Tuesday, March 21, 2023

Group dynamics can lead to poor decisions, so be on your guard


There has been the strong view that there is wisdom within crowds. Research has shown that a group will do better than the individual at predicting. The collected wisdom and ensemble from the group will be closer to reality than any one person.  

A closer look suggests that group dynamics have some major problems with making good decisions. There is a big difference between a statistical group, wisdom from the average forecast of a group, and the deliberative group as a predictor. Generally, we don't poll members of group and form their average. The normal approach is that the group will deliberate and come together to solve a problem, make a decision, or prediction.

In the case of asset management, the core group is the investment committee and when you look closely at the mechanics of an investment committee, you will likely conclude that many are dysfunctional and not very good at their core task. 

The problem with most groups is that they can amplify errors through behavioral biases no different than individuals. There can be cascade effects that opinions are swayed by a few that push the rest to a decision. There can be polarizations that is driven to greater extremes, and there is often focus on shared information and not on new information. Not much hope for the group, yet there are some simple changes that can support better group thinking. 

The solutions follow a simple framework that emphasizes using data, rewarding successes, and ensuring equal weight toward alternative opinions. 

The power of models or even an ensemble of models is that they will not have the problems of group dynamics. The issues associated with group dynamics and potential solutions is discussed in the book Wiser: Getting Beyond Groupthink to Make Groups Smarter by Cass Sunstein and Reid Hastie. Everyone should work on improving group dynamics but there is clear value with allowing an ensemble of models serve as the group. 

Monday, March 20, 2023

Disintermediation - A word very relevant for banking today


Financial disintermediation has always been an important topic for financial institutions, but it has not been the focus of research when rates were close to zero. There was disintermediation from the reach for yield, so depositors kept balances low. For their liquid funds, there was not a lot of shopping for higher rates, because all rates were low. There was not advantage of moving to a money market funds because the excess yield was limited, and the absolute yield was low. 

Go to the pandemic and the world changed. First, deposits exploded given all the extra money in the economy. Banks could not lend the money and yields were low. However, inflation grew, and the Fed started to raise rates. It is now very rational to shop your deposits to higher yielding alternatives.  

Depositors will shop for higher yields at other institutions. They will shop at money market funds. They will use their excess balances for purchases. The result is a decline in deposits which means that something must happen on the other side of the balance sheet.  Assets must be sold. 

Banks that are not competitive with rates on deposits will see disintermediation. Firms with excess deposit balances will be drawing them down. If asset liability management has a gap, there will be a real cost to equity. We have seen the extremes with several banks, but this is a global problem. 

Sunday, March 19, 2023

Credit tightening is already here, but will get worse

Bank failures and crises leads to a tightening of credit. This is the secondary effect that is often overlooked. The focus is on the immediate failure and the depositors, yet the economy will be driven by the credit channel as well. The credit situation was difficult before the bank closures. 

The bank credit standards are tightening across the board and closing in on the highs from the pandemic. There is little to suggest that this trend will change. 

Bank credit growth is slowing. Less loans are being made although a 5% growth is respectable. The trend is falling. M2 money supply growth is now negative. Of course, the supply is still high given past growth, and we will see an increase with the Fed injection of money, but the trend is lower.

The short-term credit has improved with the bank bail-out, but the combination of higher rates, tightening standards, and slowing loan growth does not paint a pretty picture. 


Dunning-Kruger Club and knowing your limitations

 “The first rule of the Dunning-Kruger club is you don’t know you’re a member of the Dunning-Kruger club.”— David Dunning

"A man's got to know his limitations" - Dirty Harry (Clint Eastwood)

We just have too much confidence relative to our knowledge. This is once again seen with the current banking crisis. We have overconfident bankers and we have overconfident regulators. Both think they can make predictions about the future; the future of rates and the future of the bank environment. Both are not aware of their limitations.

If there is too much uncertainty, there needs to be more humility on what can happen. A lack of knowledge does not mean that there should be a failure to act. Action may be required, but the policy response should be measured to ensure that the unintended consequences will drive and constrain the future.  There are many alternatives between no action and complete bail-outs. All should be considered.

The hazard of experts - How do you avoid this hazard effect with hedge fund managers?