FINANCIAL SECTOR PRO-CYCLICALITY

LESSONS FROM THE CRISIS

by Fabio Panetta and Paolo Angelini (coordinators), Ugo Albertazzi, Francesco Columba, Wanda Cornacchia, Antonio Di Cesare, Andrea Pilati, Carmelo Salleo and Giovanni Santini

All authors are with the Banca d’Italia. Fabio Panetta, Paolo Angelini, Ugo Albertazzi, Francesco Columba, Wanda Cornacchia, Antonio Di Cesare and Carmelo Salleo are with the Economic Outlook and Monetary Policy Department. Andrea Pilati and Giovanni Santini are with the Banking Supervision Department.

The contents reveal the focus of this most intelligent analysis, focussed upon the "mine-fields" of Fair Value Analysis and Incentives in relation to pro-cyclicality. This is a brave and relevant piece of work in my view. The contents are below as an explanation of why we have highlighted this paper & the url below that;-

1. The (new) financial accelerator: the role of leverage p. 12

2. Technological change and liberalization p. 22

3. Bank capital requirements p. 30

4. Accounting standards p. 46

5. Managers’ incentives p. 61

http://www.bancaditalia.it/pubblicazioni/econo/quest_ecofin_2/qf_44/QEF_44.pdf

QUOTATION

Fake alpha – As the financial crisis has revealed, bonuses are often paid based on deals that entail large immediate gains but also large risks. However, these risks were largely overlooked, as managers generated income that appeared to stem from their superior abilities but was actually just a market risk premium. Even though the bank had risk managers whose job is to contrast this tendency, risks were overlooked for at least two reasons. First, ex ante, risk remuneration is hard to disentangle from true “alpha”, so that accurate assessment often doesn’t come until after the risks have materialized as actual losses; this is especially true for tail risk – risk related to events that are rare or hard to foresee (see below). Second, top managers are themselves partly remunerated on the basis of short-term earnings through bonuses and stock options (to the extent that high short-term earnings help boost stock prices), so they may also have incentives to overrule risk managers.