Risk Regulations PDF

RISK REGULATIONS LECTURE 1—SOME BASIC NOTIONS OF FINANCIAL MARKETS AND INSTITUTIONS Financial Markets – Definitions Financial markets are for financial assets. The economy is a combination of tangible and intangible assets. Financial assets/financial instrument/security are intangible assets (vs tangible ones) whose value is a claim to future cash (not its physical properties). Financial markets allow more efficient consumption smoothing. Economic functions Main economic function is to transfer resources across time and space (change of state) from those who want to supply capital to those are in demand (e.g. intertemporal consumption smoothing). This happens through: 1. Capital allocation (tahsis) Financing function 2. Risk allocation Risk management function (e.g. risk sharing, risk diversification, hedging) 3. Information transfer Price discovery/asset pricing 3 main groups of financial assets 1. Money/means of payment (legal tender1, fiat money2, quasi money3 [means of payment] e-money and virtual currencies/stable coins]) - Mean of exchange - Unit of account - Store of value 2. Securities (book-entry instruments) - Rights and obligations (e.g. control or profits on a company) - Any form of financial return Tradeable on capital markets à if transferable (no restrictions to transferability, but left to national interpretations) 3. Derivatives (contracts) - Contract (exchange of cash flows) à “Financial instruments whose value (price of contract) is derived from the value of an underlying asset (e.g. equity, bond or commodity) or market variable (e.g. interest rate, credit risk, exchange rate or stock index)”. Futures (or forwards) Options Swaps Exotic instruments by asset classes (currency, equity, rates, credit and commodity) à Over-the-counter (OTC) or on-exchange 1 Legal tender is money, especially a particular coin or banknote, which is officially part of a country's currency at a particular time. 2 Fiat money is a government-issued currency that is not backed by a commodity such as gold. Fiat money gives central banks greater control over the economy because they can control how much money is printed. Most modern paper currencies, such as the U.S. dollar, are fiat currencies. 3 The term quasi money refers to assets which can be easily converted to cash because they are in high demand and are issued by entities with excellent creditworthiness. Examples of quasi money include gold certificates, bonds issued by creditworthy governments and certificates of deposit issued by creditworthy banks. ***FOR INFO*** Classification of financial markets n By nature of claim (priority risk) - Equity (residual claim) - Debt (fixed income) n By maturity of claim (duration risk) - Money market - Capital investment n By seasoning of claim (liquidity risk) - Primary - Secondary n By immediate or future delivery (counterparty risk) - Cash or spot market - Derivative market n By organisational structure (operational risk) - Auction markets - OTC markets - Intermediated markets The hierarchy of financial markets Asset-backed derivatives market Corporate bond and Equity markets Government bond market T-Bill Market and Foreign exchange (forex) market Money market The key role of money markets4 The money market does not actually include ‘money’, but financial instruments with maturities of 12 months or less. o Instruments must be reissued frequently. - Unsecured deposit market (lending with no collateral -teminat-) - Secured lending (repo5) market (lending against collateral) - Short-term commercial paper and govies o Mainly large, safe, well-known borrowers: Governments, central banks, banks, and blue-chip firms. 4 Money markets (together with government bond issuance) help to create the yield curve for risk free interest rates, which are used for pricing purposes (like pricing of corporate bonds). Yield curve: A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity. 5 A repurchase agreement (repo) is a short-term secured loan: one party sells securities to another and agrees to repurchase those securities later at a higher price. The securities serve as collateral. The difference between the securities’ initial price and their repurchase price is the interest paid on the loan, known as the repo rate. Key financial actors and activities The role and functions of financial intermediation 1. Maturity transformation - Funding long-term assets (household’s mortgage) with short-term liabilities (deposits or deposit-like). - The maturity of the funds/assets is what we look at in this type of operations. 2. Liquidity transformation - Tapping liquid claims (e.g. cash-like liabilities) to buy harder-to-sell assets, like securities (with similar or not so distant maturity). - The lower is the maturity the higher is the liquidity, so often maturity and liquidity transformation do coincide (to come together in position or happen at or near the same time). 3. Credit transformation - Transform low risk liabilities (e.g. time deposit) into a high risk investment (loan to an innovative SME). 4. Risk transfer (hedging) - Taking the risk of a borrower’s default (or of a future risk event) and transferring it from the originator of the loan (exposed person) to another party (e.g. credit default swap). Financial intermediation6 Financial intermediaries ensures that funds can flow from holders, who are looking to generate returns, to capital seekers (typically companies, governments and households), attempting to improve allocative (tahsisli) efficiency for their clients. 6A financial intermediary is an entity that acts as the middleman between two parties in a financial transaction, such as a commercial bank, investment bank, mutual fund, or pension fund.Financial intermediaries serve as middlemen for financial transactions, generally between banks or funds. These intermediaries help create efficient markets and lower the cost of doing business. Intermediaries can provide leasing or factoring services, but do not accept deposits from the public. Financial intermediaries offer the benefit of pooling risk, reducing cost, and providing economies of scale, among others. Main actors/activities a. Deposit-taking institutions, i.e. banks (with different business models) b. Shadow banking activities c. Market infrastructure (including broker and payment institutions) o Financial news/data companies d. Insurance e. Asset managers & pension funds f. Gatekeepers Other (non-financial) actors - Central banks - Households - Non-financial firms a. Deposit-taking Institutions Core services Deposit collection - Collecting deposits and offering redemption at par7 (with deposit protection and government guarantees) Payment services - Debit cards, electronic banking, FX, etc. à Not only by DTIs Loan underwriting8 - Commercial loans, consumer loans, mortgages, credit cards, etc. à Main core function for DTIs that rely on stable funding (money creation) Investment services - Brokerage, investment advice, underwriting, etc. 7Par value is the price at which a bond was issued, also known as its face value. 8Underwriting is the process by which your lender verifies your income, assets, debt and property details in order to issue final approval on your loan application. Key Balance Sheet Items Assets: cash / trading book (e.g. securities and derivatives) / secured loans to corporates&interbank (including RRP9) / secured loans to consumer (e.g. mortgages) / unsecured loans to consumers&corporates. [secured and the unsecured ones are also in the banking book] Liabilities: short-term deposits / long-term deposits / short-term funding (including repo) / long-term funding (including bailinable bonds) / equity. Macro risks 1. Bank runs - Sunspot runs Self-fulfilling panic due to exogeneous event caused by extereme liquidity and maturity transformation event - Fundamentals-based runs Linked to the business cycle and the worsening of economic conditions, so banks cannot meet their obligations. 2. Systemic risk For instance, concentration risk towards specific sectors. - Sovereign-bank nexus 3. Leverage risk (too-big-to-fail institutions) Financial institutions may become so large, complex or interconnected that their distress or failure would cause serious harm to the financial system and the economy. As a result of implicit TBTF subsidies, banks do not bear all the downside risk of their actions, and so tend to take on too much risk. Micro risks a. Credit risk (counterparty risk) b. Market risk -interest rate risk, -equity risk, -FX risk, -commodity risk c. Operational risk d. Liquidity risk e. Other risks (business/strategy, reputational, compliance) 9 “reverse repo” or “RRP,” is a transaction in which the Desk sells a security to an eligible counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. Those risks’ impact is on: Liquidity óSolvency ó Profitability b. Shadow Banking10 According to the FSB, the “shadow banking system” can broadly be described as credit intermediation involving entities and activities (fully or partially) outside the regular banking system. Some authorities and market participants prefer to use the term “market-based finance”. à The term shadow bank was coined by economist Paul McCulley in 2007: - Nonbank financial institutions that engaged in maturity transformation. - Commercial banks engage in maturity transformation when they use deposits, which are normally short-term, to fund loans that are longer term. Shadow banks do something similar. Forms of shadow banking 1. Funding with deposit-like characteristics - E.g. money market funds à Potential issue: systemic risk (herd behaviours) and investor protection 2. Maturity and liquidity transformation - E.g. ETF11s, securitised products à Potential issue: circumvention (atlatmak) of capital regulation and hidden risks 3. Credit risk transfer - E.g. securitised products à Potential issue: hidden risks and knock-on effects (outside prudential supervision) 4. Using direct/indirect financial leverage - E.g. repos, securities lending. à Potential issue: systemic impact and knock-on effects 10 They raise (mostly borrow) short-term funds in the money markets and use those funds to buy assets with longer-term maturities. But because they are not subject to traditional bank regulation, they cannot borrow in an emergency from the Federal Reserve (US Central Bank) and do not have traditional depositors whose funds are covered by insurance; they are in ‘shadows’. 11 An Exchange-Traded Fund (ETF) is a type of pooled investment security that holds multiple underlying assets, rather than only one. A repo transaction – key characteristics 1. Obligation of the seller to buy back the assets at a different price 2. Obligation of the buyer to give back fungible assets at a future data and at a different price (if on demand is called ‘open repo’) 3. Pricing takes place with a ‘haircut’ 4. Transfer of ownership (buy and re-purchase) 5. Temporary use of assets (for buyer) and temporary use of cash (for seller) à It acts de facto as a collateralised loan (economic function) à Repos are classified as a money-market instrument, and they are usually used to raise short-term capital. c. Market Infrastructure (Piyasa/Pazar Altyapısı) A market infrastructure is a system administered by a public organisation or other public instrumentality, or a private and regulated association or entity, that provides services to the financial industry for trading, clearing and settlement, matching of financial transactions, and depository functions. Trading infrastructure (stock exchanges and alternative trading venues) o Trading mechanisms (quote-driven, order-driven and hybrids) Post-trading12 infrastructure (CCPs, CSDs, Custodian Banks) Brokers Dealers, market-makers and liquidity providers Payment institutions Data service/benchmark index providers (e.g. Bloomberg, stock exchanges) What is the Distributed-Ledger Technology (DLT) or blockchain: can it change our financial system? - In centralised ledger system; institutions such as central banks and private banks maintain own records (ledger) of transactions/positions. Central banks and private banks function as intermediaries. Central banks and private banks validate the recorded information and safeguard against double-spending or counterfeit. 12 Post-trading refers to the activities that take place after an exchange of securities has been agreed upon. This includes clearing and settlement. Clearing and settlement is the term used to describe the processes and the infrastructures required to finalise a transaction. These processes enable transfer of ownership of the securities from the seller to the buyer transfer of payment from the buyer to the seller Efficient and safe post-trade infrastructures are a key element of a well-functioning financial market. If they don't work correctly, investors face more risks and higher costs. - In distributed ledger system; distributed ledger is a database consensually shared and synchronized across a network of computer nodes. Transaction records (ledgers) are kept in these nodes and are visible to anyone. Peer-to- peer transactions take place without an intermediary such as banks. Transactions get verified by nodes (miners) for double-spend or counterfeit. Blockchain is one type of distributed ledger. à It was the outcome of a movement against Wall Street. à The attempt is to shift away from a centralised architecture, which relies on trust among a selected number of financial institutions. à The decentralised blockchain is also called ‘trustless system’, where transactions are executed and validated through a series of computations. Key components of a blockchain i. Cryptography (communication in the presence of advesaries) ii. Consensus mechanism (who gets to amend the database) iii. Ledger (any record of economic activity or financial relationship) Key characteristics 1. Decentralisation & consensus-based governance -Validation of transactions and block mining is trustless. -Governance has different degrees of flexibility. (Bitcoin vs. Ethereum) 2. Transparency -Embedded traceability of transactions and ownership vs. reliance on third parties 3. Security -Role of cryptography to limit tampering 5. Privacy -Anonymity 6. Scarcity (store of value) 7. Transfer, lend and exchange value -Cryptography solved the double spending problem. d. Insurance Balance Sheet ** Mismatch between assets (short-term) and liabilities (long-term) Assets: cash / reinsurance share of TR, Premium receivable and other assets (e.g. loans) / investments (e.g. securities) Liabilities: technical reserves (e.g. premia) / other liabilities (including bonds) / equity Risks Counterparty credit risk Market risk Operational risk Concentration risk (specific sectors) Idiosyncratic risks - Catastrophe risk - Underwriting risk o Inaccurate pricing, selection of undesirable risks, etc. - Reserve risk - Claims management risk o Inappropriate claim settlements Life insurance additional risks: - Longevity risk - Mortality and sickness risk - Persistency / early termination risk e. Asset Management & Pension Funds Balance sheet of the management company does not say much. What counts are the Assets Under Management (AUM), which are the assets over which the financial institution has control on behalf of a client, but it does not own them and they are often kept in segregated accounts. This money is invested in multiple investments/pension funds, run by the asset managers. f. Gatekeepers Gatekeepers can be defined as: reputational intermediaries who provide verification and certification services to investors. These services can consist of: -verifying a company’s financial statements (as the independent auditor does), -evaluating the creditworthiness of the company (as the debt rating agency does), -assessing the company’s business and financial prospects vis-a-vis its rivals (as the securities analyst does), -appraising the fairness of a specific transaction (as the investment banker does in delivering a fairness opinion). - This definition can also include lawyers when they provide their reputation to validate the legality of a financial transaction. - Self-regulatory organisations (SROs; Professional bodies, standard setters, etc.) - Financial newspapers are also in a broad sense gatekeepers. Other actors à Households and non-financial firms (private savings) Financial assets: cash and deposits / loans / securities and derivatives / mutual and other investment funds / insurance and pension schemes. à Central banks - Lender of last resort (liquid backstop) - Micro and macroprudential supervisor à Governments - Fiscal backstop (recovery and resolution) - Regulatory / policy risk Some basic notions of EU legal and institutional framework for financial markets regulation Two key principles 1. Freedom of establishment (art. 49-55 TFEU) 2. Freedom to provide services (art. 56-62 TFEU) With well-established legal boundaries for non-exclusive (shared) compentences (yetki): - “Prudential supervision of credit institutions” (art. 65,1(b) TFEU) is a national compentence - Subsidiarity principle (art. 5,3 TEU) - Proportionality principle (art. 5,4 TEU) Legal Acts and Procedures Legislative instruments - Legislative acts (art. 289 TFEU) o Directive (principles/objectives) o Regulation (rules) o Decision (individual) o Guidelines o Recommendations - Non-legislative acts o Delegated acts (art. 290 TFEU) o Implementing acts (art. 291 TFEU) o Non-binding legal acts (e.g. guidelines) Legislative procedures - Co-decision procedure (ordinary) - Approval procedure (specific cases) - Simplified procedure (non-binding measures) The Lamfalussy law-making process 4 levels procedure on technical legislation. - Delegation under art. 290 TFEU - ‘comitology13’ process Level 1 à Rules and implementing powers - Co-decision with enhanced transparency Level 2 à Common implementing measures - Comitology advice (now ESAs’ advice) - Acts are adopted by the Commission Level 3 à Interpretations and peer review of implementation - Network of securities regulators to ensure consistent transposition Level 4 à Checking compliance with EU legislation - Stricter enforcement by the European Commission THE EUROPEAN SUPERVISORY AUTHORITIES (ESAs) 13 The term ‘comitology’ refers to the set of procedures through which the European Commission exercises the implementing powers conferred on it by the European Union (EU) legislator, with the assistance of committees of representatives from EU Member States. These committees use 2 types of procedures: examination and advisory. ESFS (European System of Financial Supervisors) – Mainly regulatory agencies… 1. Binding Technical Standards’ procedure (art. 10-15, ESAs regulations) - Formally adopted by the Commission (endorsement -onay-) o Regulation or decisions (after CBA -cost benefit analysis- and consultation) - Regulatory Technical Standards (RTS) o Delegated acts (art. 290 TFEU) à to supplement or amend non- essential elements of the legislative act o EP and Council can ‘revoke’ delegation entirely or ‘object’ individual RTSs. - Implementing Technical Standards (ITS) o Implementing acts (art. 291 TFEU) à where uniform conditions are needed for implementing legally binding EU acts (typically implemented by MS) o Only agreement between ESAs and Commission (implementation) - Frequently used tools (e.g. EMIR and MiFID/R) 2. Guidelines and/or recommendation (art. 16, ESAs) - 2 months deadline (‘comply or explain’ regime) 3. Opinions and Q&A (ESAs Review) 4. No action letters (ESAs Review) …But they have some supervisory and emergency powers 1. Investigating breaches of EU law Supervising competent authorities -info request-, individual (binding) decisions addressed to firms (after recommendation to CA and Commission’s opinion) 2. Peer reviews of competent authorities 3. Emergency powers Coordinating role Binding decisions to CAs in emergency, or to individual firms (if CA doesn’t comply or act fast) 4. Binding mediation in case of disputes 5. Temporary prohibition of financial activities If threat to orderly functioning and integrity (no emergency) Review every 6 months, but can go up to 12 months. …an deven direct supervisory powers, in the case of ESMA, or exclusive competences. 1. Direct supervision of some financial services providers - Data service providers - Critical benchmark providers - CRAs (credit rating agencies) - Greater role in CCP (central counterparties) supervision 2. Assessing ‘equivalence’ of foreign legislation - Monitoring regulatory and supervisory developments in countries that have been considered ‘equivalent’ regimes. LECTURE1-PART2 THE BENEFITS OF COOPERATION—ROBINSON CRUSOE’S ECONOMY A Robinson Crusoe’s economy assumes an economy with one consumer, one producer. In this scheme, he is cut off from the rest of the world, with only a single economic agent (himself) who is both a consumer and a producer and all commodities on the island have to be produced or found from existing stocks. - One person, one good The consumption/production function is usually concave -içbükey- with declining marginal returns of labour (ability to pick up coconuts for one hour more of work). - One person, two goods Now, it’s a choice of production/consumption between two goods. - Two people, two goods RC can produce at most 10 coconuts or 5 fishes and viceversa for Friday. (so RC has comparative advantage in coconut and Friday in fish) They can bargain products without costs. Cooperation would lead to a superior outcome (RC and Friday only produce what they are best at) THE COASE THEOREM (What role for regulatory intervention?) Coase’s criticism to dominant view on how to address market failures The dominant theory was mainly based on Arthur Cecil Pigou’s work. Pigou’s central tenet (ilke) is that: - Individuals, in pursuing their ‘self-interest’ (their natural tendency), may cause damage to others and only State action (and not changes in the legal system) can address that. So the result that time is that: - Governments should always tax (subsidise) commodities generating negative (positive) effects. “polluter pays” principle. While Coase14 does not necessarily dispute the risks of acting only based on self-interest, Coase challenges the dominant view that it will not always lead to a more favourable outcome in terms of total welfare. Especially if the cost of bargaining for the one causing the damage is too high, while the value for the society of producing that product is higher than putting the polluter out of business with large Pigouvian taxes. He shows that liability rules can lead to cooperation and be more effective in frequent situations. To show that, he has to prove that this natural tendency (self-interest) does not always need the State to fix its negative externalities. Coase Theorem—Main thesis Strong version: If neighbours and factory can cooperate without frictions (sürtüşme), the initial allocation (tahsis) of rights won’t affect the possibility to reach the efficient solution. The law does not matter. Weak version: Only refers to cooperation (bargaining) leading to an efficient outcome (not necessarily the same with or without the law) ** We ignore distributional effects. (because in that case the law would be necessary) But only consider outcome in terms of positive net total welfare (Kaldor-Hicks efficiency15) 14 Dışsal ekonomilerde mülkiyet hakları tesis edilirse mübadele maliyetinin sıfır olması koşuluyla taraflardan biri diğerinin zararını karşılayarak sosyal optimuma ulaşılır ve ekonomik etkinlik sağlanır. Mülkiyet hakkının hangi tarafa tahsis edildiği ekonomik etkinlik açısından önem taşımamakta, ancak faydanın taraflar arasındaki dağılımını etkilemektedir. 15 An outcome is an improvement if those that are made better off could in principle compensate those that are made worse off (eğer daha iyi durumda olanlar prensipte daha kötü durumda olanları telafi edebiliyorsa, bir sonuç bir gelişmedir), so that a Pareto improving outcome could (though does not have to) be achieved. Under Kaldor–Hicks efficiency, an improvement can in fact leave some people worse off. Pareto-improvements require making every party involved better off (or at least none worse off). Underlying Assumptions in Coase’s Theorem16 1. There are only few parties involved. 2. They are perfectly independent from each other (no other relations among the parties involved that can impact decisions). 3. They have mutual full knowledge of gains and damages, which lead to act cooperatively and not so strategically to affect the efficient outcome. 4. There is absence or negligible transaction costs (Coasian vacuum). Positive conclusions 1. Efficiency hypothesis – The outcome of bargaining will be a social optimum irrespective of the initial allocation of rights (given some externality and provided that parties fully cooperate with no transaction costs) 2. Invariance hypothesis – The efficient use of resources will depend on the allocation of rights only if transaction costs prevent bargaining. 3. If property rights are clearly specified (no matter to whom and there are no friction to bargaining), the internalization of externalities won’t need legal remedies. Normative conclusions 1. If the positive conclusions are true, the first objective of the regulation is not the allocation of rights per se, but the elimination of barriers/frictions to the parties’ cooperation. 2. If regulation fails in doing so, the law has to minimise the harm caused by failures in private bargaining via legal tools. These tools include compensatory damages or equitable solutions [allocation of rights] (also called liability and property rules). 16The theorem is based on cooperation and it’s the starting point of economic investigation of legal norms. Main criticisms 1. Efficiency Hypothesis à regardless of how rights are initially assigned, the resulting allocation of resources will be efficient à Ignores distributional effects (it just looks at higher total welfare) 2. Invariance Hypothesis à the final allocation of resources is invariant (not changing) to the assignment of rights. à Bargaining produces reallocation that can create an “income or wealth effect” This income effect will de facto reduce the acceptable level of pollution for the polluted. The assumption was: There must be no wealth effects. The efficient solution will be the same, regardless of who gets the initial property rights. 3. Endowment Effect17 à Initial allocation of rights does matter for formation of reserve price. Two consequences: - Sellers tend to value their items far more highly than potential buyers, so fewer deals take place. - People that received an item of value for free are more likely to overvalue it. 4. Social Norms à Sometimes social norms develop without bargaining or laws or assignment of rights. 5. Long-run à In the long-run the legal rule may matter in terms of output and price, so affecting the final result. 6. Assumes the existence of rents (no perfect competition) à If liability to the polluter, no money for the filter in perfect competition. FINANCIAL MARKET EFFICIENCY THEORIES Are financial markets different? Many argued they are. Bachelier (1900) à stock price changes are random Farma (1965) à stock prices are a random walk Random walk theory suggest that changes in stock prices have the same distribution and are independent of each other: therefore, it assumes the past movement or trend of a stock price or market cannot be used to predict its future movement (based on Kendall 1953). 17It’s an emotional bias. The endowment effect describes a circumstance in which an individual places a higher value on an object that they already own than the value they would place on that same object if they did not own it. Endowment effect can be clearly seen with items that have an emotional or symbolic significance to the individual. Research has identified "ownership" and "loss aversion" as the two main psychological reasons causing the endowment effect. THE EFFICIENT MARKET HYPOTHESIS (EMH)18 The theory is concerned with whether prices at any point in time “fully reflect” available information. If anyone can predict prices (no random walk), the expectation of that price will cause the price to move before you can act. Only new information can move prices, but ‘new’ is unpredictable. So price changes are random. à Investors should only decide the risk-return profile (passive investment) à There’s no mispricing (you can not beat the market) à Fundamental and historical analyses are largely ineffective to predict price movement. Implications: 1. So markets act as if all the information is immediately and costlessly available (zero transaction costs) 2. New information, which will cause prices to change, is always reflected into prices (it matters the speed of response) 3. There’s no ‘free lunch’ (higher returns only if you take more risks) 4. The more private information, the more somebody can profit trafing on it (depending how efficient the market is) Market Efficiency Taxonomy (Sınıflandırma) Different forms of market efficiency, according to different definition of ‘available information’ (Fama,1970) 1. Weak form: information subset is just historical prices or return sequences (trend analysis is always useless) 2. Semi-strong form: information subset is all publicly available information (includes information on fundamentals) – financial statements 3. Strong form: markets have monopolistic access to any information necessary to price discovery (which includes inside information) – prices are purely random Depending on the form of efficiency, the time to reach the efficient prie equilibrium will be different. But the ‘full reflection’ in price will always take place! 18 The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all information and consistent alpha generation is impossible.Alpha (α) is a term used in investing to describe an investment strategy's ability to beat the market. According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices. Therefore, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can obtain higher returns is by purchasing riskier investments. Proponents of EMH posit that investors benefit from investing in a low-cost, passive portfolio. Opponents of EMH believe that it is possible to beat the market and that stocks can deviate from their fair market values. Main criticisms 1. There are anomalies in empirical evidence - Stocks can exhibit momentum and reversal (vs. weak form) –in some cases even trend analysis can actually be effective - Value stocks (low market to book value) can beat the market (vs. semi- strong form) - Slow response to new earning announcements (vs. strong form) –because it says information immediately effects the market 2. All investors are not fully rational (homo oeconomicus) – we have cognitive biases 3. Information collection is a costly process. - …so it is unlikely that all already available information will be reflected in prices –theory assumes everybody has the same conditions to collect information - Arbitrage can be costly or even not possible (e.g. ban or short selling) - Arbitrage can also become costlier, and less like, the further away from fundamentals prices move. So, the price may not always be fair. 4. The initial distribution of information is relevant. -Information invariance hypothesis is wrong. – it depends who is getting this info first and how he/she acts about it News immediately reflected into prices depending on who is acting on it. à The efficient market theory is, however, useful in judging the relative efficiency of one market compared to another. (this one is more responsive than the other, etc.) The inevitable role of arbitrage19 Arbitrage is the competitive nature of human being lurking behind the EMH. They bring stock prices back to efficiency. It’s their function. But it is not risk free, i.e. there might be times where there is not enough trading to fill the evaluation gap. 19Arbitrage is the simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset's listed price. Arbitrage exists as a result of market inefficiencies and it both exploits those inefficiencies and resolves them. Key assumption of EMH 1. Individualism - Social welfare is only as a sum of all individual welfare, so no value for collective action. 2. Individuals only care about utility maximization. – This may not be the case because of the cognitive biases 3. Information to maximize that utility is readily available. – getting the information may be costly 4. Absence of externalities - All costs are internalised 5. Competitive markets LECTURE 2 – MARKET FAILURES The Great Debate Stiglitz ó Friedman Both of them 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) Rule of law led by; - Government intervention (through regulation) For Stiglitz A drawback: Governments can fail and they usually fail. - Individuals (through private law & judicial recourse) For Friedman A drawback: The adjustment to equilibrium through private law may take longer that expected (because of frictions in negotiation), plus distributional effects. NOTE: This course looks at incentive problems that lurk behind key financial market failures, not to avoid crises but to minimise the costs of crises and maximise the benefits of good periods. Market failures: (also they are sources of transaction costs) - Information asymmetry - Public good provision - Negative externalities - Knightian uncertainty - Market power (e.g. natural monopol yor cartel) - Bounded rationality A market failure can be described as a situation in which allocation of resources obtained through market economy is not efficient in a Kaldor-Hicksian perspective, and this can lead to the loss of economic value. Transaction costs A transaction cost is generally defined as any (direct or indirect) friction to parties’ negotiation. - Search costs High for unique goods/services and low for standard ones - Bargaining costs Not all information is public (to establish the other party’s reserve value for a good or service) The more private information, the higher the cost More parties creates collective action problems Behavioural biases, hostility, etc… - Enforcement costs Simultaneous exchange or not Complexity Multiple agents à Opportunism (self-interest) is central in the study of transaction costs. (Williamson 1979) à Transaction costs can lead to vertical integration20 (Williamson 1979). A. INFORMATION ASYMMETRIES Information asymmetry refers to all those situations in which one party to a transaction has an informational advantage over the other. Knowledge of given benefits and costs is private information. Transaction costs emerging from the asymmetry of information among parties may lead to: - Structural mispricing (adverse selection)21 - Opportunism/strategic behaviour (moral hazard)22 - Lock-in effect and underinvestment (hold-up). 20 Vertical integration is a corporate strategy that involves growth through streamlining operations. This occurs when one company acquires a producer, vendor, supplier, distributor, or other related company within the same industry. 21 In economics, insurance, and risk management, adverse selection is a market situation where buyers and sellers have different information. Pre-contractual information asymmetry. Bu yüzden de mesela faiz oranları (güvenlik sebebiyle tam olarak kişinin bilinmemesi sebebiyle) ortalama olarak belirlenir. 22 Moral hazard is the risk that a party has not entered into a contract in good faith or has provided misleading information about its assets, liabilities, or credit capacity. Moral hazard can exist when a party to a contract can take risks without having to suffer consequences. à Three main sources of informational asymmetries in financial services: 1. Credence23 (güven) nature of financial services 2. Private information24 3. Transaction-specific investments (TSIs)25 Search goods Quality can be ascertained to a great extent before the purchase, during the search process. (e.g. pen, book, table…) Experience goods Quality can be ascertained only after the use, costlessly. (e.g. car) Credence goods Quality cannot be ascertained even after normal use. (e.g. financial products, car repair services) Assessment requires additional costly information. In the case of financial products, the investor frequently has to buy advice or other risk signalling mechanism to understand more about quality. Due to structural contract incompleteness, specification costs are very high. (so TCs) à Credence qualities can lead to ‘churning’ (çalkalanma) in investment advice. “Excessive buying and selling of securities in your account by your broker, for the purpose of generating commissions and without regard to your investment objectives.” (SEC) à It is a misuse of the fiduciary role (başkasının yatırımını yönetenin rolü) between intermediary and customer, due to the lack of monitoring by the latter (e.g. due to information asymmetry). 1. Adverse Selection Risk/quality assessment costs (inability to evaluate risk) – pre-contractual. ** Market for lemons. Buyer is unable to assess quality. Seller of good products will have no incentive to sell these good goods. They will sell goods with marginally lower quality until the value is equal to a lemon good. Outcome: good quality are gradually driven out of the market. 23 Yeterli bilgin olmadığı için uzmanın dediğine güveniyorsun. Mesela aracın %50 güçlü diyor tamirci, aslında %90, sen ama bilmediğin için tamirciye inanıyorsun. 24 Individuals tend to act opportunistically, i.e. withhold information if this benefits them. If parties disclose simultaneously their private information, there would be optimal allocation. However, this does not happen as parties behave strategically (opportunistically). -prisoner’s dilemma- 25 TSIs can involve both physical and human capital. Switching costs (sunk costs) of the investment can create ‘lock-in effects’ and ‘path dependency’. For instance, TSIs in opening or closing a bank or brokerage account leads to lock-in effects because of higher switching costs in changing financial service provider. (banka hesap kapama zor). **Outcome: Market breakdown (worst scenario in the spectrum) Key conditions: 1. Unobserved characteristic of product/service/individual 2. Divergence of interest between parties (i.e. advantage by withholding information) 3. Some gainful exchange among parties Two main implications (uygulama alanı): - Misselling - Deterioration (bozulma, kötüye gitme) of market quality. Market forces unable to reach a clearing price where demand meets supply. **Borrowers withhold (alıkoymak) information Bank and borrowers with different risk profiles. Two types of borrowers: low and high risk. The bank is only able to assess their risk to a limited extent. Low risk borrowers are structually mispriced. Outcome: Credit rationing (in equilibrium) - The interest rate may itself affect the riskiness of the loan pool: à Sorting potential borrowers adversely (olumsuz olarak) -adverse selection effect- Or the higher the interest rate, the higher chance of having more high risky borrowers. à Affecting the action of borrowers -incentive effect- Higher interest may affect the risk profile of the borrower’s choice of project (higher risk higher return) **OTC derivatives markets and interbank markets Mispricing & market breakdown (e.g. Lehman Brothers in 2008) ** Credence nature of financial products Inability to price risk properly Adverse Selection – Remedies i. Risk signalling mechanisms - Collateral (e.g. secured lending) -teminat- - CRA ratings - Educational achievements (e.g. specialised degree) ii. More investments in screening (to sort counterparts with private info) - Active mechanisms o Tests, background checks, etc o Contracts with incentive pay schemes vs fixed wages - Passive mechanism o Infer (anlam çıkarmak) private information from observable actions (of the company or of a benchmark: e.g. CDS26 spreads) iii. Vertical integration o No need for contracting 2. Moral Hazard Post-contractual information asymmetry. (Arabana sigortayı bedavaya yaptırırsan arabayı korumaya çalışmazsın) - Too high monitoring costs - E.g. insurance market Being insured with a too low risk premium may make people lax to take precautions to avoid or minimise losses. Outcome: opportunistic behaviour of the agent (exploitation -sömürü-) Three conditions: 1. Divergence -uyuşmazlık- of interest between parties (i.e. advantage by deviating -sapma- from contract) 2. Some gainful exchange between parties 3. Difficulties in enforcing the contract/agreement Agency costs: 1. Monitoring costs (to check agent’s actions) 2. Incentives for the agent (to align interests) – the client should still be interested in making an insurance 3. Residual losses (catch all category to include all the costs for the negligent behaviour of the agent) Examples of moral hazard: a. state deposit guarantee Risk-taking behaviours and too-big-to-fail institutions b. dispersed ownership management vs. shareholders c. credence nature of financial products inability to shop around& intermediary can free-ride 26 A credit default swap (CDS) is a financial derivative that allows an investor to swap or offset their credit risk with that of another investor. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse them if the borrower defaults. NOTE: Too-big-to-fail financial institutions are typically those entities that have: a. enormous size and complexity b. too interconnected with other financial institutions or non-financial entities c. internationally active d. provide essential services (such as payment systems, underwriting, etc.) à consequences are: - They can cause widespread distress and contagion if failure becomes unavoidable - Their size and interconnection may inevitably lead to a bail-out - There is no exit - They create distortions (çarpıtma, bozukluk) to competition through an artificial funding advantage and implicit subsidies To address the moral hazard risks stemming (kök salan) from TBTF entities, the global regulatory agenda (led by the FSB) is focusing on ways to make these entities pay mor efor their opportunism: >> capital surcharges >> total loss-absorbing capacity >> resolvability requirements >> higher supervisory expectations n The idea of splitting them up, bank structural reforms, did not find enough political support in the EU. In the US, there is the ‘Volcker Rule’, i.e. a federal regulation that limits certain risky investment activities, such as dealings with hedge funds and private equity funds. Moral Hazard—Remedies 1. More resources for monitoring and verification ,, greater transparency by the agent ,, third party monitoring (gatekeepers’ role) ,, monitoring for penalties or rewards 2. Competition among information providers ,, the level of quality of information would increase 3. Monitoring by markets (e.g. market for corporate control) ,, if you’re a listed company, your market would be monitored by markets 4. Explicit incentives in contracts (e.g. reward) 5. Bonding (for short-term projects) ,, posting (göndermek?) an amount of money to be forfeited (kaybedilecek) in the event of inappropriate behaviour (e.g. deposit) -kütüphane kartını kaybedersen 5 euro- 3. Hold-up TSIs transaction-specific investments-, among others, can lead to hold-up behaviour. Ex post strategic behaviour by a party to exploit the contract incompleteness about future events when that party enjoys a position of strength derived from the other party’s TSI or legal specifications within the contract or allocation of rights. It leads to: - Distrusts increases, so do monitoring costs (with risk of apathy by the one taken hostage) - Renegotiation will take longer under a hold-up threat - Increase of inefficient investments to improve the post-negotiation position - Reduction of transaction specific investments It typically happens in non-standardised contracts/relationship. Small creditor in debt restructing process Outcome: underinvestment (and resource misallocation) Remedies: a. Transparency b. Long-term contracts c. Statutory protection PUBLIC GOOD PROVISION (2nd market failure) A good or service is public if everybody can benefit from it, without reducing its availability (non-rivalry) and with no possibility to exclude who doesn’t pay for it (non-excludability). - Large pool of individuals benefit from it (purest form at global level) Delivered by the governments through different means, such as: a. Lender of last resort b. Prudential and business conduct regulation - These characteristics lead to free riding. Some countries may underinvest in financial stability to free ride on other countries’ efforts: à Leading to underproduction of financial stability at global level. à New supranational agreements and institutions to overcome this coordination problem (e.g. IMF). Degree of purity depending on size of benefitting pool of people. With small numbers the coordination problem is more manageable. Outcome: Markets have no incentive to provide this good. Exclusion Consumption Feasible Not feasible Rival Private Common goods goods Non-rival Club/toll Public goods goods Public good provision – Remedies 1. Direct public intervention Public institutions with binding powers provide the service (e.g. supranational institutions that intervenes to impose standards for greater global financial stability) 2. Public subsidies for the public good provision by ultimate beneficiaries Incentives from other schemes (e.g. link exclusive provision of services to obligations to preserve financial stability) Use of the taxation system to make citizens and businesses pay for basic science research carried out by private companies. (for example covid vaccines) NEGATIVE EXTERNALITIES Costs of someone’s activity that are involuntarily imposed on third parties (social marginal costs vs. private marginal costs). à Generator of these social costs does not internalize them. Remedies Pigouvian Tax (internalisation) à polluter pays It may not always lead to the most efficient outcome (e.g. SMC < SMB -benefits-) à so Coase advocated for incentivising bargaining. Central Clearing Counterparty A central clearing counterparty (CCP), also referred to as a central counterparty, is a financial institution that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for trades in foreign exchange, securities, options, and derivative contracts. CCPs are highly regulated institutions that specialize in managing counterparty credit risk. à Clearing Service The link between trading and settlement in which the obligations of each party to a transaction are finalised, that is, the process of transmitting, reconciling and confirming payment orders (or security transfer instructions) prior to settlement, possibly including the netting of instructions and the establishment of final positions for settlement” n After confirmation before settlement - Bilateral or centralised CCPs Negative externatilites from central clearing -Accelerated (hızlandırılmış) by a clearing obligation- 1. Negative impact on market liquidity Collateral (teminat) requirements pro-cyclicality 2. Race-to-the-bottom27 in risk standards Adjust collateral requirements to reach the critical volume of transactions. Potential Remedies: - Stronger initial margins by CMs - Capital buffers (too-interconnected-to-fail; Pigouvian tax-like) - Sound risk management regulation Prudential rules to redistribute burden a la Pigou and business conduct rules to create trust for negotiation a la Coase. (for example between CCP and CMs) KNIGHTIAN UNCERTAINTY Knight’s distinction between risk (measurable probability) and uncertainty (Knightian unpredictability) matters. à When there’s uncertainty, markets do not properly function, as price discovery mechanisms break down. Knightian uncertainty may require additional safeguards to make markets work, such as - Reduce areas of regulation that give rise to arbitrary outcomes (e.g. insolvency problems) - Capital buffers - Insurance (government-sponsored, if its cost kills exchange) 27 The race to the bottom refers to a competitive situation where a company, state, or nation attempts to undercut the competition's prices by sacrificing quality standards or worker safety (often defying regulation), or reducing labor costs. MARKET POWER It is the ability to raise price above the competitive level for a sustained period. It is a spectrum that goes from perfect competition (firms are price takers) to monopolistic power (the firm is price maker). In financial markets, exploitation of market power (and resulting market failure) often comes from the attempt to extract (ayıklamak) rent from specific contractual relations (via unfair commercial practices). à Bundling28, tying29… à It is typically the conduct (davranış) that is subject to scrutiny (inceleme) by competition authorities. LECTURE 3 – BOUNDED RATIONALITY THEORIES AND OBJECTIVES OF FINANCIAL MARKET REGULATION 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.”. 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) The Theory of Satisficing (Simon 1944)30 - Search costs are independent from the dimension/complexity of the choice. - We should rather talk of an ‘aspiration’ process, i.e. expectations about choice are ‘adaptive’ to the circumstances (to the search costs) and not independent from search costs (as for rational expectations). Individuals make choices that are merely ‘satisficing’, not ‘utility optimising’. 28 Bundling is a marketing strategy where companies sell several products or services together as a single combined unit. The bundled products and services are usually related, but they can also consist of dissimilar items which appeal to one group of customers. Bundled products are typically offered at discounts to stimulate demand, lifting revenues often at the expense of profit margins. 29 Tied selling, which is against the law, occurs when a company conditions the sale of a product or service only if that customer purchases some other product or service. 30 Satisficing is a decision-making strategy that aims for a satisfactory or adequate result, rather than the optimal solution. Instead of putting maximum exertion toward attaining the ideal outcome, satisficing focuses on pragmatic effort when confronted with tasks. This is because aiming for the optimal solution may necessitate a needless expenditure of time, energy, and resources. The satisficing strategy can include adopting a minimalist approach in regards to achieving the first attainable resolution that meets basic acceptable outcomes. Satisficing narrows the scope of options that are considered to achieve those outcomes, setting aside options that would call for more intensive, complex, or unfeasible efforts to attempt to attain more optimal results. 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) BOUNDED RATIONALITY Human behaviour is contingent on context and other psychological factors that maket hem deviate from a ‘rational’ choice. Key cognitive biases and heuristics affect: Judgment (i.e. valuation of different options) Decision-making (i.e. taking the utility-maximising decision) Bounded willpower and self-interest These are two additional cases of violation of the utility maximisation at individual level. - Bounded willpower refers to situations in which people take action knowing it is against their long-term interests. Many 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. The Expected Utility Theory31 & Its Anomalies This hypothesis states that under uncertainty, the weighted average of all possible levels of utility will best represent the utility at any given point in time. 31Expected utility refers to the utility of an entity or aggregate economy over a future period of time, given unknowable circumstances. Expected utility theory is used as a tool for analyzing situations in which individuals must make a decision without knowing the outcomes that may result from that decision The expected utility theory was first posited by Daniel Bernoulli who used it to solve the St. Petersburg Paradox. Expected utility is also used to evaluate situations without immediate payback, such as purchasing insurance The assumptions (ASMs) of the Expected Utility Theory32 (EUT) still today dominate the normative approach to economic theory. - By Bernoulli, 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. - St Petersburg Paradox (SPP) shows that the EV is infinite. Bernaoulli tried to solve it by introducing the concept of ‘utility’ i.e. an individual utility for given levels of monetary income. Utility is a non-linear function with decreasing marginal utility of income (concave). 5 assumptions behing the EUT 1. Dominance 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, they don’t prefer B to A. 2. Transivity If someone prefers A to B and B to C, so they then prefers A to C. 3. Invariance/ Independence The individual should be indifferent to how basket of goods with the same utility are presented. Procedure invariance à preferences over prospects/lotteries are independent of the method used to elicit them. Description invariance à 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. 4. Completeness Individuals are able to compare alternatives and to make a ranking 5. Monotonicity ‘More is generally good’ and does not influence preferences between two goods with the same utility. NOTE: Decision-makets’ attitudes towards risk = averse, neutral, or seeker. n Key violations of EUT - Allais’s Paradox 1. Common Consequence Effect 2. Common Ratio Effect Result: Violation of indepence/invariance. 32Expected utility theory is used as a tool for analyzing situations in which individuals must make a decision without knowing the outcomes that may result from that decision, i.e., decision making under uncertainty. These individuals will choose the action that will result in the highest expected utility, which is the sum of the products of probability and utility over all possible outcomes. The decision made will also depend on the agent’s risk aversion and the utility of other agents. This theory also notes that the utility of money does not necessarily equate to the total value of money. This theory helps explain why people may take out insurance policies to cover themselves for various risks. The expected value from paying for insurance would be to lose out monetarily. The possibility of large-scale losses could lead to a serious decline in utility because of the diminishing marginal utility of wealth. - Ellsberg Paradox Result: People tend to bet for or against information they know, violation the dominance assumption. This also shows the preference for certainty in people’s decision-making. So the beginning of the research that led to the Prospect Theory. The Prospect Theory It tries to embed the violations of transitivity, dominance and invariance into a theory to understand better how people assign value to the different options (still maximizing their utility). Two main effects, assessed by the Prospect Theory, that violate EUT: 1. Certainty Effect (Allais/Ellsberg paradoxes) A reduction of the probability of an outcome by a constant factor has more impact when the outcome is 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 This shows diminishing marginal sensivity to deviations from reference point (more sensitive to first large negative deviation) This also shows tendency to take undue risk when facing a loss, i.e. giving more value to losses (as a result of risk aversion). à Implications (affects) 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) – fear of missing out. 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. 3. Isolation Effect Result: Violation of dominance—people tend to ignore the first step. à The Status Quo Bias From loss aversion (combination of certainty and reflection effects mainly), research has also discovered another important bias: the status quo bias. 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. – Status quo bias can lead to inertia (eylemsizlik) in savings behaviours. Ex: pension savings and the use of autoenrollment schemes. à Endowment Effect33 A direct consequence of loss aversion, combined with a status quo/reference point bias. 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). à Cumulative Prospect Theory—The new weighting function As a result of a combination of certainty and reflection effects, the cumulative prospect theory applies weighting 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 (azalan duyarlılık), not only with respect to outcomes but also with respect to changes in probabilities (and the perceptions of them). - You tend to underestimate little probabilities; you tend to overestimate the higher probabilities. Three Main Conclusions: 1. People tend to think of possible outcomes usually relative to a certain reference point (often 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 à 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 à probability weighing 33The endowment effect describes a circumstance in which an individual places a higher value on an object that they already own than the value they would place on that same object if they did not own it. Endowment effect can be clearly seen with items that have an emotional or symbolic significance to the individual. Research has identified "ownership" and "loss aversion" as the two main psychological reasons causing the endowment effect. vs. certain outcome Low probability High probability Win Risk proneness Risk aversion Loss Risk aversion Risk proneness Cases of probability weighing Insurance: people are averse to pay more premiums because they overweigh the small probability of loss of non-payment. EUT (Expected Utility Theory), 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. The Equity Premium: Excess return on stocks over fixed income; the larger- than-expected observed disparity implies a large degree of risk aversion in standard models of asset pricing. Agents are myopic (due to loss aversion). In the short run, equity has likely negative returns, so premium is consistent with the prospect theory. Assuming that people are almost twice as sensitive to small losses as to corresponding gains, the premium is consistent with the hypothesis that investments are evaluated annually. à Bounded rationality – Other theories Preferences Reversal It shows that the choice between two lotteries is the contraty 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) –aslında hesaplama yapınca bu şekilde ama çoğunluk burada P-beti seçiyor. People respond differently to choice and evaluation. Result: violation of (procedure) invariance & transitivity assumptions (unique) Regret Theory A decision maker chooses between two prospects based not only on the outcome he receives but also on the outcome he would have received had he chosen differently (anticipated regret) Result: systemic violation of transivity and monotonicity assumptions 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 a way that sharply directs the decision maker to compare acts and states’. 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. Mapping Biases in Evaluation & Decision-making 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 a. 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% drivers. Implications: - If negotiating parties assess value of alternatives in self-serving ways, this erodes space for an agreement around their reservation values. - 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. - 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 bargainers that are trying to get what is fair. 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 (çıkmaz). b. Anchoring and adjustment 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 costs34. 34Sunk costs are those which have already been incurred and which are unrecoverable. In business, sunk costs are typically not included in consideration when making future decisions, as they are seen as irrelevant to current and future budgetary concerns. 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 (mecbur bırakmak) or disclose information about the underlying characteristics of the anchoring numbers vis-a-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 them. c. Hindsight Bias In hindsight, people tend to overestimate what could have been anticipated in foresight (creeping determinism). People naturally integrate an 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. - Ongoing discussion in Europe about presenting past performance to retail investors in disclosure documents. Remedies: There is no successful strategy. Some have reduced the bias, such as informing about the bias or forcing parties to unlearn about the event that taught them about precedent ones. i. 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 over saving (perceived as a loss). Tendency to go for immediate gratification (like the certainty effect) over long-term benefits. Examples: 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 (regulator choose it for you), financial education. ii. 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 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. iii. Overconfidence Bias Situation that leads to unfounded optimism and suppression of evidence that confutes the argument. People tend to overestimate (to be confident 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. 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. What is left of the EMH? Believers of EMH consider behavioural biases simply as temporary and soon somebody will arbitrage them out. 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) derived from adaptive expectations developed by Simon. - Prices reflects 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. 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 à arbitrage is competed away (making it unprofitable) AMH à arbitrage can be profitable based on ‘environmental’ conditions becoming more conductive to such trades. Survival (AMH) vs. Utility Maximisation (EMH) Mar Moral Hazard Advers Negativ Hold-up Bounded Market ket e e Rational Power Failu Selecti Externa ity re on lities Driv Private Qualit Uncerta Contract Irrationa Monopo er information y inty incomplete l listic evalua ness behaviou attempt tion r inabilit y Even Opportunism Marke Illiquidi Underinves Cognitiv Rent t t ty & tment e biases extracti breakd contagio & on / own n heuristic dead s weight loss Rem Transparency/co Risk Safegua Contractua Transpa Reduce edy ntractual signals rds l incentives rency / barriers incentives or special default to clauses options entry/ex etc. it (via remedia l actions or sanction s) Financial Market Regulation Objectives, Key Strategies and Limits Theories of Regulatory Intervention à Public Interest Theories Markets are a form of organization which, as reinforced by certain (normally private) legal institutions, is supposed to advance economic welfare, more specifically allocative efficiency. Its objectives 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) Market forces alone are insufficient (due to these weak assumptions behind) - Individualism (total isn’t sum of individual welfares) - Fully rational (utility-maximising behaviour) and fully informed individuals - No externalities (contracts, property rights and tort might not be enough) - Competitive markets (private law cannot guarantee full competition) Private law (allocation of rights) is insufficient to deal with non-economic goals - Distributional effects - Paternalism (safety regulations; e.g. seat belt use) - Community values Wrong to assume that what is socially desirable can always be left to a market decision. For instance, resolution of public good issue can only be a collective choice. That’s why we have property rights (e.g. common good tragedy or tragedy of the commons)35. à Private Interest Theories Regulation can fail. - More role for self-regulation (reputational capital) - Regulatory capture (recruitment from industry, victiom of itself) Positive Theory - Regulation is a response of politician to interest group. - Regulation raises barriers for newcomers and helps to freeze markets (lisencing…) Normative Theory - Regulation never achieves allocative efficient, in Pareto sense, but in a Kaldor-Hicks one, unless it addresses unproductive activities, unless rent seekers create wasted resources devoting to capturing wealth transfers (unproductive activity) o 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. o Pareto efficiency means allocation of resources in which no someone is made better off without anyone else being made worse off. Regulatory failures? - Inadequate response - Regulatory capture (recruitment from industry) Overall, there may not always be solid evidence for many interventionist measures and there are areas where private interests prevail, but it’s largely the public interest theory that usually prevails. Because private law is insufficient to deal with non-economic goals, so we intervene with regulations. 35The tragedy of the commons is an economics problem in which every individual has an incentive to consume a resource, but at the expense of every other individual—with no way to exclude anyone from consuming. Objectives of Financial Market Regulation Overarching objectives - Deal with anomalies that do not allow intermediate reflection of information into prices (EMH) à ex ante - Rectifying (düzeltmek, doğruya çevirmek) the negative impact of market failures à ex post Five more targeted objectives: 1. Investor protection Ex: issues of securities, investment services provision. - Information, conduct and prudential regulations - Consumer protection in retail finance relies on behavioural considerations 2. Financial stability - Systemic risk and domino effect - Micro and macro prudential regulation 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 EX ANTE REGULATORY STRATEGIES IN FINANCIAL MARKETS 1. Entry regulation (get a licence, etc) – 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 (how to run the business ex ante) – 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 (you have to disclose the risks) – 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 (rules to financial stability) – The rules that direct how financial firms that have systemic impact should manage their assets and liabilities. à Capital adequacy rules for banks and some investment firms [liability rules]; à Rules on liquidity and maturity (nature) of asset holdings [asset rules]; à Rules on investment policies (such as risk profile) of portfolio management and risk allocation activities. 5. Governance regulation (how to manage or organize) – 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. 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. SCOPE FUNCTION TOOL Ex Ante Strategies - Licencing - Qualification Entry Regulation Participation requirements Profiling - Product regulation - Structural restrictions Conduct Regulation Trading - Trading restrictions - Conduct of business Disclosure Information Regulation Education & price discovery Prudential Regulation Stability - Balance sheet Board structure Governance Regulation Governance Compensation Risk management Ownership restrictions Ex Post Strategies - Lender of last resort Insurance Insurance Bail outs Resolution procedures Resolution Stability Limits of Financial Market Regulation Regulatory strategy Rule versus principle-based regulation (ex: UK Financial Service Authority) Rule-based: very prescripted Principle-based: Leaves more flexibility, it could lead too much flexibility, and not too sufficient to protect from market failures. Institutional design 1. Functional/institutional à insurance, securities, banking 2. Single (or consolidated, ex: UK FCA in early 2000s) 3. Twin Peak (prudential & business conduct) - Today’s institutional design in Europe is a combination of 1 and 3. - The Twin Peak is gradually becoming the dominant model. 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) LECTURE 4 – FINANCIAL MARKET FUNCTIONING AND THE ROLE OF DISCLOSURE EMH – prices fully reflect available information. - Only new information can move prices, but it is unpredictable. - So prices changes are random. - Depending on the form of the efficiency, time to reach the efficient price equilibrium will be different. But eventually full reflection. Implications 1. zero transaction costs 2. only new information can move prices 3. there’s no “free lunch” (more risks-more returns, no space for systematic arbitrage) 4. the more private information, the more somebody can profit by trading on it A market is liquid when it’s: - Tightness/speed (the possibility to turn over a position at the fastest speed technically possible). Involves three tasks: o Production of information § Firm specific (e.g., quality of management) § General market information (e.g., industry prospects) o Verification of accuracy § Explicit information (e.g., financial reports) § Implicit information (e.g., price movements or volume trading) o Pricing information § Analysing information (not in isolation) § Trading (transmission of information to the market) - Depth/quantity (market’s ability to absorb quantities) o Portfolio adjustments (to align with investors’ predetermined level of risks) o Consumption/investment adjustments (liquidating investments for consumption and vice versa) o Divergence of opinions (trading between large investors with lower and higher valuations) - Resiliency (the speed to which prices return to their fundamental value after a move) – ability to reflect available information depends on the form o Strong § Low amount of newly available information. Price embeds: inside, public and historical information o Semi-strong § Fair amount of newly available information Price embeds: public and historical information o Weak § High amount of newly available information. Price only embeds historical information. Three similar components under the EMH: - Fully reflect: i. Pricing process (speed) ii. Liquidity provision (quantity) iii. Available information (price resiliency) ** these help us to understand how regulation can guide markets towards allocative efficiency. à reality: there is no stable equilibrium. Prices will always try to reflect new information but will never succeed. Grossman and Stiglitz suggested that: - Arbitrage is costly, so never equilibrium. - The Grossman-Stiglitz Paradox is a paradox introduced by Sanford J. Grossman and Joseph Stiglitz in a joint publication in American Economic Review in 1980 that argues perfectly informationally efficient markets are an impossibility since, if prices perfectly reflected available information, there is no profit to gathering information, in which case there would be little reason to trade and markets would eventually collapse. o Prices convey information from informed to uninformed investors o The greater noise, the less informative the price system is, reducing expected utility of uninformed investors. Market Participants 1. Insiders They rely on non-public firm-specific information Unable to process general market information 2. Noise Traders Noise traders falsely believe that they have special information about the future price of the risky asset. It can increase costs for arbitrageurs. They can lead to some short-term gains (e.g., housing bubble) On average, they do not lose against other players. 3. Liquidity Traders Do not collect information. Only allocate resources between savings and consumption. They mainly act with “buying and holding” strategies and they only care about liquidity (bid/ask spread) 4. Information Traders or Analysts Professional investors (analysts) Institutional investors, money managers and others (e.g., hedge funds) Collect, evaluate and price both firm specific and general info Specialists or market makers Liquidity providers setting the bid/ask spread at a price. They pass on losses against more informed traders to liquidity and noice traders via bid-ask spread. Not as informed as analysts on firm-specific information. Stock pickers Slower than analysts (often relying on analysts services). NOTE: There are only two groups that can promote market efficiency. Insiders and analysts (information traders) trade to capture the value in their informational advantage. à A trade is therefore triggered when the price change is not justified by known information but by “new” information. Result: regulation protects analysts. àTrading against a superiorly informed trader or based on fradulent information may result in systemic losses (amplifying adverse selection risks) and so asset mispricing, leading to a freezing of market activities. Result: regulation prosecutes insider trading and market manipulation. However, both liquidity and noise traders have only indirect impact on market efficiency, because they are: -not losing against analysts and insiders -not distorting market prices (in the short term they can, but not in the medium) -bearing the costs of illiquidity -holding the other side of the trade for informed traders (analysts). **This inner nature of market activity creates a constant incentive to gain an information advantage, so improving price accuracy, liquidity and overall market efficiency. Analysts are the only group that promote efficient and liquid capital markets. * They counter the action of noise traders based on better information. * The more they can counter price deviations, the more prices will reflect available information, the more markets will be efficient. Caveats -ikaz- to apply: -Deviations between price and value will always happen. (analysts may need a big pocket to stay in the market) -What matters is the adjustment mechanism and analysts are an essential part: >> Searching, verifying, analysing/pricing firm-specific and general info is costly >> The higher these costs, the larger will be the price deviation will need to be to compensate analysts. The Role of Regulation Regulation should aim to increase the accuracy of analysts in capturing price/value deviations by: - Reducing costs of pricing information - Reducing risks of not capturing the deviation (e.g., misleading information) All of the rules below need effective enforcement mechanisms to work! à A. Mandated disclosure rules Reducing the probability of misevaluation by reducing the costs of pricing information à B. Prohibition of fraud and manipulation (see lecture 5) Reduces probability of encountering misleading information (so risk of not capturing the price deviation) à C. Prohibition of insider trading (see lecture 5) Reduces the risk of crowding out analysts, so deteriorating market quality under adverse selection. A. Mandatory Disclosure Their main objective is to protect investors (upholding the caveat emptor principle) But investors do not read prospectus. So, investor protection can be achieved: 1. Directly, via the role of intermediaries and professional investors (analysts) 2. Indirectly, via the possibility to use this document against defrauding issuers in the enforcement of investor rights (ex post) à mandatory disclosure reduces the costs of pricing information So, more analysts will operate in the market, the higher probability of reducing the gap between price and valuation. General benefits for the firm in the reduction of cost of capital via: 1. showing the credible commitment In the case of issuers, especially future ongoing disclosure (together with the role of the underwriter) Barriers to exit and public/private enforcement make this commitment to indefinite disclosure credible 2. Reducing price/value deviation (improves price accuracy), which: Improves liquidity by reducing transaction costs (bid/ask spread) from information asymmetry and creating a competitive market for analysts Lower risk in corporate acquisitions 3. Helping to monitor management, so increasing appeal for institutional investors (relational investment) Mandated disclosure reduces searching costs, avoiding duplicative efforts by analysts. Standardised formats (comparable with other firms’ info) also reduce analysis (pricing) costs. Also, it reduces space for insider trading and increases availability of information that can reduce price/value gap. à increasing the availability of analysts and reducing noise trading. Mandated disclosure also benefits liquidity traders. à lower asymmetric information among traders. Lower risk for liquidity traders to trade against more informed traders and lose. Why does disclosure need to be mandatory? - The firm is the one that can produce firm specific information at the lowest cost. Opponents of mandatory disclosure says that it is already in the interest of the firm to provide as much information as possible, because it reduces the cost of capital. à so, they say it’s duplicative and expensive. Ø Other reasons for the firm not to disclose (negative impact of disclosure) Disclosing may reveal firm’s commercial strategies. Providing value to the firm’s stakeholders (e.g., creditors and employees) that can be used to improve their negotiating position. Reducing the possibility to exclude other interested parties from using it against the firm. Increases the risk of litigation. - Optimal supply of information by listed companies is a public good with important externalities. o Non-rival and non-excludible externalities consist of: § Improvements to market liquidity § More efficient public pricing (incl. standardisation) § More effective monitoring of management THE SYSTEM OF MANDATORY COMPANY DISCLOSURE Going public o Disclosure at issuance § Prospectus rules § Admission to listing/trading requirements o Ongoing disclosure § Accounting rules (GAAP) Common language § Financial reporting Periodic reporting Event-driven Private company o Limited information disclosure § Limited accounting rules Three types of primary markets issuance: i) initial public offerings (IPOs), ii) captive issuance (private placement to selected investors), iii) fringe direct offerings. Companies can go public also via “reverse merger” (i.e., purchasing a publicly listed company and then merging in one publicly traded one). Benefits of going public: Lower cost of capital Increased visibility and profile with customers and suppliers Eligibility for inclusion in indexes and attract more investors Diversification of investor base Exit options for owners Incentives for managers and employees to participate to company’s success Have an independent real time valuation of the business Costs of going public: Administrative costs from more stringent legal obligations More dependence from exogenous factors More external scrutiny and disclosure ~Disclosure at issuance Prospectus to be published when securities are offered to the public or admitted to trading on a regulated market situated or operating within a MS. Prospectus Regulation’s key exemptions: certain types of securities, offers, admission to trading, an offer of securities to the public from a crowdfunding service provider. There’s a possibility of opt-in. Prospectus rules: 1. need for pre-approval by national competent authorities (NCAs) In terms of completeness, comprehensibility, consistency 2. pre-approval defines ex post liability (costly legal options) Civil liability for a clearly identified responsible, but not for summaries. 3. Must include: The assets and liabilities, profits and losses, financial position, and prospects of the issuer and of any guarantor. The rights attaching to the securities; and The reasons for the issuance and its impact on the issuer. 4. To be published in a single document or divided in i) a registration document, ii) a securities note, iii) a summary. 5. Combination of soft (general info) and hard (financial/historical info) is key. 6. Essential information about the issuer includes risk factors that are material and specific. (strategic/operational/financial/compliance risks) à there is a simplified disclosure for secondary issuance of securities ‘fungible to existing’ listed ones. Regulation also looks deeper into investor and issuer types: 1. summary à useful for retail investors 2. growth prospectus à to reduce fixed costs on smaller issuers with a specific summary ~Ongoing Disclosure Two main sets of accounting standards that are benchmarks: 1. The US Generally Accepted Accounting Principles (GAAP) Developed by FASB and the GASB. 2. The International Financial Reporting Standards (IFRS) Developed by IASB. Used in 166 countries and required for listed companies. Its application is more complex, as principle-based accounting (big divergence with rule-based US GAAPs). Under EU rules, listed companies must prepare their consolidated financial statements in accordance with IFRS. Subsidiaries (alt şirket) of the group may follow national GAAPs. Other requirements apply to non-listed and small businesses. >> a simplified reporting regime for SMEs and a very light regime for micro- companies. >> EU countries can opt to extend the use of IFRS to annual financial

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