Obama's Financial Reforms and Rajan Committee
I wrote an article in today’s Financial Express comparing Obama’s proposals for financial regulatory reform in the United States with the Rajan Committee proposals in India. Obama’s speech is available here and the full report is available here. The Rajan Committee report is available here.
On Wednesday, US President Obama unveiled an 89 page blueprint for reforming financial regulation in the US in response to the financial crisis. The proposals have several striking similarities with the recommendations of the Raghuram Rajan Committee in India a few months ago.
Obama outlined the need for overhauling the regulatory structure very succinctly. He said that where there were regulatory gaps, regulators lacked the authority to take action and where there were overlaps, regulators lacked accountability for their inaction. The US and India face this problem of regulatory gaps and overlaps far more acutely than many other countries (like the UK, Singapore or Germany) which have a more streamlined regulatory architecture.
While recognising this problem, both the Obama and Rajan proposals make only incremental changes to the existing architecture and eschew more ambitious proposals to scrap the system altogether and start all over again. The reality is that even these proposals might test the limits of what is politically feasible.
Obama called for the creation of a Financial Services Oversight Council (FSOC) which is very similar to Rajan’s Financial Sector Oversight Agencies (FSOA) in terms of its composition and structure. Both bodies consist of the heads of all regulatory agencies and have a permanent secretariat. One difference is that the FSOC is chaired by the Treasury Secretary.
The much bigger difference is that Rajan’s FSOA was also to be the macro-prudential regulator for systemically important financial conglomerates and organisations. Under Obama’s proposals, the macro-prudential regulator for such conglomerates (unimaginatively called Tier 1 Financial Holding Companies) is the Federal Reserve Board. Arguments can be made in favour of both models. In the Indian case, the critical concrete question would be whether the RBI should be the macro-prudential regulator for the LIC or whether this role should be performed by all sectoral regulators meeting together.
Obama calls for the creation of a Consumer Financial Protection Agency (CFPA) whose role is very similar to that of the Office of the Financial Ombudsman (OFO) proposed by the Rajan Committee. The key difference is that the CFPA is vested with vast statutory powers while the OFO was conceived of as having much of the characteristics of a self-regulatory organisation. I believe that while there is merit in starting out with less formal statutory powers, the OFO should also move in the direction of the CFPA whose bite is as formidable as its bark.
On the markets, the corner piece of the Rajan report was the merger of the commodities derivatives regulator (FMC) into the securities regulator (SEBI). In the US too there were high expectations about merging the CFTC into the SEC, but Obama has stopped short of this.
Given the perception of the SEC today as a failed regulator (Bear Stearns, Lehman and Madoff), it is perfectly understandable that the President is reluctant to reward it with greater powers. The one regulator whose failures were even more egregious than that of the SEC – the OTS which regulated AIG – is proposed to be disbanded. Another infamous regulator – the OFHEO which regulated Fannie and Freddie – has already been replaced by the FHFA. In this context, the SEC should count itself lucky that it has been left largely intact.
In the long run, however, a merger of the CFTC into the SEC is inevitable and if Mary Shapiro’s attempts to reform the SEC succeed, we might not have to wait for the next crisis for this to happen. In India, the arguments for folding the FMC into Sebi are very strong and there is no need to wait at all.
Obama’s proposal (like the Rajan report) calls for moving most Over The Counter (OTC) derivatives towards centralised clearing and bringing them under the purview of the market regulators. This is absolutely necessary. Obama’s blueprint also states that key settlement and clearing agencies should have access to central bank accounts and facilities to reduce their dependence on banks. This is an extremely important issue in India as well where the dependence of securities clearing agencies like NSCCL and CCIL on commercial banks has become an unacceptable source of systemic risk.
Obama’s reforms recognise the importance of preserving vibrant financial markets. Obama rightly states that the role of the government is not to stifle the market, but to strengthen its ability to unleash creativity and innovation. The goal is to restore markets in which we reward hard work and responsibility and innovation, not recklessness and greed. He also says that the purpose of regulation is to allow markets to promote innovation while discouraging abuse, and to allow markets to function freely and fairly, without the risk of financial collapse.
These are important principles to keep in mind. The current global crisis has discredited the existing regulatory regime for financial markets; they have not discredited financial markets themselves.
Posted at 9:42 pm IST on Fri, 19 Jun 2009 permanent link
Categories: crisis, regulation
Stocktaking on the use of credit ratings
Earlier this week, the Basel Committee (along with IOSCO and IAIS – the Joint Forum) published a report entitled “Stocktaking on the use of credit ratings” which documents the use of credit rating in banking, securities and insurance regulations in several major countries around the world. What struck me while reading the report is the fact that the US appears as an outlier in its pervasive use of credit rating in all aspects of its financial regulations.
Surprisingly, the UK uses credit ratings very little apart from what is mandated by Basel-II. In particular, the UK does not use credit ratings at all in determining what securities a regulated entity can or cannot invest in. (Just in case, one worries that somebody in the FSA might have made a mistake while checking boxes in the survey questionnaire, the report states categorically, “ the United Kingdom Financial Services Authority (UK FSA) noted that credit ratings are not used in any of its three financial sectors for asset identification.”)
For a country like India whose regulations use ratings quite extensively, this is an opportunity for a hard rethink. The current global crisis has shown that rating agencies can horribly wrong. More importantly, the crisis has reminded us that even when ratings measure idiosyncratic risk well, they are a poor signal of systemic risk.
Posted at 10:38 am IST on Thu, 18 Jun 2009 permanent link
Categories: credit rating, regulation
Bankers’ pay and incentives
Much has been written about how (a) bankers’ pay is excessive and (b) the incentive created by these pay structures encourage risk taking. A lot of this discussion has treated bankers’ pay as a corporate governance problem without considering the special characteristics of banks. I was therefore delighted to read this paper by Bebchuk and Spamann which is like a breath of fresh air.
Bebchuk and Spamann point out that because of the excessive leverage of banks and the explicit and implicit support of the government, the shareholders are incentivized to support excessive risk taking. Therefore the standard corporate governance ideas of aligning the interests of managers with that of shareholders are useless when it comes to banking. They propose that regulators should step in and require that incentives be linked to the total value of the firm and not just the value of the equity.
Bebchuk and Spamann do not address the issue of bankers’ pay being excessive though that has a similar explanation. Deposit insurance and implicit government guarantees create the potential for huge rents in banking. The only way to extract these rents is by highly complex (and possibly deceptive) risk taking strategies that get past regulatory restrictions. Implementing these strategies therefore requires a great deal of expertise and skill which are in short supply. Therefore when shareholders try to extract rents by hiring smart people to implement complex risk taking strategies, most of the rents are in fact extracted by the managers themselves. To view this as a corporate governance problem is a mistake. It is a problem of government policy that encourages rent seeking.
Bebchuk and Spamann also correctly point out that the managers whose personal wealth has been destroyed by the collapse of their banks were not necessarily stupid or ex ante irrational. Ex ante, they could well have been responding correctly to the incentives that they faced and the probabilities that they estimated.
Posted at 4:11 pm IST on Fri, 12 Jun 2009 permanent link
Categories: banks, regulation
Away on vacation
I am away on vacation for about six weeks. I will not be posting on my blog till mid-June. Comments on my blog during this period will also be moderated only after I come back.
Posted at 12:13 pm IST on Tue, 21 Apr 2009 permanent link
Categories: miscellaneous
Satyam sale and the walk away option
Now that the government appointed Board of Satyam has sold a controlling stake to Tech Mahindra, it is useful to examine how the implicit walk away option can prove so damaging to the current Satyam shareholders and how it can be hugely beneficial to Tech Mahindra. This analysis confirms what I have been arguing for some time now: the decision to sell a partial controlling stake instead of selling the whole company was not in the interests of the shareholders.
The implied valuation of probably less than six months revenues for the transaction is quite low except for the unknown liabilities of the company in several US class action law suits. It is these unknown liabilities that make the walk away option hugely valuable. What makes walk away feasible is the fact that Satyam’s value is not in the form of tangible assets, but largely in the form of its customers and employees.
Over a period of two to three years, Tech Mahindra which is itself in the same industry could transfer the entire Satyam business to itself. This could be done as new contracts are signed or existing contracts are renewed. Over the same time frame, the employees of Satyam could also be shifted to the Tech Mahindra payroll. Once this process is complete, Satyam would have some cash and other assets and potentially huge liabilities.
The walk away option is that if the liabilities turn out to be larger than the cash and other assets, Tech Mahindra can walk away and put Satyam into bankruptcy. If the liabilities turn out to be small, then Tech Mahindra can merge Satyam into itself and absorb the surplus assets. Option pricing theory teaches us that the more the uncertainty (volatility) the greater the value of this walk away option. Since the uncertainty today is huge, the option is hugely valuable.
The fact there were (as some people put it) only two and a half bids for Satyam suggests that a number of potential bidders who thought that they would never exercise the walk away option (for reputational or other reasons) chose not to bid at all. Without the walk away option, the risks were simply too high.
There are two other reasons why Tech Mahindra would prefer to transfer the Satyam business to itself. First, it owns only 51% of Satyam and therefore earns only 51% of the revenues of Satyam. If the contract is renewed with the parent company itself, it gets 100% of the revenues. Second, Satyam commands a low valuation in terms of price-revenue multiples (less than 0.5 at the bid price) while Tech Mahindra commands a higher valuation (about 1.0). Moreover with the Satyam acquisition, Tech Mahindra would try to position itself in the league of the top tier software companies which command multiples of about twice revenues.
Even if we consider a price to revenue multiple of 1 for the parent and 0.5 for the subsidiary, a dollar of revenues at the parent adds a dollar to the market capitalization, while a dollar of revenue at the subsidiary adds only 0.25 to the parent’s market capitalization. The financial motivation for shifting business to the parent are very high even without the walk away option.
What this means is that while today’s sale is great for the employees and customers of Satyam and for the Indian software industry, it is not so great for the shareholders. They get very little money now (except for the 20% open offer) and might find after three years that they own shares in a shell company that has little or no value.
The shareholders would certainly have preferred a sale of 100% of the company that gives them cash now.
Posted at 5:30 pm IST on Mon, 13 Apr 2009 permanent link
Categories: corporate governance, fraud, regulation
Lessons from Overend Gurney after 150 years
In 1866, the then privately owned Bank of England allowed the largest discount house in the world, Overend and Gurney to fail. In its time, Overend and Gurney was clearly far more systemically important in world finance than Lehman was when it failed. It was not the Lehman of its day, not even the Goldman, but something bigger. It was second only to the Bank of England itself. Its discount business was probably equal to the other big three discount houses (Alexander, Bruce Buxton and Sanderson) put together (W. T. C. King, “The Extent of the London Discount Market in the Middle of the Nineteenth Century” Economica, New Series, Vol. 2, No. 7 (Aug., 1935), pp. 321-326). Milne and Wood (“Banking Crisis Solutions Old and New”, Federal Reserve Bank of St. Louis Review, September/October 2008, 90(5), pp. 517-30) give an even bigger estimate: “its annual turnover of bills of exchange was equal in value to about half the national debt, and its balance sheet was ten times the size of the next-largest bank.”
Its failure caused a panic which used to be described (until the current crisis) as the last true panic in London. In the long run, however, the financial system was hugely strengthened by the decision not to create moral hazard by bailing out the insolvent Overend and Gurney in 1866.
I would like to end with quotes from two well known Austrian economists. First from Israel Kirzner: “every mistake made in the market by one entrepreneur represents an opportunity for another.” Second from Ludwig Von Mises “Those fighting for free enterprise and free competition do not defend the interests of those rich today. They want a free hand left to unknown men who will be the entrepreneurs of tomorrow.” The regulatory mistake of the last decade or more has been defending the interests of those rich today; this is a mistake that continues today with all the bail outs that we are seeing.
Posted at 10:55 am IST on Tue, 7 Apr 2009 permanent link
Categories: banks, crisis, failure
Do not blame the efficient market hypothesis
I have a piece in today’s Financial Express arguing that we should not blame the Efficient Market Hypothesis (EMH) for the current crisis. I do not think that regulators were fooled by the EMH. The truth is the exact opposite; regulators were fooled because they did not take the EMH seriously.
In the run up to the G20 summit, several global regulators have put out blueprints for reforming global financial regulation – apart from the Turner review in the UK, we have had proposals by the US Treasury, the People’s Bank of China, former Fed Chairman, Alan Greenspan and several academics and practitioners.
Several of these proposals make eminent sense: greater capital requirements for banks and near banks; orderly bankruptcy process for systemically important financial institutions; more robust regulation and supervision.
The emerging consensus is however wrong in asserting that mistakes in financial regulation were caused by the belief in the Efficient Market Hypothesis (EMH). The Turner review says for example that: “The predominant assumption behind financial market regulation – in the US, the UK and increasingly across the world – has been that financial markets are capable of being both efficient and rational.... In the face of the worst financial crisis for a century, however, the assumptions of efficient market theory have been subject to increasingly effective criticism.”
I do not think that regulators were fooled by the EMH. The truth is the exact opposite; regulators were fooled because they did not take the EMH seriously. Had they done so, regulators would not have been as complacent as they were during the last decade. The EMH very simply states that there is no free lunch; whenever you see an abnormally high return, EMH warns us that there must be an abnormally high risk lurking behind it.
For example, an EMH believer would not have invested in a Madoff fund because according to the EMH, Madoff style returns are not possible. In fact, critics say that an EMH fanatic would not pick up a hundred rupee note from the road because according to the EMH, that note cannot be there – either the note is fake or somebody must already have picked it up. Yes, EMH can make you miss some investment opportunities, but it will also protect you from hidden and unknown risks.
What would the EMH have told Greenspan when he saw the profits of the financial sector rise from 15-20% of total corporate profits in the 1970s and 1980s to over 40% in the last decade? EMH would have told him that there are only two possibilities: either financial institutions were becoming impregnable monopolies or they were taking incredibly high risk. The former hypothesis could be easily ruled out because financial deregulation was making the financial sector highly competitive particularly when one considered competition from the shadow financial system and from foreign players. If Greenspan actually believed in the EMH, he should have been very very worried.
When banks tried to make money with “arbitrage CDOs” by tranching pools of securities in different ways, the EMH would have argued that the value of a pie does not depend on how it is cut. Investors and regulators who believed in the EMH would have been sceptical of some of those AAA ratings.
Again, when banks increased their leverage ratios to absurdly high levels, a regulator who believed in the Modigliani-Miller (MM) theory of capital structure would have mulled over Miller’s own words (way back in 1995): “An essential message of the MM Propositions as applied to banking, in sum is that you cannot hope to lever up a sow’s ear into a silk purse. You may think you can during the good times; but you’ll give it all back and more when the bad times roll around.”
The MM theory implies that banks seek higher leverage mainly to exploit the subsidy provided to them in the form of deposit insurance and lender of last resort. Greater capital requirements for banks do not therefore have a significant social cost though they are costly to the shareholders and managers of the banks.
As Nouriel Roubini points out: “people are greedy in every industry, people in every industry try to avoid regulation sometimes with lies, sometimes by cheating or avoiding, whatever. But there’s only one industry, the financial industry, in which this thing leads, over and over again, to financial crisis. It happens for two reasons. One because banks have deposit insurance and deposit guarantees.... Two, we have lender of last resort support”.
The point is that regulators who believed in the EMH and the MM theory would have regulated banks far more tightly. Alan Greenspan claims that prior to 2007, the central premise was that “the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency.” Sorry, the EMH says no such thing. In fact, the theory says that if owners and managers can keep the profits and pass on losses to the taxpayers, they would be selfish enough to avoid keeping a sufficient buffer. The EMH would have disabused Greenspan and other regulators of the naïve assumption that bankers could be trusted.
Posted at 11:04 am IST on Wed, 1 Apr 2009 permanent link
Categories: crisis, market efficiency
Indian Financial Sector Self Assessment Report
Updated: Ajay Shah corrects me and points out that this is not a true FSAP but an imitation of the real thing. Even less reason to take it seriously. Incidentally, I think that the real FSAP itself is a waste of time if not worse. But that is beside the point.
The Indian financial press is today full of stories based on the Financial Sector Self Assessment Report prepared jointly by the Reserve Bank of India and the Ministry of Finance.
I think the coverage given to this self assessment report is quite disproportionate to its true significance because the report is prepared as part of the country’s participation in the Financial Sector Assessment Programme (FSAP) conducted by the IMF and the World Bank.
As anybody who has prepared or evaluated a self assessment report knows, it is critically important for such a report to demonstrate (a) an awareness of major weaknesses and (b) some thinking about possible measures to overcome them. If these are present in the self assessment, the external evaluator can and often does condone all the weaknesses!
By these standards, the self assessment report does an admirable job. But by the same token, it is silly to think that the report reflects the thinking of the RBI or the government on any of these matters.
Posted at 9:22 pm IST on Tue, 31 Mar 2009 permanent link
Categories: regulation
Links
Links to some interesting stuff that I have been reading
- The quiet coup by Simon Johnson. Many others like William Buiter have written about crony capitalism and regulatory capture in the US (I too blogged about it a year ago). But none is as comprehensive, as persuasive and as chilling as this piece by a former chief economist at the IMF and a co-founder of the must-read Baseline Scenario blog.
- Are Stocks Really Less Volatile in the Long Run? by Pastor and Stambaugh. “Conventional wisdom views stocks as less volatile over long horizons than over short horizons due to mean reversion induced by return predictability. In contrast, we find stocks are substantially more volatile over long horizons from an investor’s perspective. This perspective recognizes that parameters are uncertain, even with two centuries of data, and that observable predictors imperfectly deliver the conditional expected return.”
- An old (2006) paper by Edward Altman on bond defaults. Altman argued that the low default rates of the mid 2000s was due to excess liquidity and that default rates were likely to rise back to the long term average as this liquidity receded – perhaps as early as 2007. “But as investment managers like to say, the past is not necessarily a perfect guide to future performance. The question is which past will manifest in the next few years. Will it be the longer patterns of the past 30 years or will the most recent past continue to dominate? I have always believed in ‘regression to the mean,’ and in this case I mean the long-term mean and not the average of the recent past. ”
- Blame Washington more than Wall Street for the financial crisis: transcript of a panel discussion featuring (among others) Niall Ferguson, Nouriel Roubini and Jim Chanos. One nice quote from Roubini: “actually greed in some sense is good, is one of the drivers of capitalism. But we know that greed has to be controlled by three things. By fear of losses, by the fact they should not expect to be bailed out, and by a system of prudential regulation and supervision of the financial system because financial markets without ruling institutions are like the law of the jungle.” And one from Ferguson: “And I move in conclusion, that we should blame Washington more than Wall Street, for this crisis. Not least because in my view, Washington sold itself to Wall Street. And I very much fear, is still in hock to it.”
Posted at 7:58 pm IST on Mon, 30 Mar 2009 permanent link
Categories: miscellaneous
Obstfeld on FX Reserves and Panic of 2008
I have been reading an NBER Working Paper by Obstfeld, Shambaugh and Taylor Financial instability, reserves, and central bank swap lines in the panic of 2008. These are well respected authors, so I was quite disappointed to find that they have made several errors and missed several key features of what they call the “panic of 2008.”
Most important of these is the fact that currency depreciations during 2008 were driven to a very great extent by the foreign currency liabilities of the banks and of the corporate sector. This reality was staring them in the face in the form of Iceland, but they amazingly treated Iceland as an outlier and dropped it from all their analysis. They seemed to have forgotten that in risk management, the outlier is the data and everything else is a distraction. Iceland was an extreme case, but the short dollar position of banks and companies were a critical factor behind currency depreciations in the three large emerging economies that Obstfeld et al plot in Figure 1 (Russia, India and Korea).
Failure to consider the exposure of the banking system leads them to under estimate the reserve needs of emerging economies. They make the statement that countries like India “do have foreign reserves sufficient to allow them to act as crisis lenders to foreign governments.” This is simply not true.
Obstfeld et al make another mistake in asserting that for countries like Korea, the swap lines from the US Fed served only a signaling purpose because these countries had plenty of reserves and the magnitude of the swap line was not meaningful in relation to the reserves. This again is simply false. Earlier this month, the Wall Street Journal quoted a finance ministry official as saying that the Bank of Korea had drawn down more than half of the swap line and that it might need a second or third line. Korea is really short of reserves and it has also been reported that not all of its reserves are sufficiently liquid.
It is distressing to find such serious errors in a paper by economists of such high standing who have done so much of widely cited work in this field. I know a working paper is supposed to be for dissemination in preliminary form and is not necessarily subject to peer review, but still ...
Posted at 6:25 pm IST on Fri, 27 Mar 2009 permanent link
Categories: crisis, international finance
Exchange competition and governance
The Mint has two articles on exchange competition and governance which quote me extensively. I made the following statements:
Competition is always good, but in the exchange space one must also ensure that this doesn’t go in a totally different direction, where the competition is on who’s the least governed exchange.
Where one trades is driven by liquidity more than anything else. People want the ability to trade and will chase liquidity. An exchange with a near-monopoly in a particular contract can raise margins and transaction charges significantly without losing much market share.
Even with a low ownership stake, one entity can control an exchange. And with an ownership cap, the threat of takeover is diminished, giving the entity in control a free run.
In other jurisdictions, the regulatory role of exchanges have been separated to non-profit entities to avoid conflict of interest. Such options could be considered in India.
Listing would improve accountability and lead to better disclosures. Besides, inspections and enforcements by the regulator could be strengthened.
My position is that competition is always good and the regulators should endeavour to get as much competition as possible and design a regulatory framework to deal with the consequences of competition. I believe that the “fit and proper” requirement that regulators consider while licensing regulated entities leads to unwarranted complacency. Regulators must assume that their regulatees are unfit and improper and frame regulations on this assumption. If this leads to a harsher regulatory regime than would prevail otherwise, so be it.
When I talked about listing, I had not read about the collapse of CLICO/CIB. With $24 billion of assets and 60 subsidiaries, operating in several fields, and spread over 20 countries – in the Caribbean, Central and North America and Europe, CLICO was one of the leading financial conglomerates in the Caribbean region before it failed. A couple of days ago, I read the speech of the Governor of the Central Bank of Trinidad and Tobago about the episode where he says:
For all its tremendous growth over the last several years, CLICO has remained a private company which has shielded the company from the kind of scrutiny (through, for example the submission of quarterly accounts) to which public companies are exposed.
I am veering round to the view that all systemically important financial intermediaries – banks, insurance companies, mutual funds, exchanges, operators of settlement and payment systems and so on – should be listed.
Posted at 4:09 pm IST on Sat, 21 Mar 2009 permanent link
Categories: corporate governance, exchanges
More on Sovereign Defaults
I blogged about sovereign defaults in November last year. Since then, I have been reading a lot about sovereign defaults with a focus on defaults by sovereigns who were great powers at the time of default. I have also been doing some reading about credit default swaps on sovereigns.
Turning first to sovereign defaults, I went back to the famous Stop of the Exchequer by Charles II of England in 1672. I regard Charles II as one of the greatest kings of England (one Royal Society is worth a few sovereign defaults!) What struck me was the brazen manner in which the sovereign proclaimed his default:
... his Majesty, being present in Council, was pleased to declare that ... his Majesty considering the great charges that must attend such preparations, and after his serious debates and best considerations not finding any possibility to defray such unusual expenses by the usual ways and means of borrowing moneys, by reason his revenues were so anticipated and engaged, he was necessitated (contrary to his own inclinations) upon these emergencies and for public safety at the present, to cause a stop to be made of the payment of any moneys now being or to be brought into his Exchequer, for the space of one whole year ... unto any person or persons whatsoever by virtue of any warrants, securities or orders, whether registered or not registered therein, and payable within that time, excepting only such payments as shall grow due upon orders on the subsidy, according to the Act of Parliament, and orders and securities upon the fee farm rents, both of which are to be proceeded upon as if such a stop had never been made.
... and that in the meantime ... his Treasury be required and authorized to cause payment to be made of the interest that is or shall grow due at the rate of six pounds per cent, unto every person that shall have money due to him or them ... so postponed and deferred.
English Historical Documents, 1660-1714 By Andrew Browning, p 352
Next I turned to the US abrogation of the gold clause in 1933. Investors in the US protected themselves from the debasement of the currency by demanding a clause requiring repayment in gold or in coins of specific weight and purity of gold. In 1933, the US abrogated this clause with a resolution that is again striking in its brazenness:
House Joint Resolution 192, June 5, 1933
Joint resolution
To assure uniform value to the coins and currencies of the United States and currencies of the United States. Whereas the holding of or dealing in gold affect the public interest, and are therefore subject to proper regulation and restriction; and
Whereas the existing emergency has disclosed that provisions of obligations which purport to give the obligee a right to require payment in gold or a particular kind of coin or currency of the United States, or in an amount in money of the United States measured thereby, obstruct the power of the Congress to regulate the value of the money of the United States, and are inconsistent with the declared policy of the Congress to maintain at all times the equal power of every dollar, coined or issued by the United States, in the markets and in the payment of debts.
Now, therefore, be it Resolved by the Senate and House of Representatives of the United States of America in Congress assembled,
That (a) every provision contained in or made with respect to any obligation which purports to give the obligee a right to require payment in gold or a particular kind of coin or currency, or in an amount in money of the United States measured thereby, is declared to be against public policy; and no such provision shall be contained in or made with respect to any obligation hereafter incurred. Every obligation, heretofore or hereafter incurred, whether or not any such provision is contained therein or made with respect thereto, shall be discharged upon payment, dollar for dollar, in any coin or currency which at the time of payment is legal tender for public and private debts.
These measures were challenged in the US Supreme Court which upheld them stating (Norman v. Baltimore & O.R. Co., 294 U.S. 240):
We are not concerned with their wisdom. The question before the Court is one of power, not of policy.
Contracts, however express, cannot fetter the constitutional authority of the Congress. Contracts may create rights of property, but, when contracts deal with a subject-matter which lies within the control of the Congress, they have a congenital infirmity. Parties cannot remove their transactions from the reach of dominant constitutional power by making contracts about them.
The Supreme Court also upheld the abrogation of the gold clause for the government’s own borrowing. The concurring opinion of Justice Stone in Perry v. United States, 294 US 330) was unusually blunt:
... this does not disguise the fact that its action is to that extent a repudiation of its undertaking. As much as I deplore this refusal to fulfill the solemn promise of bonds of the United States, I cannot escape the conclusion, announced for the Court, that in the situation now presented, the government, through the exercise of its sovereign power to regulate the value of money, has rendered itself immune from liability for its action. To that extent it has relieved itself of the obligation of its domestic bonds, precisely as it has relieved the obligors of private bonds.
Finally, I looked at the world’s leading serial defaulter. “Spain defaulted on its debt thirteen times from the sixteenth through the nineteenth centuries, with the first recorded default in 1557 and the last in 1882.” (Reinhart, Rogoff and Savastano, “Debt Intolerance”, Brookings Papers on Economic Activity, 2003(1), 1-62)
I was most interested in the defaults of Philip II, who “failed to honor his debts four times, in 1557, 1560, 1575 and 1596.” (Drelichman and Voth, The Sustainable Debts of Philip II: A Reconstruction of Spain’s Fiscal Position, 1560-1598)
Drelichman and Voth find that:
Contrary to the received wisdom, we show that Philip II’s debts were sustainable for most of his reign. ... Overall, Habsburg Spain’s fiscal discipline was similar to that of other hegemonic powers, such as eighteenth-century Britain or twentieth-century America.
Philip II managed to run a primary surplus in every year of his reign for which we have data. The king never borrowed to cover interest. ... the average primary surplus increased throughout the period as the Crown strove to deal with the increasing interest payments.
With this as background, buying CDS protection on the leading sovereigns of today does not appear to me to be the madness that Krugman claims it to be: “A world in which the US government defaults would be a world in chaos; how likely is it that these contracts would be honored?”
First of all, Alea blog points out “No, they are not crazy, the contracts will be honoured: 100%, guaranteed, for a simple reason, most sovereign CDS are packaged in fully funded credit derivatives first-to-default credit linked notes, therefore the protection buyer gets the cash upfront and is not exposed to the protection seller credit risk.”
He also points to the prospectus of one of these credit linked notes under which a Belgian bank could end up buying credit default protection against the Belgian government (and other governments) from a Belgian dentist. It would work perfectly. Of course, the Belgian dentist is exposed to default risk of the bank, but if the sovereign is solvent, it would probably backstop its bank and the risk of default is low in today’s moral hazard filled world.
Second, Credit Trader points out that the denomination of the CDS in Euros increases the value of the CDS significantly because it effectively becomes a quanto derivative. Third, the inclusion of the restructuring event as a default event makes a world of difference.
One of the scenarios that I consider plausible is that similar to the gold clause repeal, the US could decide that inflation indexed treasury bonds (TIPS) would be redeemed in nominal dollars and not inflation indexed dollars. I am not a lawyer, but I would imagine that this would pass master with the US Supreme Court just as the gold clause resolution did. I would also imagine that such an action would amount to a default event (restructuring) that triggers the CDS payment. That is why as I argued back in November, having the contract governed by a non US law is very useful.
Today, TIPS are a very attractive asset if investors could protect themselves against the US defaulting on its indexation obligation. Buying TIPS and then buying CDS protection on the US government appears to me to be a very sensible trade and not madness at all.
Posted at 5:03 pm IST on Sun, 15 Mar 2009 permanent link
Categories: sovereign risk
Has Barro solved the equity premium puzzle?
I have been reading the paper on stock market crashes and depressions by Barro and Ursua which among other things appears to solve the equity premium puzzle. The equity premium is called a puzzle because the historical return on stocks (over multi-decadal time frames) has exceeded that on bonds by too wide a margin to be justified by the higher risk of stocks in a standard utility theory framework.
The equity premium was a puzzle because the return on stocks is not too highly correlated with consumption and in a standard utility framework, the relevant risk is actually consumption risk. Crudely speaking, the risk is that you do not have enough money from your investments to support your consumption precisely when incomes are low and therefore the investment money is needed. I say crudely speaking because in the frictionless models of the permanent income hypothesis, consumption is supposed to be a function of wealth (including human capital) and not of income at all. A model of risk premiums which ignores liquidity constraints so brazenly might not be very satisfying to finance people, but that is a different issue altogether.
The solution proposed to this puzzle is essentially that the entire consumption risk of equities is a tail risk. It arises from the high probability that stock market crashes are accompanied (with a variable lag) by an economic depression. One big advantage of depressions over wars and other calamities as the explanation for the equity premium is that depressions make risk free bonds very attractive assets.
Of course, Barro has been saying this for a few years now, but now he has the cross country data to back him up. “Conditional on a stock-market crash [multi-year real returns of -25% or less], the probability of a minor depression (macroeconomic decline of at least 10%) is 30% and of a major depression (at least 25%) is 11%.” Taking this tail risk into account is sufficient to justify the observed equity premium for plausible values of risk aversion.
I think this is definitely a promising line of analysis. Of course, a major econometric problem is that the lag between the stock market crash and the economic depression is not uniform (in some cases, it is even negative due to measurement errors). Barro and Ursua therefore “focus on the 58 cases of paired stock-market crashes and depressions ... and ... calculate the covariance in a flexible way that allows for different timing for each case.”
I am sure that a lot of methodological refinements are needed to understand the phenomenon better, but I like this approach. For Indian readers, it is interesting to note that the sample includes one episode from India (apart from the World War): during 1946-1949, real stock prices fell 49% while real GDP fell 18% during 1947-1950. That makes the current crisis seem quite bearable!
Posted at 3:44 pm IST on Thu, 12 Mar 2009 permanent link
Categories: CAPM, financial history
Is there any such thing as macro-prudential risk?
I have been grappling with this question ever since reading The Fundamental Principles of Financial Regulation by Markus Brunnermeier, Andrew Crockett, Charles Goodhart, Avinash D. Persaud and Hyun Shin. All the authors are well respected economists; and Brunnermeier, Persaud and Shin, in particular, have been among those whose writings I have admired a lot during this crisis. Yet, I am not convinced about their concept of macro-prudential risk as opposed to the micro-prudential risk that traditional risk models are allegedly concerned with.
My problem is that at least since Markowitz, risk has always meant portfolio risk. The riskiness of any asset is the contribution that it makes to the portfolio in which it is held. For an equity portfolio, therefore the risk of a stock is its covariance with the portfolio which is the approximately the same as the beta if the portfolio is highly correlated with the market portfolio. In a value at risk (VaR) model for a credit portfolio, the marginal risk of a loan is equal to its expected loss conditional on the total portfolio loss being equal to the VaR level (see for example, Hans Rau-Bredow, 2002). This is true in particular of the Basel II models as well.
Brunnermeier et al are rightly worried about herding behaviour where many banks hold similar portfolios and are thus exposed to the same risks. But in this situation, each bank’s portfolio is highly correlated with the aggregate portfolio of the banking system. Thus Basel II and similar allegedly micro-prudential risk models are in fact capturing the macro-prudential risk of each loan. At this point, (following Brunnermeier et al) I am also ignoring the technical inadequacies of the Basel II risk models. The question being asked is whether conceptually they are addressing the right risk. I think they are.
One of the problems I had with Brunnermeier et al is that they seemed to be focused on the wrong conditional probability. They frequently ask the question: conditional on a bank failing what is the probability that there is a systemic crisis. They argue correctly that this probability is higher for a bank with a AAA portfolio than for a bank with a BBB portfolio. I think the correct question to ask is the reverse conditional probability: conditional on a systemic crisis, what is the probability that the banks in question fail. This probability is higher for the bank with a BBB portfolio and this is consistent with the Basel II risk weights.
At this point, it is also worthwhile to remember that the capital required for a AAA loan is far in excess of its unconditional probability of default. In fact, the unconditional probability of default is the “expected loss” which in Basel II is supposed to be covered by the credit spread and is not supposed to come out of the capital charge at all. The capital charge deals exclusively with the “unexpected loss” and is defined by conditionalizing on a systemic shock.
In short, I think today’s risk models are conceptually addressing macro-prudential risk because in any portfolio risk model these are the only risks that matter. Whether they are measuring these risks right is a totally different question (see my last blog post).
Brunnermeier et al have a long discussion about liquidity risk and maturity mismatches as a macro-prudential risk. The example of Northern Rock permeates this discussion. I think the diagnosis of Northern Rock as a liquidity risk which seemed to make sense in 2007 (I was guilty of this diagnosis myself) has been invalidated by developments in 2008. The silent run that banks like WaMu witnessed have shown that there is no safety for a bank in retail deposits. Nor is there safety in retail term deposits. All banks allow customers to prematurely encash their term deposits with modest penalties. In bank runs, people queue up to do exactly that as for example in the mini runs that we had on ICICI Bank in India. The behavioural maturity of core deposits is a meaningful notion in normal times; in periods of crisis, the behavioural maturity is zero. In wholesale markets, maturity is ill defined because of put and call features combined with step-up coupons. Normal maturity assumptions about these bonds have been invalidated during the current crisis. In short, maturity mismatch is not a well defined term during a systemic crisis.
In this context, I am perplexed by the irrational fear of bank runs among regulators and academics alike. We must not forget that frequent runs and near runs are the principal defence that we have against Ponzi schemes (both Madoff and Stanford were ultimately exposed by runs on them). Solvent institutions with normal access to central bank liquidity support can survive runs. Banks that cannot survive a run despite the central bank liquidity window are fundamentally flawed; they need to fail.
Posted at 9:40 pm IST on Thu, 5 Mar 2009 permanent link
Categories: crisis, regulation
Risk Management Lessons for Derivative Exchanges
A few days ago, I finished a paper on Risk Management Lessons from the Global Financial Crisis for Derivative Exchanges. The abstract of the paper says:
During the global financial turmoil of 2007 and 2008, no major derivative clearing house in the world encountered distress while many banks were pushed to the brink and beyond. An important reason for this is that derivative exchanges have avoided using value at risk, normal distributions and linear correlations. This is an important lesson. The global financial crisis has also taught us that in risk management, robustness is more important than sophistication and that it is dangerous to use models that are over calibrated to short time series of market prices. The paper applies these lessons to the important exchange traded derivatives in India and recommends major changes to the current margining systems to improve their robustness. It also discusses directions in which global best practices in exchange risk management could be improved to take advantage of recent advances in computing power and finance theory. The paper argues that risk management should evolve towards explicit models based on coherent risk measures (like expected shortfall), fat tailed distributions and non linear dependence structures (copulas).
Posted at 4:48 pm IST on Tue, 3 Mar 2009 permanent link
Categories: exchanges, post crisis finance, risk management
Did 7th January tell us about anything about the governance discount?
On January 7, 2009, when the fraud at Satyam was revealed, investors did not think of Satyam as an unfortunate exception; most of them thought of it as symptomatic of the problems that could be lurking in many other leading Indian companies. Stocks of several other companies fell dramatically on that day in a manner that did not seem to reflect industry specific shocks. Within the information technology industry itself to which Satyam belonged, some stocks with a reputation for above average corporate governance rose while some other stocks fell dramatically.
To those who believe in the strong form efficiency of stock markets, it is tempting to believe that the market was telling us something about the perceived governance weaknesses of some Indian companies. In this context, it is worthwhile to ask whether the reaction of the market on that day was a panic reaction that was reversed over a period of time.
On January 7, 2009, nine out of the fifty stocks in the S&P CNX Nifty Index fell by more than 10% while the index itself fell by 6%. The median stock in the 50 stock index fell by only 5% while the median price decline of these nine stocks was 15%. I looked at what happened to these nine stocks week after week up to the end of February. Far from reversing course, these stocks extended their losses. While the index fell by 11% and the median stock in the Nifty fell by 17% from pre-Satyam levels, the median fall for the nine stocks was 37%. That is right, the median of these nine stocks underperformed the index by a whopping 26%. Only one of these nine stocks fell less than the index; the other eight underperformed the index by margins ranging from 12% to 35%.
In the case of the real estate stocks, is it possible to argue that the fall was industry wide; though one could counter argue that in this case, the entire industry was perceived to be plagued by governance problems. In most other cases, the market perception about governance appears to be the dominant theme. Of course, even if we believe that the market is telling us something, we do not know whether what it is saying is right or not.
Posted at 8:57 pm IST on Mon, 2 Mar 2009 permanent link
Categories: corporate governance, equity markets, fraud
Impairment test equals integrity test
I have a piece in today’s Financial Express arguing that the impairment test in the year end financials is a test of the integrity of Indian corporate sector.
Corporate India faces a significant test of the integrity of its financial statements at the end of this financial year when it has to apply an “impairment” test to a variety of assets under accounting standard AS 28. If assets are impaired, they have to be written down and the loss has to be charged to the profit and loss account.
Though AS 28 came into effect for listed companies from the year 2004-05, this is the first time that a large number of companies will be confronted with potential impairment on a large scale. Under AS 28, the requirement to carry out an impairment assessment arises only when there are external or internal indications that an asset may be impaired. The significant worsening of the domestic and global economic environment, sharp declines in market prices and deterioration in the economic performance of many assets would trigger the application of the impairment test for several classes of assets during this year.
There are four important categories of assets where impairment is likely to have taken place. These are: (a) goodwill from recent acquisitions (particularly, international acquisitions), (b) mines and other natural resource assets, (c) commercial real estate, and (d) capacity rendered redundant by demand destruction.
Indian companies made large international acquisitions at high prices during the boom. The current market value of several of the acquired companies would be well below what was paid for them. Their current and forecasted operating performance would also be much worse than what was projected at the time of acquisition. This would normally lead to a heavy impairment charge.
Some kinds of acquisitions would probably escape this charge. For example, if a foreign company was acquired mainly for its brands and marketing network or for its technology, the acquired company might not have an independent set of cash flows that can be used for an impairment test. In this case, the impairment test may have to be applied to the entire consolidated business. Companies whose shares are trading above book value are unlikely to be in the situation where the entire business is impaired and so no impairment charge may be needed.
Commercial real estate is another prime candidate for an impairment test because of the steep correction in market prices. Here again, if the real estate was bought for corporate offices or for other purposes which do not produce identifiable cash flows, impairment charges may not result unless the whole business is impaired. Real estate that was bought for development or for letting out or for producing revenue directly (as in infrastructure projects or retail stores) would be prime candidates for impairment.
Similarly, the sharp fall in commodity prices could trigger impairment charges for many natural resource assets like mines in India or abroad that were bought at the height of the boom.
Finally, the global recession has created excess capacity in a variety of industries. New capacity is coming on stream while even the old plants are running below capacity. Many of these assets might have to face an impairment charge. In many cases, it may be possible to argue that the low capacity utilisation is a temporary phase. But in some industries, the demand destruction has been too large for such a sanguine view.
Companies whose shares are trading below book value are in a worse situation. Their entire business may be impaired and they may have to write down many assets including unproductive corporate assets (ranging from art collections to aircraft) which have seen huge declines in price.
Banks and financial companies are in a separate league because the treatment of their impaired loans and investment is governed by different regulations. These losses are bound to rise, too, but that is another story altogether.
Stock markets are forward looking and are likely to have already factored in the deterioration in asset values in their valuation. Recognising this known loss in the published accounts would not cause a further drop in share prices. On the contrary, markets are likely to reward companies which are honest about what has happened, reflect this reality in their accounting and have a realistic plan to deal with their problems.
Markets are more likely to punish companies that try to avoid an impairment charge by using various accounting subterfuges. Such companies would be telling the world that their accounts cannot be trusted at all and that they are Satyams in the making. That would force the market to assume the worst and mark down even assets that are not actually impaired.
Many companies, however, do not seem to understand this. They appear to be under the delusion that all would be fine with the world if only they can find a way to avoid admitting the impairment that has taken place. That is why I think that the impairment test could end up being an integrity test for Indian accounting.
Posted at 12:15 pm IST on Mon, 2 Mar 2009 permanent link
Categories: accounting, corporate governance
SEC confirms Dalmady analysis on Stanford
Within hours of my posting about Dalmady’s analysis of possible fraud at Stanford International Bank, I received a comment on my blog telling me that I was spreading lies and that I should recant:
Try to do some investigative work instead of building upon lies ... When you want something successful to fail you present the perception, associate it with something negative (Madoff) and watch the masses panic ... You have now created the reality ... I hope you put as much energy in recanting this story as you do posting them ...
I did not lose sleep over this comment because by the time I read that comment, the SEC had filed its complaint against Stanford confirming most of what Dalmady had surmised.
I found the SEC complaint short on hard facts. Did I really know anything more on reading this complaint than I did after reading Dalmady? I am not sure.
And, there were some things in the complaint that did not sound right to me like the assertion that it is “impossible” for a large portfolio to produce identical returns of exactly 15.71% in two successive years. If exact means that there was no rounding at all in arriving at 15.71%, then it is in fact almost impossible. But then it is quite improbable that a really large portfolio would produce a return which is exact to two decimal places (with no rounding error) in even one year. The return on a $8 billion portfolio at around 15% would be over a billion dollars and would therefore have twelve significant digits when measured in dollars and cents. Suppose that the return in percent is also computed to twelve significant digits. The probability that only the first four significant digits (1, 5, 7, 1) are non zero and the other eight significant digits are zero would then be about 10^(-8) or about 1 in 100 million. Quite improbable!
But if what they mean is that the return rounded to two places was 15.71%, then that is not impossible at all. If the range of returns is say 5% (500 basis points), then the probability of the return being the same as the previous year’s return to two decimal places (one basis point) is 1/500 or 0.2%. Since the SEC examined at least 10 years of data (their example is of 1995 and 1996 returns), the probability that they would find at least one year in which this happened is 1/50 or 2%. Certainly, 2% is not my idea of impossible or even improbable.
Posted at 4:33 pm IST on Wed, 18 Feb 2009 permanent link
Categories: bankruptcy, fraud
Replacing the Maytas board is not warranted
I was interviewed by CNBC Awaaz today on the government decision to move the Company Law Board to replace the Maytas Board in connection with the Satyam scandal. I disagreed with the move though I was among the first to argue that the government should replace the Satyam board early last month (see here and here). The Maytas situation is different both because the urgency of the Satyam case is lacking and because there are serious conflict of interest issues.
Satyam presented a complete governance vacuum: the Chairman had confessed to a fraud, the promoters probably no longer held much of their shares, and the independent directors had lost all credibility. This is not the case in Maytas. Second, Satyam had value only as a going concern as the tangible assets were a small fraction of its enterprise value. Maytas on the contrary is in real estate which is almost as valuable in liquidation as it is on a going concern basis.
More importantly, the prime allegation in respect of Maytas is that money looted from Satyam ended up in Maytas. This means that the stage is set for litigation between Maytas and Satyam. The government by taking over both these companies is interposing itself into a commercial dispute between two companies. Since Satyam is a much more high profile case, the temptation would be there for the government to favour the Satyam shareholders over the Maytas shareholders. This alone is a strong argument for not allowing the government to appoint a new Maytas board.
What does make sense is for the Company Law Board (CLB) to forbid any mortgage or sale of property by Maytas. The CLB could also order an emergency meeting of the shareholders to elect a new board. This was not a feasible option in the Satyam case because of the urgency emanating from the intangible nature of its assets.
The power to replace the board is an extraordinary power to be exercised only in extraordinary situations. Power has a tendency to become addictive; having used it once, the temptation is to use it again and again even when the circumstances do not warrant it. This temptation must be resisted.
Posted at 12:55 pm IST on Wed, 18 Feb 2009 permanent link
Categories: corporate governance, fraud, regulation
Dalmady: The blogging Markopolos?
A week ago, I blogged about Pellechia’s suggestion that Markopolos should have blogged about Madoff instead of taking his suspicions to the SEC. I mentioned then that the problem is that the blogger would fear regulatory action for “rumour mongering.” Now we do have Alex Dalmady blogging about another possible Ponzi scheme.
Dalmady is smart. His five page article in the Venezualan publication Veneconomy of January 2009 gets to the “case study” only after two pages of general discussion about scams and mentions the name of the entity (Stanford International Bank) only on page 4. His description of the whistleblower’s dilemma is very well put:
Another thing many can’t grasp is why these scams aren’t uncovered. The truth is that most of them are “found out” all by theselves or when the circumstances make it obvious. ... And it’s not just because the participants are happy while they are collecting profits. It’s that a good scam is really hard to detect and almost impossible to uncover without inside help.
Being “almost sure” is usually “not enough.” How do you blow the whistle when you’re “almost sure”? It’s preferable to not get involved and the skeptic will keep it to himself. Frankly, what does a whistle blower have to gain? So normally he’ll back away from the suspicious deal and leave things as they were.
His conclusion is also well hedged: “be careful with animals that look like ducks that say that they’re something else. Because they could be that other something, although it’s very likely that they are just ducks.” Dalmady repeatedly invokes the Heisenberg uncertainty principle to say that one can never be sure of anything. He finally ends with an appeal in the postscript: “Please, do not accuse me of destabilizing the financial system.”
Dalmady followed that article up with a blog post on a site called of all things the Devil’s Excrement. His writings created quite a stir in the blogosphere with Felix Salmon for example posting about it here, here and here.
Post Madoff, there is greater willingness by bloggers to put their neck out and voice their suspicions about fraud. But the mainstream media is still running scared. The Financial Times for example gives this view of their internal decision processes at its Alphaville blog:
PM: Well, been looking at this SIB – Sir Allen Stanford story
PM: rather fruity
PM: Anyway – think we are cleared to publish our stuff now
NH: only taken 12 hours
PM: Not huge new revelations – beyond that printed elsewhere
PM: This was a very good pick up by a certain Long Room member
NH: it was fascinating stuff
NH: and if you want to know what we are talking about
NH: there are stories in Business Week
NH: and on Bloomberg
NH: if u are interested
NH: for our story we just need sign off from the editor now
The media knows that banks are treated with kid gloves because a bank run is supposedly such a terrible event. I think regulators and the broader society must learn to live with frequent bank runs and an occasional bank failure as the price of a healthy financial system.
One of my favourite quotations from Milton Friedman is his statement somewhere to the effect that banks are not regulated because they are different, they are different because they are regulated. All kinds of frauds (and incompetence!) find shelter behind that regulatory veil.
Posted at 12:25 pm IST on Tue, 17 Feb 2009 permanent link
Categories: bankruptcy, fraud
Rakesh Mohan (BIS) report on Capital Flows and Emerging Economies
The Committee on the Global Financial System (CFGS) of the Bank for International Settlements established a Working Group under Dr. Rakesh Mohan of the Reserve Bank of India (RBI) to study capital flows and emerging economies. The Group submitted a very interesting and valuable report last month.
The group was originally set up primarily to study the implications of capital inflows for emerging economies, but the changed environment has made it a very valuable study of how the global crisis is impacting emerging economies and how these economies are responding to the crisis. The Working Group should be commended for interpreting their mandate broadly and covering the events of 2007 and 2008.
Even to people like me who have been following recent developments in several emerging countries keenly, there is a wealth of fascinating data and case studies in the report. Most of us find it easy to follow what is happening in the US and in our own country. The experiences of other countries – especially emerging economies – is not well documented in the publicly accessible literature. The blogosphere is not exactly littered with Bloomberg terminals and Datastream subscriptions, and even those with access to these find that quality reporting and analysis is not readily available for non US economies.
The conclusions of the report are also well balanced and sensible recognizing the beneficial effects of capital flows – particularly foreign direct investment and foreign portfolio equity investment. It also lays stress on the development of the domestic financial sector including pension funds. There is a clear recognition that the price-stability focus of monetary policy can be undermined by paying too much attention to exchange rate objectives.
The group was clearly racing against time to finish the report as events pushed them far beyond their original mandate. As a result, the proof reading of the report has probably been a little spotty as well. I spotted a couple of errors that would almost certainly have been eliminated by a more leisurely proof reading process:
- In three different tables (C2, E1 and E3), the report states that the market capitalization of India’s stock market at the end of 2007 was 317% of GDP. Though end-2007 was the height of the stock market bubble in India, 317% is still nearly twice as large as the real number. I suspect that somebody carelessly added up the market capitalization of the BSE and the NSE without correcting for the double counting resulting from most large companies being listed on both exchanges. (My preferred rough and dirty measure is the market capitalization of the BSE, but more refined estimates are certainly possible). I am sure that given more time for proof reading, this error would have been corrected.
- While discussing Korea, the report states (page 120): “Following the Lehman failure, the spread of CCS [Cross Currency Swaps] over interest rate swaps widened significantly, and both banks and corporate borrowers faced a sharp increase in the cost of swapping borrowed dollars into local currency.” My memory was that the problem was the reverse – in late 2008, Korean borrowers were swapping local currency into dollars to repay maturing dollar debt and it was the cost of doing this that rose sharply. Graph H11 confirms that this was indeed the case: the spread “widened” to a huge negative value (the graph shows that the CCS rate itself went to zero and then turned slightly negative). Again, a less hurried proof reading would I am sure have caught the error.
But this is mere nitpicking about a report that I enjoyed reading. I strongly recommend that all those interested in how emerging markets are coping with these troubled times should read the whole report especially Chapter H on the developments in 2008.
Posted at 3:56 pm IST on Mon, 16 Feb 2009 permanent link
Categories: international finance
Takeover code exemption for Satyam
I was interviewed yesterday on NDTV Profit, UTV and CNBC on the new takeover norms for Satyam-like companies. The transcript and video of the CNBC interview and the video of the NDTV interview are available on their respective websites. I made the following main points:
- The existing takeover code envisages a takeover process which is run by the buyer. The acquirer initiates the process and decides when to make an open offer. When a company is trying to sell itself, we want a process which is controlled by the seller. The seller would like to set a deadline for submission, evaluate all competing bids and choose the winner. The new norms are designed to facilitate this and this is good.
- The takeover code proved inadequate to run a good auction of Satyam and if it failed in Satyam it could fail anywhere else where a company wants to sell itself. We should have recognized that and added a new chapter to the takeover code to facilitate this for all companies and not just for Satyam-like companies.
- I am uncomfortable with the provision in the new norms saying that once the Board has chosen a bidder and this accepted by SEBI, then somebody else cannot make a competitive bid. What SEBI is really saying is trust the board, trust Sebi to find out who is the best buyer. Once they have done that nobody else can appeal above the board, above Sebi directly to the shareholders. I find this fundamentally unacceptable. The company belongs to the shareholders – anybody must have the right to go directly to the shareholders.
While I did not explicitly mention it in the interviews, I was thinking of Wells Fargo offering a higher price for Wachovia after the regulators had sold it to Citi. Had the board been controlled by the regulator and had the shareholders also been shut out of the decision making, the Wells deal would obviously not have been possible.
Posted at 8:56 pm IST on Sat, 14 Feb 2009 permanent link
Categories: corporate governance, regulation
What if Markopolos had blogged?
Ray Pellecchia writes on his blog that Markopolos could have stopped Madoff simply by writing a blog after his complaints to the SEC fell on deaf years. There is a serious problem with this suggestion – the SEC itself.
Regulators around the world may be too dense to understand the niceties of Madoff’s purported split strike conversion strategy, but they are smart enough to act and act quickly agaist somebody trying to spread what appear to be malicious rumours. (Please remember that there is no such thing as an anonymous blogger when the state is after you.)
The very fact that the SEC investigated the complaint and found no merit in the complaint would have made it evident that that blog post was just a baseless rumour. Add in the fact that Markopolos was a rival hedge fund manager and the grounds for acting against the rumour mongerer are plain as daylight. From whatever I have seen of regulators anywhere in the world, it would have been suicidal for Markopolos to write that blog.
This is an example of how a regulator makes things worse merely by its existence. Absent an SEC or an FSA or a SEBI, a Markopolos could stop a Madoff by blogging. Because such a regulator exists, Markopolos is powerless!
Posted at 5:46 pm IST on Tue, 10 Feb 2009 permanent link
Categories: fraud, regulation
Towards a new takeover code
I wrote a piece in today’s Financial Express about aligning the takeover code more closely with market prices.
It has long been evident that the SEBI takeover regulations have been founded on a fundamental and deep rooted distrust of market prices. But it is only a high profile situation like Satyam that makes us realise that this distrust has made the regulations unworkable.
Sebi has announced that it “recognised the special circumstances that have arisen in the affairs of [Satyam] and concluded that the issue needs to be dealt with in the general context. Accordingly it was decided to appropriately amend the regulations/ guidelines to enable a transparent process for arriving at the price for such acquisition”.
I would argue that treating market prices with greater respect is perhaps the simplest solution to the problem which is by no means confined to situations of fraud like Satyam.
The takeover regulations stipulate that if any person wishes to acquire 15% or more of the shares of a company, then such an acquirer must make an open offer to the shareholders to buy at least 20% of the shares of the company. It is also stipulated that the open offer must be at a price which is the highest of (a) the average market price during the previous 26 weeks, (b) the highest price at which the acquirer has bought shares of the company in the previous 26 weeks and (c) the price at which the acquirer has agreed to buy shares from the promoters or other shareholders.
In the Satyam case, the problem is that share prices have fallen by more than 80% and the 26 week average is possibly much higher than what any acquirer would be willing to pay. The argument that is being floated is that the prices before January 7, 2009 were based on a fraudulent set of financials and therefore, those prices should somehow be disregarded.
Unfortunately, the problem extends far beyond Satyam. For about half of the BSE 500 companies, the last six month average share price is greater than the current market price by 40% or more. For two-thirds of the BSE 500 companies, the six month average exceeds the current market price by 25% or more. Normally, there is a control premium that an acquirer has to pay to take over a company and therefore the acquisition price is about 20-30% above the pre-bid market price.
In today’s situation, for somewhere between half and two-thirds of the top 500 companies, the takeover regulations mandate an offer price that is higher than a reasonable control premium. Sebi has unwittingly shut down the market for corporate control for about half of India’s largest companies. This is absolutely unacceptable.
Fraud is not the only reason why a company’s share price can fall dramatically. Changes in fundamentals of the company, the industry or the entire economy can lead to sharp falls in market prices. Within the BSE 500, for example, many of even the better companies in real estate, infrastructure, textiles, steel, metals, aviation and commercial vehicles are in the situation where the six month average price is 40% above the current market price.
The purpose of the takeover regulations is to create a healthy and vibrant market for corporate control which allows companies to become more efficient through acquisitions and restructuring. In today’s depressed conditions, this mechanism is needed more than ever.
Unfortunately, in India, there are some vested interests of merchant bankers and small investors who would like the takeover regulations to become a mechanism for providing a free lunch to minority shareholders. The same investors who clamour for ending fuel and food subsidies are eager to get their own free lunches through open offer pricing.
For the takeover regulations to serve their true purpose, they must give primacy to freely functioning markets and get away from the administered pricing regime that they have become today. To begin with, we should abolish the 26 week average for large liquid stocks where market prices are more reliable.
But even for small stocks, we should rely on the intelligence of the investors. After all, there is no regulation which requires new issues of shares to be made at prices linked to the last six months average share price to take care of market manipulation. We simply expect investors to make their own assessment before buying shares. Why can we not expect them to make their own assessment before selling shares?
Another funny thing is that a potential acquirer is not allowed to reduce the offer price in response to changed conditions. In the US, we have seen companies pay a break up fee and walk away from acquisitions when there is a severe adverse change in economic conditions. In India, we have designed the regulations to discourage hostile acquisitions: even if hostile acquirers discover serious problems, they can not easily walk away. We should allow bid terms to be negotiated by contract and not frozen by regulations.
Posted at 8:44 am IST on Thu, 5 Feb 2009 permanent link
Categories: corporate governance, regulation
Markopolos on the SEC
Last year, I blogged about the Markopolos submission to the SEC (way back in 2005) in which he argued that the Madoff fund was a Ponzi scheme. I wrote then that the Markopolos submission was extremely persuasive and well argued and was a good example of forensic economics. His prepared testimony to the US Congressional hearings is even better at explaining his deductions. He talks about how his army special operations background trained him “to build intelligence networks, collect intelligence reports from field operatives, devise lists of additional questions to fill in the blanks, analyse the data and send draft reports for review and correction before submission.”
The entire 65 page document is worth reading in full. What I found most interesting (after having read the 2005 submission) is what he has to say about the SEC. What happens when he turns his forensic mind at the SEC itself is really fascinating. He pulls no punches either in his diagnosis or in his recommendations:
- Unfortunately, as bad a regulator as the SEC currently is, and the SEC certainly is a bad regulator, it is the best of a very sorry lot.
- ...the SEC is a group of 3,500 chicken tasked to chase down and catch foxes which are faster, stronger and smarter than they are.
- Amazingly, the SEC does not give its employees a simple entrance exam to test their knowledge of capital markets! ... Talented CPAs, CFAs, CFPs, CFEs, CIAs, CAIAs, MBAs, finance PhDs and others with finance backgrounds need to be recruited to replace current staffers. ... I caution the SEC to avoid focusing on any one of the above professional certifications at the expense of the rest because all are relevant and necessary. ... Diversity will ensure that group think is kept at bay. ... Right now the SEC is overlawyered. Hopefully it can transition away from this toxic mix as quickly as possible.
- SEC staffers need to be encouraged to attend industry conferences ... [and] ... educational meetings. ... Either the SEC is anti-intellectual and intentionally maintaining staff uneducated about the capital markets or it is ignorant.
- SEC staffers ... with industry credentials [like CPA, CFA etc] ... are not allowed to have their designations printed on their business cards ... if the SEC allowed its few credentialled staff to put these credentials on their business cards, it would expose the overall lack of talent within the SEC.
- But if you walk into an SEC regional office, you won’t see any of these journals [Journal of Accounting, Journal of Portfolio Management, Financial Analysts Journal, Journal of Investing, Journal of Indexing, Journal of Financial Economics and so on]. ... Apparently all the SEC uses is Google and Wikipedia because both are free.
- If an SEC staffer doesn’t know derivative math, portfolio construction math, arbitrage pricing theory, the capital asset pricing model, both normal and non-normal statistics, financial statement analysis, balance sheet metrics or performance presentation formulas then they shouldn’t be hired other than to fill administrative or clerical positions.
- ... the SEC needs to recruit foxes in senior, very high paying positions that offer lucrative incentive pay for catching foxes and bringing them to justice. ... highly successful industry practitioners who have succeeded financially during their long careers.
- Compensation at the SEC needs to be both increased and expanded to include incentive compensation tied to ... enforcement revenues.
- It is my belief that SEC examiners are so inexperienced and unfamiliar with financial concepts that they are literally afraid to interact with real finance industry professionals and choose to remain isolated in conference rooms inspecting pieces of paper.
- ... most SEC Regional Offices are lucky to have even one Bloomberg terminal for the entire region’s use. Whereas your typical investment firm would have one Bloomberg per analyst, trader and portfolio manager.
- Fortunately, the US has two very competent securities’ regulators who do a truly fantastic job and at an unbelievably low cost. Unfortunately, they are the New York Attorney General’s office (NYAG) and the Massachusetts Securities Division (MSD). ... one alternative solution is to disband the SEC and give its budget to the NYAG and the MSD.
- ... consider moving the SEC out of Washington because Washington is a political centre and not a financial centre
I think that by and large Markopolos is on the right track though I disagree with a few of his recommendations. The question is whether any of this is likely to happen. Unfortunately, state failure is as endemic as market failure (if not more).
Posted at 8:16 pm IST on Wed, 4 Feb 2009 permanent link
Categories: fraud, regulation
Open offer price: CNBC Interview
I was interviewed by CNBC today morning on whether the open offer pricing norms need to be changed to account for the steep fall in Satyam share price after the exposure of the fraud. The CNBC web site has the transcript and the video. The key passage from the interview is the following:
We need to make changes in the open offer which are not specific to Satyam but general enough to cover all cases. When we are talking about a company which is very liquid ... one should assume that what is happening in the market is a fair reflection of its fair value and simply allow people to buy at a price which is dictated by the market.
The whole idea of 26-week average ... essentially reflects a distrust of market prices – a belief that market prices can be manipulated. I think that belief is inapplicable when we are talking about a very liquid stock. So, I think the way we should move forward is to say ... 26 weeks average is not required when we are talking about a stock which is reasonably liquid.
We might say top 100 stocks, top 500 stocks or we might go by impact cost or we might say that anything on which the derivatives are allowed to trade where there is a reasonable degree of openness and resilience about the market price there is no need to average anything. The latest price is the measure of what the share is worth.
Posted at 5:16 pm IST on Mon, 2 Feb 2009 permanent link
Categories: equity markets, regulation
Open the books
I wrote a piece in the Financial Express today on the enhancements to corporate disclosure that are required in the aftermath of the Satyam fraud.
Ramalinga Raju was in jail two days after he confessed to a $1.5 billion fraud at Satyam and has remained there since then. By contrast, Bernie Madoff is still ensconced in his home more than a month after he confessed to a $50 billion fraud in the United States. Two days after the Raju confession, there was a new board of directors for Satyam taking charge of its assets and trying to preserve as much of shareholder value as possible. Meanwhile, Madoff has spent his time out on bail mailing a million dollars worth of jewellery as gifts to his friends and relatives, putting them beyond the reach of the investors whom he has defrauded.
On the whole then, the Indian government has done better than the low expectations that we have of our rulers, while the US has conformed to the images of crony capitalism that has characterised its bailout era.
But complacency would be a mistake on our part. Emerging markets are held to higher standards than developed markets, and it is essential to use Satyam as an opportunity to make a series of much-needed disclosure and governance reforms. The question to ask is not whether these reforms would have prevented Satyam; the relevant question is whether these reforms would help bolster investor confidence in the Indian corporate sector at a time when it has been badly shaken.
Much as the government might like to portray Satyam as an unfortunate exception, the fact is that most investors, both in India and abroad, think of it as symptomatic of the problems that could be lurking in many other leading Indian companies. Of course, companies will voluntarily increase their disclosure standards to signal that they have nothing to hide. But this by itself is not enough. Disclosure is most effective and useful to investors when it is carried out in a uniform way by many companies. This is where regulators have a role to play.
Increasing the quality of quarterly disclosures is very important. Satyam was, of course, subject to this requirement as a US listed company and it is conceivable that these disclosure requirements forced a confession in early January 2009 shortly before the results of the quarter ended December 2008 were to be unveiled. Absent the pressure of this disclosure requirement, it is not beyond the realm of possibility that the deception might have been kept up for another quarter till the year end in March 2009.
I have written in the past (FE, November 27, 2008) on the need to force companies to reveal the complete balance sheet and not just the income statement highlights on a quarterly basis. This needs to be pushed forward more rapidly. On the same lines, a more rapid move to international accounting standards is desirable. Certain key standards like AS 30 on financial instruments could be targeted for accelerated adoption and implementation.
Greater regulatory scrutiny of corporate disclosures is also essential. The Raghuram Rajan Committee on financial sector reforms (of which I was a member) has recommended that India should adopt a system of reviewing the accounting filings of companies on a selective or sample basis on the lines of what the SEC does in the US.
Equally important are measures to improve private sector scrutiny of corporate disclosures. In the US, the Edgar database of regulatory filings with its full text search capability and its XBRL based interactivity is a huge boon. It is difficult to see how private sector scrutiny of the kind carried out by footnoted.org could ever be done without Edgar. The dissemination of corporate disclosures by the exchanges and by Sebi on their websites does not come remotely close to what Edgar achieves in the US. We should make it a top priority to get our own Edgar style repository functional as quickly as possible.
I am also a proponent of combining regulatory review and private sector scrutiny in innovative ways. For example, a short seller who believes that there is something wrong with the accounts of a company should be able to demand a regulatory review by paying a fee to cover the regulator’s costs. Needless to say, the results of the review should be announced only publicly so that the short seller does not get any advance information. He would of course benefit from the price impact of the review findings on any pre-existing short positions.
I am invariably told that this scheme would be misused by people to embarrass their corporate rivals. My flippant response is that there is nothing wrong in harnessing corporate rivalry in such a constructive way to improve the credibility of corporate disclosures. More seriously, if a review leads to a clean chit, the public announcement of this would benefit the target company. This in itself would act as a disincentive against frivolous review requests by people endowed with deep pockets.
Posted at 7:03 am IST on Thu, 22 Jan 2009 permanent link
Categories: accounting, crisis
Basel is fighting the last war and that rather badly
The Basel Committee has put out a set of proposals for revising the Basel II capital requirements.
One of the things that Basel is now correcting is a discrepancy between the risk level of 99% that was laid down during the market risk amendment of 1996 to Basel I and the level of 99.9% that was laid down in Basel II in 2004 for the banking book. The proposed Guidelines for computing capital for incremental risk in the trading book require risk in the trading book to be measured at the 99.9% level and at a one year horizon. The Committee admits that:
Owing to the high confidence standard and long capital horizon of the IRC, robust direct validation of the IRC model through standard backtesting methods at the 99.9%/one-year soundness standard will not be possible. Accordingly, validation of an IRC model necessarily must rely more heavily on indirect methods including but not limited to stress tests, sensitivity analyses and scenario analyses, to assess its qualitative and quantitative reasonableness, particularly with regard to the model’s treatment of concentrations. Given the nature of the IRC soundness standard such tests must not be limited to the range of events experienced historically. The validation of an IRC model represents an ongoing process in which supervisors and firms jointly determine the exact set of validation procedures to be employed.
I think this is a futile attempt to preserve the 1990s era risk management technology (value at risk, linear correlations and normal distributions) embodied in Basel II. The only way to get to the 99.9% level in any plausible way is to use fat tailed distributions (say student with four degrees of freedom) explicitly and also to move to non linear dependence models (copulas); when one is doing all this, one might as well give up the theoretically discredited value at risk measure and move to a “coherent risk measure” like expected shortfall. Suggesting the use of stress tests as a way to arrive at the 99.9% standard is akin to changing the subject when you do not know what to say.
What I found even more troubling is the following statement in the other consultation document “Revisions to the Basel II market risk framework”
In addition, a bank must calculate a ‘stressed value-at-risk’ based on the 10- day, 99th percentile, one-tailed confidence interval value-at-risk measure of the current portfolio, with value-at-risk model inputs calibrated to historical data from a period of significant financial stress relevant to the firm’s portfolio. For most portfolios, the Committee would consider a 12-month period relating to significant losses in 2007/08 to be a period of such stress, although other relevant periods could be considered by banks, subject to supervisory approval. This stressed value-at-risk should be calculated at least weekly.
This document has been in the making for a longer period and perhaps reflects the Committee’s thinking at an earlier point of time – it still talks of 99% instead of 99.9%. That apart, what puzzled me is the belief that 2007-08 represented the ultimate in terms of financial stress. Since they say 2007/08 and not 2007/2008, it clearly refers to the financial year 2007-08 and excludes the severe stress in the second half of calendar year 2008.
More importantly, the idea that even calendar year 2008 is the ultimate in stress is debatable. There have been no sovereign defaults (ignoring Ecuador) while the big risk for 2009 and 2010 is certainly the possible default of a G7 sovereign and the related possibility of the break-up of the Eurozone. Risk managers who think that the worst is over in the current crisis are not worth their salaries today. I am shocked that the Basel Committee is encouraging this kind of shoddy thinking.
Posted at 1:51 pm IST on Wed, 21 Jan 2009 permanent link
Categories: post crisis finance, regulation, risk management
More on Siemens
I have not so far been posting links to my TV interviews though these days, videos and transcripts are often made available on the web sites of the TV channels. I am beginning to remedy that by posting links to the video and transcripts of an interview of January 15 on CNBC about the Siemens story that I blogged about two days earlier.
Some excerpts from the interview:
It doesn’t look fair at all – both the valuation and the entire manner in which it has been done. First of all, looking at the valuations, an IT firm being sold at six months of revenues looks quite absurd. We have the mainstream IT stocks trading at something like 2-3 times revenues, and this is half a year revenues, even by price earnings multiple, which looks very low about half of what mainstream companies sell at.
The other part of the problem is the process by which it is being conducted. The day Siemens announced that they were selling; they said nothing about the valuations, they said nothing about the financial performance of the subsidiary. Couple of days later, after all hell has broken loose, they come out with details about this and the information, which they disclose is even more troubling. It even gives an impression that the financial performance has actually been turned down – the revenues have fallen, the profit margin has collapsed and there is a situation in which somebody could give a low valuation to the stock.
The entire process looks really bad and when one looks at Satyam-Maytas, at least, on day one, they told us what the valuation was. Here on day one we were told nothing about the valuation, it is really troubling.
When you are talking about something which is really captive, the margin is entirely a function of transfer price. To believe that the kind of IT that Siemens does, they are really into relatively high value IT, and to believe that the profit margins are so low it strains credibility. Moreover, these are not third party prices; these are not arm’s length prices; these are internal transfer prices.
Posted at 9:45 pm IST on Sun, 18 Jan 2009 permanent link
Categories: corporate governance, regulation
Siemens related party transaction
Two days after the Satyam fraud was announced, Siemens Limited, a 55% subsidiary of Siemens AG of Germany informed the stock exchanges that “the Board of Directors of the Company at its meeting held on January 09, 2009, has approved the divestment of its 100% stake comprising of 6,815,000 Equity Shares of Rs 10 each in its subsidiary Siemens Information Systems Ltd, Mumbai, to Siemens Corporate Finance Pvt. Ltd., a 100% subsidiary of Siemens AG, subject to receipt of all requisite consents, approvals.” In its press release, the company stated “This is pursuant to the change in structure of the global software business, where SISL businesses have also been aligned with the parent group. In the new model, SISL will serve as an internal software factory supporting the R&D and product development initiatives for business sectors globally. It will also focus on increasing its presence in the domestic market and continue to act as an offshore development centre for Siemens worldwide.”
The response of the stock market has been brutal: the stock fell almost 30% from Rs 298.00 to Rs 211.80 while the Nifty index fell by only 6% from 2920.40 to 2744.95. The press release does not mention anything about valuation or consideration, but clearly the market sees this as a valuable business being transferred to the dominant shareholder at a discount to its fair value. Investors are powerless here because unlike in the Satyam-Maytas case, here the parent company has a majority shareholding.
India should probably look at the UK model for dealing with such situations. Rule 6.1.4(3) of the UK listing rules, requires that a company that seeks listing of its equity shares in the UK should demonstrate that “it will be carrying on an independent business as its main activity.” In practice, rather than refusing to list an issuer that fails to satisfy this requirement, the UK regulator looks to see how a lack of independence will be managed. This means satisfying itself that an issuer that has a controlling shareholder is capable of carrying on its business independently of that shareholder.
For example, when the promoters of the Sterlite group in India listed their business in the UK as Vedanta Resources plc, the restrictions that they agreed to as a condition for listing included the following (Vedanta Resources plc, listing particulars, page 68-70):
- The Board and the Nominations Committee and most other committees to which significant powers are delegated shall at all times comprise a majority of directors who are independent of the promoters
- Neither the promoter-director nor any non-independent directors shall be permitted to vote on any resolutions of the Board to approve any arrangement or transaction with the promoters
- The promoters may not exercise voting rights in the company in respect of any transactions or arrangements between the company and the promoters.
- The promoters shall not invest in certain specified businesses directly or indirectly except through the company.
- Transactions and relationships between the company and the promoters shall be conducted at arm’s length and on a normal commercial basis
Restrictions of this kind might have helped prevent the Siemens transaction provided they were coupled with a requirement that a related party transaction should be put to shareholder vote if say 10% of the shareholders so demand. The institutional investors with 25% shareholding would then have been able to demand a shareholder vote and then vote it down with Siemens AG unable to vote its shares.
Posted at 9:35 pm IST on Tue, 13 Jan 2009 permanent link
Categories: corporate governance, regulation
Gold standard and Austrian economics
After I mentioned the gold standard in my last post on three centuries of UK interest rates, I received a number of comments relating to the gold standard and Austrian economics.
Mahesh asks about the advantages and disadvantages of going from a paper currency to the gold standard. I do not think of the gold standard as something to do with the physical commodity called gold; I think of it in terms of targeting the price level rather than the inflation rate.
Nowadays central banks target the inflation rate, not the price level. Suppose the initial price level was 100, the inflation target was 2% and actual inflation is 5%, then the central bank writes a suitably remorseful letter to the government explaining its failure to meet the target. In most cases, the government might accept and even endorse the explanation, though in the worst case, it may replace the head of the central bank. In either case, the inflation target for the next year would remain at 2%; the implied target for the price level at the end of the second year would be roughly 107 (105 plus 2% inflation).
Under the gold standard, essentially you are (implicitly) targeting the price level. In the above example, with desired annual inflation of 2%, the target price level at the end of two years is roughly 104. Since the price level at the end of the first year is already 105, implicitly the inflation target for the second year is -1%. High inflation in one year has to be compensated by deflation the next year. This is what we see during the gold standard era in the inflation graphs in my earlier post. During periods of war, there may be inflation for a few years, but this is acceptable if people believe that it will all be reversed in due course. You can even go off the gold standard temporarily if people believe you will come back to it.
Ideally in such a world, the detrended price level is a stationary process in econometric terms. In modern inflation targeting, the price level is a non stationary random walk (unit root process). For long term decisions, the reduction in volatility achieved by eradicating the unit root is huge.
The gold standard in practice also involved much lower inflation rates – most multi-decadal inflation rates are in the range of -½% to +½%. On a hedonic adjusted basis, this almost certainly implies persistent deflation, probably related to the inability of gold supply to keep pace with the growth of the global economy. I am not convinced that the trend rate of growth of the price level is hugely important so long as the detrended price level is a stationary process. If you worry about menu costs and money illusion, you may be less sanguine than I am.
In my view, the benefits of the gold standard had nothing to do with gold itself. I tend to regard gold as a (rational?) speculative bubble that has lasted five thousand years. The demonetization of silver in the late nineteenth century led to a collapse of the equally long lived (and equally rational?) silver price bubble. There is an ever present risk that the same could happen to gold one day. If the bimetallic ratio of 5-8 between gold and silver prices that prevailed for several millenia before the nineteenth century reflects the relative intrinsic worth of the two metals, gold could fall catastrophically. Of course, this might not happen in my lifetime nor in yours; that is why the bubble could be a rational speculative bubble.
Pravin asks whether inflation during the gold standard was due mainly to wars or government actions. Inflation could result not only from fiscal expansions but also from private sector credit expansions. Generically, I like to think of inflation in any one country under the gold standard as a deviation from purchasing power parity (PPP). Inflation would cause a departure from PPP, but since PPP asserts itself only over a period of a few years, this departure could persist for a short period, but in the medium to long term, the price level mean reverts to its old level.
Another complication is that even in a land with metallic money, one needs detailed historical evidence to determine whether the coins were accepted “by tale” or “by weight”. Until the nineteenth century, it was probably true that debased currency was accepted “by tale”, and therefore what appears to be silver (or gold) currency is actually fiat money.
As far as Austrian economics is concerned, I find Hayek, Schumpeter and Minsky to be most in accordance with my tastes. The gold standard is not to my mind among the more important ideas in Austrian economics. But then I am not an economist. I find that I am able to hold Keynesian, monetarist and Austrian ideas in my head almost simultaneously without getting a severe headache.
Posted at 1:23 pm IST on Tue, 13 Jan 2009 permanent link
Categories: currency, gold, international finance
UK official interest rate at 315 year low
Last week, the UK reduced its interest rate to the lowest level ever in its 315 year history. I found this surprising since there is very little in terms of economic environment that the Bank of England has not seen in these three centuries. It is all the more puzzling when the interest rate graph is juxtaposed with a graph of inflation rates (see figures below).
It is interesting to see that negative inflation rates are quite common prior to the twentieth century. The average inflation rate was negative in the entire nineteenth century. But even in this period, while interest rates went down to 2% on several occasions, they never dropped to the 1.5% level reached last week.
What is also interesting is that for 103 years from 1719 to 1822, the Bank of England did not change its rate even once. England lost an empire in one continent while gaining an empire in another; it fought the Seven Years War and the Napoleonic wars; inflation rates ranged from +30% to -23%, but interest rates remained fixed at 5%!
Deflation was quite common in the eighteenth and nineteenth centuries, and apparently was not damaging to growth. Perhaps, there is something pernicious about fiat (paper) money that makes inflation and deflation so scary. Under the gold standard, the price level had a tendency to mean revert so that high inflation was followed quickly by deflation; therefore even 30% inflation did not create inflationary expectations, and even 20% deflation did not create deflationary expectations.
Posted at 1:17 pm IST on Mon, 12 Jan 2009 permanent link
Categories: financial history, monetary policy
Satyam: old lies and new truth or new lie?
This is my fourth post on the Satyam fraud, and what I am concerned about in this post is the willingness of people to believe a liar’s confession blindly. To my cynical mind, the fact that a person admits to have been lying for several years is reason to suspect that what is put forward as the new truth might just be a new lie.
What makes me more suspicious is that the “confession” actually paints the most benign picture possible. What the Satyam Chairman is saying that he never siphoned any money from the company. While many people suspected that Satyam profits were diverted to group companies, the former chairman is saying that the profits were never there. He is also trying to paint the Maytas deal as a last ditch attempt to save Satyam instead of the other way around.
My question is why should we believe all this. How credible is the claim that an IT business with a blue chip client list was not profitable? How credible is the attempt to exonerate everybody else? Should we consider the possibility that the problems were in other group companies of the promoters and that Satyam lost everything while trying to bail them out?
The finance profession is supposed to train one to be skeptical and cynical about everything. The lack of sufficient skepticism and cynicism is itself a cause for concern as it suggests that markets are still too trusting.
Posted at 10:34 am IST on Thu, 8 Jan 2009 permanent link
Categories: corporate governance, fraud, regulation
Satyam and accounting regulation
In 2002 after the Enron debacle in the US, I wrote (sections 9.3.1 and 9.3.2 of this paper) that though the US system of review of accounting filings by the SEC did not work in the case of Enron and other frauds, it was still necessary for India to have a system of review of accounting filings. What I proposed (for the US as well as for India) was a system where short sellers could force regulators to review any specific filing by paying a fee. I even estimated the fee that should be charged.
In the same paper, I also argued that a credible body to oversee the audit firms in India is also needed.
The Raghuram Rajan Committee (of which I was a member) did recommend regulatory review and audit oversight in its report (see page 139-140). It also recommended the use of XBRL in all accounting filing to facilitate the system of regulatory reviews.
I think the world also needs to figure out ways of making auditing a more competitive industry. In my Enron paper, I argued that it should become easier to create new audit firms and for auditors to advertise directly to shareholders.
Nakedshorts points out that three of the big four audit firms (PricewaterhouseCoopers, Ernst & Young and KPMG) are potentially in the dock as auditors of the Madoff feeder funds in the US. (PricewaterhouseCoopers were also the auditors of Satyam). If the post Enron experience (the demise of Anderson) were to be repeated post Madoff with no regulatory forbearance, it is not inconceivable that a majority of the big four auditing firms would cease to exist in 2009. Stunning as that would be, it would not be more surprising than the disappearance of the majority of the Wall Street investment banks in 2008.
In this context, we need to fundamentally rethink the industry structure of the auditing industry. More competition is absolutely critical.
Posted at 3:31 pm IST on Wed, 7 Jan 2009 permanent link
Categories: accounting, corporate governance, fraud, regulation
Saytam: why government needs to act now
In my last blog post, I briefly stated what the government needed to do:
- appoint an interim board/administrator/receiver to take charge of the assets of Satyam – whatever little is left of them;
- initiate a thorough fact finding investigation of what went wrong, and how.
What I did not do was to highlight the urgency of the first step:
- Today, Satyam has a vacuum at the top. The promoters are gone; and the independent directors who would normally take charge in a situation like this have no credibility left.
- Satyam is a large company with global visibility and global clients. These clients would expect that they would continue to be serviced.
- Even if Satyam is to be sold, somebody has to run the sale.
- In the next few days, if nothing is done, both clients and employees would leave in droves and there would be nothing to sell.
I think this needs action today or at the very least within 24 hours.
Posted at 2:37 pm IST on Wed, 7 Jan 2009 permanent link
Categories: corporate governance, fraud, regulation
Satyam requires government intervention
The fraud that has been disclosed in Satyam Computer Services Limited comes at a time when the Satyam board has lost all credibility. This requires extraordinary action. Only a new board can investigate the fraud and run the company until a general body meeting is held to elect a new board.
The company needs a new governance regime. One option is that the existing board meets for the sole purpose of co-opting a new set of directors and then the old board withdraws from the scene. The second option is for the government to step in. This is a fit case for section 398 and 401 of the Companies Act which give broad powers to the Company Law Board acting on an application by the government to make orders for “the regulation of the conduct of the company”s affairs in future ”.
I think this is also a fit case for an investigation under section 234(7) and 235 of the Companies Act.
Posted at 12:58 pm IST on Wed, 7 Jan 2009 permanent link
Categories: corporate governance, fraud, regulation
44 years of inflation adjusted stock prices in India
Above is a plot that I have put together of the real (inflation adjusted) stock price index in India from 1965 to 2008. The plot is on a log scale – each horizontal grid line represents a doubling of the real stock price.
I have divided the sample into three periods and it is obvious that all the action happens in the middle period from 1985 to 1994. On a point to point basis, practically the entire increase in real stock prices happens during this period.
The compound annual growth rates on point to point basis are: 0.57% (1965-1984), 18.95%(1985-1994) and 0.33% (1995-2008). Since point to point comparisons are misleading, I have also plotted exponential trend lines (straight lines on the log scale plot) for each of the three time periods. These trend lines also tell the same story of huge growth during 1985-1994 and tepid growth before and after. The compound annual growth rates from the trend lines are: 1.78% (1965-1984), 17.62%(1985-1994) and 6.39% (1995-2008).
This is not really surprising. Most of the movement towards a free market economy took place during the Rajiv Gandhi prime minister-ship in the mid/late 1980s and the Manmohan Singh finance minister-ship during the early 1990s. Since then, reforms have been at a glacial pace. India learned the wrong lessons from the Asian Crisis and seems to be learning the wrong ones again from the current crisis.
Notes on the data
- The nominal stock price index is obtained by chaining together the Economic Times stock price index (hand collected at fortnightly intervals from 1965 to 1979), the BSE Sensex from 1979 to 1990, and S&P CNX Nifty thereafter.
- The price index chains together various series of the Consumer Price Index (Urban Non Manual Employees) and a small initial period (1965-1968) of the Consumer Price Index (Industrial Workers). Since the CPI is not yet available for November and December 2008, the October 2008 index level is carried forward to this period as well.
- The real index obtained by dividing the nominal stock price index by the Consumer Price Index was re-based to equal 2 on January 1, 1965. The log scale plot uses logarithms to the base 2 to facilitate ease of interpretation. The lowest point of the real index is 1.12 in July 1975 and the highest point is 31.18 in January 2008.
Posted at 12:37 pm IST on Sun, 4 Jan 2009 permanent link
Categories: CAPM, equity markets, financial history
India in a ZIRP world
I wrote a column in the Financial Express today about why Indian interest rates need to come down much more when the world interest rate is going down to zero.
While discussing the magnitude of interest rate cuts in India – the RBI cut repo rate and reverse repo rate by 100 basis points each and CRR by 50 basis points on Friday – we need to remember that the entire developed world appears to be converging to a zero interest rate policy (ZIRP). This is a completely unprecedented situation and points to interest rates much lower than what we are accustomed to seeing.
India is an open economy and even the capital account is quite open for all practical purposes. Indian interest rate policies are therefore strongly influenced by global interest rate. A comparison of the Indian repo rate and the US Fed Funds Target since 2000 shows that Indian tightening and easing follows US tightening and easing with a lag. Essentially, an open economy forces the RBI to follow what the “world central bank” does; and the only flexibility that it has is to delay its response by a few months.
Now, the US has pushed its interest rate down to virtually zero. Japan has also done the same, and the European Central Bank is also being dragged down that path much against its wishes by the sheer strength of global forces. In that situation, how low should Indian interest rates go?
The plot above shows the spread between the Indian repo rate and the US Fed Funds target with key tightening and easing episodes demarcated on it. Because of the lag between US and Indian central banks, this spread fluctuates a lot.
For example, in July 2006, the US had completed its tightening cycle and India was still half way through its tightening cycle. The spread between the two rates fell to an abnormally low level of 1½% with the Fed Funds target at 5¼% and the Indian repo rate at 6¾%. Over the next nine months, India tightened by another 1% to 7¾% while the US rate remained unchanged at 5¼%. In April 2007, with both central banks having completed their tightening cycles, the spread was 2½% which can be regarded as a “natural” spread between the rates in the two countries reflecting differences in the respective inflation rates and other structural characteristics of the two economies.
In September 2007, the US began easing interest rates in response to the financial crisis. At that time, the crisis in the US appeared very remote to us, and India left rates unchanged for several months. Then earlier this year, the RBI raised interest rates by 1¼% to 9% in response to the inflation scare which gripped the country at that time. The spread between US and Indian rates rose to an extraordinary level of 7½% in October 2008.
Since then, India has been easing more sharply than the US and the spread came down to 6½% by the end of 2008. But this is still a very high spread. If we consider the April 2007 spread level of 2½% as a “natural” spread, then the Indian repo rate needs to come down to well below 3%.
That is a much steeper cut than what RBI has made. But even that might be an underestimate of what would be needed. The US has gone beyond zero interest rates to a regime of quantitative easing which pushes long rates down to low levels. Since it is not possible to make interest rates negative, quantitative easing achieves the same effect of negative interest rates by expanding the balance sheet of the central bank.
This means that to achieve the same spread against the “effective” (quantitative easing adjusted) interest rate in the US, Indian rates would have to come down even more. Similarly, European interest rates are lower than what they appear to be because the expansion of the ECB balance sheet has some of the characteristics of quantitative easing.
I believe that the RBI should cut its interest rates very rapidly to a level consistent with global interest rates for four reasons. First, the prospect of further cuts in rates in future makes long term government bonds a one way bet – they are today the most attractive asset for any bank on a risk adjusted basis. There is no point exhorting banks to lend when the central bank rewards “lazy banking” through the gradualism of its interest rate policy.
Second, India can afford a fiscal stimulus only if interest rates have first been brought down to very low levels. Otherwise, the weak fiscal capacity of the state is wasted on paying an excessive interest rate on its borrowings.
Third, the weakening of the currency caused by low interest rates is a stimulus that the economy needs very badly.
Finally, since many economists now project inflation at 2% or so by the end of this fiscal year, steep rate cuts are needed to prevent real interest rates from becoming excessive.
Posted at 7:50 am IST on Sat, 3 Jan 2009 permanent link
Categories: crisis, monetary policy
Fair value accounting
Earlier this week, the US Securities and Exchange Commission (SEC) released a 259 page study on mark to market accounting as required by the TARP related legislation. The study contains a lot of useful data about the extent of mark to market accounting in the US financial sector as well as the extent to which fair value accounting uses opaque valuation methods (Level 3, often called “mark to myth”).
The key takeaway is that for all the “modernization” of the financial sector that we read about, mark to market accounting covers less than half of all assets of the large financial firms. The percentage of assets where fair value changes impact reported profits is even lower at 25%. It is only the (erstwhile?) broker dealers who have practically all their balance sheet in fair value or in short term assets whose historical cost is practically the same as fair value. The insurance companies have a large percentage of fair value assets, but insurance is an industry where the valuation of liabilities matters more than the valuation of assets. For banks, less than a third of assets is at fair value.
The percentage of fair value assets which is in Level 3 is not too bad at around 10%. What I found more troubling is that around three-quarters of fair value assets are Level 2, leaving only about 15% for Level 1. This is a measure of how little of the financial sector assets are traded in exchanges or other liquid markets as opposed to opaque OTC markets. This is another respect in which the “modernization” of the financial sector has been much more limited than I would like.
The characterization of financial institutions as storehouses of illiquid and opaque assets is as true today as it was decades ago.
Posted at 2:44 pm IST on Fri, 2 Jan 2009 permanent link
Categories: accounting, risk management
More on teaching finance
My last piece on teaching finance the hard way received a large number of interesting and valuable comments and I shall try to respond to them in this post.
Sahil is right that the quality of finance teaching leaves a lot to be desired. In my view, however, this is a result of the rapid growth of the financial sector in recent years. My simplistic way of looking at this is that if a fraction h of the people in a profession become educators and each educator can educate k people in a year, then the sustainable rate of growth of the profession is given by the product hk. In recent years, we have tried to grow the finance profession much faster than hk.
There are two ways to do this. First is to increase h by bringing in people who are not good educators. I recall a similar thing happened in the software field a few years ago. A programmer friend of mine went to an IT institute to enroll in a course, and they took him on as a faculty member instead. The second route is to increase k by reducing the depth and number of courses that a person is required to take before qualifying as a finance professional. Such an approach leaves the keen student thoroughly dissatisfied as Sahil explains in his comment.
As the growth rate of the financial sector slows down, I see this problem solve itself. It should now be possible for fewer (and hopefully better) teachers to teach in greater depth to smaller classes as I suggested in my last post.
I agree with Gaurav that Minsky is somebody that all finance professionals should have read. I recall reading Minsky before I had studied any serious finance and my impression is that this is a book that any serious student can read on his or her own and I doubt whether a course is needed on this. If at all it is to be taught, I think this is more economics than finance; perhaps, it should be taught along with a course on Austrian economics. (Yes, Paul Krugman thinks that “the Austrian theory of the business cycle is about as worthy of serious study as the phlogiston theory of fire”, but I do read the Austrian Economists’ blog).
Balu Kanchappa complains that finance case studies prepared at management schools have lot of bias in favour of institutions and context – the writers of the case studies focus more on ‘practice’ than ‘principles’. What the case writers do is less important than what happens in the class discussion. The case method is about applying theories to specific situations and so a large amount of detail is required. There is advantage in using cases from different geographies and different time periods so that students acquire the ability to apply broad principles to any context in which they might have to work.
Finance Guy takes issue with my reference to the mass market. What I had in mind was what I have described above as k. I was not talking about the quality of the students at all. There was a problem in the quality of the faculty (the expansion of h) and there was a problem in terms of the interest of the students in the subject. I do not think that there ever was a problem with the quality of the students. When I talked about the mass market, I was referring to the attempt to increase k by having broad brush courses that cover a large number of topics superficially. This makes it impossible to cover topics in depth.
At a personal level, I would also like to add that to a crass materialist like me, “mass” is not a pejorative term at all. Also, I have no desire to contribute to the production of “leaders”; in fact, my deep preoccupation with free markets is partly a rebellion against leadership of all kinds.
Both Finance Guy and Hemchand believe that there is a role for intuition and gut feeling in finance. This may or may not be true, but intuition is not something that can realistically be taught, and my post was about the teaching of finance. I was not and am not writing about what skills you need to succeed in finance.
Finally, I do not believe in the “infallibility” of models; on the contrary, the thing that I like most about models is that they describe their own fallibility and limitations explicitly and openly. And, I like to use models in the plural implying that there are several models each of which has a different restricted domain of applicability rather than one grand “theory of everything”.
Posted at 8:16 pm IST on Thu, 1 Jan 2009 permanent link
Categories: Bayesian probability, post crisis finance