Lecture 3 Bounded Rationality Theories PDF

Lecture 3 Bounded rationality theories and objectives of financial market regulation Diego Valiante, Ph.D. Opinions expres...

Lecture 3 Bounded rationality theories and objectives of financial market regulation Diego Valiante, Ph.D. Opinions expressed are strictly personal and cannot be LEIF Master Programme attributed in any way to the European Commission.  Agenda The Robinson Crusoe’s economy Coase Theorem and its evolution Key market theories Efficient Market Hypothesis (EMH) Market failures 1. Information asymmetry 2. Public good provision 3. Negative externalities 4. Knightian uncertainty 5. Market power (e.g. natural monopoly or cartel) 6. Bounded rationality Objectives, regulatory strategies and limits of financial markets regulation © Valiante Diego - 2  Some introductory remarks So far, we have looked at market failures involving parties that are acting ‘rationally’. Now, we relax this assumption, introducing the concept of ‘bounded rationality’ ‘Bounded rationality’ refers to “behaviour that is rational in its intentions, but in reality is only limitedly so.” (H. Simon 1957) – It involves somebody that tries to behave rational, but in reality that does not happen because of the factors we are going to discuss next. – Please, note that this is nor ‘irrationality’ in stricto sensu (which is an unconscious unpredictable behaviour), nor ‘rational apathy’ (conscious economically rational behaviour not to act) © Valiante Diego - 3  The theory of ‘satisficing’ (Simon 1944, 1956) Utility maximisation is a simple concept (even mathematically; first derivative equal to 0), but the reality is much more complex. Expectations about choice are ‘adaptive’ to the circumstances (to the search costs) and not independent from search costs (as in the case of rational expectations). – Instead of optimisation/maximisation, we should talk of an ‘aspirational’ process, i.e. individuals make choices that are merely ‘satisficing’, not ‘utility optimising’. Let’s think of a bunch of needles in a haystack – Find the one that is good enough to sew (the search costs depend on the density of these needles among all needles in the haystack) – Find the sharpest one (the search costs depend on the overall size of the haystack) – Search costs are dependent from the dimension/complexity/context of the choice. © Valiante Diego - 4  6. Bounded rationality Optimisation requires ‘commensurability of value of choices (i.e. measurability by the same standard), but that is not possible under: – Uncertainty (negative/positive effect in different circumstances) – Multiple agents (some are going to lose and some will gain) – Multiple dimensions (gain and losses are expressed in two different dimensions) We will see how the optimisation function does not say much about the ‘real’ utility function. Human behaviour is contingent on context and other psychological factors that make them deviate from a ‘rational’ choice. Key cognitive biases and heuristics (rule-of-thumb strategies) affect: – Judgment (i.e. valuation of different options) – Decision-making (i.e. taking the utility-maximising decision) © Valiante Diego - 5  6. Bounded willpower and self-interest Bounded willpower and self-interest are two additional types of violation of the utility maximisation at individual level (Jolls et al. 2000) – Bounded willpower refers to situations in which people take action knowing is against their long-term interests Most people say that they prefer not to smoke and then pay money to obtain a drug that helps them to quit – Bounded self-interest refers to situations in which people act as if they care about others People care about being treated fairly and want to treat others fairly if they are themselves being treated fairly There are, more generally, concepts like ‘altruism’ and ‘loyalty’ that are not always explained by rationality or bounded rationality theories. It is de facto the unconscious behaviour of individuals acting on ‘hidden interests’ This is not the case for bounded rationality biases and heuristics, whose factors are visible, just not entirely to the one affected by them. – So, you can prevent them from a policy standpoint, while an ‘irrational’ behaviour in stricto sensu (or a behaviour driven by hidden interests is unpredictable. © Valiante Diego - 6  Quiz Time © Valiante Diego - 7  The Expected Utility Theory & its Anomalies © Valiante Diego - 8  The Expected Utility Theory (EUT) – Expected Values The Expected Utility Theory (EUT) and its assumptions still today dominate the normative approach to economic theory. – Easy to model mathematically, which accelerates logical thinking First formulation. By Bernoulli in 1738, who resolved the St Petersburg Paradox (SPP), which tried to show the weakness of the expected value (EV) theory. – EV says that every individual would pay for a lottery up to the expected value. SPP shows that a lottery where you toss a coin and you get head, you would receive €2 and the game ends. If you get tail, you can toss it again. The prize this time for head is €4 and so on. – The EV is infinite → EV = (1/2*2+1/4*4+1/8*8+…) © Valiante Diego - 9  The Expected Utility Theory (2) - Utility Bernoulli tried to solve it by introducing the concept of ‘utility’, i.e. an individual utility for given levels of monetary income. As a result the expected value of the lottery is: Utility is a non-linear function with decreasing marginal utility of income (concave) © Valiante Diego - 10  The Expected Utility Theory (3) - Assumptions This finding was only formalised in 1944 by Von Neumann & Morgestern (VNM), which led to establish 5 assumptions behind the EUT (Debreu 1987): – Dominance, i.e. the mean of choices with same utility is always preferred or if one of the alternatives has a slightly better feature, it should be preferred. If someone prefers A to B, she doesn’t prefer B to A. – Transitivity, i.e. if an individual prefers A to B and B to C, so she then prefers A to C; – Invariance/independence, i.e. the individual should be indifferent to how baskets of goods with the same utility are presented q≽r then (q, p; s, 1-p) ≽(r, p; s, 1-p) for each value of p Procedure invariance → preferences over prospects/lotteries are independent of the method used to elicit them Description invariance → preferences over prospects/lotteries are purely a function of the probability distributions of consequences implied by prospects and do not depend on how those given distributions are described – Completeness, i.e. individuals are able to compare alternatives and to make a ranking; – Monotonicity, i.e. ‘more is generally good’ and does not influence preferences between two goods with the same utility © Valiante Diego - 11  The Expected Utility Theory (4) – Risk Decision-makers’ attitudes towards risk (averse, neutral or seeker). © Valiante Diego - 12  Key violations of the EUT – Allais’s Paradox Allais’s Paradox (1953) 1. ‘Common consequence’ effect 2 set of 2 choices/prospects (1 choice from each to be taken) – s1 = (€1M ,1) and r1 = (€1M ,0.8;€2,1M ,0.1;€0,0.1) – s2 = (€1M ,0.20;€0,0.8) and r2 = (€2,1M ,0.1;€0,0.9) Common consequence → subtracting 1m, 0.8 Prevailing choice is s1 and r2, instead of s1 and s2 Irrespective of the expected value of each decision prospect, people tend not to choose in a consistent way. Result: Violation of invariance HP! 1. ‘Common ratio’ effect Certainty effect (2 subsequent choices) – s1 = (€3k ,1) and r1 = (€4k,0.8;€0,0.2) – s2 = (€3k ,0.25;€0,0.75) and r2 = (€4k,0.2;€0,0.8) Common ratio → Dividing probability by 1/4 Prevailing choice is s1 and r2, instead of s1 and s2 Result: Violation of independence HP! © Valiante Diego - 13  Key violations of the EUT – Ellsberg Paradox Ellsberg Paradox (1961) – An individual is told that an urn contains 90 balls from which 30 are known to be red and the remaining 60 are either black or yellow. He is asked to choose between the following gambles: Gamble A: – $100 if the ball is red Gamble B: – $100 if the ball is black – And one between the following: Gamble C: – $100 if the ball is not black Gamble D: – $100 if the ball is not red – In most cases people will choose A over B and D over C. Result: People tend to bet for or against information they know, violating the dominance HP – Dominance says that if A is preferred to B, B cannot be preferred to A – C is just another way to go for red (but you are betting against it!) This also shows the preference for certainty in people’s decision- making. So the beginning of the research that led to the Prospect Theory. © Valiante Diego - 14  The Prospect Theory © Valiante Diego - 15  Prospect Theory (Kahneman & Tversky) PT tries to embed the violations of transitivity, dominance and invariance (some discussed before) into a theory to understand better how people assign value to the different options (still maximising their utility). Three main effects that violate the EUT are assessed by the PT: 1. Certainty effect (see Allais/Ellsberg paradoxes) A reduction of the probability of an outcome by a constant factor has more impact when the outcome was initially CERTAIN than when it was merely PROBABLE The overestimation of ’certainty’ leads to risk aversion when choosing between two positive probable outcomes and to risk proneness when choosing between two negative ones. 2. Reflection effect (facing losses) A(- €4000, 0.8) vs B(- €3000, 1) o A(- €4000, 0.8) preferred to B(- €3000, 1)* in 92% of the times; C(- €4000, 0.2) vs D(- €3000, 0.25) o C(- €3000, 0.25)* preferred to D(- €4000, 0.2) in 58% of the times This shows diminishing marginal sensitivity to deviations from reference point (more sensitive to first large negative deviation) 3. Isolation effect (see next slides) While, when facing gains, the certainty effects leads to choose the outcome with probability 1, when facing losses, there is a strong preference to go for a probable loss instead of a sure loss, i.e. giving more value to losses (as a result of aversion to losses) © Valiante Diego - 16  Prospect Theory - The ‘new’ utility function © Valiante Diego - 17  Prospect Theory – Loss aversion Implications of loss aversion for investment decisions 1. Underinvestment in equity or other products where market risk is present (myopia) 2. Holding onto losing investments for too long and selling winning ones too early (as a result of the reflection effect) 3. Anger over a loss of capital tends to be higher than over a loss of returns 4. Anger over interim losses in long-term investing products is often dominant © Valiante Diego - 18  Prospect Theory – Implications of loss aversion From loss aversion (as a combination of certainty and reflection effects mainly), research has also discovered another important bias: the status quo bias (Samuelson & Zeckhauser 1988) – Experiment: Old and new faculty members at Harvard were offered to new health care plan options. Assuming that health care preferences were similar between the two groups, the distribution of plans options between the two groups should be the same, or similar at least. The result was that, compared to the new faculty members, only few members of the old faculty chose new options. It could be psychologically explained by previously made commitments, sunk cost thinking, cognitive dissonance, regret avoidance and so on. Status quo bias can lead to inertia in savings behaviours. – Ex: pension savings and the use of autoenrollment schemes © Valiante Diego - 19  Prospect Theory – Implications of loss aversion (2) The ‘endowment effect’ (Thaler 1980, Kanheman, Tversky and Thaler 1990) is a direct consequence of loss aversion, combined with a status quo/reference point bias, EXAMPLE (Kahneman, Knetsch and Thaler 1990) – 2 groups (A with and B without a mug; people are endowed randomly of a mug) – Given the task to assign a value for the sale of their item between $0.5 and $9.5 – A could take the mug home if it did not manage to sell it – Group A set a reserve price on average of $7. Group B at $3.5. © Valiante Diego - 20  Prospect Theory – Implications of loss aversion (3) EE explains observations of large gaps in hypothetical buying and selling prices in ‘contingent valuations’ (i.e. economic value of goods that are not normally traded, like environmental damage) The EE happens when there is an opportunity to sell an item that isn’t easily replaceable – Switching costs can enhance the impact of the endowment effect – EE is more persuasive when transaction costs are low The EE is at core of one of the Coase Theorem’s major criticisms, i.e. ignoring income effects when stating that the allocation of resources will be independent of the assignment of property rights (with no transaction costs). © Valiante Diego - 21  Prospect Theory – Isolation Effect 3. Isolation effect Violation of dominance (ie if someone prefers A to B, it will never prefer B to A), as people: 1. Tend to choose (3k, 0.25) over (4k, 0.2) in the first situation 2. Tend to choose (4k, 0.2) over (3k, 0.25) in the second situation (which is also the best option) Result: People tend to ignore the first step when they are presented with two subsequent choices, as in the first example (isolation effect) © Valiante Diego - 22  Cumulative Prospect Theory - The ’new’ weighting function (Kahneman and Tversky, 1992) As a result of a combination of certainty and reflection effects, the cumulative prospect theory (CPT) applies weighting (perceptions) to the cumulative probability distribution function. It integrates loss aversion in the cumulative probability distribution. The key feature of CPT is that it permits a satisfactory modeling of diminishing sensitivity, not only with respect to outcomes but also with respect to changes in probabilities (and the perceptions of them). © Valiante Diego - 23  Cumulative Prospect Theory – …but no full agreement on its actual shape © Valiante Diego - 24 Source: Al-Nowaihi &Dhami, 2010  Cumulative Prospect Theory - Three main conclusions 1. People tend to think of possible outcomes usually relative to a certain reference point (often the status quo), rather than to the final status (conclusion shared by the original PT). 2. People have different risk attitudes towards gains (i.e. outcomes above the reference point) and losses (i.e. outcomes below the reference point) and care generally more about potential losses than potential gains → loss aversion – Both EE and Status quo biases are consistent with aversion to losses relative to a reference point. 3. As a result of a combination of loss aversion and reference point biases, people tend to overweight extreme, unlikely events, but underweight "average" events → probability weighing © Valiante Diego - 25  Some examples of probability weighing (Camerer et al. Advances in Behavioural Economics) Probabilistic Insurance – People are averse to pay the actuarily adjusted premium of an insurance that it requires to pay (1-q)*c, where c is the premium and (1-q) that the payment of the premium will take place. – They tend to overweigh the probability q of non-payment being (too) small (e.g. misread the terms, insolvency of the insurer etc) and so probability of premium payment too high. – Survey data suggest that people dislike probabilistic insurance and demand more than a 20% additional reduction in the premium to compensate for a 1% probability of insured event to occur. (Wakker, Thaler & Tversky, 1997). EUT, instead, assumes that agents will be risk neutral for small risks, since the utility function is mostly linear. Reality is that risk averse behaviour is generated by nonlinear probability weighing, even if the utility function is linear. © Valiante Diego - 26  Cases of probability weighing (Camerer et al. Advances in Behavioural Economics) The equity premium ‘puzzle’ – Def: Excess return of stocks over fixed income (not only justified by risk). – The larger-than-expected observed disparity implies a large degree of risk aversion embedded in standard models of asset pricing (Mehra and Prescott 1985). – Agents are myopic (due to loss aversion). In the short run, equity has likely negative returns, so the premium is consistent with the prospect theory (risk seeking behaviour). – Assuming that people are roughly twice as sensitive to small losses as to corresponding gains, the premium is consistent with the hypothesis that investments are evaluated annually (Benartzi & Thaler 1995). – With this level of risk aversion, a person would be indifferent between a coin flip paying either $50k or $100k and a sure amount of roughly $51,200!!! © Valiante Diego - 27  Other bounded rationality theories © Valiante Diego - 28  6. Other bounded rationality theories – Preference reversal Preferences reversal (Slovic and Lichtenstein 1968, 1971, 1973) – It shows that the choice between two lotteries is the contrary of the given preference via the attribution of a monetary value (probability of win will influence a choice between two lotteries). – Example: €-bet (€200, 0.1) vs P-bet (€20, 0.8) – Majority chose P-bet When asked to give a sale price (monetary value) – M(€)>M(P) People respond differently to choice and evaluation Result: Violation of (procedure) invariance & transitivity assumptions (unique) © Valiante Diego - 29  6. Other bounded rationality theories – Regret theory Regret theory (Loomes & Sugden 1982) – A decision maker chooses between two prospects(state- contingent payoffs) based not only on the outcome he receives but also on the outcome he would have received had he chosen differently (anticipated regret) – Result: Systematic violation of transitivity and monotonicity – It can explain preference reversal, Allais’s paradox and common ratio & isolation effects – Main criticism: regret effects are primarily framing effects that ‘occur only when the decision is framed in a way that sharply directs the decision maker to compare acts and states’ (Harless 1992) – The anticipated pain of regret is reduced or eliminated if people do not know the outcome of the forgone choice. – Systematic issue in financial services, especially with excessive use of past performance information or overconfidence behavior in stock markets. © Valiante Diego - 30  Mapping of biases © Valiante Diego - 31  6. Bounded rationality – Mapping biases in evaluation & decision-making (not exhaustive list!) ’Debiasing through law’ (expression used by Jolls & Sunstein 2005) Selected behavioural biases affecting preferences in the decision-making process Judging Alternatives Making Decisions Self-serving bias Procrastination Optimism Information overload Anchoring and adjustment Overconfidence Representativeness heuristic Framing Hindsight Loss aversion Social preferences Immediacy or hyperdiscounting bias Endowment effect Source: Author’s own elaboration based on Chater et al. (2008) and Valiante (2008). © Valiante Diego - 32  6. Bounded rationality – Judging Alternatives/Evaluation (1) Self-serving bias – Tendency of parties to arrive at judgements that reflect a self- serving bias, i.e. their belief for instance of fairness. We tend to put ourselves in the top 50% of drivers, ethics, etc – This has 3 implications (Sunstein eds 2000): 1. If negotiating parties assess value of alternatives in self-serving ways, this erodes space for an agreement around their reservation values. 2. If parties believe that their notion of fairness is impartial and shared with the other party, they will interpret the other party’s aggressiveness in bargaining not as an attempt to achieve what they think is fair, but like an exploitation attempt of gaining from an unfair strategy. 3. If parties are willing to sacrifice not to settle at an unfair level, and their concept of fairness is self-served, there is no space for negotiation with counterparts that are trying to get what is ‘fair’. © Valiante Diego - 33  6. Bounded rationality – Judging Alternatives/Evaluation (2) – Remedies: This bias comes from the tendency that individuals have to neglect contradictory evidence (e.g. social networks), so ‘debiasing’ could take place by forcing them to consider the weakness of their case for fairness. This reduced the cases of impasse (Babcock et al 1996) – Example: Anderson & Robinson (2017) show that people who mistakenly believe that they are financially literate end up with mass advisors that steer them towards high-fee funds, compared with people that are aware of being illiterate (who get higher returns with cheaper default products). The latter do not anchor themselves to a ‘self-serving’ belief. So, making default pension products available and transparency to dissuade financially literate people to only rely on one advisor’s judgement could be one of the remedies. © Valiante Diego - 34  6. Bounded rationality – Judging Alternatives/Evaluation (3) Anchoring and adjustment (Tversky and Kanheman 1974, 1986) – People frequently fail to ‘adjust’ their assessment from pre-existing cognitive anchors or reference points, so leading to under or overestimate certain given probability of an event. – This gives more importance to the sunk costs – Examples: 1. The borrower’s choice to get a variable interest rate for a mortgage may be ‘anchored’ to a long period of low interest rate and home value appreciation. 2. Another trick that somebody may use when selling an investment product is to say “we usually give 1% return on these products, but we will give you 2% this time only”. – Remedy: Oblige or disclose information about the underlying characteristics of the anchoring numbers vis-à-vis the item that is being evaluated (bringing up differences). Difficult to devise outside labs, so recognising anchoring when it happens. Explaining what anchoring is, before the evaluation is made, may help. In the second example, the retail investor could be presented with average returns for risk/return profiles on the market to check whether that risk/return profile is a good deal for him/her. © Valiante Diego - 35  6. Bounded rationality – Judging Alternatives/Evaluation (4) Hindsight bias (Fischhoff 1975) – In hindsight, people tend to overestimate how much could have been anticipated in foresight (‘creeping determinism’). – People naturally integrate a known outcome and the events that preceded it into a coherent story, downplaying other factors that could have led to alternative scenarios and so overstating the predictability of past events. – Known outcome is de facto the reference point – Example: Take two groups of people, who are given information about an event and potential follow-up scenarios. The group that was informed about which of the outcomes actually occurred, tended to overestimate the probability they would have given to each of these scenarios. (also p96, Sunstein eds 2000) For instance, it influences judges’ evaluation abilities or investors, especially retail. Case study. The existence of this bias led to discussions about presenting past performance to retail investors in disclosure documents (KID vs PRIIP KID), as it may lead to overestimate probability of similar or even better returns. Remedies: – There is no successful strategy. – Some have reduced the bias, such as informing about the bias. Disclosure about past returns not being proxy of future performance) or forcing parties to ‘unlearn’ about the event that taught them about precedent ones (Rachlinski in Sunstein eds 2000). © Valiante Diego - 36  6. Bounded rationality – Making decisions (1) Procrastination bias – Situation in which an individual decides to postpone costs, even though bearing these costs now would generate higher future benefits, such the decision to consume (perceived as a gain) over saving (perceived as a loss). – Tendency to go for immediate gratification (like the certainty effect) over long-term benefits – Example: Purchasing the first product offered without comparing products and providers (shopping around perceived as a [sunk] cost) Younger people save less because of their lower income and so their bigger perception of saving as a loss (even if they have space to save) – Remedies: Simplify decisions (e.g. standardised disclosure), committing devices (automatic enrolment into saving schemes), default options, financial education. © Valiante Diego - 37  6. Bounded rationality – Making decisions (2) Information and choice overload – This bias shows the inaction when confronted with large choice or large amounts of information, leading to inability to identify important information and increasing likelihood of dissatisfaction. – It may be caused by the inability to identify important information. – Example: Prospectus disclosure at issuance for retail investors (long and complex documents) – Remedies: Ease comparability through summary disclosure, restrict choice or financial education © Valiante Diego - 38  6. Bounded rationality – Making decisions (3) Overconfidence bias – Situation that leads to unfounded optimism and suppression of evidence that confutes the argument. – People tend to overestimate (to be overconfident about) the probability of an outcome if an example of the event has recently occurred. Therefore, consumers are generally overconfident in their abilities and in their future (e.g. stock price rallies). – Example: Housing bubbles (long-term rise in house prices) – Remedies: Considering opposite scenarios is a useful tool for encouraging individuals to be critical of their own decision-making, to avoid overconfidence and limit the suppression of disconfirming evidence © Valiante Diego - 39  What is left of the EMH? © Valiante Diego - 40  What is left of the EMH? Believers of EMH consider behavioural biases simply as temporary and that soon somebody will arbitrage them out… – “…but this last conclusion relies on the assumption that market forces are sufficiently powerful to overcome any type of behavioural bias, or equivalently, that irrational beliefs are not so pervasive as to overwhelm the capacity of arbitrage capital dedicated to taking advantage of such irrationalities.” (Lo 2004) The degree of market efficiency is related to environmental factors characterizing market ecology, such as the number of competitors in the market, the magnitude of profit opportunities available, and the adaptability of the market participants. So the concept of ‘adaptive markets hypothesis’ (AMH; Lo 2004), derived from adaptive expectations developed by Simon. An evolutionary theory… – Prices reflect as much information as dictated by the combination of environmental conditions and the number and nature of distinct groups of market participants (e.g. retail investors and hedge funds), each behaving in a ‘common manner’ in the economy. – More species, more efficiency (investor base?). © Valiante Diego - 41  What is left of the EMH? “Under the AMH, investment strategies undergo cycles of profitability and loss in response to changing business conditions, the number of competitors entering and exiting the industry, and the type and magnitude of profit opportunities available (forces of natural selection).” (Lo 2004) – EMH → arbitrage is competed away (making it unprofitable) – AMH → arbitrage can be profitable based on ‘environmental’ conditions becoming more conducive to such trades Survival (AMH) vs Utility maximisation (EMH) © Valiante Diego - 42  Summing up – Market Failures & Remedies © Valiante Diego - 43  Mapping sources of market failures and remedies Information asymmetry Sources of Moral Adverse Negative Knightian Bounded Market Hold-up Market Hazard Selection Externalities uncertainty rationality Power Failure Private Inability to Contract Social information Unpredicta- ‘Irrational’ ‘Monopolistic Driver assess incomplete- marginal (high monitoring bility behaviour attempt’ costs) quality ness costs Rent Inefficient Cognitive Market Underinvest- Illiquidity & extraction/D Event Opportunism resource biases & breakdown ment contagion ead weight allocation heuristics loss Contractual Cost Transparency internalization Transparenc Reduce barriers incentives or to entry/exit (via Remedy /contractual Risk signals (Pigouvian Safeguards y/default remedial actions special taxes, incentives options etc or sanctions) clauses safeguards..) © Valiante Diego - 44  Financial market regulation objectives, key strategies and limits © Valiante Diego - 45  Theories of regulatory intervention © Valiante Diego - 46  Theories of regulatory intervention – Public Interest Theories (PubIT) Markets are a form of organisation which, as reinforced by certain (normally private) legal institutions, is supposed to advance economic welfare, more specifically allocative efficiency. Private law (allocation of rights only) is insufficient to deal with non- economic goal. Objectives of regulation for PubIT include: – Establishing remedies to market failures (e.g. competition policies) – Achieving distributional effects (e.g. inequality) – Paternalism (e.g. seat belt) – Community values (e.g. supporting a brand) Theories based on the role of market forces alone are insufficient, due to weak assumptions: – Individualism (total isn’t sum of individual welfares) – Full rationality (utility-maximising behaviour) and fully informed individuals – No externalities (contracts, property rights and tort might not be enough) – Competitive markets (private law only cannot guarantee full competition) © Valiante Diego - 47  Theories of regulatory intervention – Private Interest Theories Regulation can fail – Regulatory capture [recruitment from industry, victim of itself] – Role for self-regulation in some instances (e.g. gatekeeping) Positive theory – Regulation is a response of politician to interest group – Regulation raises barriers for newcomers and helps to freeze markets (e.g. licensing) Normative theory – Regulation never achieves allocative efficient, in Pareto sense, but in a Kaldor-Hicks one, unless rent seekers create wasted resources devoted to address wealth transfers [unproductive activity]) Kaldor-Hicks efficiency means allocation of resources in which the benefits of those who are better off outweigh the damages of those who are worse off. Pareto efficiency means allocation of resources in which no someone is made better off without anyone else being made worse off. © Valiante Diego - 48  Objectives of financial market regulation Overarching objectives – Deal with anomalies that do not allow immediate reflection of information into prices (EMH) → ex ante action – Rectifying the negative impact of market failures → ex post action Five more targeted objectives 1. Investor protection Information, conduct and prudential regulations – Consumer protection in retail finance relies on behavioural considerations Ex: Issues of securities, investment services provision 2. Financial stability Systemic risk and domino effect Micro and macro prudential regulation © Valiante Diego - 49  Objectives of financial market regulation (2) 3. Market efficiency Informational efficiency Mainly on secondary markets (continuous company evaluation) 4. Competition Market power 5. Market integrity Financial crime, like market abuse or money laundering © Valiante Diego - 50  Regulatory strategies © Valiante Diego - 51  ‘Ex ante’ regulatory strategies in financial markets 1. Entry regulation – The rules disciplining the ability of (would be) participants in the financial system to engage in financial transactions with other participants. – It includes licensing rules, restrictions on new financial products offered to different categories of investors and so on. 2. Conduct regulation – Appropriate standards of conduct for participants in the financial system (for instance, restrictions on how trading of securities should be done on the market, conflict of interest rules, marketing and sale techniques or handling of client assets). – Conduct of business rules is the most extensive regulatory category. 3. Disclosure regulation – The rules intended to secure dissemination and comprehension of information about financial firms and their products. – It relies on the principle of caveat emptor. 4. Prudential regulation – The rules that direct how financial firms that have systemic impact should manage their assets and liabilities. 1. Capital adequacy rules for banks and some investment firms [liability rules]; 2. Rules on liquidity and maturity (nature) of asset holdings [asset rules]; 3. Rules on investment policies (such as risk profile) of portfolio management and risk allocation activities. 5. Governance regulation – The rules on the way in which firms are organised and managed. – This includes rules on executive compensation, board structures and directors’ duties, restrictions for corporate events, like mergers and acquisitions, and so on. © Valiante Diego - 52  Ex post regulatory strategies in financial markets 1. Insurance Regulation – Rules triggered by the failure or financial distress of a financial firm. – They provide a backup provision of liquidity (deposit guarantee scheme, lender of last resort function of a central bank) 2. Crisis Management Regulation – Rules creating resolution mechanisms that should operate more effectively and efficiently than ordinary insolvency laws to minimise the destructive loss of value coming with a bank failure. © Valiante Diego - 53  Different approaches to regulatory strategies for financial markets Scope Function Tool Ex ante strategies Licensing Participation Qualification requirements Entry regulation Profiling Product regulation Product regulation Structural restrictions Trading restrictions Conduct regulation Trading Conduct of business Information regulation Education & price discovery Disclosure Prudential regulation Stability Balance sheet Board structure Compensation Governance regulation Governance Risk Management Risk Management Ownership restrictions Ownership restrictions Ex post strategies Insurance Insurance Lender of last resort Bail outs Resolution Stability Resolution procedures Source: Based on Armour et al., Principles of Financial Regulation, 2016 © Valiante © Valiante Diego Diego - 54  Limits of financial markets regulation © Valiante Diego - 55  Limits of financial market regulation (Armour et al. 2016 & Moloney et al. 2015) Regulatory strategy – Rule versus principle-based regulation (ex: UK Financial Service Authority) Institutional design choices 1. Institutional → insurance, securities, banking Function-based supervision 2. Single (or consolidated: ex: UK FCA in early 2000s) Consolidated supervision 3. Twin Peak (prudential & business conduct) Goal-defined supervision – Today’s institutional design in Europe is a combination of 1 and 3 – The Twin Peak is gradually becoming the dominant model. © Valiante Diego - 56  Limits of financial market regulation (Armour et al. 2016) Informational challenge – Markets are dynamic, regulation is static – Size and complexity of the financial system Regulatory arbitrage – Innovation to respond to regulation Equity derivatives & stamp duty Securitisation & capital adequacy rules Enforcement and sanctions – Low probability to be caught, high reward (risk of under/overdeterrence) Regulatory capture – Revolving doors, budget linked to industry size, overreliance on firms to overcome informational barriers (complexity) – Are judicial review or Cost-Benefit Analysis (CBA) the solution? Political self-interest (e.g. re-election) © Valiante Diego - 57  The ‘Great’ Debate © Valiante Diego - 58  The ‘Great Debate’ https://youtu.be/g_W https://www.youtube.com 9SsstO9Y /watch?v=BPnJHfiFWJw Up to 4:46 © Valiante Diego - 59  The Great Debate What do they agree upon? – Both Joseph Stiglitz and Milton Friedman relies on the rule of law – Both agree that governments have a role to play (e.g. Friedman limits its role to the defence of public goods, like military defence and basic science). – Individuals’ activity can create negative externalities (damages). What sets them apart? – Rule of law led by government intervention (through regulation) for Stiglitz, led by individuals (through private law & judicial recourse) for Friedman The drawbacks of each argument? – A drawback with Friedman argument is that the adjustment to equilibrium through private law may take longer than expected (because of frictions in negotiation), plus distributional effects (for instance, he claimed that we need to get rid of food and safety regulations→ who benefits from that?) – A drawback with Stiglitz’s argument is that regulators/supervisors can also fail and usually do fail. © Valiante Diego - 60  Recommended readings Jolls, Christine; Sunstein, Cass R.; and Thaler, Richard (1998), "A Behavioral Approach to Law and Economics", Faculty Scholarship Series Paper 1765 Armour J., D. Awrey, P. Davies, L. Enriques, J. N. Gordon, C. Mayer and J. Payne, Principles of Financial Regulation, OUP, 2016 (Part A.3 and A.4) Ogus A. Regulation: Legal Form and Economic Theory (Chapters 2, 3, 4 and 8) Lo, Andrew. (2004). The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective. Available at https://www.researchgate.net/publication/228183756_The_Adaptive_Marke ts_Hypothesis_Market_Efficiency_from_an_Evolutionary_Perspective (focus on the critics to the EMH and the raise of bounded rationality theories) Additional readings – A Behavioral Model of Rational Choice Author(s): Herbert A. Simon Source: The Quarterly Journal of Economics, Vol. 69, No. 1 (Feb., 1955), pp. 99-118 Published by: The MIT Press Stable URL: http://www.jstor.org/stable/1884852 – References throughout the lecture © Valiante Diego - 61  Diego Valiante LEIF Master Programme [email protected] www.unibo.it