Reflexivity Theory: Japan Banks Victims of Prevailing “FEAR” Bias

In George Soro’s theory of reflexivity, the concept basically deals with two way psychological interaction or a feedback loop between the participant’s perception and the situation in which they are engaged in.

According to George Soros, “Financial markets are always wrong in the sense that they operate with a prevailing bias, but the bias can actually validate itself by influencing not only market prices but also the so-called fundamentals that market prices are supposed to reflect in.”

In other words, where the conventional thinking of establishing market prices has been premised on the anticipation of changes in the underlying fundamental conditions of a security or market, on the contrary markets can do the opposite- they can actually shape the fundamentals via the prevailing biases (market momentum).

For instance, the sharp selloffs today, which is the prevailing bias, have brought share prices down enough for some companies operating under regulatory capital ratios to raise capital even when corporate fundamental conditions are healthy.

We are referring to Japanese banks, according to the Economist (highlight mine),

``UNTIL recently Japanese banks had largely avoided the agonies of the credit crunch that had caused such difficulties in much of the rest of the world. Now the misery has well and truly come to Tokyo. The culprit is not toxic derivatives and swaps, but ordinary shares held by banks in Japanese companies. These cross-shareholdings, a peculiar feature of Japanese capitalism, are having pernicious effects. As share prices fall, banks are force to revalue their assets, which in turn reduces their capital ratios. The result is a need to raise capital quickly.

``In the past four trading days, the Nikkei 225-share index has tumbled by 23%. On Monday October 27th the index plunged by 6.4% to 7,162.90, the lowest level in 26 years. Mitsubishi UFJ Financial Group (MUFG), Japan’s biggest bank, plans to raise as much as ¥990 billion ($10.6 billion) by issuing new common shares of perhaps ¥600 billion and preferred securities of ¥390 billion. Mizuho Financial Group and Sumitomo Mitsui Financial Group are said to be planning their own capital increases.

``The government is scrambling to help out. It is poised to announce a set of new measures, including spending perhaps ¥10 trillion to buy shares in companies that the banks hold (in an off-market transaction, so their values do not fall further). This was a tactic used by the Banks’ Shareholdings Purchase Corporation to respond to a banking crisis in 2002. The government may also request that pension funds and life insurance firms buy equities to support the market, though whether they would respond remains to be seen.”

Courtesy of Topix Banking

So what has caused the miseries of the Japanese banks, again from the Economist, ``Share prices are tumbling fast largely because foreign hedge funds have been forced—by the need to meet margin calls and redemptions—to liquidate positions. Investors are also worried that a big global recession will hurt Japan’s exporters, just as a domestic slowdown hurts other firms. Exporters are battered, too, by the steep rise in the value of the yen. It has soared by 11% against the dollar and around 21% against the euro in October, as the yen carry trade unwinds and amid a general flight to safety.”

So global deleveraging has prompted fear which brought upon severe market price distortions enough to require compliance of capital ratios by raising capital of affected companies. And government would now step in to provide assistance. This essentially validates Soros’ reflexivity theory at work.

To consider Japanese banks were thought to be in very a good financial position, such that they were intending to regain international dominance just a few months ago with acquisitions of distressed US financials, to quote again the Economist,

``Just a month ago, fresh from MUFG’s offer of ¥950 billion for a 21% stake in Morgan Stanley, and Nomura’s purchase of operations of the bankrupt Lehman Brothers in Asia, Europe and the Middle East, Japanese bankers felt they were once again dominant on the international financial stage. They were rich with capital and willing to spend, at a time when other institutions were desperate. Now they are victims not of contagion, but of collateral damage.”

So a fear driven market has virtually thrown everything out with the bathwater.