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Godfrey Cadogan is a Research Scientist in Risk and Uncertainty at the Institute for Innovation and Technology Management, Ted Rogers School of Management, Ryerson University. His research focus is on application of diverse branches of mathematics such as algebraic topology, number theory, group... More
  • A Regulator's Exercise Of Career Option To Quit And Join A Regulated Firm's Management With Applications To Financial Institutions

    The following is a summary of the results presented in the hyperlinked paper entitled: A Regulator's Exercise of Career Option To Quit and Join A Regulated Firm's Management with Applications to Financial Institutions

    For firms in a regulated industry, the public sector often define their operating parameters. Thus firms' profit opportunities are constrained. Moreover, regulatory agencies provide oversight and enforce those constraints which are delegated to regulators who interact with firm management. Thus, there are risks in the process. If regulators fail to enforce the constraints as expected, there are moral hazard costs that the public may bear. By contrast, if regulators exceed the intended constraints, then firm profitability is affected and that may lead to firm inefficiency. In that context, for the duration of their careers, regulators hold a range of valuable options which, depending on how they are exercised, may benefit the regulated firms and their shareholders at the expense of the public or vice versa. Hence, the regulator problem is embedded with moral hazard risk that the public may wish to curtail.

    Consider the American banking sector. Within established parameters and guidelines, commercial bank franchises are intended to meet public credit needs while providing returns to their shareholders. Monitoring and examining the bank "franchises" in the U.S. give rise to a range of regulators - depending on whether the institutions are federally or state chartered. Further, regulations arise with respect to protections for depositors. Other related considerations of risk and return drive further monitoring and restrictions in banking. For example, financing activities and asset acquisitions are also constrained (e.g. no common stock investments); prices may be regulated or not (e.g. Regulation Q); capital adequacy may be proscribed both with respect to quantity and to mix of debt and equity; asset growth may be facilitated or not (e.g. appropriate collateral, and margin requirements on stock purchases etc). It is normal in banking for regulations to produce push - pull tensions, with management desiring greater degrees of freedom than may be allowed under the status quo.

    Such tensions provide opportunities wherein regulators might exercise their discretion to support the management "push" or the public "pull" in their reports to bank management, to policy makers, and the public. For example, it is a regulator's responsibility to evaluate management and bank performance on such things as earnings and financial leverage and to assign comparative institutional rankings (e.g. CAMELS scores). In that process, the regulator builds a career whose market value changes with the exercise of their discretion. This process is known, and as a result, costly departure barriers are established to restrain regulators and minimize conflicts of interest. However, it is likely that market for [ex]regulators discount such departure costs.

    In our model, a regulator designs an abstract mechanism that embeds regulatory signals in the firm's capital structure to induce the firm to engage in some desired action. For instance, she may engage in regulatory forbearance for highly levered firms, or [s]he may favor tax cuts on capital gains or tax deduction of interest expense or deregulation of an industry because a particular firm that [s]he intends to join after leaving her regulatory position is an industry leader. So [s]he designs a mechanism, i.e. a vicarious contract, for that purpose. However, agency conflicts arise from information asymmetry when the regulator has information about career options [s]he plans to exercise in the future, and stake holders in the firm or members of the public do not.

    Oct 28 6:58 AM | Link | Comment!
  • The Risk Premium For Minority Banks Altruistic Portfolios In Underserved Communities

    Motivated by behavioral asset pricing theory, we introduce a statistical risk accounting model to characterize the compensating risk premium required to sustain minority banks' (MBs) altruistic motive to provide credit in underserved communities. The research is available at the hyperlink The Risk Premium for Minority Banks Altruistic Portfolios in Underserved Communities, and it is accompanied by charts and other graphics that perhaps tell a better story than that presented here. Our model predicts that increased bank capitalization, and brokered deposit (BD) exceptions, compensate risk when the incremental internal rate of return they induce is negatively correlated with the internal rate of return on extant MB loan portfolios. Thus implying, paradoxically, that loan portfolios levered by increased capital, and brokered deposits, militate against altruistic motives. This suggests that for a given amount of altruism, minority banks are better served by tactical portfolio allocation in an expanded investment opportunity set. Using Federal Reserve Statistical Release (12/2011) on select FFIEC Form 031 (``Call Report") data, we fit a risk-return function for minority banks and estimate the compensating risk premium for return on assets. We provide back of the envelope formula for estimating minority bank profitability based on loan loss ratio, leverage ratio, and operating expense. And we provide a ranking of minority banks for profitability, and price of risk. These results have implications for the efficacy of U.S. Dep't of Treasury's Community Development Financial Institutions (CDFIs) Fund capacity building and bank capitalization initiatives, and de facto brokered deposit programs, as compensating risk mechanisms for minority and women owned banks. For they are excepted under Section 29 of the Federal Deposit Insurance Act, enacted through the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) (eff. 1989), and the Dodd-Frank Wall Street Reform and Consumer Protection Act (eff. July 2010) mandatory evaluation of such programs.

    Oct 28 6:45 AM | Link | Comment!
  • Trading Rules Over Fundamentals: A Stock Price Formula for High Frequency Trading, Bubbles and Crashes
    The Financial Industry Regulatory Authority (FINRA) held a conference here on May 23, 2011 in which several proposals addressing the impact of high frequency trading (HFT) on stock and derivative prices were setforth. In fact, HFT is one of the most actively researched areas of market microstructure and asset pricing theories at this time. The evidence suggests that computer algorithms that portend HFT do not price assets on the basis of fundamental valuation. They appear to be driven by arbitrage opportunities. Fortuitiously, while addressing here issues raised in an award winnning paper by Prof. Robert Jarrow entitled Active Portfolio Management and Positive Alphas: Fact or Fantasy?, a stock price formula for high frequency trading was developed. As far as this writer knows, it is the only stock price formula for HFT. That formula plainly shows how the stock price of highly liquid stocks is influenced by high frequency traders strategies. It is based on exposure to hedge factors, and the volatility of hedge factors. For instance, the forrmula allows an analyst to  price a spot index using data on exposure to and volatility of the relevant E-mini contracts. That paper is entitled Trading Rules Over Fundamentals: A Stock Price Formula for High Frequency Trading, Bubbles and Crashes. While the math may be fairly sophisticated to some, the salient characteristics are reported in relatively nontechnical terms in the introduction. Hopefully, the stock price formula stimulates others to derive a better formula.
    Jan 03 2:49 PM | Link | Comment!
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