My Blog

October 3, 2007

But this doesn’t this mean that a rational Chinese bank will never engage in a foreign acquisition.  On the contrary, it makes sense for state-controlled Chinese banks to make foreign acquisitions because the main shareholder, the government of China, has a much more complex incentive structure than do other shareholders. 

As a shareholder, of course, the government would like to see rising share prices, and to that extent it should not encourage foreign acquisitions.  However the government’s position is not so simple.  In addition to its role as shareholder, the government has at least two other important roles.  First, it guarantees the bank’s depositors, so it effectively absorbs any improvement or deterioration in the bank’s creditworthiness.  Second, it regulates the banks as part of its overall responsibility for the health of the banking system.

It turns out that both roles also involve optionality.  Creditors and regulators are effectively short put options on the asset value of the company because their exposure to increases in asset value is limited, while their exposure to declines is unlimited.  Because they have differing incentive structures, their objectives differ.  This is just a variation on what is known as the agency problem in corporate finance, in which managers (whose incentives, incidentally, are very similar to those of creditors) have goals that often conflict with those of shareholders.

Because the government in its role as guarantor and regulator is effectively short a put option on the asset value of the bank, this creates a strong incentive to minimize volatility.  Lower volatility increases asset value, and so reduces the intrinsic value of the put option (the value of a put option always decreases as asset value rises), while lower volatility always reduces time value. 

Along with being long a call option as a shareholder, the government is short a put option as guarantor and regulator, and as such it unambiguously benefits from any reduction in volatility.  In this case the option framework simply makes explicit what we intuitively know: unlike shareholders, creditors and regulators worry far more about downside risk than about upside profits. 

What the framework adds to the analysis is that for nearly insolvent banks, the interests of creditors and regulators are diametrically opposed to those of shareholders.  Since its interests as guarantor and regulator almost certainly exceed its interest as shareholder, the government has a strong incentive to encourage behavior which may hurt shareholders in general but will benefit the government and all other creditors.  China’s state-controlled banks are likely, in other words, to behave in ways which benefit managers, regulators and creditors at the expense of shareholders because its largest shareholder has a very complex incentive structure.

China’s government is not the only government whose interest may conflict with that of bank shareholders – this always happens in the case of banks with questionable loan portfolios whose deposits are implicitly or explicitly guaranteed, as the S&L crisis in the US during the 1970s and 1980s demonstrates.  But because of the government’s mixed role as guarantor, regulator, and principle shareholder, it is important that investors understand that although their long-term interests may be similar to that of the government – a rapidly growing economy which translates into an increasingly valuable banking franchise – in the short term incentives are aligned in very different ways. 

The option framework makes two clear, and easily verifiable, predictions.  First, Chinese banks will almost certainly acquire assets and operations abroad because it is in the best interest of their regulator and primary shareholder that they do so.  Second, any Chinese bank that makes a relatively large acquisition abroad will see its share price fall significantly.  This may not happen immediately on the announcement of the acquisition – a surge of nationalist pride often causes the share prices to rise – but within days or weeks large institutional investors will dump shares until its price falls to reflect the reduction in time value.

Comments (5) for "Should Chinese Banks Acquire...

Very interesting. Some quick and therefore risky thoughts (i.e. this may be wrong) from my groggy theoretical memory of options: a) Wouldn’t the volatility effect depend on how an acquisition was funded? E.g. an acquisition funded by more debt produces a consolidated option structure with less intrinsic value (i.e. less in the money, more at the money) and therefore more time value and more gamma than one funded by more equity. So the reduction in the volatility of assets due to diversification might be offset to some degree by an increase in the underlying leverage of the option structure. b) Perhaps another way of approaching the government’s position is through Miller-Modigliani. The more of the entire capital structure that a single investor owns, the less important is the capital structure to his risk position and the more purely dominant is the risk of the underlying assets – in this case, an asset base with risk reduced by diversification. This will reduce both short put and long call values, but the effect would presumably become more neutral on balance as the government’s ownership/guarantee approaches 100 per cent of the capital structure. By jkh - 10/2/2007 11:35 PM

This is really interesting because this calls into question one of the basic assumptions of corporate finance which is that the well being of the company is measured by its share price. If an insolvent risky Chinese bank were to buy a solvent one, it would seem obvious to me that this would be "good" for the company, not withstanding the drop in share price. Along these lines, it would seem therefore that incentive structures that encourage management to increase share prices may simply cause them to accquire more risk at the expense of long term corporate stability, which nicely explains dot-coms..... By Twofish - 10/3/2007 7:18 AM

Thinking out loud.... 1) How does this apply to minority shareholders? 2) How does this apply to *solvent* banks? Most banks are highly leveraged structures that are always skating on the thin ice of insolvency. 3) How does this apply to a situation in which a person has a given utility function? The regulator has a different loss profile than the shareholder, but the regulator also has a different utility function. 4) How does this apply to different shareholders with different utility functions? I have to think through this, but I wouldn't be surprised if the result is that unregulated banks are inherently unstable and that banks need to be highly regulated to function. By Twofish - 10/3/2007 7:26 AM

Something that really bothers me about the option framework. In a Black-Scholes world, volatility only affects the price of an option, it shouldn't affect the price of the stock. It will affect the *return* of a stock, but that shouldn't change the price of the stock. Now since we have empirical evidence that it does, then the conclusion is that we are not living in a Black-Scholes world. This opens up the question of what world we are living in. I have a feeling that there are two effects here 1) people are investing not based on the current value of the stock but rather on the expected future value of the stock 2) people have non-linear utility functions, and if you have a non-linear utility function (i.e. you don't care if the stock falls but you really care if it rises or vice versa) then volatility does under the picture. One bit of thinking that I have is that when people buy an option, they are actually hedging against their own personal utility function, which explains why people buy and sell options. There is some cool work by Robert Jarrow on how options behave in the middle of an asset price bubble. This line of thought also explains why and how assets are misallocated in a bubble. In Black-Scholes world, everything can be reduced to risk-neutral prices and so there isn't any incentive to buy risky stocks over treasuries. In a bubble, we are no longer living in a world in which Black-Scholes or Miller-Modigliani apply. The question is: 1) How do you make cash money from these insights? 2) How do you structure the rules so that you maximize social welfare? We've been talking about the national balance sheet. There is probably an equivalent concept of the national utility function. Those two questions are linked. You would be structure the rules so that in making cash money people engage in behaviors that maximize social welfare. By Twofish - 10/3/2007 4:26 PM

“ In a Black-Scholes world, volatility only affects the price of an option, it shouldn't affect the price of the stock.” I believe you’ve missed the underlying premise. This isn’t about stock options – it’s about stock as an option. Simplified, equity is an option on assets at a strike price equal to the debt. Nearly insolvent entities are equivalent to ultra highly leveraged solvent entities where the equity position is isomorphic to a barely in the money option struck at a very high price – big vega, big gamma, lots of juice. Similarly, most of the risk in debt is equivalent to a put option on assets at a strike price equal to the debt. That’s also part of the theme here. By jkh - 10/3/2007 6:30 PM