Eric Tymoigne
Assistant Professor, Lewis and Clark College
Research Associate, Levy Economics Institute
of Bard College
Abstract
For
more than 40 years, Hyman P. Minsky thrived to develop a theoretical framework
that can help to understand the instability of capitalist economies. At the
core of his analysis is the Financial Instability Hypothesis that states,
“stability is destabilizing,” i.e. that a period of economic stability creates
a financial environment that makes an economy susceptible to a debt-deflation
process. This framework emphasizes the importance of studying the needs and
sources of position-making operations, and defines the essence of financial
fragility as Ponzi finance. The latter, contrary to bubbles or financial
imbalances, is easy to capture, is non-arbitrary, and is strongly related to
fraud and price instability. This approach to financial instability focuses on
the financial practices sustaining a specific price and growth trend, rather
than on arbitrary norms of “prudence,” or the “irrational” behaviors of
individuals. By defining financial fragility via the Ponzi finance criterion,
central bankers will increase their powers of persuasion and justification, as
well as the legitimacy of their actions. This criterion also provides the
foundation for a new regulatory framework that is highly proactive at capturing
changes in financial practices.
By discouraging, and if necessary forbidding,
legal and illegal Ponzi processes, the central bank will promote price
stability, will help to constrain fraudulent behaviors, and will promote
financial stability.
Keywords: Financial Crisis, Economic Boom, Minsky, Regulation, Supervision,
Central Banking
JEL Codes: E58, E61, G01.
Introduction
Since the
end of the 1990s, economists have been increasingly interested in issues
related to the role of financial stability and asset prices for central
banking. Those issues includes, among others, the relationship between
financial stability and price stability, the role of asset prices for inflation
targeting, and the role of the central bank in the management of asset-price
bubbles (Tymoigne 2009a). The current financial crisis has reinforced this
interest in financial issues, and concerns about systemic risk are at an all
time high with many major reports on financial reform dealing with this issue
(Tymoigne 2009b).
While some
contemporary economists have provided some interesting explanations of the
causes of financial instability and their implications for central banking,
most economists have ignored the contribution of Hyman P. Minsky. He spent his
entire career studying those issues, and his framework of analysis provides a
solid point of departure to study them. Minsky argues that the common
denominator of all systemic financial crises is found in the way economic
activities are financed and funded. He argues that during periods of relative
calm, when economic results are good, people tend to rely more and more on funding
methods that require growing refinancing and/or liquidation at rising prices in
order to service debt commitments. Minsky calls this Ponzi financing and argues
that its growing use is the normal result of long-term economic stability,
rather than the results of market or individual imperfections (asymmetry of
information, behavioral biases, lack of financial education, etc.).
The concept
of Ponzi finance provides several insights when one tries to provide an answer
to the role of asset prices for central-bank policy, and, more broadly, to
regulatory and supervisory issues. For example, rather than focusing on the
notion of bubble, central bankers should focus on the financial practices
underlying a given asset-price trend. Similarly, rather than focusing only on
the detection of fraudulent practices, regulators and supervisors should focus
also on the financial practices sustaining an activity because Ponzi finance
can be perfectly legal.
The first
part of this paper provides a quick refresh on Minsky’s financial instability
hypothesis. The second part explains the notion of Ponzi finance. The third
part presents some of the implications Ponzi finance in terms of asset-price
management and regulation. The fourth part quickly shows how this Ponzi approach
to financial instability can be implemented.
Financial Instability
Hypothesis
The current
literature on economic instability focuses on imperfections in order to explain
booms and busts. Those imperfections concerns market mechanisms (leading to
market failures) or individuals (leading to irrational exuberance and
pessimism). In terms of the former, Mishkin (1991, 1997) and Kiyotaki and Moore (1997)
explain how an initial adverse shock propagates in the economy through
asymmetries of information in order to create a debt-deflation process. Suarez
and Sussman (1997, 2007) have completed this imperfection view of economic
instability by focusing on the reversion mechanisms. In terms of individuals’
imperfections (relative to the homoeconomicus
framework), behavioral finance provides an explanation “anomalies” and
“behavioral biases” like excess optimism, excessive confidence, excessive
rationalization, or excessive agreement among analysts (De Bondt 2003). This
provides an understanding of how mania, panics, and crashes occur even if there
are no market imperfections. Both types of imperfection can be combined to
provide a broader view of financial instability.
Minsky and
other Post Keynesian economists provide a very different explanation of
economic stability that does not focus on imperfections but rather on the
internal logic of capitalist economies. Contrary to the previous economists,
Minsky argues that market mechanisms do not lead to a stable equilibrium but
rather generate instability. This holds true even if there are no imperfections
from the part of markets and individuals. One of the main reasons Minsky
reaches such a different conclusion is because the premises of his analysis are
very different. He focuses on monetary economy rather than a real exchange
economy. In the former, money is never neutral (because it is needed to begin
the economic process and because the relevance of an economic activity is
judged in relation to its monetary profitability rather than its productivity),
and people live in an uncertain world, which leads to a social rationality (in
which behaviors based on social conventions and other heuristics are rational)
rather than a hedonistic rationality.
Given such
different premises, the explanation of the financial crisis is also very
different and is summarized by the financial instability hypothesis. According
to the latter, over enduring economic expansion, the economic units leading the
growth process (possibly followed by other economic units if time allows) tend
to become more and more financially fragile to the point that a not unusual
adverse fluctuation in key economic variables (income, interest rate, etc.)
generates economic instability. This tendency does not result primarily from
mania and over-optimism and may not be accompanied by any bubble.
In order to
conceptualize the degree of financial fragility (i.e. the propensity of an
entity to be financially unstable), Minsky created three categories that
characterize a specific financial state: hedge finance, speculative finance and
Ponzi finance. Each of these categories is expected to require more or less
position-making operations, i.e. refinancing and/or asset liquidation, in order
to meet debt commitments (e.g., hedge finance is not expected to require any
position-making operations). Position-making operations are needed each time
net cash flows from core economic activity (operating income less operating
expenses) and cash reserves are too low to service debts.
According to
Minsky’s financial instability hypothesis, over enduring economic expansions,
there are forces in the economic system that push more and more economic units
away from hedge finance and toward Ponzi finance. This growing use of Ponzi
finance results from deliberate choices (induced by will or by necessity) and
from forces beyond economic agents’ control that weaken their financial
position. The forces at play are numerous and varied (Tymoigne 2009a, 2010) and
Minsky always emphasizes their dialectical aspects. If one focuses purely on
the economic forces at play, there are at least four economic factors that
promote instability.
First,
competition for monetary accumulation pushes economic agents to try to guess an
uncertain future in order to obtain a bigger monetary profit relative to their
competitors. This race toward the future is the source of the productivity of
the capitalist system, but also of its instability. Indeed, it forces
individuals to forget about the big picture concerning where the economy is
heading, and to narrow their effort on beating the competition by all means
(sometimes illegal) because their own economic survival is at stake. One of
this means is the use of debt; for example, managers are not rewarded for
managing a stable business but for an aggressive expansion of their market.
Second,
competition is an essential ingredient in the formation of conventions and
their wide use by economic agents. Indeed, given the fast pace,
“in-the-present” world of entrepreneurial leadership, the sociological and
psychological factors brought forward by Keynes, Galbraith, Tversky, Kahneman,
Shiller and others tend to be exacerbated. Also, competition pushes competitors
to follow those who perform best, and to ignore information that is too costly
to obtain or, even if costless, that could threaten a competitive position
(Morgenson 2008; Schinasi 2006; Galbraith 1961).
A third
economic factor that promotes instability is the shortening of the maturity of
debts. According to Minsky, the proportion of short-term debts (short relative
to the maturity of the operations they fund) tends to grow over a sustained
economic expansion, because they are less expensive and because refinancing
operations grow. Shorter maturity compounds the effect of higher interest rates
on debt-service payments by increasing the speed of repayment. Shorter maturity
also creates a need to refinance and so make an economic unit more vulnerable
to disturbances in the financial sector.
A final
economic factor that may promote instability is financial innovations. The
latter are essential to maintain the profitability of financial institutions
because, like for any other industry, the market for a given product always
ends up saturating. Over a period of enduring expansion, innovations involve
extending the use of existing financial products to more risky enterprises and
the creation of financial products with higher embedded leverage. This is
required by market mechanisms in order to maintain profitability at a
satisfactory level and not to lose market shares, and this was illustrated
nicely by the last mortgage boom (Tymoigne 2009b). In addition, new financial
products are marketed as sophisticated products that are better able to measure
and/or to protect against risks associated with leverage, which tends to let
people believe that the use of debt is safer than in the past (Galbraith 1961;
Tymoigne 2009b).
Ponzi Finance
The central
concept that defines financial fragility is Ponzi finance, which is also called
interest-capitalization finance; both income and capital servicing on
outstanding debts are expected to be met by position-making operations. A Ponzi
process is an unsustainable financial process. Indeed, in order to persist it
requires an exponential growth of financial participation, which is not
possible because, ultimately, there is a limited number of economic agents that
can participate either physically or financially. This unsustainability is all
the more true that Ponzi finance creates a strong pressure to perform because
creditors must be paid (to avoid legal, reputational, and financial costs),
which gives the incentive to take more risk and to be involved in fraud.
Ponzi processes
may not be masterminded by a single individual, or a small group of
individuals, but, rather, may be sustained (and approved) by the whole society.
In any case, those already in the Ponzi process have an incentive to picture a
good view of the future to entice others to join the process. This is
reinforced by the great returns that the Ponzi scheme may have provided in the
past, which, combined with competitive pressures and social pressures, gives
additional incentives to join.
Some forms of
Ponzi finance are more dangerous than others, which depends on the way the
economic units involved in it plan to get out of it. The most dangerous of all
Ponzi finance processes are those for which liquidation and/or unlimited growth
of refinancing are necessary for the process to continue, also called pyramid
schemes; there is no way to terminate the process besides collapse or
widespread restructuring of financial commitments. Examples of those processes
are the mortgage practices of the 2000s, consumer finance practices of the past
two decades, and the Madoff scheme. The least dangerous Ponzi finance practices
involve the temporary use of growing refinancing before net cash flows from
assets operation are expected to become large enough; this usually implies that
the economic units involved in the Ponzi process have some market power. For
example, the construction of investment goods takes time and must be financed;
however they do not generate any cash inflows (for producer and acquirer) until
they are finished and installed in the production process. Thus, a producer’s
(and his creditors’) profitability depends on the capacity to sell the finished
product at high enough price.
From the point of
view of systemic stability, both types of Ponzi finance (pyramid/structural or
production/temporary) are a source of concerns because, as long as they exist,
the economy is potentially subject to a debt-deflation process. It is thus
important to forbid pyramid processes, and to discourage as much as possible a
Ponzi financing of economic activities. In addition, production Ponzi
processes, even though “respectable” (Minsky 1991: 16), become highly dangerous
when they sustain a pyramid process. In this case, the buyers of new capital
assets borrow extensively to acquire the latter, and, independently of their
motive (speculation or operation), plan ultimately to meet debt services
through growing refinancing and/or by selling the capital assets at a higher
price. The housing boom of the past decade is a good illustration of a case for
which the two types of Ponzi finance were interconnected (Wray 2007; Kregel
2008; Tymoigne 2010).
Ponzi finance is
different from speculation and is not generated necessarily by greed or fraud.
Speculation is defined as taking an asset position with the expectation of
making a capital gain from selling the asset. In a speculative deal,
liquidation is a means to make a monetary gain, whereas, in a Ponzi process,
liquidation is a means to service financial commitments, without necessarily
involving making a gain from liquidation. In fact, people involved in a Ponzi
process may hope that they will never have to liquidate their position (at
least in net terms) because this would lead to a collapse of the process.[1] Speculation with borrowed
money is a form of Ponzi finance; however, the latter occurs in speculative and
non-speculative activities. For example, the recent mortgage boom was sustained
by a Ponzi process that involved individuals who truly wished to stay in their
home (Tymoigne 2009b, 2010). In addition, Ponzi finance may not be entered by
choice but may be forced on individuals by rising interest rate, rising costs
of operation, unexpected large decline in after-tax revenues and other
unexpected factors affecting cash inflows and cash outflows. Finally, Ponzi
finance is also different from fraudulent behaviors because some individuals
may enter Ponzi processes while playing by the rules of law, and while
following the norms of behaviors established by society. Thus, everybody may
behave “wisely” or “properly” but still may contribute a great deal to a rising
financial fragility.
Ponzi Finance and the
Financial Instability Hypothesis: Some Implications
Bubbles
There has been a
tremendous amount of debate among economists about the role of the central bank
in the management of bubbles. Some authors want the central bank to intervene
directly to prickle the bubble, whereas other state that the central bank
cannot do that effectively and has no role to play in the valuation of assets
(Tymoigne 2009a). If one follows the previous framework of analysis, this focus
on bubbles is not appropriate for economic and policy reasons.
In terms of
economics, what really matters for economic stability[2] is not how well asset
prices are valued relative to a “fundamental” value, but the financial
practices that sustain an existing price trend. Everybody may agree that assets
are priced well, but this state of affairs may be sustained only by Ponzi
financial practices, which are unsustainable even if financial markets are
efficient. Thus, by focusing its effort on discovering bubbles, the central
bank will miss the trends that generate instability and may see bubbles where
there may be none. Finally, if somehow the central bank thinks there is a
bubble but the latter is does not depend on a Ponzi process, then, from the
point of view of financial stability, it is not relevant because, when it
burst, it will only generate minimum financial disruptions.
In terms of
policy, a central bank that decides to intervene to prick the bubble puts
itself in the odd spot of justifying its action. Even if this only temporary
deflates asset prices, central bankers will be condemned as “wealth killers”
and will be subject to tremendous socio-political pressures to leave asset
prices alone. The justification of its action is all the more difficult that
the determination of a “fundamental” value is subject to a social valuation and
that this valuation sustains massive financial interests. People already in the
market must find ways to justify/rationalize why they took an asset position
and, especially if there is a Ponzi process at play, must find ways to pain a
rosy view of the future to attract more people in the process (Shiller 2000):
The mass escape
into make-believe, so much a part of the true speculative orgy, started in
earnest. It was still necessary to reassure those who required some tie,
however tenuous, to reality. And, […] the process of reassurance—of inventing
the industrial equivalents of the Florida climate—eventually achieved the
status of a profession. (Galbraith 1961: 16-17)
The
point is not that no fair price can be determined, but, because this fair price
rests on a vision of the future, it is subject to interpretation, and
fundamentals are a social creation sustained by a convention (or “model of the
model”). The latter provides a vision of the future and defines some norms of
proper behaviors, which provides an anchor for current and past decisions. An
example of a convention is the New Economy story of the 1990s that was used to
justify (ex post) the seemingly unjustifiable rise in stock prices.[3] Thus, financial-market
participants may protest that the central bank is imposing a view of the future
that is in direct contradiction with the views of thousands of professionals
who are deeply connected to the market. This confrontational approach is,
therefore, extremely ineffective at promoting financial stability in a smooth
way.
Financial Imbalances
Borio and Lowe
(2002, 2003) and other authors have proposed to avoid the problems posed by the
management of bubbles by focusing on the notion of financial imbalances.
According to those authors, the latter can be checked by looking at the growth
of credit, the growth of investment, and the growth of asset prices. To these
different measures, it is possible to attribute thresholds that will define if
there is an unsustainable boom in the economy.
While this is an
improvement over the bubble argument because it focuses, at least in part, on
the financial practices sustaining an economic trend, and while it might be the
only thing that can be done practically for the moment given the limitation of
data and modeling techniques, there are at least two drawbacks to this approach
that both relate to the definition of the trend.
First, one needs
to define the appropriate trend for the variable that measures financial
imbalances. If based on historical data, critics will state that past data are
irrelevant because the system has changed in such a way that a higher growth
path of credit can now be sustained by the economy. This will be justified by
the new financial products that allow to protect against financial risks more
thoroughly and by the “long” period of economic stability (which will be
brought forward as the ultimate illustration of the competitiveness and
efficiency of the financial sector). In addition, even if everybody agrees that
the trend used is the “normal” trend that should be followed, norms changes
overtime and tends to be influenced by the optimism and pessimism of economic
agents. Thus, if the normal trend is set right after a period of financial
debacle, it may be too stringent and may constrain economic growth. On the
contrary, over a long period of economic stability, the normal trend may be
loosened to accommodate the needs of economic growth, without accounting for
the financial implications of this change.
Second, defining
an arbitrary norm for the growth of asset prices is not dealing with the heart
of the problem, i.e. the fact that financial positions are becoming more
fragile over periods of enduring expansion. Thus, as long as the growth of
credit will be below the normal growth trend, it will be assumed by regulators
that there are no problems and that economic units are engaged in “safe” and
“prudent” financial practices. However, as the financial instability hypothesis
makes it clear, it is when everything seems “normal” that dangerous financial
practices develop; therefore, central bankers and other supervisors should be
especially careful in their analysis of financial institutions during normal
times.
In the end, there
is no a priori “right,” “proper,” or
“optimal,” leverage ratio, credit growth ratio, and other ratios; this can only
be determined by the financial practices that a certain trend generates:
Inasmuch as the
nature of mortgage debt changed markedly between 1929 and 1962, the larger
household debt-income ratio in 1962 may not indicate a greater sensitivity to a
shock. (Minsky 1963 (1982): 10)
What
matters is how matched cash inflows and cash outflows are matched (given
maturity mismatch, leverage, etc.). A high cash-flow mismatch, in the sense
that outflows far outweigh inflows for normal business operation, requires the
use of position-making operations and this is what defines fragility. Ponzi
finance requires a growing use of position-making operations and so is
extremely fragile.
Financial Stability and
Price Stability
The relationship
between financial stability and price stability has been subject to numerous
studies. Some authors (e.g., Anna Schwartz) argue that price stability
guarantees financial stability, while others (e.g., Borio and Lowe) argue that
financial stability is a requirement for price stability (Tymoigne 2009a). If
one follows the financial instability hypothesis, it can be argued that
financial and price stability are interdependent but also that periods of
stability contain the seeds of instability.
Price stability
(i.e. low and stable inflation rate) provides entrepreneurs with an economic
environment in which the management of their business is much easier to
perform. This encourages entrepreneurs to project themselves longer in the
future and so promotes investment. However, a period of price stability also
promotes more adventurous funding mechanisms (in terms of both the quantity and
quality of external funding), and a decline in margins of safety against
expected and unexpected financial problems. This progressively leads to the
growing voluntary and involuntary use of Ponzi finance. Ponzi finance involves
either expectation of rising prices (output prices and asset prices) or growing
refinancing, or both. If Ponzi practices embed an expected capacity to raise
output price in order to meet financial commitments, and if entrepreneurs have
some market power, upward price instability will be generated. When the Ponzi
practices unfold, deflation will set in.
Financial
stability implies hedge financing and the latter usually involves the
generation of cash inflows by growing market shares. If this is case, financial
stability will promote price stability. However, hedge financing may also
depend on expected high inflation in order to generate the necessary cash
inflows from operations; in this case, the maintenance of financial stability
requires output-price instability.
Overall,
therefore, the relationship between price stability and financial stability is
not as straightforward as one may think. Price stability depends, in part, on
financial stability, and financial stability depends, in part, on price
stability; but there is no magic bullet. Focusing on the financial aspects of
economic affairs, which is where the central bank is the most effective, is the
best way the central bank can promote both financial stability and price
stability. It can do so by promoting healthy hedge financing and by
discouraging Ponzi financing.
Banking Regulation and
Supervision
Traditionally, the
regulatory financial framework has been organized in order to detect frauds and
“imprudent” risk management, and to make sure that economic incentives are set
“properly” to promote smooth economic growth. The current financial crisis has
shown one more time that this type of framework is not appropriate, and one can
provide several critiques to the willingness to improve risk management (by,
for example, having a flexible counter-cyclical capital adequacy ratio that
better fine-tuned financial risks) instead of reforming financial regulation
and supervision in a more profound way.
First, it is a
fact that in a society in which people are free to choose, they hate being told
what to do or being constrained in their decisions, especially financial
decisions. This is all the more so when those regulatory constraints are on the
way of lucrative activities, competitiveness, large egos, and immediate
improvement in the standards of living. As a consequence, economic agents will
adapt to the new regulatory framework and will innovate in their financial
practices in order to bypass (government and private) regulatory constraints.
Given that dramatic changes in regulation only occur during crises and are done
mostly with the input of financial institutions (which then know all the regulatory
holes in the new law), the innovative drive is sure to make the new regulatory
framework very rapidly irrelevant. Again, Minsky was ahead of all of us on this
issue:
To the extent that
the examination procedure lags rather than anticipates financial innovation,
higher insurance premiums [and capital requirements] on what examiners take to
be riskier institutions may not be a deterrent to risk-taking. In an expanding
economy, the increased cost of doing business caused by higher deposit
insurance premiums [and capital requirements] will be an incentive for banks to
invent new, unregulated forms of financing. (Campbell and Minsky 1987: 258)
Thus,
we need something different from a reactive and rigid regulation of risk
practices:
Anticipatory
vigilance upon the part of the regulators is required to prevent increased risk
exposure. But such vigilance, combined with intelligence, could contain
particular unit risk exposure without the imposition of risk-related premiums
or capital requirements. (Campbell and Minsky 1987: 258)
Having
a proactive and flexible regulatory framework that constantly accounts for changes
in financial practices (new products, new financial institutions, new
accounting methods, new ways of using of the previous things, etc.) and includes
them immediately in regulations, would be much better than improving
risk-management.
A second problem
with the view that improving risk-management will improve financial stability,
is that it is a highly permissive policy. Financial institutions are allowed to
do whatever they want as long as they meet the regulatory requirements. It does
not matter what financial practices they have and how excessive the risk they
take is, as long as capital is “high enough” and that they have a “prudent”
maturity matching and amount of reserves. Unfortunately, matched maturities,
low leverage ratio and high liquidity ratio do not necessarily reflect a prudent
and well-managed business, and a company may be able to sustain those ratios
only by participating in a Ponzi process (either as a direct manager, or, more
seriously, as part of the growth process of the overall economy). To take an
analogy, it is does not matter how many times a day a kid brushes his teeth,
eating candies continuously will result in cavities and a diabetic condition.
Third, setting the
appropriate weight on maturity mismatch and other proxies of systemic risks is
heavily influenced by our current experience (Brunnermeier
et al. 2009: 42). Overtime, financial institutions
may claim that this weight is too stringent and does not reflect the fact that
the institutional framework has changed and is now better able to account for
systemic risk. They will put forward as ultimate proof the “long” period of
stability and their record profitability and competitiveness. As a consequence,
there may be pressures to lower the weight attached to systemic risk, or
pressures to overlook facts that may call for rising CAR. This is so even if
CARs are set in function of a rule and this may take the form of a legalization
of new “creative” accounting practices. In addition, setting too stringent
weights will constrain economic growth and will draw further complaints.
All these problems
lead to a fourth problem. Indeed, bad regulation is destabilizing and creates
perverse incentives that compound the weaknesses of an existing regulatory
framework. Thus, inappropriate regulation and supervision may contribute to the
emergence and diffusion of a Ponzi process at the level of the overall economy.
Overall,
therefore, we need something better than a new reactive regulatory and
supervisory framework. We need a proactive framework built around the core
concept of position-making operations coupled with the financial instability
hypothesis. This regulatory framework would not be based on institution or
function but on the financial practices of specific entities, a sector of the
economy, and the whole economy. These practices would guide proposed changes in
institutional structures and the regulations of financial products. As a consequence,
the regulatory framework would be far reaching, would be quickly adaptable and
would be applied to all financial institutions without exception.
Fraud Detection
In addition to
focusing its effort on determining “prudent” management and making sure that
financial institutions comply with those norms of prudence, regulation and
supervision have concentrated their effort on detecting and eliminating frauds.
Unfortunately, this has been rather unsuccessful for both political and
conceptual reasons. Black (2005), a criminologist and former FSLIC supervisor
who was involved in the S&L crisis, explains why fraud detection has failed
for both reasons. Regarding conceptual aspects, he notes that the current
regulatory and supervisory framework promotes the emergence of frauds, and that
economists do not have the proper framework to understand why the top managers
of companies may be willing to use their own company to develop fraudulent
schemes:
The conventional
wisdom [among economists] is that moral hazard explains the debacle, that
control fraud was trivial, and that insolvent S&Ls honestly made ultrarisky
investments (and became high fliers) that often failed. All aspects of the
conventional wisdom proved false upon examination. (Black 2005: 13)
Criminologists
argue that one needs to think like a thief in order to understand fraud. In
this case, it is optimal to maximize adverse selection, to pay a high price for
insolvent companies, to hire incompetent yes-men, and to submit the entire
company to the optimization of fraud. This so even if CEOs and other top
managers have a large holding of stocks of the company they are looting. All
those behaviors are irrational in the current economic framework because “few
economists are prepared to see business people, particularly patrons, as
criminals” (ibid.).
Ponzi finance is
central in the propagation of fraud and its sustainability. Indeed, it allows a
company to grow very fast and to record enormous profits, which makes it
difficult for supervisors and regulators push for more supervision (Black
2005):
Fitch believes that
much of the poor underwriting and fraud associated with the increases in
affordability products was masked by the ability of the borrower to refinance
or quickly re-sell the property prior to the loan defaulting, due to rapidly
rising home prices. (Pendley et al. 2007: 1)
By
focusing their efforts on the detection of Ponzi finance, supervisors and
regulators will have a more effective way to detect frauds, and to push for
more detailed and lengthy supervision of suspicious financial institutions.
Indeed, in addition to the detection of illegal practices, the source of
profitability becomes a concern. It is well known by all financial-sector
professionals that companies can generate zero cash flows (even more so if cash
flows from business operations is concerned) even if they are highly
profitable, and that accounting profit can be manipulated easily to meet
expectations (Das 2006: 138ff.). In both cases, a high profit (in addition to
other accounting tricks) may hide a growing need for position-making
operations.
Ponzi Finance, Financial
Instability Hypothesis and Central Banking
Regulators and
supervisors need to focus their attention on the financial practices that
sustained an economic activity. They should be especially worried when
refinancing loans are growing rapidly relative to outstanding debts, and when
the liquidation of encumbered assets is seen as a normal and convenient way to
meet debt commitments. This was illustrated very well by the recent mortgage
boom that was sustained by a Ponzi process that involved, in addition to frauds
and risky borrowers, prime and honest borrowers who truly wished to stay in
their home (Tymoigne 2009b, 2010). By focusing on financial practices and by
taking the concept of Ponzi finance as criterion of instability, regulators
will have a clear non-arbitrary point of reference to justify their action.
Checking for Ponzi Finance
In order to detect
Ponzi financial processes, several things should be analyzed. Most important of
all is the analysis of cash inflows and cash outflows induced by assets and
liabilities (both on- and off-balance sheet), and the determination of the
position-making needs and practices. Once this is done, supervisors should focus
their attention on detecting the sensitivity of balance sheets to declines in
asset prices and to the unavailability of expected refinancing channels.
Theoretically, this can be done for a single financial institution, a specific
sector of the financial sector, the entire financial sector, or the whole
economy. For the moment, this has been mainly restricted (in a limited way) to
individual financial institutions in order to detect fraudulent activities and
imprudent behaviors, but a macroeconomic perspective would be very helpful to
catch legal and illegal Ponzi practices. At this point, we are missing
macroeconomic accounting framework that focuses on cash flows (rather than
income (NIPA) or balance sheet (Flow of Funds)).
In terms of
balance sheet, a Ponzi process usually implies high maturity mismatch, high
leverage and the use of exotic refinancing sources, but this state of affair
can be hidden by complex “creative” accounting practices and by the fact that
it is relatively recent. In addition, the central characteristic of Ponzi
processes is that there is a cash-flow mismatch, i.e. the fact that net cash
flows from normal business operation are expected to be too low to meet cash
outflows on debt commitments. Even if maturities are matched, there may still
need a need to refinance and to liquidate. For example, say that an economic
entity has a perfect maturity matching with a 10-year fully amortized
promissory note on its asset side and a 10-year unamortized debt on its
liability side. Even though both maturities are matched, the cash-flow pattern
of each side is extremely different, leading probably to a need to refinance in
10 years.
Measuring Creditworthiness
Promoting the notion of Ponzi finance also leads to a
redefinition of creditworthiness based on cash flow rather than credit history;
this is especially true for regulatory and supervisory purposes.
Creditworthiness should be differentiated from probability of default, credit
rating and FICO score. Indeed, rather than measuring the risk of emergence of a
Ponzi process (“how will you pay on time?”), these three concepts measure the
risk of loss for the lender (“will you pay on time?”) independently of the
repayment method. Of course, the probability of default is highly relevant for
financial institutions because some borrowers may default even if they still
can repay. As the current crisis shows, if home value declines steeply and
generates large negative net worth, it may make economic sense for some
individuals to default even though they could still easily service their
mortgage (Elul 2006). Thus, probability of repayment is much more important for
bankers than knowing how a borrower will repay. Similarly, credit “ratings are
driven by the size of credit support, which is, in turn, driven by the expected
losses from the pool, which are driven by the inherent risk of default in the
pool” (Kothari 2006: 61). Thus, “ratings of mortgage-backed structured
instruments relied heavily on CARs’ assumptions about future house price
movements and broader economic conditions” (Financial Stability Forum 2008:
35). Indeed, house-price trends affect the default probability (by affecting
the negative-equity trigger) and the recovery rate, which are both central to
determine average expected losses. Finally, the FICO score also tries to answer
the “will you pay on time?” question based on past delinquencies, past
foreclosures, outstanding debt amounts, types of credit and other factors
present in the credit report (Fair Isaac Corporation 2007: 10). It ignores totally
cash flows.
As the reader may have noted, one of the main problem
with the credit-history approach to creditworthiness is that a destabilizing
feedback loop emerges. Indeed, some people will qualify for a loan not because
it is expected that they can service payments but because it is expected that
collateral prices will go up. Thus, the rating process may encourage a Ponzi
process: for example, the faster the housing price growth, the higher the
recovery rate and the lower the default rate, the lower the expected loss, the
higher credit ratings and the more people qualify, which sustains the growth of
house price…until not enough people can be qualified to overcompensate for
foreclosures. Thus, a Ponzi process may contribute to a decline in default probability
and an increase in credit ratings, while creditworthiness would actually worsen
if judged with the criterion “how will you pay on time?”
By taking a cash-flow approach to creditworthiness,
the risk of occurrence of a Ponzi financial process will be limited and so the
possibility of large negative equity
will also decline (negative equity is not the only source of default and has to
be quite large to generate default), which lowers the default probability and
so contributes to the health of financial institutions. Further work should be
devoted to this distinction between creditworthiness, willingness to repay on
time, and expected loss. Financial institutions are more interested in the
latter two because they affect directly their profitability greatly but a good
credit history may have been sustained only on the basis of Ponzi finance
(which indirectly, and through long and complex lags, negatively impacts
profitability). We need a painstaking analysis of borrowers’ cash inflows and
cash outflows based on sources.
The cash-flow approach to creditworthiness should be a
central element to determine if a financial product is adequate for a specific
customer. It aims at determining if borrowers can repay on their own, rather
than if lenders can recover their stakes by
any means. This measurement of creditworthiness should be based on expected
operational net cash inflows relative to full cash outflows from liabilities
(many people were qualified during the mortgage boom on the basis on
introductory interest rates). In addition, the liquidation of encumbered assets
should be considered as an abnormal source of cash inflow and so should not be
included in the measurement of the capacity to repay. Doing otherwise will
contribute to a Ponzi process.
None of this implies that lender should not include
the possibility that the value of assets will decline before granting a advance
of funds, but that is different from figuring out if a borrower can meet debt service payments on its
own. Relevant questions would be “what is the decline in house price that will
prevent to recover stakes in the event a borrower unexpectedly defaults?” “what
is the decline in home price that would be necessary to generate a default?”
Thus, home prices matter to determine the profitability of a mortgage, but they
would be used as a means to determine the available buffer against unexpected
incapacity to pay, rather than as a means to figure out capacity to pay; they
would be used in a defensive strategy rather than an offensive strategy.
Managing Financial Inventions
Maintaining a
competitive profitability requires that financial institutions constantly
innovate by creating new financial products or by using existing financial
products in new ways. Over enduring periods of relative calm (small short
recessions), those innovations involve higher leverage, higher credit risk, and
higher liquidity risk, and it is the duty of regulators to adapt regulation and
supervision as quickly as possible before things get out of hands. Regulators
must discourage Ponzi innovations, even if financial institutions claim that it
is the only way they can maintain their profitability and stay competitive,
because ultimately they lead to financial crises, destroy financial
institutions, and threaten the viability of the entire economy. In addition,
given that competition is the only mechanism used to select financial
innovations, the “good” innovations are the ones that raise profitability
irrespectively of the impact on systemic risk, which is at odd relative to the
way society regulates inventions in other sectors. Thus, rather than pushing
for all kinds of financial innovations that provide short-term monetary gains
and lead to long-term economic instability, a government should motivate
financial firms to create financial products that make them reputable for a
sound and reliable financial system. This is where a good understanding of
systemic risk based on a cash-flow analysis becomes very important. Not all
inventions are worth becoming innovations.
In addition to monitoring financial innovations, a
patent system could be created to reward safe innovations. Too much competition
prevents the emergence of well-crafted innovations, and promotes sloppy
financial products that do not respond to the needs of customers and that are
prone to generate Ponzi processes. Das provides a nice insider view of those
tendencies:
We need
‘innovation’, we were told. We created increasingly odd products. These obscure
structures allowed us to earn higher margins than the cutthroat vanilla
business. The structure business also provided flow for our trading desks. […]
New structures that clients actually wanted were not that easy to create. Even
if somebody came up with something, everybody learned about it almost
instantaneously. […] Margins, even on structured products, plummeted quickly.
(Das 2006: 41)
A patent system would help
financial companies to take the time to create innovations that respond to the
needs of clients and that promote safe financial practices. Combined with
government monitoring, it would encourage financial institutions not to
innovate more (they already innovate a lot), but, to develop better financial
innovations. This will be good for the competitiveness of financial
institutions by raising the quality of financial innovations.
Conclusion
This paper shows
some implications of putting the concept of Ponzi finance at the core of
central banking policies. Ponzi finance provides a common denominator to grasp
unsustainable financial tendencies, to promote financial and price stability,
and to detect fraudulent behaviors. It also promotes a smoother economic growth
that relies on stronger financial grounds. Finally, it also provides a clear,
non-arbitrary and unique criterion to manage financial stability because Ponzi
finance is the essence of financial fragility. Ponzi financial processes are
collapse-prone and pyramid-Ponzi process always collapse, no matter how
sophisticated and well-informed individuals are, and no matter how efficient
and transparent financial markets are.
The concepts of
Ponzi finance and Financial Instability Hypothesis, when combined, have several
consequences for central banking. In terms of the management of asset prices,
they show that what matters is not the relationship between market value and
fair value, i.e. bubbles, but the financial practices that sustain an
asset-price trend. This will allow the central to intervene more forcefully and
convincingly in the financial-market, through moral suasion or through direct
management of financial practices (leverage ratio, asset positions, etc.) in
order to promote financial stability.[4] Raising interest rates, if
the asset-price trend is sustained by a Ponzi process is not the way to go
because the system is then extremely fragile. In terms of regulation and
supervision of financial institutions, they show that what matters is not how
“well” or “prudently” managed financial institutions are relative to arbitrary
norms. We need a more proactive regulation that directly prevents companies to
take excessive risk, the latter being defined in relationship to Ponzi finance.
This implies managing the financial practices of financial institutions as well
as the structure of the financial sector. Bubbles and financial imbalances are
too loose concepts to give a strong legitimacy to regulators and supervisors,
and they are inappropriate to deal with the detection of unsustainable
financial practices. The same applies to CAR and other regulatory ratios
because they are both too rigid and too permissive.
This type of
central banking activities would imply putting a lot more focus on financial
stability relative to what has been done currently, with central bankers mainly
concerned with output-price stability. In order for that to be the case,
meetings similar to the FOMC meetings should be established that focus
exclusively on financial issues and that involve financial regulators and
members of Wall Street and Main Street. That would allow regulators to stay in
touch with changes in financial practices and would allow them to detect Ponzi
processes early. While all this could be done by relying solely on qualitative
analysis and brainstorming sessions, a good tool to develop would be a
macro-accounting framework that accounts for the financial interdependences
between financial institutions. This framework would emphasize cash-flow
interdependences and the needs for position-making operations, as well as the
strength and sources of the channels allowing those operations to proceed.
There are
many other implications of taking the financial instability hypothesis
seriously in terms of market structure, of the creation of a regulatory
institution that is able to deal with financial issues properly, of the type of
financial institution that should be regulated and supervised, of financial
education, and of off-balance sheet accounting (Tymoigne 2009a, 2010).
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[1] Gains for the individuals involve in the process come from holding
the asset (e.g., a home), fees from managing the schemes, and other monetary
compensations funded by attracting additional participants.
[2] Even though bubbles may not affect economic stability, they usually
generate a misallocation of resources.
[3] Greenspan and other central bankers were strong believers in the
New Economy story (Tymoigne 2009a). In this case, we are back to the previous
problem generated by wondering if there is a bubble or not; this is asking the
wrong question because what matters are the financial practices that sustain
economic growth and asset prices.
[4] This direct management already exists (e.g., prompt corrective
actions), but it is only applied in a reactive way (problems may develop and
take dangerous proportions well before regulatory ratios are violated) and a
rigid way (a given regulatory ratio may be too stringent).