash flow. A lot of them don't convert; they stop paying interest while the bank is in violation of its asset-to-liability requirements, but continue to sit around waiting to pay out again if the bank's situation improves. If the problem is a temporary market dip, or the bank has enough going-concern value that it can ultimately make it, these bonds don't get wiped out; they will lose some value when things look dicey, but it does relatively little harm to let them sit there dormant if the bank gets into trouble, only coming back if the bank's problems turn out to be temporary. It makes a lot of sense to me that they would largely work this way. Even from a short-term standpoint, a bond that works this way is a relatively small encumberance to selling or borrowing against assets, as the liability in practice remains small as long as there's much question of the bank's being able to repay secured loans.

The big exception, though — the point at which it seems like you have to make the coco's impairment final — is when the bank is being sold, especially if it's being sold as a matter of distress. In theory it might make a kind of sense to have the cocos paid off based on a sort of option value, but I can see why, as a practical matter, you might prefer that they be redeemed at par or zero. There's no longer an actual bank here (whose assets and liabilities could be assessed), so the best you could imagine is that it somehow continues to hedge the value of the assets the bank had when it was sold. Prospective buyers may well be averse to carrying around this strange option, and if the assets of the old bank are being folded into those of the purchasing bank, determining whether they recovered or not becomes onerous. Situations like this are usually messy and difficult as things are, and the value of being able to write this liability to zero in these situations seems compelling.

A week ago, the largest bank in Switzerland (UBS) acquired the second-largest bank in Switzerland (Credit Suisse). Both banks did the deal under duress from their primary regulator; Credit Suisse was on the brink of failure, but wanted to keep trying to recover, while UBS saw the balance sheet of Credit Suisse as unsafe at any price. Credit Suisse had some cocos that explicitly provided that they could be converted into nothing in a situation like this, and a lot of the holders of the cocos were disappointed to learn this. Cocos issued by banks in the European Union tend not to have such a provision. The Swiss cocos, indeed, had the provision that they would convert into nothing if the asset-to-liability ratio, as determined by accountants, were breached, even if the bank continued as a going concern. In actual fact, it is clear that UBS (and other potential suitors) thought that Credit Suisse's assets were worth a lot less than their accounting value; perhaps they should have been written down shortly before the takeover, anyway. After the fact, the fact that it was in the provisions of the bond (and was well within the spirit of how the bonds were intended to behave) means, of course, that they could do this; my assertion in this post is that such bonds should be written to be zero-able in this sort of situation, but that, outside of such forced-sale situations, the way the rest of Europe does things — with payments suspended, but the bond still sitting there, dormant, to potentially claim upside surprises if the bank recovers — makes more sense to me.

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[1] This is especially important if the loan is a fixed-rate loan, i.e. the amount of dollars that are to be paid along the way is set when the loan is made. A lot of business loans have interest rates that adjust with time, which reduces this problem.

[2] There are in fact a number of requirements, and especially large banks these days are in trouble with the regulator if traditional accounting measures of assets aren't enough above liabilities, but also if other measures of assets aren't enough above other measures of liabilities.

[3] Again, this doesn't apply to all of the requirements that the largest banks face.

[4] And, to be clear, banks often have some assets that don't really have clear market values; if nothing else, traditional banks have office furniture, and any guess as to how much it could be sold or pawned for in an emergency is going to be pretty imprecise.

Tiebout sorting and local governance

I'm a fan of Tiebout sorting and institutional diversity in general; I would like for people moving to an area to have a practical choice of what kind of town and neighborhood they live in, and (for example) for people who want high taxes and high services to be able to live in a town that provides that while people who want low taxes and fewer municipal services to be able to choose that, instead of having towns in an area that have more between-town homogeneity and contentious fights in each town, with few people getting what they actually want.  Furthermore, citizens who want to pay high taxes to invest in long-run improvements (better roads, better schools, etc.) should be able to secure those investments from people who might move in and vote for lower taxes, milking the assets (in which the previous residents invested) as they depreciate.  To the extent that it's practical, people should get the local governance they want by choosing the town, rather than by changing it.  

There are extents, of course, to which it's not practical, or otherwise not desirable.  You don't want towns generally to feel they don't have to serve anyone who finds it comparatively easy to move, and a town that is poorly run needs to be ultimately accountable to voters.  If the preferences of citizens of a metropolitan area shift, even if you want to continue to have a variety of options, the mix of options will need to change.  While it may make sense for the people with less of a practical exit option to carry more weight in shaping how the town changes, you don't want institutional arrangements that lead to no towns in an area serving a large group of people in that area just because those people can move.  While I raise this as a warning against too little direct and immediate democratic accountability, it's also a danger of too much direct and immediate democratic accountability; Mayor Curley of Boston seems to have intentionally driven voters who didn't vote for him out of the city and into the suburbs to cement his hold on power.  The institutional arrangement should ensure that citizens who are willing and able to move between towns are well-served, while also making it hard enough for them to change the towns that they give serious consideration to voting with their feet and don't remove options for everyone.

In light of these considerations, I'm envisioning a conglomerate metropolitan area, perhaps like London, which has 32 "boroughs" with some variety of institutional arrangements and a fair amount of devolved power, but some centralized power as well.  One thought that I have is that the boroughs would have councils with some seats elected by the locals with the least practical exit options (however determined) but additional seats appointed by the central body, which would be elected by voters without regard to exit options.  If the population of a borough drops, perhaps the make-up of the local council would be less locally determined; perhaps there would also be some funding tied to population.  The hope is that the boroughs would be fairly distinct from each other, and people moving to the area for the first time or relatively able to move from one borough to another would have a variety of attractive options, while making it difficult for them to choose a different borough and try to make it more like those that already exist.

price controls and rationing

 There's been inflation, and there have been calls for price controls, and so I've been reading a bit about price controls in history.  Pretty much every time price controls with substantial bite[1] are implemented, you get shortages and black markets; additionally, I had failed to consider how expensive enforcement costs frequently are.  Usually the government gives up on price controls fairly quickly as it becomes clear that the problems created are worse than any mitigation; exceptions seem to be in cases where there is some other form of rationing taking place, typically in war time.

There may be a semantic argument whether rationing avoids shortages or repackages them, and they certainly don't avoid the black markets or enforcement costs, but they do create a little bit more reliability; sometimes consumers are unable to buy as much as the rationing system entitles them to, but it will be less common that they will be unable to buy anything than it will if there is not rationing and similar price controls are enforced.  This made me wonder whether, if price controls did gain political popularity now, we could mitigate some of their effects by implementing a rationing program as well.  After a bit more thought, though, it occured to me that this is a bit redundant; if you impose and enforce a rationing program, that should bring down market demand and reduce prices.  If the rationing is tight enough to bring prices to where you would "control" them, the control becomes superfluous; if it is not, then it isn't enough to restore the sort of reliability being sought with the controls in place, either.

As a political matter, perhaps the price controls would not be superfluous; the price controls may be the popular part, at least to the extent that people don't realize that it will amount to stochastic rationing.  The implementation cost, even if greater than many people appreciate, may also be less than that of a rationing system, and it would certainly tend not to fall directly on individual consumers to the same degree; carrying around ration coupons would be less convenient than heading to the store and seeing what they have in stock.  It would, however, keep prices "controlled" while substantially mitigating the biggest problem simple dictated price controls present — and you wouldn't even need the price controls themselves to do it.

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[1] If the price is set at $5, and the market price would be $5.10, effects will naturally be minimal; if the price is set at $5 and the market price would be $20, but only for a couple of weeks, some of the effects won't have time to develop.  I'm mostly considering settings where the price is kept well away from the free price for a substantial period of time.

Reg NMS

There is renewed discussion of the possibility of banning payment for order flow in the United States, and the proposed ban appears to be addressing some issues in the wrong way.  Those issues are oddities of "Reg NMS" --- that's "National Market System" --- that convert a dozen or so stock exchanges into a single, abstract "stock market".  And my proposal, ultimately, is that we ban exchanges from charging commissions to liquidity takers.

I want to note that this is ultimately an accounting requirement --- and Reg NMS is why it matters.  If I place an order to an exchange to buy a stock for $64.03, and the lowest price at which anyone is willing to sell is $64.05, the order sits there until someone comes along to sell at $64.03.  If and when they do, the exchange typically charges each of us a commission; I'm really paying $64.031, and they're clearing $64.028.  If the seller were not allowed to pay a commission, you could report the price as $64.031 instead, and charge me a .3 cent commission instead of .2 cents; the same cash changes hands in the same ways, we're just reporting the trade differently.

The problem is that, for many orders subject to certain concessions to the laws of physics (namely the speed at which information can be transmitted), an order to trade "at market" has to go to the exchange with the "best" price.  Because of this, some exchanges actually have a negative commission for liquidity providers --- they might charge me $64.029, and only pay the seller $64.026.  By telling a seller (or, more to the point, the seller's broker) who will only clear $64.026 by selling on my exchange that they can sell there for "$64.03", they can attract a sell order that could perhaps have cleared more (net of commissions) somewhere else.  By requiring that the commission be paid by the trader whose order is resting on the book, you're simply aligning the reported bids and asks with the prices that would actually be obtained by a trader hitting them.

Most of "payment for order flow" similarly constitutes a sleight-of-hand involving careful but economically meaningless distinctions between "prices" and "commissions".

bounded cognition in evolutionary game theory

Suppose you have a set of agents that, for behavioral and strategic reasons, all "cooperate" with each other, but would recognize if one of the other agents started to "defect"; cooperating would be an evolutionarily stable strategy in this context.  If the society gets larger you might expect there to be a point (Dunbar's number, for example) where the agents can't keep track of all of the other agents anymore; suppose, in fact, that we have 1400 agents, each of which is designed to keep track of 140 agents.  As long as all but a couple of agents continue to "cooperate", you're still fine; if the number creeps above 20 or so, then the information required to keep track of who has been cooperating and who has been defecting gets to 140 bits, and so one might suppose that would overwhelm the agents, and there would be a tipping point around there where cooperation would break down.

free will

 At some point I intend to read some philosophical works on free will and determinism, but I want to record a thought I have that may be unoriginal, refuted, or both.

"Free will", as I think about it, I believe entails the ability to take an action that was not predetermined.  ("Causality" on some level requires free will, because I have to have a sensible way of thinking that Y did happen when X did happen but wouldn't have happened if X hadn't happened; I need for the very notion of a counterfactual to make sense.  Part of the reason I'm interested in free will is that I'm interested in causality.)  Perhaps, however, if I live in a world that is ultimately deterministic but in which I in some practical sense can't predict whether X will happen, but can predict that Y will happen if X does, perhaps that gives rise to the perception of "free will" that I require.  If minds of the a similar order of complexity to my own are unable to predict whether I will do X or not, perhaps that amounts to "freedom".

This perhaps fits into the notion of "compatibilism" -- again, I haven't read as much as I eventually should.

rationing

My previous post mentioned power shortages in Texas; to some extent generally, but especially when there are power shortages, retail allocation of electricity in the United States is mostly not done by a market mechanism.  Similarly, the covid vaccine is not being allocated by market mechanisms.  In both cases, more centralized government or quasi-government organizations are making decisions about priorities.

In all cases, it seems that an important consideration for the prioritization schemes should be pump-priming; you have this resource that is bitingly scarce, with a high marginal benefit, and so first and foremost you would prefer not to have to make choices, that is to have as much production as possible.  In both cases we seem to have had failures of this sort; some of the shortage of gas to gas-powered electricity generators appears to have been due to power cuts to gas infrastructure, and while health care workers were given high priority for vaccines, apparently the vaccine makers themselves were not, and have suffered some slowdown because of employees out during the third wave.

In an idealized market, the gas systems would have outbid other buyers for power, and vaccine producers, being paid marginal benefit for additional vaccine production, would outbid most buyers to allocate those vaccines to their own employees.  In a (politically and otherwise) realistic market, I don't know whether that would have worked out.  In any case, it seems like a useful point for future designers of rationing schemes to keep in mind; if a scarce good is extremely valuable, then using some of it to produce more of it is probably a good idea.