Category: Faculty

Stress test scenarios miss the boat

Professor Jonathan Parker

The Dodd-Frank act requires that large financial institutions be more closely monitored for exposure to systematic risks.  A key part of this monitoring is stress testing.  Regulators announce a set of adverse scenarios, and financial institutions calculate and report their losses in each scenario.  Regulators get to see how exposed the institutions are.

The OCC has now released the scenarios for 2014.  You can easily download and look at them here.  The scenarios detail lots of economic outcomes: each scenario has 28 variables that mostly turn bad.  But I am really disappointed – this regulatory approach is not addressing the financial-crisis type exposures at all.

There are only three scenarios, one of which is the baseline scenario. The other two are really two typical recessions – one bad, one worse.  What use is this?  Where are those once a century scenarios, like a house price collapse?  Where are the unlikely but possible bad scenarios like a run on the US dollar or US debt?  How about a large fiscal inflation?  In none of the adverse scenarios do long interest rates.  My suggestion: reverse the detail – more scenarios, each with fewer variables.  There are many factors in asset pricing for a reason – there are many sources of risk.  Regulators seem to think there is only one.  Be more creative. Think about unlikely bad outcomes  That’s the entire benefit of the exercise.  Make banks think about these scenarios; make regulators aware of how bad (or not) the unlikely scenarios would be.

Large financial institutions do not have to evaluate their losses in the scenarios that keep me up at night.  I hope the regulators also do not sleep so well.

Jonathan A. Parker is the International Programs Professor in Management and a Professor of Finance at the MIT Sloan School of Management.

Optimal Contracting and the Securitization of Human Capital

Professor Jonathan Parker

An interesting new company, Fantex, is securitizing human capital.  They are offering assets whose payouts are determined by a given athlete’s future earnings, in this case both Arian Foster and Vernon Davis, players in the National Football League.  Here is a New York Times article from today, and here is a more complete description from former Goldman Sachs employee and current Grantland writer Katie Baker.  (Before heading out to buy, note that the convertible bonds that the story describes are pretty complex and not just a bond backed by a share-of income.)

This financial innovation could be bad thing, and I expect that sports leagues make this illegal, or at least a violation of the terms of contracts.

Why?  Because private contracts like NFL contracts are typically carefully structured by employers and employees to balance risk-sharing and incentives (and to be consistent with salary cap rules).  On the one hand, employees do not want lots of income volatility.  For a given expected income, people prefer to be paid a certain amount, rather than having to bear uncertainty due to variations in future performance, particularly due to factors that are beyond their control.  On the other hand, employees that get paid more if they do better have an incentive to do better, to train harder, eat right, etc.  Would someone work as hard if they were only getting fifty percent of the money they earned?   In general, economists think not.   This dis-incentive is the source of the economic cost of taxes, why higher taxes mean lower output.  So contracts provide insurance and a safe payment where the effects of monetary incentives are weak or the effects of forces beyond the employee control are large (such as for injuries).  Similarly, contracts provide incentives and a variable payment where the effects of incentives are large and mostly controlled by the employee (such as attendance at practice or weight gain).

The central lesson of this theory is that incentives are costly.  Because employees dislike risk, a contract involving more incentives has to pay more on average to the employee to compensate for bearing the additional risks.

Now suppose that an optimal contract is agreed to by both parties.  But now a new securitization market opens, and the employee takes the incentives part of the contract, for which they are on average being paid more, and securitizes it so as to insure the risk away (at least partly).  The employee has just re-written the contract in a way that is disadvantageous to the employer who now no longer has an employee with (as strong) incentives to perform well.  Anticipating this possibility undermines the writing of the original contract.

An analogy might help.  Imagine a CEO who was highly incentivized by company stock and as a result highly paid securitizing his human capital.  Securitization the CEO’s human capital would look like the CEO shorting the company stock – turning the expected high income into a sure thing, unaffected by company performance.  Thus CEO contracts and US regulations prohibit this.  And this is socially optimal (at least the bit about prohibiting shorting own-company stock).

So, while, the general idea of securitizing human capital seems great, it can undermine incentives.  For contractual relationships (rather than spot labor markets), it opens the possibility for employees to change incentives after contracts have been written.  In the case of Arian Foster, we are only talking about 5 percent of earnings.   But if I were the NFL, I would be quite concerned about my employees using financial instruments to weaken the strength of incentives.

Jonathan A. Parker is the International Programs Professor in Management and a Professor of Finance at the MIT Sloan School of Management.

 

 

Professor Robert C. Merton featured speaker at Global Leader Series Economic Forum

Professor Robert C. Merton

Organized by the CUHK Business School, The Global Leader Series Economic Forum held on 16 October “proved a great success, filling the Grand Ballroom of Kowloon Shangri-La with over 600 participants and drawing an impressive array of eminent speakers and attendees. Titled ‘The Rise of the Asian Century’, the forum featured four world-renowned economists: Prof. Liu Mingkang, former Chairman of the China Banking Regulatory Commission; Prof. Robert C. Merton, 1997 Nobel Laureate in Economic Sciences and School of Management Distinguished Professor of Finance at MIT Sloan School of Management; Prof. Lawrence J. Lau, Chairman of CIC International (Hong Kong) Co., Limited; and Prof. Fred Hu, Chairman of Primavera Capital Group. Before a captivated audience, they knowledgeably presented their views on the challenges and opportunities of Asia’s economic and financial development as China continues to gain prominence.”

Click here to see the video footage from this event.