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IMF Paper Introduces A New Financial Soundbite: Presenting "Rational Bubble-Riding"

Remember when one of the hot Fed buzzwords of 2014 was "macro-prudential regulation", a phrase which was supposed to mean that the Fed can centrally plan every asst price, as well as catch asset bubbles in the making and prick them, also leading to such hilarious contraptions as the "Bubblebusters" - the Fed's own committee To "Avoid Asset Bubbles." The phrase has since quietly disappeared. And thanks to a new IMF White Paper we may know the reason why.

According to IMF researcher Brad Jones, who wrote "Asset Bubbles: Re-thinking Policy for the Age of Asset Management", the "business risk of asset managers acts as strong motivation for institutional herding and "rational bubble-riding."

This is a critical observation, and one which suggests that the mere groupthink of massive asset managers is what leads to not only herding, lack of originality and the "hedge fund hotel" phenomenon, but also to recurring and ever greater asset bubbles.

As Jones further writes, "subdued leverage is not a sufficient condition for financial
stability—if systemic risk, and activity in the wider economy, is shaped
importantly by large shifts in risk premia owing to the "rational herding" motivations of asset managers."

This also explains why "rational" asset managers no longer "hedge" but merely piggyback on each other's ideas, and why some precursor events to bubble pops involve far less intellectual concepts such as simply demonstrating that the groupthink is wrong: such as housing can only go up, or "Lehman Brothers is fine."  

In short, anyone trying to answer "why asset bubbles have posed—and will likely continue to do so—a threat to economic stability despite financial markets being characterized by more complete information" is urged to ask the guys below: not only do they no longer have any alpha creation capabilities but they mask their lack of alpha capabilities with massive beta-boosting leverage!

 

So for all those curious where the next bubble burst will emerge from, the table above is as good a place to start as any. Because in a world in which central banks have "removed all risk" and to extract any return over the risk-free rate (which in the new normal is now the stock market) one has to layer ever greater and greater leverage and collude behind the scenes at idea dinners and on anonymous websites to generate attractive IRRs, the world's asset managers are no longer a stabilizing force, one meant to isolate, capture  and profit from arbitrage and valuation opportunities, but merely the latest systemic destabilization factor.

As such, when the next systemic collapse comes, taxpayers will be on the hoot to not only bail out the banks (both commercial and central) but the hedge fund community as well.

You are welcome.

* * *

From the conclusion of Asset Bubbles:Re-thinking Policy for the Age of Asset Management

By process of deduction, this paper seeks to offer an explanation for why asset bubbles have posed—and will likely continue to do so—a threat to economic stability despite financial markets being characterized by more complete information, a greater array of securities through which to express views, and a more pronounced impact of sophisticated institutional investors, than ever before. The arguments advanced here suggest other candidate explanations for the persistence of bubbles, such as limits to learning, frictional limits to arbitrage, and behavioral errors, are unsatisfactory (by themselves at least) as they are inconsistent with the aforementioned trends sweeping across global capital markets. By contrast, investment manager incentives, the nature of the principal-agent relationship, and the growing presence of institutional investors, are all entirely consistent with the persistence of financial bubbles. Importantly, this explanation does not require a baseline assumption of widespread irrationality in the conventional sense. Simply put, it can be entirely rational—from the perspective of business and compensation risk—for asset managers to knowingly ride bubbles because of benchmarking and the short-term performance appraisal periods often imposed on asset managers by asset owners.

To the extent that this diagnosis is close to the mark, it has potentially important policy implications.

First, it suggests that bubble episodes will be at least as frequent as in the past, and quite possibly more so, as institutional assets under management continue to increase in both absolute and relative terms (particularly in the emerging markets).

Second, it suggests remedial policies need to be multifaceted in nature. While countercyclical monetary and macroprudential policy may be best placed to lean against conventional leverage-driven asset booms (notably in real estate markets), they are not particularly well suited to dealing with the challenges posed by the rapidly growing asset management industry. Contemporary discussions of financial instability are heavily conditioned by the build up of leverage that culminated in the 2008 crisis, and understandably, measures aimed at avoiding a similar scenario in the future have been front and center in subsequent policy initiatives. However, subdued leverage is not a sufficient condition for financial stability—if systemic risk, and activity in the wider economy, is shaped importantly by large shifts in risk premia owing to the ‘rational herding’ motivations of asset managers (even in the absence of leverage), then this traditional focus may be too narrow (Feroli and others, 2014; Stein, 2014; Haldane, 2014). Moreover, as risk-taking migrates out of the formal banking sector, policy makers must guard against the risk of ‘fighting the last war.’ Put differently, while they will always comprise a key component of the policy making toolkit, there are likely to be limits to what countercyclical policies can achieve alone. Time-invariant policies related to the design of principal-agent contracts and financial benchmarks—addressing the cause, not simply the symptoms, of institutional behavior—have a key role to play in mitigating the impact of institutional frictions on financial stability.

More broadly, while the behavior and failure of banks has been studied for centuries, similar analysis of the institutional asset management industry is, by contrast, a greenfield site—yet the risks and opportunities presented by asset management could be every bit as important (Haldane, 2014). Whether it be asset management industry characteristics (along the dimensions of size, concentration, and interconnectivity), or asset management activities (duration mismatches, securities lending, fire sales and herding), there are a variety of channels by which the industry could pose a threat to financial stability. Care will need to be taken in distinguishing the degree to which asset managers passively transmit risk (in passing through the decisions of asset owners) as distinct from originating new sources of risk themselves. Nonetheless, if present indications are any guide, these will serve as fertile grounds for future research aimed at safeguarding the international financial system.