The idea that financial markets are efficient is fascinating. A compelling story about market efficiency is the one about the Space Shuttle Challenger disaster. The Challenger broke apart within minutes after its launch on 28 January 1986. I remember it very well. It was a cold day, I was in Groningen, the Netherlands. I cycled back home from school listening to my Walkman radio when I heard the news. It is one of those moments one never forgets: where were you when the Challenger exploded?
Months later I learned that the disaster was caused by faulty O-rings. These were manufactured by a firm called Morton Thiokol.
Few people realized however, that, on that day, across the Atlantic, where trading had just started, investors quickly figured out which company was responsible for the faulty O-rings. Morton Thiokol’s share price that day dropped about 12 percent. The spare price drop was large. Shares of other NASA suppliers dropped, but not as much.
The wisdom of crowds – evidence from New Zealand
This is fascinating of course: while a special commission headed by former Secretary of State William Rogers took months to conclude that the disaster was caused by the faulty O-rings, the stock market had figured it out in hours. Investors swiftly identified Morton Thiokol as the firm manufacturing the defective parts. (See this paper by Maloney and Mulherin, who documented the stock price reaction to the Challenger crash).
The wisdom of crowds is not restricted to exploding Space Shuttles. Investors quickly absorb all sorts of information that affects firm value.
The last weeks were no different: Our bank supervisor revoked ANZ Bank’s accreditation to model its own operational risk capital requirements. This decision was significant. It reverberated across the financial markets:
Paralysis by analysis
The news about ANZ made me wonder about the impact of the Reserve Bank’s announcements. I have read many articles about the costs of the Reserve Bank capital plans. Ian Harrison, for example, suggests that the “great big beautiful capital wall” will cost 30 billion dollar. Perhaps. Others have made different estimates.
The Reserve Bank used its own variation of the wisdom of crowds: it encouraged us to submit comments. Now there are plans to use focus groups to assess how New Zealanders feel about risks in our financial system. Experts will review the analysis and advice underpinning the proposals.
Sure, doing some proper homework is the right thing to do. But stacking yet another analysis on top of a growing heap of studies can easily lead to paralysis.
Applying the wisdom of crowds to the RBNZ capital plans
Because of the looming threat of paralysis by analysis, I thought it would be interesting to study market responses to the RBNZ capital plans. Thanks to Python and Pandas, I could run such a study on my eight-year old desktop PC.
It did not take long to collect news-items that could affect investors. The Reserve Bank publishes all capital-related initiatives on its website. Then there are the media and there is this blog, which also documents New Zealand capital events.
all capital-related initiatives on its website. Then there are the media and there is this blog, which also documents New Zealand capital events.
In all, I retrieved 18 capital announcements since the start of 2017.
A focus on CoCos
The next step was to identify the relevant securities. Without direct listings, I had to rely on securities issued by the Big-4 banks. But I did not want to use share prices – I have no clue who owns the four large Australian banks. Russian oligarchs? Who knows.
Instead, I chose to examine market responses to CoCo capital instruments. These capital instruments are held by sophisticated institutional investors: pension funds and insurance companies. I am much more interested in their assessment of plans. They invest on our behalf. If a pension fund suffers from some poor plan, then either we have to pay more into that fund, or a pensioner receives less.
Thanks to Basel III, banks document which CoCos they have in issue. See this example from Westpac. I found 20 of these CoCos and retrieved their prices around each RBNZ capital announcement. To be accurate: I measured the price behavior of the CoCos form the day before the announcement until the day after the announcement.
Good news, bad news
If, during these three days a CoCo investor earned a positive return on her CoCo holdings, then that would be good news. If the investor lost, then that would be bad news. I adjusted the returns for the return on the Australian market index. If a CoCo investor gains one percent and the market gains three percent, then the CoCo investor loses two percent against the market.
The results of my small ‘wisdom of crowds’ study are as follows:
The spikes measure the return on a portfolio of CoCos issued by the Big-4 over three days. The sample amount of outstanding CoCos is $20bn (face value). The returns, ranging from -3% to +3%, look small. But they are important once you compound them over a full year. A one-percent daily return doubles roughly every seventy days.
A couple of spikes stand out. The green spike occurs on the date of the decision on Kiwibank’s convertible capital instruments: 14 March 2017.
I am careful about causality and association. The fact that a spike ‘happens’ on an announcement date could be the result of other news. This may, for example, explain the red positive spike on 15 November 2017, when Westpac’s capital requirements increased after a breach of regulatory obligations. One alternative explanation for that spike is that the market anticipated a much higher penalty for Westpac – and felt relieved after learning about the actual requirement increase.
From that speech onward, most of the capital announcements coincide with negative returns, except for todays’ response, which predictably coincides with Geoff Bascand’s olive branch interview in AFR.
The large negative red spike coincides with the 17 May announcement of the censuring of ANZ. In dollar amounts: $20bn times 3 percent amounts to $600 million lost – an expensive Friday afternoon for sure.
The wisdom of crowds. It is what it is.
And yes, there are caveats. I examined CoCos issued from the parent banks, so there will always be some noise. There may be confounding events too. But I ran variations on the study documented above: I used longer and smaller event windows, etc. Nothing really changed my inferences. The picture above is, in the absence of intra-day data and the presence of corroborating media news, fairly accurate.
The results are important, in part because these are not share returns. The returns are on investments of institutional investors, who generally invest on our behalf.