International Banking ConferenceMSC Sinfonia – South Africa

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Global Financial Crises

Economic forecasts

Incorrect use of information

Picky financial instruments

Financial interactions

Achieving greater permanence in the real economy?

1.The context matters

Uncertainty

Institutional frameworks

Profit maximization

Rationality

2.Strategic games

Prisoner’s dilemma

Rules, sanctions and

communication

Incomplete information

games

Collaborative games

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Uncertainty is not an Insuperable Condition

Uncertainty is a situation where outcomes cannot be evaluated using probabilities.

Financial players make investment decisions based on their forecasts of future profit.

The resulting strategic decisions actually drive a systematic escalation on the markets

An underlying condition

Different levels

Managing institutions to

reduce uncertainty

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But Reducing Uncertainty has a Cost

Profit maximization?

Potential outcomes?

‘The phenomenon that produces overlapping distributions of potential outcomes’

A random behavior model

Environmental adoption

Realized positive profits

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E. Ostrom (2005, p. 3)

“The opportunities and constraintsindividuals face in any particularsituation, the information they obtain, thebenefits they obtain or are excludedfrom, and how they reason about thesituation are all affected by the rules orabsence of rules that structure the situation.Further, the rules affecting one situation arethemselves crafted by individualsinteracting in deeper-level situations.

(…) If the individuals who are crafting andmodifying rules do not understand howparticular combinations of rules affectactions and outcomes in particularecological and cultural environment, rulechanges may produce unexpected and, attimes, disastrous outcomes.Thus, understanding institutions is a seriousendeavor.”

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Creating a Collaborative Governance Model

Actors’ implication in rules’ elaboration and supervision

Face to face communication

Monitoring in question:

Trust, self determination, external interventions

Such propositions are not easy to apply to financial systems where governance is generally entrusted to international, public and private institutions.

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Strategic Games

Linking market processes and institutional contexts using GT is possible

When uncertainty prevails, actors can use game theory in order to choose the dominant strategy to follow.

A Prisoner’s dilemma

Global financial crises:

Inescapable situations for the

actors?

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Strategies, Interactions and Playground

A Bank

The bank foresees a situation where its returns are increased, and associated risks are unchanged:

…….….Solution B (for bank 1) and C (for other banks)

Unchanged credit offer

Increased credit offer

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Outcomes : solution A…

Solution A: Increased risks, relative returns unchanged (in the beginning of the financial bubble..)

Solution D : not better, as it implies no lending activities...

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Other banks

Other banks

Bank 1

A(0,0)

B(1,0)

C(0,1)

D(1,1)

IC UC

IC ICUC UC

RISK +++Relative returns +-

RISK +-Relative returns +-

Motivating Actors to Cooperation

For Ostrom, implies the construction of a new game, based on clearly specified rules and monitoring processes.

Banks and the Central Authority are supposed to know the ‘maximum amount’ of credit to distribute in the system.

This ‘amount ‘ is supposed to prevent the system from any financial crash, and the Central Authority will manage against any speculative escalation.

Cooperation

Snap up and sanction

speculative escalations

…complete versus

Incomplete Information

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However…Too Strict Conditions

The probability to be able to sanction correctly behavioral drifts must be higher than 75%!

Impossible at an international level, where banks and entrepreneurs are managing their activities in a globalized world

The problem: the accuracy of the information obtained by the Central Authority..

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Another Solution: Communication and SELF Governance

In a game where actors’ strategies are not depending on the accuracy of the information obtained by the Central Authority.

2 Rounds for:

• A negotiation of a collective way of functioning (under the form of a contract)

• Contracting strategies and enacting for a central authority

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Focus on Effective Realized Profits

As they progress with their market operations, banks finally develop convergent expectations on their ‘effective earnings’.

There is no one solution to this game…

The main difference with the prisoner’s dilemma is that there is here a serious incentive for cooperation.

A self governed game can constitute a first step of justification towards collaborative but free governance of a financing system.

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Limits

One bank and a group of banks: big players and followers?

Herding behaviors, experience …

If bubbles are initially nucleated at times of burgeoning economic fundamentals in so called ‘new economy’ climates…

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