More on OTC derivatives
I have several comments by email on my blog post yesterday on OTC derivatives. This post responds to some of them and adds some more material on the subject.
One of the papers that I did not refer to in yesterday’s post was a paper by Riva and White on the evolution of the clearing house model for account period settlement at the Paris Bourse during the nineteenth century. Streetwise Professor linked to a conference paper version of this in his post while Ajay Shah pointed me to an NBER version of the same paper.
The account period settlement at the Paris Bourse was similar to the ‘badla’ system that prevailed in India until the beginning of this century. All trades during a month were settled at the end of the month so that the stock market at the beginning of the month was actually a one month forward market. At the end of the month, the settlement could be postponed for another month on paying the price difference and a market determined backwardation or contango charge. In fact, this system for trading individual stocks continued even after the introduction of stock index futures (CAC 40) in the Paris market. Crouhy and Galai, “The settlement day effect in the French Bourse,” (Journal of Financial Services Research, 1992) provide a good description of this market and explore the working of the cost of carry model in this market.
Coming back to Riva and White, they document the emergence of a clearing house model in which the Paris Bourse guaranteed all trades on the exchange. The bourse not only guaranteed settlement of trades between two brokers but also repaid the losses suffered by the defaulting broker’s clients (except during a period from 1882 to 1895). This clearing house guarantee was supported by a capital requirement for all brokers and by a guarantee fund, but not by any margins. The entire process seems to have been driven by the government and the central bank.
By contrast, the US futures exchanges introduced initial and variation margins well before they introduced the clearinghouse in 1883 as documented in the Kroszner paper that I mentioned in my post yesterday. The existence of margins eliminates most of the moral hazard problems that plagued the clearing house in Paris and required state intervention of some form or the other. The US thus saw a private ordering emerging without any involvement of the state.
India ran the ‘badla’ system in the nineteenth and through most of the twentieth century without any margins and without any clearinghouse guarantee. While France solved the risk problem in its usual dirigiste style and the US solved it using private ordering, India seems to be a case of state failure and market failure until the last decade of the twentieth century. In fact, the problem was solved only a few years before the abolition of ‘badla’ itself.
Now I turn to some other papers relevant to the regulation of OTC derivatives.
Viral Acharya and several coauthors have written extensively on the regulation of OTC derivatives, and I will mention two. Acharya and Engle have a nice paper that explains the key issues in the context of the proposed US legislation.
Acharya and Binsin have a conference paper explaining how an exchange is able to price counterparty risk better than the OTC market because it is able to see the entire portfolio of the counterparty. Streetwise Professor criticizes this on the ground that exchanges charge the same price to everybody and do not discriminate. I think this criticism is incorrect – exchanges do not discriminate in the sense that they apply the same risk model to everybody, but the standard SPAN type model is a portfolio model where the margin is not on an individual position but on a portfolio. The incremental margin requirement for any position thus depends on what else is there in the portfolio. Thus the risk is priced differentially.
The Acharya and Binsin paper must be read in conjunction with a paper by Duffie and Zhu who show that the efficiency gain from central clearing is best realized when there is a single clearing house for all derivatives and the gains may disappear if there are separate clearing houses for different products and even more so when there are competing clearing houses for the same product. This in my view is only an efficiency issue and does not detract from the reduction of systemic risk from the use of central clearing.
For those interested in data about the magnitudes involved in these markets in terms of risk and collateral requirements, a good source is an IMF Working Paper on “Counterparty Risk, Impact on Collateral Flows, and Role for Central Counterparties.” For more detailed information about the CDS market, there is an ECB paper on “Credit default swaps and counterparty risk”
Posted at 6:10 pm IST on Wed, 13 Jan 2010 permanent link
Categories: derivatives, exchanges, regulation
Regulation of OTC Derivatives
Last month, the UK Financial Services Authority (FSA) and the Treasury put out a document entitled “Reforming OTC Derivative Markets: A UK perspective.” My one line summary of this document is that the UK does not wish to make any significant changes to the regulations of the OTC markets. A cynic would say that this is explained by the fact that London dominates the OTC derivative markets globally.
This month there was a nice paper by Darrell Duffie and two co-authors for the New York Fed advocating not just central clearing, but also encouraging the use of exchanges and electronic trading platforms, as well as post-trade price transparency. I like this report though the Streetwise Professor thinks that this is tantamount to socialist planning.
Streetwise Professor has been arguing in a series of posts on his blog that OTC markets have evolved naturally and must therefore represent an efficient outcome absent demonstrable externalities. This argument deserves serious consideration and is one to which I am sympathetic.
One of the early and clear enunciations of the private ordering argument is a paper over ten years ago by Randall Kroszner (“Can the Financial Markets Privately Regulate Risk?,” Journal of Money, Credit & Banking, 1999) which describes the historical evolution of exchange clearing in the last century and compares it to the development of the OTC markets. As I re-read this paper, I was struck by two statements in the paper.
- Kroszner argues that the large derivative dealer “effectively creates its own ‘mini’ derivatives exchange, with its own netting, clearing, and settlement system.” with the International Swap Dealers Association (ISDA) providing partial standardization of contractual terms.
- Kroszner also points out that: “Credit rating agencies are the effective regulators in setting standards for capital, collateral, and conduct, much like clearinghouses and government regulators, but do not have a direct financial stake in the transactions.”
This analysis provides one perspective on what went wrong during the crisis. First, the “regulation” provided by the rating agencies was an absolute disaster and the “mini derivatives exchange” run by the large derivative dealers turned out to be far less robust than the derivative exchanges.
At the same time, private parties have no incentive to move from the failed model to the robust model because the failed model now comes with the wrapper of a “Too Lehman-like To Fail” guarantee from the government. In the absence of this government guarantee, private ordering might have been relied on to do the right thing, but in its presence, things are different.
Posted at 2:45 pm IST on Tue, 12 Jan 2010 permanent link
Categories: derivatives, exchanges, regulation
Currency in circulation
The Chief Cashier of the Bank of England, Andrew Bailey, gave a fascinating speech last month on various aspects of currency in circulation in the UK. The key point is that while cheques have been in terminal decline in the UK (see this blog post), cash has in recent years been growing not only in notional value, but even as a percentage of GDP.
Bailey thinks that people are increasingly using cash as a store of value (and not just as a medium of exchange) partly because of a lack of confidence in the banking system and partly because at near zero interest rates, the opportunity cost of holding cash is negligible. If people are indeed stuffing cash under their mattresses, it tells us how harsh the global financial crisis has been.
Another interesting point is about the quality of notes. In India, ATMs typically give out better notes than the bank branches do, but Bailey tells us that in the UK, it is the reverse. The new generation of ATM machines can dispense notes so soiled that a human teller would regard them as unfit to be dispensed. One almost hopes that India remains stuck in the old generation of easily jammed ATMs that give out relatively clean notes.
The most important point that Bailey makes is that “banknotes are central-bank money in a form that can be held by the public, in other words the retail equivalent of reserve accounts at the central bank.” I would like to push this point further – if technology allows electronic accounts to be maintained at near zero cost, should not the central banks provide electronic reserve accounts to all citizens? As India moves toward issuing a unique identity number to every citizen, would it not be nice for each such number to be linked to a no frills account at the RBI?
Why in other words should only the rich and powerful institutions have access to central bank money? When a variety of tax laws and money laundering laws attempt to prevent the use of central bank money in the form of cash, should they not then facilitate the use of central bank money in the form of electronic reserve accounts at the central bank?
The shocking thing in finance is that financial markets settlements do not reach the highest standards of DVP (delivery versus payment) – simultaneous and irrevocable payment in central bank money. If you go to a grocery shop, pay for your purchases in cash and walk out with your goods, the transaction conforms to the highest standards of DVP because cash is central bank money. In most financial markets on the other hand, we do not get this level of DVP because the settlement systems do not settle in central bank money. This is a shame.
Posted at 1:36 pm IST on Mon, 11 Jan 2010 permanent link
Categories: currency
Foreign Investment: Direct versus Portfolio
Ever since the Asian crisis, there has been a sort of consensus that foreign direct investment (FDI) is the best and most stable form of capital inflows while foreign portfolio flows (FII in Indian parlance) are more volatile and therefore less desirable.
Ever since the global crisis began, I have been reading a lot of financial history (starting with the last 500 years and slowly going further back). It now appears to me that the aversion to the volatility induced by portfolio flows is extremely short sighted.
In the long run, the volatility gets washed out and what counts is the average growth rate of the economy. The short term (high frequency) is all noise (volatility) while the signal (mean) is apparent only in long time series (low frequency). Lessons drawn from short time series of data are probably wrong.
Looking back at some of the major emerging markets of the nineteenth century (US, Canada, Australia and Argentina) puts things in a totally different perspective. I particularly enjoyed the discussion about nineteenth century US in Chapters 7 and 8 of Atack and Neal, (The Origin and Development of Financial Markets and Institutions; From the Seventeenth Century to the Present, Cambridge University Press, 2009).
Of all the big emerging markets of the nineteenth century, the US relied most on portfolio flows and Argentina relied the most on foreign direct investment. By 1890, the results of the different trajectories were quite apparent.
In the long run, the volatility of the growth rate is largely irrelevant; it is the average that counts. Despite frequent financial crises and corporate bankruptcies, the US grew faster. More importantly, it was also able (despite the damage inflicted by populist politicians like Andrew Jackson) to build a domestic financial system that ultimately made it less dependent on foreign markets and institutions.
Applying that historical lesson would suggest that India should remain friendly to foreign portfolio flows while developing domestic financial markets. We must simply learn to live with the volatility and occasional crises that come in their wake.
Posted at 1:37 pm IST on Fri, 1 Jan 2010 permanent link
Categories: international finance
Indian coupling with global risk aversion in 2009
I wrote a column in the Financial Express today about why Indian markets were swayed by global developments in 2009.
Indian markets in 2009 appeared to dance almost completely to the tune of global developments, reminding us of how strongly integrated we are with world financial markets.
Unlike China, the Indian economy does not depend so much on exports for its growth. Collapse of global trade in 2008 and early 2009 did impact sectors like textiles, diamonds and software services, but collapsing exports did not crush the whole economy because many other sectors thrived on domestic demand.
India’s tight coupling with global markets was not due to trade linkages, but to its dependence on foreign portfolio flows for risk capital. Over the last few years, more and more Indian investors have sold their shares in Indian companies largely to foreign investors (but also partly to Indian promoter groups seeking to increase their stakes).
Foreigners might have bought because they are more bullish about our country than we are, or because their global diversification makes them less concerned about India-specific risks. What is important is that Indian asset prices are now increasingly determined by foreign investors.
This dependence has three implications. First, when foreign portfolio flows reversed, as in late 2008 and early 2009, risk capital disappeared completely. A few companies with strong balance sheets were able to raise modest amounts of debt locally, but those with weaker balance sheets found that they could not raise money at all.
When the corporate sector talked about a liquidity crunch in early 2009, it was really bemoaning the lack of risk capital. Banking system liquidity was probably adequate by early 2009, but this liquidity was not risk capital that could meet the needs of cash-strapped businesses. It was the return of foreign risk capital in mid-2009 that saved the day for these companies.
The second implication of India’s dependence on foreign risk capital is that asset prices in India depend on global risk aversion as much or even more than on domestic sentiment. Capital inflows can ignite asset-price bubbles and outflows can prick the bubbles.
Many of us worried about asset-price bubbles in India in 2007, particularly in the stock markets and in real estate. This view can be debated, but if it is accepted, some of the air went out of these bubbles in 2008 and early 2009, and the bubbles might have been inflated again in the second half of 2009. They could deflate again if global risk appetite reverses in 2010.
The third implication of reliance on foreign risk capital is that equity portfolio flows have a strong effect on the exchange rate. Reserve accumulation by the central bank dampens currency appreciation but does not eliminate it completely. A regime of managed exchange rates creates difficulties for the conduct of monetary policy.
Despite all these problems, foreign risk capital (unlike debt capital inflows) brings huge benefits to the economy. Even in the extreme scenario where all inflows are sterilised in the form of reserves, capital inflows provide dramatic risk reduction for the economy as a whole.
This benefit was clearly visible in late 2008 and early 2009 when foreign investors sold shares at prices well below what they had paid only months earlier and converted the rupee proceeds into dollars at exchange rates much higher than the rate at which they had bought rupees when they came in.
Whenever foreign investors sell cheap after buying dear, they make a loss and India as a nation makes a profit. More importantly, we as a country make a profit precisely when the economy is not doing too well. This is a wonderful risk hedge that is worth all the costs that come with it.
Looking forward to 2010, it is quite likely that the ups and downs of global markets will be felt in India as well. Major downside risks remain in the global economy and the question is how well positioned we are to cope with their impact on India.
The Indian corporate sector has used the recovery of 2009 to repair balance sheets in a variety of ways. A lot of the rebuilding of balance sheets has been made possible by foreign risk capital.
Some companies have raised new equity in 2009 largely in the form of private placements and sales to strategic investors. Many companies that found themselves struggling to roll over short-term debt in 2008 have taken advantage of benign conditions in 2009 to refinance short-term debt with longer-term debt.
A few companies have also addressed the problem of busted convertibles. The recovery of 2009 enabled them to successfully exchange old convertibles that had uncomfortably high conversion prices for more viable instruments. The re-emergence of mergers and acquisitions activity also allowed some companies to carry out asset sales to rebuild their balance sheet strength.
As a result of all this, the Indian corporate sector is better positioned to face new challenges in 2010.
Posted at 12:48 pm IST on Tue, 29 Dec 2009 permanent link
Categories: crisis, international finance
Letting large banks fail
I wrote a column in the Financial Express today about the reform legislation winding its way through the US Congress. I argue that the regulatory goal of making large banks failure proof will not be realized and that it is better to have a policy of letting even large banks fail.
Towards the end of 2008, US policymakers halted the panic phase of the global financial crisis with three simple words: “No more Lehmans.” In the short run, this statement could mean that there would be no more bankruptcies like Lehman – any large financial entity on the verge of failure would be simply bailed out. AIG was the first beneficiary of the new policy.
However, in the long run, the ‘No more Lehmans’ policy can only mean that there would be no more failures like Lehman. Either financial entities should be unimportant enough to be safely left to the bankruptcy courts when they fail, or they should be robust enough to make their failure extremely unlikely.
In this context, the US House of Representatives has passed a comprehensive 1,279-page Financial Reform Bill, but the Bill could change significantly before it is passed by the Senate and becomes law. How effective would this law be in eliminating Lehman-like failures?
First, the new US provisions (as well as the recent Basel proposals at the global level) impose higher capital requirements on financial institutions. While higher capital would reduce the chances of failure, it would not make failures so unlikely that governments can safely promise to bail out any large bank that slips through the cracks. Other elements of the new legislation are, therefore, designed to make it easier to let large institutions fail.
A second key part of the legislation extends the existing resolution mechanism for failed banks to systemically important non-banks and bank holding companies. Under the old law, Lehman could not have been resolved in this manner and while the banking part of Citigroup could have been resolved, the holding company itself (which owned many of the foreign subsidiaries) could not have been.
The new resolution mechanism makes it easier for the regulator to contemplate the failure of a large entity because the messy bankruptcy is replaced by a more orderly resolution process. There is also a provision for a bailout fund (Systemic Dissolution Fund) to facilitate the resolution process, but this fund is to be financed by contributions from the financial industry itself.
The problem with this proposal is that while it avoids bailing out shareholders of a large entity, it actually formalises the bail-out of their creditors through the systemic dissolution fund. It would, therefore, have the perverse effect of encouraging banks to become even larger to exploit this implicit guarantee from the government.
A third key element in the legislation is the reform of the OTC (over-the-counter) derivatives market. Lehman was not spectacularly large in terms of assets and liabilities. The systemic importance of Lehman (and even more so of AIG) came from OTC derivatives.
Lehman was a large dealer in OTC derivatives and AIG was a large counterparty for subprime-related credit default swaps. They were not too large to fail, but were described as too interconnected to fail. Reform of OTC derivatives is intended to prevent this kind of a situation from arising.
The straightforward solution to the OTC derivative problem is to move these derivatives to the exchanges where a central counterparty (the clearing house) collects margins from all participants and assumes responsibility for all trades. Lehman did have a portfolio of 66,000 contracts totalling $9 trillion of interest rate swaps cleared by LCH.Clearnet in London. LCH not only resolved the Lehman default without any loss, but also returned a large part of the margins that it had collected from Lehman.
To understand the difference with the OTC market, suppose that Lehman had sold $100 billion of a certain OTC swap to some parties and bought $90 billion of the same OTC swap from others. Its failure would force all its counterparties to terminate their $190 billion of Lehman deals and establish new contracts with other counterparties. When all these trades are done through an exchange, the clearing house would have to liquidate only the net position of $10 billion, and this is easier because of the margins that the clearing house has collected.
The US law tries to mandate clearing of standardised OTC derivatives, but the proposals are riddled with loopholes that threaten to make them ineffective. First, it does not mandate exchange trading; it only mandates clearing and that too if a clearing house accepts the concerned derivative for clearing. Second, many OTC derivatives lack price transparency and are therefore illiquid. Without a push towards transparency, many derivatives will simply be unacceptable for clearing. Third, minor changes in terms may make a derivative non-standardised and therefore not subject to clearing.
All in all, the 1,000-odd pages of complex provisions riddled with loopholes in this legislation will not make Lehmans sufficiently unlikely in future. I would suggest that ‘No more Lehmans’ is not the correct policy after all. True capitalism is about letting insolvent banks fail, however painful that might be.
Posted at 2:33 pm IST on Wed, 23 Dec 2009 permanent link
Categories: banks, regulation
How broken are the OTC markets?
The SEC has filed a complaint against the world’s largest inter dealer broker ICAP which dominates trading in US government securities and many other OTC markets. ICAP has settled the charges for $25 million and an undertaking to implement remedial action to be suggested by an independent consultant.
The charges are very serious:
- ICAP displayed thousands of fictitious trades designed to mislead other traders about the true state of the market; and
- ICAP brokers executed thousands of trades to liquidate ICAP’s positions against customer orders in violation of the stated workup protocol.
It is depressing that charges of such seriousness are settled without an admission of guilt. The alleged actions shake the very foundations of market integrity and make one wonder whether OTC markets can be trusted at all.
Around the same time that I was reading this complaint, Rortybomb alerted me to a Bloomberg story of a few months ago about an investigation against Markit. The charges here are of a very different nature but they are disturbing in their own way. It is alleged that Markit agreed to provide price information to a clearinghouse only if the latter agreed to clear only trades that involved a dealer.
The question in my mind now is how badly broken are the OTC markets. Whenever, people describe the stock exchanges as casinos, my response is that even if many of the participants are only gambling, the stock exchange still performs the socially useful purpose of price discovery. OTC markets that do not provide transparent price discovery do not perform this function and are much closer to pure casinos. Those that distort the price discovery are worse than casinos.
Posted at 5:20 pm IST on Sun, 20 Dec 2009 permanent link
Categories: exchanges, investigation, regulation
Getting rid of cheques
The UK Payment Council this week announced a plan to abolish cheques in less than a decade. Actually, it is the clearing of cheques that would be closed on October 31, 2018, but that is as good as abolishing cheques themselves.
The report points out that “A number of countries including The Netherlands and Sweden have already largely or totally eliminated cheques. However volumes of paper credit payments in these countries remain significant. The cheque replacement programme in the UK would be going beyond these countries in aiming to modernise the payment system ...”
The usage of cheques in the UK peaked nearly two decades ago in 1990 and has been falling relentlessly since then. “Cheque use is in long-term, terminal decline.” The UK therefore proposes to shift remaining users of cheques to paperless channels (ATMs, mobile banking, internet banking and stored value cards) over the next decade and then get rid of cheques completely.
The report has a section on “cheque dependent consumers.” This group consists mainly of individuals with degenerative conditions and individuals living in care homes or with mobility problems. The main advantage of cheques is that they allow third parties to assist the user by filling up the cheque before the user signs the cheque. My own sense is that biometrics would be safer than reliance on a third party in such situations.
Interestingly, the report also discusses a few UK statutes which do not allow any alternative to paper payment – these include penalties for dog fouling, litter, releasing greenhouse gases and cigarette smoke.
Posted at 9:34 pm IST on Fri, 18 Dec 2009 permanent link
Categories: technology
Samuelson and finance theory
I found it surprising that most of the Samuelson obituaries do not refer to the impact that he had on finance theory. Along with Modigliani and Arrow, Samuelson was among the few mainstream economists who had an enduring impact on finance theory.
Indeed it appears odd that while modern finance theory is often regarded as the bastion of free market economics, it owes so much to Samuelson who was the dominant left wing economist of his era. By contrast, Samuelson’s great right wing rival, Milton Friedman, contributed very little to modern finance theory apart from his famous pronouncements on destabilizing speculation.
Samuelson more or less established the modern “martingale” concept of market efficiency (as opposed to the now largely discredited random walk model) in his landmark paper entitled “Proof that Properly Anticipated Prices Fluctuate Randomly.”
Samuelson also had a strong influence on option pricing through his doctoral student Robert Merton though Samuelson’s own work in this area is completely obsolete.
Above all, I think the mathematical approaches that Samuelson brought to economics were necessary prerequisites for modern financial economics to develop.
Posted at 6:06 pm IST on Wed, 16 Dec 2009 permanent link
Categories: derivatives, financial history, market efficiency
Principles based securities regulation
Cristie Ford has posted on SSRN an interesting paper on “Principles-Based Securities Regulation in the Wake of the Global Financial Crisis.” The paper argues that the Global Financial Crisis has not discredited principles based regulation.
According to Ford, what the crisis has done is to demonstrate that principles based regulation requires as much (and sometimes more) regulatory resources and trained staff as any other form of regulation. Principles based regulation “requires greater regulatory capacity in terms of numbers, resources, and expertise than has been allocated to it in some of the infamous examples of regulatory failure in the past two years – the failure of Northern Rock in the UK, and of the the SEC’s CSE Program”.
Principles based regulators also must have the ability to obtain transparent and reliable data directly, for otherwise, they effectively cede the field to the regulatees.
Ford also argues that regulators’ hiring decisions must be based not only on applicants’ relevant industry and legal expertise, but also with a view to whether applicants seem to have sufficient confidence and independence of mind.
Ford’s paper is an insightful analysis of the issues involved and is definitely worth reading.
Posted at 4:17 pm IST on Tue, 8 Dec 2009 permanent link
Categories: regulation
Pirate stock exchanges and the origin of stock exchanges
Reuters has an interesting report on the stock exchange set up by Somali pirates to fund their activities. It is a fascinating story of how a stock exchange is operating in a near-barter economy. One of the shareholders got her “dividend” for contributing a grenade launcher which she received as alimony from her ex-husband.
The interesting thing is that this is exactly how finance began. Meir Kohn provides the following interesting description of the capital market before 1600 (page 13-14):
While landowners and governments could finance themselves with long-term debt, this option was generally not available to business: it lacked the security and the reliable cash flow required for a debt issue. On the other hand, business could promise substantial gains if things went well to compensate for the possibility of loss if things went badly. This potential for extraordinary returns did provide a basis for equity finance.
The fundamental problem of equity finance is to ensure equity-holders a fair return on their investment. Today, there exists a complex of institutional mechanisms to address this problem – accounting procedures and an accounting profession, legal protections, extensive reporting and analysis of financial information. Since none of these existed before 1600, equity finance had to rely on a simpler mechanism: wind up the business periodically, and divide up the proceeds among the shareholders. This procedure was possible, because business was largely commercial and did not require any substantial investment in fixed capital.
A few months ago, I wrote a post on ultra-simplified finance which revolved around equity markets. To see how powerful equity markets can be even when there is almost nothing else by way of a financial system, one has three choices:
- read Kenneth Arrow’s classic paper (“The role of securities in the optimal allocation of risk-bearing”);
- go back in time to the pre-industrial era;
- take a trip to Somalia.
Posted at 1:30 pm IST on Thu, 3 Dec 2009 permanent link
Categories: exchanges
Payment and Settlement Systems
I wrote a column in today’s Financial Express about payment and settlement systems in India in the context of the vision statement released by the Reserve bank of India
RBI recently released a vision statement for the payment systems in India for the next three years. The mission is “to ensure that all the payment and settlement systems operating in the country are safe, secure, sound, efficient, accessible and authorised.”
It is true that the payment system in India has made considerable progress in the last few years with the emergence of Real Time Gross Settlement (RTGS) system, National Electronic Fund Transfer (NEFT) system, implementation of core banking software in most large banks and rapid spread of the ATM network. With these developments, India is gradually moving away from antiquated paper-based payments to a modern payment system. The progress is slower than one would like, but it is progress all the same.
However, the global financial crisis in 2007 and 2008 has changed the way we look at the safety and soundness of payment systems, and the RBI vision statement does not reflect these new concerns and priorities at all. In fact, the document is characterised by a pre-crisis world view that makes it largely complacent about settlement system risks.
The first lesson from the crisis is that any payment or settlement system that settles in commercial bank money is simply unacceptable as a ‘safe, secure and sound’ system. During the crisis, credit default swap spreads on some of the largest banks in the developed world as well as in India rose to levels indicating serious concerns about their solvency.
This immediately brings up the horror scenario of every payment or settlement system: pay-ins take place into the settlement banks of these systems just before the settlement bank fails. In other words, the settlement bank fails after receiving the pay-in but before making the pay-outs.
Since the major securities and derivative settlement systems in India settle in commercial bank money, this horror scenario should be giving sleepless nights to the securities regulator and to the central bank. Unfortunately, the vision statement does not betray any such concern.
I think urgent steps should be taken to allow major settlement agencies like the clearing corporations of the stock exchanges, derivative exchanges, commodity exchanges, the Clearing Corporation of India and similar entities to make settlements in central bank money. Whether this takes the form of giving them a limited banking licence or of opening up the RBI’s payment system to systemically important non-bank entities is a matter of detail that need not bother us here.
The point is that we do not have a true delivery-versus-payment (DVP) system unless the payment happens irrevocably in central bank money. Before the crisis, it was possible to pretend that large banks are safe enough to allow settlement to happen in their books. After the crisis, the regulators would be irresponsible and delusional to accept this idea.
An even bigger problem exists in the settlement of foreign currency transactions where time zone differences preclude any true payment-versus-payment (PVP) settlement of these transactions. Herstatt Risk has really not been solved several decades after Herstatt Bank in Germany failed after receiving payments in its currency but before making payments in foreign currency.
The international community has come up with the idea of having a private bank (CLS Bank) handle the global settlement of foreign currency trades. This avoids banks having to take exposure on each other, but requires them to take exposure on CLS Bank and sometimes on a participant bank that provides access to CLS Bank.
The thinking was that a settlement and custody bank like CLS Bank cannot fail, but this is a delusion. During the 2008 global crisis, questions were raised about some US banks that were largely settlement and custody banks rather than lending banks. Moreover, even settlement and custody banks can suffer from acute operational risk as was demonstrated in a famous episode two decades ago in the US. As a member of the G20, India has an opportunity to argue for putting foreign exchange settlement on a sounder footing.
Many alternatives can be thought of. First is that the IMF could take on the responsibility of running foreign currency settlement not only because it holds all the currencies of the world, but also because it enjoys multilateral guarantees that would make settlement in IMF books a true PVP. The second possibility is that the world’s major reserve currencies (and currencies of invoicing) can be persuaded to run a 24/7 RTGS that eliminates the time zone problem.
The third solution, closer in line with the post-crisis philosophy of each country taking responsibility for risks within its territory, is for RBI to run a US dollar RTGS in Mumbai by taking advantage of its huge dollar reserves. In short, a lot needs to happen before we can say that “all the payment and settlement systems operating in the country are safe, secure and sound.”
Posted at 11:05 am IST on Wed, 2 Dec 2009 permanent link
Categories: regulation
Dubai World brings Islamic finance down to earth
Back in 2007 and 2008, people were fond of arguing that the crisis was due to highly complex financial instruments and that if finance became boring, it would be a good thing. People even argued that Islamic finance would be a good idea.
This week Dubai put an end to this talk by making it clear that Dubai World would default on debt issued by its subsidiary Nakheel Development Limited. The debt falls due in the middle of December, but Dubai wants creditors to agree on a standstill till May while a restructuring is worked out.
The interesting thing is that the instrument in question is an Islamic bond – a Sukuk. The prospectus (available in the FT Alphaville Long Room) proudly refers to the “pronouncement dated 11 December 2006 issued on behalf of the Sharia Supervision Board of Dubai Islamic Bank PJSC confirming that, in their view, the proposed issue of the Certificates and the related structure and mechanism described in the Transaction Documents are in compliance with Sharia principles.” (page 34)
Of course, one can argue that there is really nothing Islamic about modern Islamic bonds other than an opportunity for some religious scholars to earn a living by issuing pronouncements on Sharia compliance. But that itself is a warning that trying to legislate simplicity in finance is often futile.
Modern corporate finance teaches us that money is made and lost on the asset side of the balance sheet. To adapt a favourite statement of the Austrian economists, losses occur when wrong investment decisions are made. The defaults on the liabilities side of the balance sheet only serve to announce and crystallize this loss. Last month, I blogged about how bank losses from loans in the current crisis exceed losses on securities. The default on the Sukuk reinforces this idea that mis-allocation of capital produces losses regardless of the composition of the liability structure.
Posted at 11:19 am IST on Fri, 27 Nov 2009 permanent link
Categories: bankruptcy, bond markets
Bayesians in Finance
At the EconLog blog, Bryan Caplan asks why academic economists are not Bayesians. Caplan was talking about a Bayesian approach to the validity of economic theories. Stephen Gordon responded with a post about why economists do not use enough of Bayesian econometrics. Both questions are valid and should cause some introspection.
The issue is probably even more important in finance where key parameters are estimated with such large confidence intervals that the prior does not get washed out by the sample. In fact, I think that one of the defining characteristics of finance as a discipline is that first moments (for example, mean returns) are estimated very poorly even with extremely large samples while second moments (variances) are somewhat better estimated.
For example, Aswath Damodaran has an interesting paper last month discussing the difficulties of estimating the Equity Risk Premium reliably. Damodaran states bluntly that:
At the risk of sounding harsh, the risk premiums in academic surveys indicate how far removed most academics are from the real world of valuation and corporate finance and how much of their own thinking is framed by the historical risk premiums they were exposed to back when they were graduate students.
What Damodaran is really saying is that despite being exposed to recent academic research using centuries of global stock market data, the posterior distributions of most academics are still strongly influenced by the prior distributions formed during their student days. In such a situation, there is merit in making the prior distribution quite explicit rather than leaving it implicit.
Classical statistics also involves priors; the tragedy is that in that framework, there are only two kinds of priors:
- Dogmatic priors which totally ignore what the data says, and arbitrarily set some parameters to zero or some other special value.
- Diffuse (or improper) priors which impose no priors beliefs at all and leave everything to the data.
Bayesians can however use the more interesting priors which reflect non trivial prior beliefs that can be overruled by the data.
At a different level, I think it is also essential to incorporate Bayesian learning into theoretical models. Rational expectations models are richer when they recognize that even with large samples, posterior distributions could have large error variances.
Posted at 2:02 pm IST on Tue, 17 Nov 2009 permanent link
Categories: Bayesian probability, CAPM, post crisis finance, statistics
Lehman, Reserve Primary or TARP?
In the popular imagination, the crisis in the global financial markets in the last quarter of 2008 is identified with the collapse of Lehman on September 15, 2008. However, many perceptive analysts believe that it was not the collapse of Lehman itself, but the resulting collapse on September 17 of the Reserve Primary Fund (a large money market mutual fund) that was the real culprit. Finally, some revisionists like John Taylor have argued that the panic started not with the Lehman collapse but with the mishandling of the TARP legislation later in September.
William Sterling has a nice paper analyzing this issue relying on a broad index of financial conditions covering money markets, bond markets and equity markets. Taylor’s use of measures related to Libor was controversial because at the time, people joked that Libor was the rate at which banks did not lend to each other. I like the more comprehensive measure chosen by Sterling.
Based on this index, all three views receive some support, but on balance Sterling rightly concludes that the revisionist case is quite weak. The financial conditions index fell 9.85 points when Lehman collapsed, and fell a further 10.37 points when the Reserve Primary Fund failed. If we regard these two as a single event, the fall in the index over the three days was 20.76 points. But the biggest single day fall was 11.77 points on the day that Congress rejected the first TARP bill. (The index is constructed as a Z-score so that each point change in the index can be regarded as one standard deviation move. Clearly, all three days are extreme tail events).
The most intriguing thing in the paper is the 12.68 point rise in the index on the day before a bailout plan for the money market mutual funds was announced. This is the largest one day change in the index in its entire history. It appears to me that this is indicative of insider trading on a truly massive scale. If this interpretation is correct, this insider trading would make Galleon look like small change.
Posted at 1:48 pm IST on Tue, 10 Nov 2009 permanent link
Categories: bankruptcy, crisis, risk management
SEC Division of Risk, Strategy, and Financial Innovation
Back in September, the SEC created a new division of Risk, Strategy, and Financial Innovation and appointed a well respected law professor, Henry T C Hu, to head it. Hu has been very active in writing about regulation and financial innovation. For example, twenty years ago he wrote a hundred page paper about the regulatory challenges of regulating the swap market arguing that the Basel framework would be ineffective in dealing with anything beyond the most plain vanilla swaps. He concluded that “the BIS Accord’s reliance on legalistic solutions – rigid, classification-based rules administered and maintained by government regulators – is reflective of a simpler, more static financial era. The process of financial innovation is now far too institutionalized and complex to be so confined. ”
Hu’s appointment was widely welcomed at the time, but it was clear that the success of the new division would depend on the people that Hu is able to hire. On this score, the news last week was good. The division announced three new hires with diverse backgrounds all relevant to the tasks that the division has to perform. The best known was Richard Bookstaber, the author of the excellent book “A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation” in which he describes his experience running firm-wide risk management at Salomon Brothers and at other firms.
Clearly, the division will soon have the talent and experience to perform its mandate: “identifying new developments and trends in financial markets and systemic risk; ... [and] making recommendations as to how these new developments and trends affect the Commission’s regulatory activities.” The open question is whether the rest of the SEC can be reformed adequately to take advantage of this.
Posted at 8:32 pm IST on Mon, 9 Nov 2009 permanent link
Categories: regulation, risk management
Indian overnight interbank market in October 2008
The Reserve Bank of India’s Report on Trend and Progress of Banking in India 2008-09 has a series of charts (Chart VII.3 on page 250) comparing the volatility of the overnight interbank interest rate in India with that of several other (mature and emerging) economies.
India and Russia stand out in the charts for the ridiculously high volatility in October 2008. The inability to keep the overnight rate close to the policy rate in these two countries is so glaring that one is forced to conclude that central banking was virtually suspended in India and Russia for a few weeks in that period.
It is not that the mature economies were doing a great job of liquidity management in those days. Only in August 2008, Willem Buiter had gone to the Jackson Hole symposium to tell the assembled central bankers that “The deviations between the official policy rate and the overnight interbank rate that we observe for the Fed, the ECB and the Bank of England are the result of bizarre operating procedures ...” (Page 531). If the mild volatility in the US and Europe appeared bizarre to Buiter, I wonder what he would say if confronted with the Indian data.
Posted at 4:28 pm IST on Wed, 28 Oct 2009 permanent link
Categories: bond markets, crisis, monetary policy
Galleon Insider Trading Charges
The US Justice Department and the US SEC filed insider trading complaints against the billionaire Raj Rajaratnam, his Galleon hedge fund and several other friends and associates a few days ago. All the interesting stuff (for example, the transcripts of telephone conversations) are in the criminal complaints filed by the Justice Department. If one reads only the SEC complaint, one would not realize that there are several smoking guns here.
The fact that the whole thing was made possible by the FBI’s use of informants and wiretaps appears to provide some support for a controversial paper by Peter Henning posted at SSRN last month. In this paper, titled “Should the SEC spin off the enforcement division?,” Henning argued that “To allow the SEC to regulate Wall Street properly, splitting off at least a portion of the enforcement function to an agency with expertise in prosecutions – the United States Department of Justice – is at least worthy of consideration as the government looks to increase regulation.”
One reason why the Department of Justice had all the advantages here is that insider trading is very simple to understand. There is no need for a PhD in finance to recognize insider trading if the prosecutors have access to all the communications that are taking place. But absent such access, insider trading is notoriously difficult to prove. So here, wiretapping expertise beats finance expertise hollow.
At another level, it was interesting to find that with all the insider information that they had from multiple sources, the defendants lost money trading AMD shares prior to its announcement of the spin off of the fabrication facilities and a capital infusion by Abu Dhabi. The complaint attributes it to a general decline in stock prices due to the global financial crisis. The defendants bought AMD stock beginning August 15, 2008, the Lehman collapse occurred in mid September, the AMD announcement happened on October 7, 2008 and the defendants sold stocks around October 20, 2008.
But the global financial crisis is not the whole story as seen from the graph below. Even if the defendants had hedged their AMD long position with a short position in the Nasdaq Composite index, they would not have made money. Yes, AMD does outperform Intel over the period, but not by a huge amount.
It appears from the graph that around the time that the defendants were buying AMD on inside information, many others were also buying. They could also have been buying on inside information or on pure rumours. The graph reminds me of the old adage: “buy the rumour, sell the fact.” It is also possible that the Abu Dhabi deal was not as attractive as people initially thought and the prices reacted to this reassessment. In other words, if Galleon had the advantage of superior information, other traders might have had the advantage of superior analysis. The complaint contains the transcript of a telephone conversation where two defendants agree on a division of labour: one of them is to collect the information and the other is to analyze it. The second person probably was not up to the task.
Posted at 4:45 pm IST on Wed, 21 Oct 2009 permanent link
Categories: insider trading, investigation
SEC response to Madoff failure
I have a column in the Financial Express yesterday about the SEC response to its failure to detect the Madoff fraud and what this means for other securities regulators worldwide. Some of my related blog posts can be found here, here and here.
After its dismal failure to detect the Madoff fraud despite plenty of warnings, the US SEC conducted a review by its own Inspector General of what went wrong. This report published in August was uninteresting as it explained it all away as incompetence and inexperience of the staff concerned.
This explanation was not completely convincing given the detailed information that people like Markopolos provided to the SEC over several years. In any case, there is little point in a 450 page report that reaches a conclusion that could be arrived at simply by applying Hanlon’s Razor: “Never attribute to malice what can be adequately explained by stupidity.”
At the end of September, however, the Inspector General released two more reports (totalling 130 pages) indicating that incompetence might not be the whole story. A survey carried out by the Inspector General found that 24 percent of the SEC enforcement staff felt that cases were improperly influenced or directed by management and 13% stated that they had observed lack of impartiality in performance of official duties.
In this article, however, I will focus on the Inspector General’s recommendations (which the SEC has already accepted) for improving the enforcement and inspections processes at the SEC. These recommendations represent very significant changes in the mindset of how to run these divisions not only at the SEC but at other regulators worldwide.
The report recommends that 50% of the staff and management associated with examination activities should have qualifications like the Certified Fraud Examiner and Certified in Financial Forensics. This recommendation is a sanitised version of what Markopolos recommended when he testified to the US Congress in February about the SEC failure to uncover Madoff despite his detailed complaints.
Markoplos argued that talented CPAs, CFAs, CFPs, CFEs, CIAs, CAIAs, MBAs, finance PhDs and others with finance backgrounds need to be recruited to replace current SEC staffers. He also claimed that SEC staffers with credentials like CPA and CFA are not allowed to have their designations printed on their business cards presumably because if the SEC allowed its few credentialled staff to do so, it would expose the overall lack of talent within the SEC.
The Inspector General recommends that all examiners should have access to relevant industry publications and third-party database subscriptions sufficient to develop examination leads and stay current with industry trends. It also talks about establishing a system for searching and screening news articles and information from relevant industry sources for potential securities law violations.
This recommendation responds at least partially to Markopolos’s testimony that most of the time all the SEC uses is Google and Wikipedia because both are free and the SEC regional offices do not have access to industry publications and academic journals.
The SEC estimates that it would cost $300,000-$400,000 annually to provide data access in one room in each office; providing access to each examiner will cost a lot more. It also estimates that it would cost $3-4 million to implement the system for searching news reports and other media, but this appears to be a one time cost rather than an annual cost.
The Inspector General wants examiners to have direct access to the databases of the exchanges, depositories, clearing corporations and various self-regulatory organisations rather than having to get data from these agencies as and when required. This is a huge change of mindset because it blurs the distinction between the self-regulatory organisations as first line regulators and the SEC as the apex regulator. It moves the SEC into the regulatory frontline.
In line with this change, the SEC proposes to train its examiners in the mechanics of securities settlement (both in the US and in major foreign markets), in the trading databases maintained by the various exchanges as well as in the methods to access the expertise of foreign regulators, exchanges, and clearing/settlement agencies.
Turning to investigation, the Inspector General wants all investigation teams to have at least one individual on the team with specific and sufficient knowledge of the subject matter (like Ponzi schemes or options trading) as well as access to at least one additional individual who also has such expertise or knowledge.
During the last quarter century, many regulators elsewhere in the world have looked upon the SEC as the gold standard in securities regulation enforcement and have consciously or unconsciously fashioned themselves on the SEC.
The lesson from Madoff is that the role model should not be the SEC of recent decades but the SEC of the 1930s and 1940s under chairmen like Douglas who believed that the management of the SEC was a higher form of business management. Or perhaps, the role model should be the modern New York Attorney General’s Office.
For regulators who are far behind even the current SEC in terms of talent and resources, the SEC experience should be a wake-up call to put their houses in order.
Posted at 12:32 pm IST on Tue, 20 Oct 2009 permanent link
Categories: bankruptcy, fraud, investigation, regulation
Mumbai elections: Do machines need a holiday?
India’s national stock markets are closed today because of elections in Mumbai where the main exchanges are headquartered. It is true that Mumbai accounts for more than half of the trading in the pan India stock markets, but still the question does arise – do machines need a holiday on election day?
It is surely possible for the stock exchange servers to keep running so that the rest of India can trade. Alternatively, the lower trading volumes on a day on which Mumbai is closed provides a wonderful opportunity to test the exchanges’ business continuity plan by running the trading engine off the back up servers outside of Mumbai.
For a variety of legal reasons, it is desirable for the disaster recovery site of the exchanges to be located in a state different from the one where the main site is located. This would provide a safeguard against any one city or state imposing exorbitant taxes and other levies on what is really a national market.
It is interesting to note that when it comes to the payment system, the nearly universal global practice is to close the system only on days which are holidays for the entire country or region. In the Eurozone for example, the Target system closes only on days which are holidays in every participating country. The Indian RTGS also closes only on national holidays though the number of holidays is larger than that of Target.
Stock markets (and more importantly, their regulators) globally have been much more willing to close the markets. The worst manifestation of this was after 9/11 when the US stock market remained closed even after the US Treasury market re-opened though the loss of lives in the Treasury market was more severe (I had a post on this subject way back in 2005).
Posted at 12:42 pm IST on Tue, 13 Oct 2009 permanent link
Categories: exchanges, regulation, technology
SEC formalizes bail out of fat fingers
Exchanges world wide have often bailed out fat fingered traders who punch in wrong buy or sell orders. I have blogged about this here, and also about a rare contrary example here and here. Such bail outs create a moral hazard problem because traders have insufficient incentives to install internal controls and processes to prevent erroneous orders.
Instead of stopping this practice, the SEC has now stepped in to formalize the moral hazard and has also set exceptionally low thresholds for such bail outs:
In general, the new rules allow an exchange to consider breaking a trade only if the price exceeds the consolidated last sale price by more than a specified percentage amount: 10% for stocks priced under $25; 5% for stocks priced between $25 and $50; and 3% for stocks priced over $50.
I believe this move by the SEC reflects regulatory capture: those who are harmed by trade cancellation are typically day traders and other small traders who have little voice in the regulatory system, while those benefited by the bail out tend to be large trading firms. (The very term day trading is always used pejoratively – when a large firm does it, the terminology changes to high frequency trading which suddenly sounds a lot more respectable).
Three years ago, I wrote: “Clearly exchanges can not be trusted with the discretion that is vested in them. The rule should be very simple. Traders should bear the responsibility (and the losses) of their erroneous trades.” I wonder now whether the regulators can be trusted with the discretion that is vested in them.
Posted at 9:37 am IST on Thu, 8 Oct 2009 permanent link
Categories: exchanges, regulation
Bank Losses: Securities versus loans
I have been arguing for some time now (for example, here) that the financial crisis in the US is looking more and more like an old fashioned banking crisis rather than a problem in the securities markets. The IMF Global Financial Stability Report released earlier this week provides strong evidence for this.
Table 1.2 in Chapter 1 shows that out of the trillion dollar losses projected for US banks, 64% would come from loans and only 36% from securities. The losses on loans are estimated as 8.1% of the total loans held by the banks while the losses on securities are 8.2% of the securities holding. These practically identical loss rates demolish the idea that we would not have had a crisis if the US had boring banks which just took deposits and made loans.
For the world as a whole, the loss rate on securities (5.9%) is significantly higher than loans (4.7%). Despite that, 67% of the $2.8 trillion losses come from loans and only 33% from securities.
Posted at 1:56 pm IST on Sun, 4 Oct 2009 permanent link
Categories: banks, bond markets
More on negative swap spreads
The universal feedback that I got on my last post on this subject was that it was very difficult to understand. So let me try again.
At the outset, let me state that in my view the negative swap spread is a result of market dislocation; I do not even for a moment believe that it is really a rational market outcome. Yet, some people are making the argument that the negative spread is rational and can be explained in terms of default risk. I am therefore, trying to analyze (and hopefully) disprove this claim; mere hand waving is not enough.
Specifically, the claim being made is that the fixed leg of the swap is less risky than the 30 year bond because there is no principal payment at the end. So I begin by making the extreme assumption that the 30 year bond can default, but all the promised payments in the swap will be paid/received without default even if the government and one or more Libor rated banks default.
My initial thinking was that:
- Libor is the floating rate at which a Libor rated bank can borrow
- The swap rate must be the fixed rate at which such a bank can borrow
- The 30 year bond yield is the fixed rate at which the US can borrow
- The T-bill yield must be the floating rate at which the US can borrow
If all this is true, then by assuming that the T-bill yield is always less than Libor, it would appear to follow that the bond yield must be less than the swap rate.
Unfortunately, this simple minded analysis is inadequate because it assumes that interest rate risk and default risk can be nicely separated from each other and do not interact. The interest rate risk is reflected in the spread between Libor and the swap rate (a rising yield curve) and also in the spread between T-bills and the long bond (again, a rising yield curve). The default risk is reflected in the spread between T-bills and Libor and also the spread between the long bond yield and the swap rate. The world would be so simple if these two risks were orthogonal to each other and did not come together in crazy ways.
To understand this interaction, suppose that on the date of default somebody makes good the default loss to us by paying us the difference the par value of the bond and its recovery value. The default loss is therefore eliminated. Does this mean that there is no loss at all due to default? No, we are now left with the par value of the bond in our hands, but that is not the same thing as receiving the remaining coupons and redemption value of the bond. If we try to invest the par value of the bond, we may not be able to earn the old coupon rate if interest rates have fallen.
A default in a low interest rate scenario is in some ways similar to a bond being called. In fact, a default with 100% recovery is completely identical to a call. Conversely, a default in a high interest rate environment has some similarities to a put; and the similarity becomes an equality if recovery is 100%. Therefore, in addition to the default risk, we need to consider the value of the implicit call or put that takes place when the bond defaults.
The situation that I envisaged in my previous post was that if the US government defaults only in a low interest rate environment, its yield must include a premium not only for default losses but also a premium for its implicit callability. The swap rate will be the yield on a non callable bond, because the swap continues even if one or more Libor rated banks default. I am assuming that the risk of the swap counterparty defaulting is taken care of by sufficient collateral. If the yield sweetener required for the implicit callability of the US Treasury outweighs the extra default premium (the TED spread) embedded in Libor, it is possible for the Treasury yield to exceed the swap rate. I emphasize that I do not consider this likely, but it is a theoretical possibility.
To demonstrate this theoretical possibility, I now present an admittedly unrealistic numerical example where this happens. I assume a default risk on US Treasury of about 15 basis points annually while Libor contains 30 basis points of default risk embedded in it. From a pure credit risk point of view, the Libor rated bank is riskier than the US, but in my extremely artificial model, the 30 year swap rate is only 4.06% while the 30 year US Treasury yield is 4.27% (roughly similar to early September numbers). This happens because in this toy model, Treasury default is perfectly correlated with interest rates and amounts to callability of the bond. In this model, the yield on a hypothetical default free 30 year non callable bond is only 3.76% while the yield on a default free 30 year bond callable after 10 years is 4.08%. This means that the hypothetical default free callable yields more than the defaultable non callable swap. The defaultable Treasury has to yield more than the default free 30 year callable to compensate for default risk.
The precise model that yields the above numbers is as follows. The US Treasury defaults with 10% probability exactly at the end of 10 years with a recovery of 55%. This corresponds to an expected default loss of 4.5% or 15 basis points annualized over the 30 year life of the bond (in present value terms, the annualized default loss is obviously slightly different). The default free term structure over the first 10 years is roughly similar to the actual US Treasury yield curve in early September. The only two numbers we need are the 10 year zero yield (3.59%) and the 10 year par bond yield (3.45%).
At the end of 10 years, there are two possibilities:
- The US government defaults and the risk free rate remains constant at 0% (zero) over the next 20 years. The probability of this is 10%.
- The US government does not default and the risk free rate remains constant at 4.75% over the next 20 years. The probability of this is 90%.
Note for the finance experts: all probabilities above are risk neutral probabilities.
In this model default is perfectly correlated with interest rates and a defaultable bond with 100% recovery would be the same as a default free callable bond. This allows us to decompose the 51 basis point spread (4.27% – 3.76%) of the US bond over a default free non callable into two components: a callability component of 32 basis points (4.08% – 3.76%) and a default loss component of 19 basis points (4.27% – 4.08%). The swap is non callable and its entire spread over the default free non callable bond of 30 basis points (4.06% – 3.76%) is due to default risk. This default loss spread is 11 basis points more than that embedded in US Treasury indicating that it has higher default risk. This 11 basis points can be interpreted as the average implied TED spread over the entire period.
While this example is theoretically possible it is clearly unrealistic. The purpose of my previous post was to prove that under realistic assumptions, it is not possible for the US Treasury yield to exceed the swap rate even if we assume that the swap payments will continue without default even after Treasury has defaulted. But that argument is necessarily abstract and complex.
Posted at 8:59 pm IST on Tue, 22 Sep 2009 permanent link
Categories: bond markets, derivatives, risk management, sovereign risk
Negative swap spread
The fact that the 30 year US dollar swap rate is lower than the interest rate on the 30 year US treasury bond was till recently something that only fixed income specialists worried about. Sure, the Across the Curve blog has been putting NEGATIVE in capital letters in each of his daily blog posts on the swap spread for several months now, but the mainstream financial media did not bother much about it. Last week, however,the Financial Times carried a detailed story ("Negative 30-year rate swap spread linger," September 9, 2009) on the subject.
Under the current view that financial markets have normalized, the negative swap spread is an embarrassment because it suggests that even a year after Lehman, simple arbitrage trades are not happening because of a paucity of the balance sheets required to put on the trades. Alternative explanations are being sought for the phenomenon, and the report states that “questions are being asked in the market about the assumption governing whether a 30-year swap is riskier than a 30-year bond.”
In this post (necessarily long and highly technical), I shall try to examine this question. I shall initially assume that the interest rate swaps have no counterparty risk because of high degree of collaterilization. This is very different from asserting that the swap rate is a risk free rate.
I shall assume that the Libor rate on the floating leg of the interest rate swap is a rate that includes a default risk component. I shall also assume that the default risk inherent in Libor is greater than that of US Treasury. More precisely, I shall assume that the TED spread (the excess of Libor over the T-Bill yield at the same maturity) is expected to remain positive. I shall also assume that the positive TED spread reflects the greater credit risk of Libor as compared to the T-Bill. Before the crisis, it was fashionable in the CDS market to assume that Libor and swap rates were risk free rates and the TED spread was due to liquidity and tax effects. I believe that this claim is untenable today.
Since banks are afloat today with huge government support, I think it is reasonable to assume that the government is more credit worthy than the banks. But I do not assume that the US government is risk free either. It too can default, but the probability of this default is lower than that of the banks.
Libor is the borrowing rate of a bank with what is often called a “refreshed Libor rating.” On every day that Libor is polled, only a sample of “sound” banks is considered. Therefore, the default risk inherent in three-month Libor is that of a bank defaulting in the next three months given that it meets the Libor creditworthiness standard today. Libor exceeds a hypothetical three month risk free rate by a compensation for this possibility of default.
Assuming that the interest rate swap itself has no default risk, the fixed rate payer should be willing to pay a fixed rate that exceeds the risk free rate because what he receives on the floating leg is higher than the risk free rate. He should also be willing to pay more than he would on a swap in which the floating leg was the US T-bill yield instead of Libor because I am assuming that the TED spread (T-bill yield minus Libor) is expected to be positive. The T-Bill yield itself exceeds a hypothetical risk free rate because of the the possibility of default by the US government.
Unfortunately, even from all these assumptions, it does not follow that the 30 year UST yield should be less than the 30 year swap rate without some further assumptions that we will come to at the end. The problem is that the interest rate swap is not terminated by the default by one or more of the Libor rated banks or by the default of the US government. Several banks may fail and Libor may still be computed the next day based on the few banks that remain. The floating rate payer on the swap would have to make floating leg payments at this Libor rate, and the fixed rate payer would have to make fixed leg payments at the fixed rate.
The holder of the 30 year bond however will not continue to receive coupons if the US government has defaulted. To eliminate the default risk of the US Treasury, we must consider a hypothetical asset swap on the 30 year bond. Consider an asset swap in which (a) the owner of a newly minted bond sells it to an asset swap buyer at par, (b) the buyer agrees to make fixed rate payments at the coupon rate of the bond, and (c) the seller agrees to make a floating rate payment at Libor +/- a spread.
Assuming that the asset swap is risk free, the asset swap seller now has a risk free stream of payments equal to the coupon of the 30 year UST bond. If it were true that the floating leg payment would be equal to the T-bill yield, then we can immediately conclude that the 30 year bond must yield less than the fixed rate of the 30 year interest rate swap. If not an arbitrageur would enter into an asset swap as a seller and simultaneously enter into an interest rate swap as a fixed rate payer. It would be left with two sources of profit from these two swaps:
- the fixed rate it receives on the asset swap would exceed the fixed rate that it pays on the interest rate swap because the 30 year bond yields more than the swap rate
- the floating rate it pays on the asset swap (T-bill yield) would be less than what it pays in the interest rate swap (Libor) because the TED spread is expected to be positive.
If US Treasury were risk free, it is evident that the floating leg would be equal to the T-Bill yield. We just add a notional exchange of principal at the end (which simply cancels out). The fixed leg must be worth par because it is economically the same as the newly minted 30 year Treasury (par) bond. Therefore the floating leg payment including the notional payment must also be worth par, but this “floating rate bond” can be worth par only if the floating rate is the risk free rate which is the T-Bill yield.
This equivalence breaks down when US Treasury can default. To understand this consider a modified asset swap which terminates without any termination payments if and when US government defaults. In this case, it is easy to see that the modified asset swap floating leg must equal the T-Bill yield. The case where the US government does not default has already been analyzed above, so consider what happens if there is a default.
In this case, we add a notional exchange between the swap buyer and the swap seller not of the principal value of the bond but of the recovery value of the defaulted bond. With this notional payment included, the fixed leg again is the same as the US treasury bond. It must therefore be worth par because the Treasury bond is a par bond. The floating leg must therefore also be worth par which means that it (including the notional payment at default of the recovery value) must be a par floater. But the T-Bill yield is precisely the yield on a par floater of the US government.
With this understanding in place, let us now return to the only possible explanation for the swap rate being less than the UST rate in a perfect market – the asset swap floating leg must exceed Libor (or the asset swap spread must be positive). In this case, in a perfect market the fixed leg (which is the UST bond yield) must also exceed the swap rate – the asset swap seller receives a larger fixed leg than in an interest rate swap but also pays a higher floating rate.
So the position is that for the current interest rates to be consistent with a perfect market, the asset swap spread should be positive while we know that the modified asset swap spread (the one that terminates on default by the US government) is the negative of the TED spread and is therefore expected to be negative. The difference between the asset swap and the modified asset swap is that after default by the US government, the modified swap terminates while the ordinary asset swap subsists.
Everything now depends on what Libor is likely to be after the default by the US government. If Libor is expected to be high, the asset swap seller would have to make large floating rate payments in return for the fixed rate payment from the asset swap buyer. The subsisting swap would therefore be a liability to the asset swap seller and he would therefore insist on paying a lower (more negative) spread in the asset swap than in the modified asset swap where this liability would not exist. This would imply that the asset swap floating leg would be even lower than the T-Bill yield and therefore much lower than Libor. The 30 year UST yield must therefore be less than the swap rate.
For the 30 year US yield to be higher than the swap rate in a perfect market therefore the asset swap must be beneficial to the asset swap seller after the default by the US government. This can happen only if interest rates are very low after default. I do not find this very plausible. I would expect sovereigns to default on local currency debt after inflation has been tried and found to be wanting. With double digit inflation, one would imagine Libor also to be in double digits and the asset swap would be a huge liability to the asset swap seller who would be receiving something like 4.5% fixed. Considering this liability, the asset swap spread should be less than the T-bill yield which in turn is less than Libor.
Thus it appears to me that a 30 year swap rate less than the 30 year UST yield is consistent with perfect markets only if we are willing to make either of the two assumptions:
- The TED spread is expected to be negative implying that banks are safer than the US government; or
- A potential default by the US government would happen in an environment of very low rates where Libor would be very low.
I find both these assumptions implausible and would believe that the phenomenon that we are seeing in 30 year swaps is due to the limits to arbitrage arising from inadequate capital and leverage.
One final question that might trouble the reader is the assumption that there is no counterparty risk in the swaps even when the sovereign itself has defaulted. Actually, if we simply assume that all the swaps terminate on default by the US government, the above arguments still go through. The fixed rate payer in the interest rate swap makes money before the default. If at this point, he is allowed to pack up his bags and go home, that is fine in this model.
This has been a difficult piece of analysis for me and I would welcome comments, suggestions and corrections.
Posted at 4:30 pm IST on Wed, 16 Sep 2009 permanent link
Categories: bond markets, derivatives, risk management, sovereign risk
Lehman Anniversary
I have a column in the Financial Express today on the anniversary of the Lehman failure.
As we examine what we have learnt in the year since the collapse of Lehman Brothers, the most important lesson for Indian policymakers is that for macro risk management purposes, India must now be regarded as having an open capital account.
From a micro-economic perspective, India has a plethora of exchange controls that often force businesses to go through several contortions to perform what would be very simple tasks in a completely open capital account. But from a macro perspective, these regulations only serve to impose some transaction costs and frictions in the process. Exchange controls have ceased to be a barrier – they are only a nuisance.
Large capital inflows and outflows do take place through three important channels which are not subject to meaningful cap – inward portfolio flows, outward foreign direct investment and external commercial borrowing. In addition, foreign branches of Indian banks and foreign affiliates of Indian companies have relatively unrestricted access to global markets. Through all these channels, Indian entities can build up large currency, liquidity and maturity mismatches in foreign currency.
Each one of these global linkages was well known to perceptive observers for a long time, but it took the Lehman collapse to demonstrate the strength of these linkages taken together. Policy makers were taken by surprise at the ferocity with which the storm in global financial markets hit Indian markets.
We must now wake up to the reality that as in the case of East Asia in 1997, the power of the corporate lobby has ensured that capital controls have disappeared in substance while remaining deeply entrenched in form. I believe that in India today, there are only three effective capital controls that have macro consequences.
First, Indian resident individuals cannot easily borrow from abroad. This ensured that Indian households did not have home loans in Swiss francs and Japanese yen unlike several countries in Eastern Europe. In India, the corporate sector has had the monopoly of speculating on the currency carry trade. From a socio-political perspective, this mitigated the impact of the crisis, though it is doubtful whether the macro-economic consequences were important.
Second, Indian companies cannot borrow in rupees from foreigners as easily as they can borrow in foreign currency. This contributed to large corporate currency mismatches which were a huge source of vulnerability during the Lehman crisis.
Third, it is difficult for foreigners to borrow rupees and therefore speculation against the rupee is more effectively carried out by Indians than by foreigners. Currency speculation by foreigners typically takes the form of portfolio inflows and outflows. This has potential macro prudential consequences, but it was not a material factor in the Lehman episode.
This, therefore, is the first lesson from Lehman – Indian regulators should now think of India as having an open capital account while framing macro risk management policies.
The second lesson is that, as Mervyn King put it, global financial institutions are global in their life, but national in their death. Each nation has to take steps to ensure that failure of foreign institutions does not disrupt its domestic markets.
The collapse or near collapse of several large US securities firms did not pose any threat to the solvency of Indian equity markets because of the margin requirements that we impose on FIIs. Under the doctrine that each country buries its own dead, foreign creditors of a bankrupt FII can lay claim to this collateral lying in India only if there is something left over after the claims of Indian stock exchanges and other Indian entities have been satisfied.
In this context, the existence of a large over the counter (OTC) derivative market in India where foreign banks trade without posting margins is a huge systemic risk. Lehman was a bit player in the interest rate swap and other OTC markets in India. As such, its collapse did not create a major disturbance. However, the failure of a large foreign bank which is very active in the OTC market would be very serious indeed.
It is absolutely imperative to move the OTC markets to centralised clearing to eliminate this source of systemic risk.
The final lesson from Lehman is that the idea that emerging markets are somehow very different from mature markets has been rudely shaken. The most mature economies of the world have had an “emerging market style” financial crisis. In the past, the US did not think that it had anything to learn from crises in emerging markets, and was therefore completely unprepared for what happened after Lehman. In retrospect, the US belief in its own exceptionalism was a colossal mistake.
India must also abandon any belief we might have in our exceptionalism and learn from the experiences of other countries so that we do not have to learn the same lessons at first hand.
Posted at 7:30 am IST on Tue, 15 Sep 2009 permanent link
Categories: crisis, international finance, risk management
Madoff and Renaissance Technologies
A short while back, I blogged about the OIG report on the SEC investigation of Madoff. One of the interesting nuggets in this report is about how the leading hedge fund, Renaissance Technologies, analysed and dealt with their Madoff exposure way back in 2003. It struck me as a good example of prudent risk management.
The first internal RenTec email about its Madoff exposure contains a brief description of the red flags, but what interests me is the risk analysis:
Committee members,
We at Meritage are concerned about our [Madoff] investment. ...... you have the risk of some nasty allegations, the freezing of accounts, etc. To put things in perspective, if [Madoff] went to zero it would take out 80% of this year’s profits.
Sure it’s the best risk-adjusted fund in the portfolio, but on an absolute return basis it’s not that compelling (12.16% average return over [the] last three years). If one assumes that there’s more risk than the standard deviation would indicate, the investment loses it[]s luster in a hurry. It’s high season on money managers, and Madoff’s head would look pretty good above Elliot Spitzer’s mantle. I propose that unless we can figure out a way to get comfortable with the regulatory tail risk in a hurry, we get out. The risk-reward on this bet is not in our favor.
In one short email, you have several lessons in risk analysis:
- Worst case scenario: Madoff goes to zero
- Risk sizing relative to risk appetite: 80% of profits.
- Analysis of tail risk, separately from the historical volatility.
- Analysis of liquidity risk (freezing of accounts).
- Concern about regulatory risk (Spitzer).
What is interesting is that this email led to a flurry of emails analysing the red flags in Madoff at great length, collecting data from published sources and from conversations with market participants. At the end of it all, there was disagreement about the course of action between those who wanted to exit the position completely and those who drew comfort from the fact that Madoff had survived an SEC investigation. Finally, they decided to reduce the exposure by 50% (perhaps as a hedge fund they had the risk appetite to lose 40% of profits in a worst case scenario, when the investment looked attractive otherwise).
What is also interesting is that these smart hedge fund managers thought that the one regulator who was likely to catch Madoff was the New York Attorney General, Spitzer. Markopolos also thought that the New York Attorney General was the best financial regulator in the country (see my blog post here).
Of course, the RenTec people come across as having a self confidence bordering on hubris. At one point, they analysed Madoff’s stock trading and determined that “the prices were just too good from any mode of execution that we were aware of that was legitimate. ... And we would have loved to figure out how he did it so we could do it ourselves. And so that was very suspicious.” They finally decided that Madoff could not be doing what they were not able to do themselves: “Well, I knew it wasn’t possible because of what we do.”
I can quite imagine the RenTec people thinking that there was no way Madoff with his AS400 could do what RenTec could not do with the 60th largest supercomputer in the world.
Yet, there is no reason we should not learn from a bunch of arrogant people.
As an aside, I thought that the internal RenTec emails were the best leads that the SEC got. These were not complaints and were not even intended to be read by SEC – they just got picked up during an SEC examination of RenTec. There was clearly no motive, no hidden agenda. The SEC was peering into the unedited thinking of some of the smartest hedge fund managers in the world.
As another aside, the very fact that these internal emails got picked up as a lead for investigation of another entity conflicts with the idea that the SEC is so badly incompetent. My Hanlon’s Razor is taking some dents.
Posted at 5:42 pm IST on Sun, 6 Sep 2009 permanent link
Categories: fraud, risk management
The SEC Madoff Investigation Report
Ever since the Markopolos documents became public, we have known that the SEC bungled its investigation of Madoff very badly (see my blog posts here and here). So when the SEC asked its Office of Investigations to investigate the SEC’s failure, there was only one question to answer – was it incompetence or was it something worse? We now have a 450 page report (with only minor portions redacted) describing how the SEC dealt with various complaints against the SEC.
In my first blog post last year, I wrote that:
I could not get away from the feeling that the SEC bungled this investigation very badly. But I also suspect that regulators are much more geared towards dealing with complaints from whistleblowers or other complaints with a “smoking gun” proof rather than some forensic economics that most regulators probably do not understand. Perhaps also the fact that a complaint comes from a rival automatically devalues its credibility in the eyes of many regulators.
I believe that in financial regulation, both these attitudes are completely mistaken. Forensic economics is usually more valuable than “smoking guns” and complaints by rivals and other interested parties are the best leads that a regulator can get.
By and large, the investigation report tells the same story. But I think the report pushes the incompetence story a bit too much to the point where it almost reads like a whitewash job. I counted the term “inexperienced” or “lack of experience” being used 25 times in the report and that count excludes several other similar phrases. When an investigator is a good attorney, the report complains that the person had no trading experience; when the person had trading experience, it complains about his lack of investigative experience.
I am a firm believer in Hanlon’s Razor: “Never attribute to malice what can be adequately explained by stupidity,” but the report’s furious attempt to document incompetence makes one wonder whether it is trying to cover up something worse than incompetence.
At several points in the last few years, the SEC staff appear to have been tantalizingly close to uncovering the fraud. They knew that Madoff was lying to them repeatedly, but their seniors seemed to be unwilling to let them go where the facts seemed to point them. On all occasions, the staff seem to have been intimidated by Madoff’s standing in the industry and within the SEC itself. Repeatedly, the senior staff in the SEC seemed to turn any complaint about Madoff into one on front running even when the complaint was not about front running or explicitly stated that front running was unlikely. Of course, front running was the one crime that Madoff was not guilty of!
The report gives a completely clean chit to the SEC where it really matters:
The OIG did not find that the failure of the SEC to uncover Madoff’s Ponzi scheme was related to the misconduct of a particular individual or individuals, and found no inappropriate influence from senior-level officials. We also did not find that any improper professional, social or financial relationship on the part of any former or current SEC employee impacted the examinations or investigations.
Rather, there were systematic breakdowns in the manner in which the SEC conducted its examinations and investigations ...
While Sandeep Parekh states that he is “impressed that such a self critical report was put up on the main page of the SEC’s website,” the SEC OIG report appears to me to be a report of self exoneration.
My adherence to Hanlon’s Razor remains unchanged, but this adherence is in spite of the OIG report and not because of it.
Posted at 4:22 pm IST on Sun, 6 Sep 2009 permanent link
Categories: bankruptcy, fraud, investigation
Corporate OTC derivatives
Last month the Association of Corporate Treasurers put out a document explaining why companies must be exempted from all the reforms being proposed for OTC derivatives. This “international body for finance professionals working in treasury, risk and corporate finance” does not want the corporate use of OTC derivatives to be subject to central counterparties, collateralization, and exchange trading.
The main argument that they give is that while the OTC derivatives reform proposals are motivated by systemic risk concerns, the corporate use of OTC derivatives is not a systemic risk:
The risk to the system as a whole from failure of a commercial customer of a bank is unlikely to be material. ...
Importantly, non-financial companies generally deal in large but not systemically significant amounts. ...
It is unlikely that a non-financial services sector company using derivatives for hedging will itself represent a systemic risk to the financial services sector.
I am amazed that the Association of Corporate Treasurers could make such claims when the fact is that the last couple of years have seen a corporate derivatives disaster on a scale that has been systemically important enough to require government bail outs.
Korea is a good example of a country where derivative losses on KIKO (Knock In Knock Out) foreign exchange options in the small and medium enterprises were so large that the government had to step in to provide liquidity support and credit guarantees on a large scale to the sector. In Brazil and Mexico, the central bank conducted foreign exchange interventions that were designed to bail out the companies that had suffered huge losses in foreign exchange derivatives.
The June issue of Finance and Development published by the IMF provides quick summaries of what happened in Asia (China, India, Indonesia, Japan, Korea, Malaysia, and Sri Lanka) and Latin America (Brazil and Mexico). These reports indicate that “An estimated 50,000 firms in the emerging market world have been affected.”
Though the losses were large ($28 billion in Brazil alone) and systemically important, they came at a time when the financial sector was losing money in trillions, and inevitably less attention was paid to those who were content to lose money by the billion.
The Association of Corporate Treasurers is particularly horrified that a company doing a derivative deal should put up collateral:
In attempting to remove the credit risk between company and bank which is not systemically significant, a serious liquidity risk for the firm would introduced instead. ...
... if a company has to put up cash collateral it turns its hedge transaction into an immediate cashflow which will not match the timing of the counterbalancing commercial cashflow being hedged – perhaps by many years. This introduces a serious cashflow problem, potentially nullifying much of the benefit of the hedge.
What I have observed is that the discipline induced by mark to market is extremely valuable in risk management. Among the rules of thumb that I like to apply to corporate risk management are the requirements that: (a) the derivative position must be acceptable if held to maturity even if the intention is to unwind the position within a short period, and (b) the mark to market losses must be acceptable even if the position is intended to be held to maturity. These two symmetric rules rule out a whole lot of speculative positions.
Finally, when the Association of Corporate Treasurers talks of liquidity risk, it must be remembered that the relevant liquidity risk is a tail risk. The day to day volatility of mark to market cash flows does not produce a significant risk to the company – this is a liquidity nuisance and not a liquidity risk. The real risk is when the mark to market losses are large enough to threaten financial distress.
Under such conditions, the uncollateralized OTC derivatives impose equally severe liquidity risk because (a) the OTC derivatives may provide for margins to be deposited in these extreme cases, and (b) other lenders (including trade creditors) start refusing to roll over their debt. Cases like Ashanti Goldfields highlight the liquidity risk of OTC derivatives to the company.
Posted at 2:11 pm IST on Thu, 3 Sep 2009 permanent link
Categories: derivatives, exchanges, risk management
In praise of noise
Lord Turner, the head of the UK FSA has gone on record in support of the Tobin Tax as part of the regulatory response to the global financial crisis. I think this idea is completely mistaken.
Short term “noise” traders played no role in the crisis. On the contrary, one could argue that the lack of noise traders in key asset classes like real estate and some pegged currencies contributed to the crisis. The “great moderation” was characterized by low volatility which lulled everybody into complacency. The excess volatility that noise traders are usually accused of generating would actually have been a good thing during the great moderation. The crisis was caused not by volatility but by tail risk and attempts to reduce volatility usually increase tail risk.
Rather than a Tobin tax, perhaps we should consider a Tobin subsidy in asset classes like real estate where there are too few noise traders. For example, anybody who sells a house within a month of buying it could get a refund of stamp duties and other taxes paid when the house was bought. In other words, the optimal rate for financial stability purposes of the Tobin tax is inversely related to the volatility of the asset class and is probably negative for many of the asset classes that were affected by the global financial crisis.
If we want to use fiscal policy to promote financial stability, I think an MM tax (more precisely, the complete or partial withdrawal of the MM subsidy) on leverage would be a much better idea. The MM (Modigliani-Miller) analysis shows that a key reason for leverage is the tax advantage arising from the tax deductibility of the interest paid on debt. If we impose an MM tax, then debt would be used mainly for its governance advantages (Jensen-Meckling). A huge deleveraging of the financial sector would become regulatorily feasible and that would be a good thing.
Posted at 3:34 pm IST on Tue, 1 Sep 2009 permanent link
Categories: crisis, exchanges, taxation
Credit card frauds
One of the world’s foremost experts on computer security, Bruce Schneier, writes on his blog about the recent theft of 130 million credit card numbers:
Yes, it’s a lot, but that’s the sort of quantities credit card numbers come in. They come by the millions, in large database files. Even if you only want ten, you have to steal millions. I’m sure every one of us has a credit card in our wallet whose number has been stolen. It’ll probably never be used for fraudulent purposes, but it’s in some stolen database somewhere.
Years ago, when giving advice on how to avoid identity theft, I would tell people to shred their trash. Today, that advice is completely obsolete. No one steals credit card numbers one by one out of the trash when they can be stolen by the millions from merchant databases.
I had read in the past about online thieves selling credit card data for a few cents per thousand cards, but I did not realize that things were so bad.
What is also interesting is that you do not need to use credit cards in online transactions, or in some fraud prone South East Asian country for your card number to land up in a stolen database. The number gets stolen from large retail chains in the best of countries.
Of course, Schneier is talking only about credit card numbers, so with the increasing use of two factor authentication, it may take something more to actually use the card, but that something more is often surprising little.
Posted at 11:54 am IST on Fri, 28 Aug 2009 permanent link
Categories: fraud
Basel Committee captured
The extent to which the Basel Committee on Banking Supervision has been captured by the banking industry that it regulates is clear from Guiding principles for the replacement of IAS 39 that it released today:
The new two-category approach for financial instruments should not result in an expansion of fair value accounting, in particular through profit and loss for institutions involved in credit intermediation. For example, lending instruments, including loans, should not end up in the fair value category.
There should be a strong overlay reflecting the entity’s underlying business model as adopted by the Board of Directors and senior management, consistent with the entity’s documented risk management strategy and its practices, while considering the characteristics of the instruments.
The new standard should ... permit reclassifications from the fair value to the amortised cost category; this should be allowed in rare circumstances following the occurrence of events having clearly led to a change in the business model
The IASB should carefully consider financial stability when adopting the timing of the implementation of the final standard.
The new standard should provide for valuation adjustments to avoid misstatement of both initial and subsequent profit or loss recognition when there is significant valuation uncertainty.
The new standard should utilise approaches that draw from relevant information in banks’ internal risk management and capital adequacy systems when possible (eg approaches that build upon or are otherwise consistent with loss estimation processes related to bank internal credit grades may be useful).
Is Basel saying for example that all through this crisis they have been quite happy with the robustness of “the underlying business model as adopted by the Board of Directors and senior management” of the banks as well their “documented risk management strategy and ... practices”?
Posted at 8:58 pm IST on Thu, 27 Aug 2009 permanent link
Categories: corporate governance, regulation
Change of address fraud
Floyd Norris points to a FINRA press release about a eight year long fraud at a Citigroup brokerage office in California.
The $850,000 fraud was carried out by a sales assistant, which as Norris points out, is about as low as you can be in a brokerage office. The critical element in the fraud as detailed in the press release was to change the address of the customer (using falsified documents) so that account statements showing the unauthorized withdrawals do not reach the customer. Of course, she was also smart enough to chose customers who were unlikely to monitor their accounts regularly and notice the absence of periodic account statements.
There is one thing here that I do not understand. The best practice in the financial industry while recording a change of address is to send a confirmation of the change to the old address. I am fond of saying that responding to a change of address request with a confirmation letter to the new address is a matter of courtesy, and nothing will happen if this confirmation does not go out. But sending a confirmation to the old address is an elementary fraud precaution and under no circumstances should this fail to happen. It is the last opportunity to the customer to stop the fraud.
So did Citigroup not have a process for ensuring this standard fraud control process? Or is sending a confirmation to the old address not as well understood and practiced in the industry as it should be?
Posted at 3:28 pm IST on Wed, 26 Aug 2009 permanent link
Categories: fraud
Winding up Lehman Europe
While much has been made about the difficulty of winding up large and complex financial institutions, it appears that it is the simplest of structures that are the hardest to wind up. Giving some of one’s things to another for temporary safe keeping on “trust” is probably older than lending money (debt markets) or selling equity interests in assets (stock markets) – it is probably older than money itself. Yet it is the simple trust structure that is proving so difficult with Lehman Brothers International Europe (LBIE) in London.
The UK High Court has ruled that the normal scheme of arrangements in bankruptcy do not apply to trust property:
51. On analysis Part 26 is concerned with the general estate of a company. It cannot override ordinary trust principles. In the case of creditors, whether actual, prospective or contingent, it deals with persons who have claims which they can bring against the pool of assets which comprises the general estate of the company. A creditor’s claim ranks pari passu with other creditors’ claims against that general estate. It is perfectly comprehensible, therefore, that Part 26 should provide that if those creditors wish to rearrange or compromise their rights against the company, they should be able to do so, by the requisite majorities, because, at the end of the day, they all look to the company’s assets for satisfaction of their pecuniary rights.
52. By contrast with that is the person who has placed his assets with a trustee. There the position is totally different: the essential feature of so doing is that the owner knows that he can have his property, which remains his throughout, dealt with by the trustee in accordance with the terms of the trust. The property is not vulnerable to interference merely because the trustee becomes insolvent: the trust remains. The fact that the trustee is a corporate trustee is likewise immaterial to the integrity of the trust; no less immaterial is that the trustee happens to be a company liable to be wound up under the Insolvency Act 1986 (or the equivalent provision in Northern Ireland), these being the types of company to which the court’s jurisdiction under Part 26 applies where a compromise or arrangement is proposed between a company and its creditors or any class of them: see section 895(2)(b).
53. The fact that the proposed scheme is confined to persons who have a pecuniary claim, however prospective or contingent that claim may be (for example a claim for damages or compensation for the delay in returning that person’s property), does not assist the administrators. While the existence of that claim may provide the basis for a scheme of arrangement directed to that and other pecuniary claims against LBIE, it does not justify interference with the underlying property rights of the property owner. Aside from the fact that the property owner’s remedy (as beneficiary under the trust) for breach of trust is principally directed to securing performance of the trust, rather than to the recovery of compensation or damages, the existence of the pecuniary claims does not affect, and is certainly not the origin of, the owner’s property rights. To suggest otherwise and to ground the intention of the scheme to interfere with the owner’s property rights merely because that owner also has a pecuniary claim against LBIE in view of the possibility that LBIE has acted (or may yet act) in breach of trust is to invert the position. Indeed, the scheme, if it is allowed to proceed, risks turning the position of the beneficial owner on its head: this is because under a trust it is for the trustee to justify and account for his dealings with the trust estate whereas under the scheme the onus will be on the owner to come forward, as a dissentient, to explain and justify why that owner’s property rights should not be dealt with and varied under the scheme.
What I found most amusing was the idea that when a hedge fund gives collateral to a prime broker with unlimited right to rehypothecate, “the owner knows that he can have his property, which remains his throughout.” But then I am not a lawyer.
The court of course thinks that the absence of a scheme of arrangement does not matter. The court has enough powers to sort things out. By that argument, one does not need a scheme of arrangement for creditors either – the courts can sort that out too.
77. Establishing what client assets of any given client LBIE holds or controls, what competing claims there may be to those assets by other clients or by LBIE (or others) and how LBIE and the administrators are to discharge their duties in respect of those assets with a view to their due distribution to those entitled to them are all matters where the court has, in the exercise of its trust jurisdiction, well-developed processes to assist the accountable trustee or other fiduciary. For example, the court is well used to authorising a trustee to make distribution of a fund where there can be no certainty that all of the claimants to it have been identified and the trustee desires the protection of a court order in the event that a further claimant should subsequently appear or matters subsequently come to light which question the basis on which the distribution is made. In one sense, dealing with the matter by recourse to the court’s assistance in this way can be simpler (and less costly) than the often complex processes involved in the promotion of a scheme under Part 26.
78. At the risk of appearing glib, I do not consider that a structured approach of this broad kind is beyond practical achievement in the exceptionally difficult circumstances of LBIE’s administration.
In short, it appears that the legal system in the foremost financial centre in the world does not have a practical way of dealing with the simplest and oldest financial contract – property held under trust.
Posted at 2:48 pm IST on Sat, 22 Aug 2009 permanent link
Categories: bankruptcy, crisis
Securitization
I wrote a column in the Financial Express today about the role of securitization.
The global financial crisis began two years counting from the first liquidity crisis in Europe and the US on August 9, 2007. Over these two years, we have found that many of the conclusions that we came to in the early days of the crisis were simply wrong.
In 2007, we thought that the problem was about subprime mortgages, that it was about securitisation and that it was about CDOs (collateralised debt obligations). Now we know that these initial hasty judgments were mistaken. Defaults are rising in prime mortgages, huge losses are showing up in unsecuritised loans, and several banks have needed a bailout.
In 2007, when the first problems emerged in CDOs, people thought that these relatively recent innovations were the cause of the problem. Pretty soon, we realised that a CDO is simply a bank that is small enough to fail and conversely that a bank is only a CDO that is too big to fail.
Both banks and CDOs are pools of assets financed by liabilities with various levels of seniority and subordination. As the assets suffer losses, the equity and junior debt get wiped out first, and ultimately (absent a bailout) even the senior tranches would be affected. In retrospect, both banks and CDOs had too thin layers of equity.
Over the last two years, our understanding of securitisation has also changed significantly. As global banks released their results for the last quarter, it became clear that bank losses are now coming not from securitised assets but from unsecuritised loans or whole loans.
The Congressional Oversight Panel (COP) set up by the US Congress to “review the current state of financial markets and the regulatory system” published its latest report a few days ago. The report focuses entirely on whole loans and paints a very scary picture. Losses on troubled whole loans in the US banking system are estimated to be between $627 billion and $766 billion.
The COP report also states that “recent reports and statistics published by the FDIC indicate that overall loan quality at American banks is the worst in at least a quarter century, and the quality of loans is deteriorating at the fastest pace ever. The percentage of loans at least 90 days overdue, or on which the bank has ceased accruing interest or has written off, is also at its highest level since 1984, when the FDIC first began collecting such statistics.”
It is becoming clear that what the US is witnessing is an old-fashioned banking crisis in which loans go bad and therefore banks become insolvent and need to be bailed out. The whole focus on securitisation was a red herring. The main reason why securitisation hogged the limelight in the early stages was because the stringent accounting requirements for securities made losses there visible early.
Potential losses on loans could be hidden and ignored for several quarters until they actually began to default. Losses on securities had to be recognised the moment the market started thinking that they may default sometime in the future. Securitised assets were thus the canary in the mine that warned us of problems lying ahead.
Until recently, it could be argued that securitised loans were of lower quality than whole loans and that at least to this extent securitisation had made things worse. But this statement is true only for residential mortgages and not for commercial mortgages, where the position is the reverse. Securitised commercial mortgages (CMBS) are of higher quality than whole loans.
The COP report states: “While CMBS problems are undoubtedly a concern, the Panel finds even more noteworthy the rising problems with whole commercial real estate loans held on bank balance sheets. These bank loans tend to offer a riskier profile as compared to CMBS, suggesting high term default rates while the economy remains weak.”
Two years into the crisis, therefore, we find that the initial knee-jerk reaction against securitisation was a big mistake.
Securitisation doubtless redistributed losses throughout the world so that losses from the US real estate emerged in unexpected places – German public sector banks, for example. But securitisation was not responsible for most of the losses themselves.
We must also remember the US home owner gets a bargain that is available to few home owners elsewhere in the world – a 30-year fixed rate home loan that can be repaid (and refinanced) at any time without a prepayment penalty. This is possible mainly through securitisation and deep derivative markets that allow lenders to manage the interest rate risks.
In India by contrast, the home owner gets a much worse deal: most home loans are of shorter maturity (20 years or less) and are usually either floating rate or only partially fixed rate. The few ‘pure fixed rate’ loans involve stiff prepayment penalties when they are refinanced. It would be sad if we keep things that way because of an irrational fear of securitisation.
Posted at 10:16 am IST on Sat, 22 Aug 2009 permanent link
Categories: bond markets
Estimating the Zimbabwe hyperinflation
Hanke and Kwok have written a paper in the Cato Journal estimating the hyperinflation in Zimbabwe in November last year. They conclude that the monthly (not annualized) inflation rate of 80 billion percent was the second highest in world history (next only to Hungary in July 1946).
I was at first skeptical about the methodology that they use. Since Zimbabwe stopped publishing inflation data during the period, Hanke and Kwok rely on the share prices of the South African insurance and investment company, Old Mutual, in the stock markets in Harare and London. This involves making two assumptions:
- that the relative price of the Old Mutual share in the two countries provides a reliable estimate of the exchange rate of the Zimbabwe dollar; and
- the depreciation of the exchange rate is a good estimate of the inflation rate in Zimbabwe via purchasing power parity (PPP).
I thought that both assumptions are highly suspect for reasons that I explain below.
We do know that, absent capital controls, the relative share price of the same company in different countries tracks the exchange rate very closely. This was true as early as the eighteenth century (Larry Neal, “Integration of International Capital Markets: Quantitative Evidence from the Eighteenth to Twentieth Centuries”, Journal of Economic History, 1985) and it is even more so today. Even the well known paper of Froot and Dabora (“How are stock prices affected by the location of trade,” Journal of Financial Economics, 1999) found problems with the pricing of twin stocks but not the prices of the same twin in multiple markets.
At the same time, exchange controls can play havoc with this assumption. For example, Indian ADR prices trade at large premia to the underlying Indian shares. The difference between Shanghai and Hong Kong share prices of mainland China companies reflects the same phenomenon. These examples suggest that relative prices could be off by nearly a factor of two in the presence of stringent capital controls.
In the kind of lawlessness that prevailed in Zimbabwe, the margin of error is I think higher. I would not be too surprised to find a deviation of prices by as much as a factor of ten.
The second assumption about PPP is even more suspect. Under normal conditions, PPP does not hold up too well except over the very long run. Lothian and Taylor needed 200 years of data to demonstrate that PPP does hold at all (“Exchange rate behavior: The recent float from the experience of the last two centuries,” Journal of Political Economy, 1996).
One would hope that to the extent that PPP is held back by sticky prices, the extreme flexibility of prices during hyperinflation would make PPP hold better. I think there is merit in this argument.
However, in situations like Zimbabwe, the US dollar would probably be valued more as a store of value than as a medium of exchange. The exchange rate is then driven by asset market considerations rather than goods market considerations. Extreme financial repression in which the real rate of interest on Zimbabwe dollar could be hugely negative (approaching -100%) would make the US dollar extremely attractive. People would then buy the US dollar not on the basis of what it is worth now, but on the basis of what it will be worth in future. At the same time, it is impossible for a foreigner to go long on the Zimbabwe dollar without assuming Zimbabwe sovereign credit risk and legal risk.
Under these conditions, I would not be surprised if the exchange rate undervalued the local currency by a factor of ten or more. Taken together with the earlier factor of ten for the stock price, this implies that Hanke and Kwok could be off by a factor of 100.
Surprisingly, this would make very little qualitative difference to the results of Hanke and Kwok. The monthly percentage rate of inflation in Zimbabwe that they estimate is roughly 80 billion. Revising it down by a factor of hundred would bring it down to 800 million. That is still higher than the third highest rate on record (Yugoslavia, January 1994) of 300 million. No plausible margin of error in the opposite direction will bring Zimbabwe within even shouting distance of the highest recorded hyperinflation (Hungary, July 1946) which was 4 followed by 16 zeroes.
Put differently, to push Zimbabwe down to third place, the Hanke and Kwok estimate would have to be off by a factor of 250. Much as I dislike the smug confidence that Hanke and Kwok seem to have in arbitrage relationships in a society where there is security of neither life nor property, I find it difficult to argue that the arbitrage relationships may be off by a factor of 250.
Posted at 3:11 pm IST on Fri, 21 Aug 2009 permanent link
Categories: crisis, monetary policy
Comments recovered from black hole
I realized a couple of days ago that many of the comments on my blog in June and July had disappeared into a black hole. I am still trying to figure out what the problem was with my blogging software (this did not affect the comments on the Wordpress mirror).
In the meantime, I have now recovered most of these comments and added them to the blog. I have also written some code to retrieve orphaned comments and bring them up for moderation so that hopefully this does not happen again.
As I have stated in the past, it is my intention to use moderation only to filter out spam and not to filter out comments that I do not like. So if you find your legitimate (non spam) comments not appearing on the blog within a few days, please do point it out to me by email.
Posted at 1:32 pm IST on Thu, 20 Aug 2009 permanent link
Categories: miscellaneous
Economics of counterfeit notes
There has been much alarmed discussion in the press about the counterfeit Indian rupee notes allegedly being smuggled into the country from across the border. As I see it, the barriers to counterfeiting currency notes are economic and not technological.
Introducing more and more complex features into the notes does not make counterfeiting impossible. What it does is to increase the scale economies in printing by requiring larger and larger initial investment and therefore larger and larger scale of production to make the printing of counterfeits economical. Scale economies are not a problem for the government itself because it anyway prints notes on a very large scale.
Scale economies need not deter the counterfeiter; it only requires the counterfeiter also to operate on a large scale. The problem for the counterfeiter is that the distribution of counterfeit notes is characterized by large diseconomies of scale.
It is pretty easy to distribute a few hundred counterfeit notes with very little chance of detection. Distribution of a million counterfeit notes however requires a distribution network that is very difficult to set up and operate without being detected.
This combination of scale economies in production and scale diseconomies in distribution imply that there is often no viable scale of operation for a private counterfeiter. The total expected cost of manufacturing and distributing the counterfeit note approaches the face value of the note itself.
Counterfeiting by a foreign government is only slightly different. To the extent that they can use the equipment used in their own note printing operations, counterfeiting may be economically viable for them at lower print runs. More importantly, if their goals are not purely economic, the profitability of the operation is not an issue.
However, the problem of the distribution channel is still an issue. The experience of German counterfeiting of UK currency notes during the second world war suggests that the technical quality of the counterfeiting is not the real problem. How to get the notes into enemy territory in large scale is the critical issue. The German experience suggests that using the espionage network to put the notes into circulation only compromises the espionage network itself.
Often, the goal of putting counterfeit notes into circulation in enemy territory is not to make a profit but to disrupt the enemy’s economy by making people distrust their own currency. The strategy of the Indian government and the RBI to deal with the problem of counterfeit notes quietly and without spreading panic is therefore a very sensible one.
For a profit motivated rogue government, the most attractive currency to counterfeit is the US dollar. An estimated 70% of US dollar notes circulate outside the US; many users of the currency are not very familiar with it; the design of these notes is relatively stable; and finally, dollar resources are very valuable in international trade.
Anecdotal evidence suggests a greater percentage of counterfeit US dollar notes (at least outside the US) than in most other currencies. Yet the percentage of counterfeit notes is still quite manageable. I think therefore that the fears that are being expressed in the Indian press about counterfeit rupee notes are excessive.
Posted at 9:15 pm IST on Mon, 17 Aug 2009 permanent link
Categories: currency, fraud
Madoff and his AS/400
The brain behind Madoff’s huge fraud has been revealed – it was the well known IBM AS/400 minicomputer. Well, that is a bit of an exaggeration, but only slightly so. The SEC complaint against a key Madoff lieutenant, Frank DiPascali, turns out to be a long litany of the accomplishments of his AS/400.
Printing millions of pages of trade confirmations (one for each stock and for each account for every fictitious trade) was one of the major uses of the AS/400. DiPascali also used a random number generator program to break up the massive trades into orders of various sizes and prices and to randomly distribute the trades across different times. Apart from the AS/400, Madoff also had a fake computer trading platform set up in the office, just in case somebody wanted to witness real time trading.
For all its prowess, the AS/400 could not generate trade blotters and order tickets. Perhaps, doing this with credible execution times, counterparties and executing brokers would have needed more powerful machines (and tick level price feeds not to mention top quality programmers) of the kind employed by the hedge funds that do high frequency trading today.
I get the sense that while Madoff was an early adopter of technology, he did not keep pace with it in the later years. As investors started demanding faster trade confirmations, the amount of time that DiPascali could look back to construct the profitable phony trades became shorter and shorter. I suspect that even if the market crash of 2008 had not blown up the Ponzi scheme, it would have become harder and harder to keep the ruse going with the aging technology that Madoff and DiPascali had available to them.
Posted at 2:11 pm IST on Thu, 13 Aug 2009 permanent link
Categories: fraud, technology
High frequency trading and rebates
High frequency trading is very much in the news these days with controversies about flash trades, rebates and so on. In this context, this paper by Foucault, Kadan, and Kandel is very interesting (hat tip Aleablog). It develops a model which explains why it may be optimal for exchanges to pay market makers for trading (in the form of rebates) while charging market takers for trading.
The paper discusses the determinants of what they call the make-take spread – the difference between the (possibly negative) fees charged to market makers and the (positive) fees charged to other traders. I found it more convenient to think in terms of the take-make spread (or the negative of the make-take spread) which can be interpreted as the subsidy to market makers.
The paper shows that a reduction in the tick size increases the optimal subsidy to market makers. They argue therefore that decimalization might have been an important factor in the emergence of rebates to market makers.
The subsidy for market makers is greater when there is a small number of market-makers relative to the number of market-takers. Quote driven markets tend to be dominated by a small number of market-makers and the rebates offered by these exchanges is in line with the predictions of the paper. The fact that order driven markets do not subsidize limit orders relative to market orders is also consistent with their model because these markets are characterized by large number of participants using limit orders.
While these are useful contribution, the paper still left me uneasy at the end. Why are quote driven markets unable to attract a large number of market makers when order driven markets have no difficulty attracting millions of limit order users? Is there something fundamentally wrong with quote driven markets that make them inherently anti-competitive leading to a cosy oligopoly of market makers?
Posted at 7:09 pm IST on Sun, 9 Aug 2009 permanent link
Categories: exchanges
Importance of better risk models
I have been writing for some time now about better risk models (my SSRN paper is here and my blog post on that paper is here). Phorgy Phynance has a fascinating graph about the difference between the normal distribution and a fat tailed (stable) distribution in computing the 1% daily VaR for the S & P 500 going back 80 years (hat tip Felix Salmon).
His second graph shows that using stable distributions would not by itself have provided any better warning during the boom years of 2005-2007. But the early warning that it provides from early 2007 onward is truly impressive. During 2007-2009, the stable distribution VaR gives about 6-9 months advance warning about where the normal distribution VaR will be. In the world of financial markets, that is more than enough warning even if you were holding a bunch of illiquid stocks.
This also means (via the Merton model) that one would have had several months advance warning of corporate credit market stresses. That good models are better than bad models might look like an obvious statement, but too many people that I talk to seem to have convinced themselves (or let Taleb convince them) that all models are useless in times of crises.
But the performance of even the stable distribution during 2005-2007 highlights the need for using data going back several business cycles. This is also a point that I emphasize in my paper.
Posted at 12:13 pm IST on Fri, 7 Aug 2009 permanent link
Categories: post crisis finance, risk management
Open source research in finance
Eighteen months ago, Bill Ackman of the Pershing Square hedge fund released his “Open Source Model” providing detailed data on 30,499 tranches of 534 CDOs to which the big US bond insurers (MBIA and Ambac) had exposure. On the basis of this model, he claimed that MBIA and Ambac were insolvent. At the time, many regarded it as a publicity stunt; after all Ackman was heavily short these insurers and was merely talking his book.
While many read Ackman’s letter, few bothered to download the actual data. This was partly because the data was really huge (110 megabytes) and the letter warned that each recalculation of the model took about half an hour on a typical workstation. Moreover, the yousendit link where the data was uploaded expired within a few days. In any case, after the near-collapse of the bond insurers, people lost interest in the model.
However, last month Benmelech and Dlugosz published a paper on what they called “The Credit Rating Crisis” which relies partly on this data to document the failures of the rating agencies. Among other things, Benmelech and Dlugosz show that CDOs rated by only one rating agency were more likely to be downgraded than those rated by two or more agencies. They also confirm what was well known anecdotally about one particular rating agency being worse than the others.
This suggests that open source research can work in finance. One way to get transparency about the balance sheet of financial institutions might be for the regulators to create large detailed databases which anybody can analyse. I think several gigabytes of data would do the job, but even if the data grows to a terabyte or more, it would be well worth the effort.
Updated: Changed “collapse of the bond insurers” to “near-collapse of the bond insurers”
Posted at 12:09 pm IST on Wed, 29 Jul 2009 permanent link
Categories: market efficiency, short selling
More on Debt Management Office and the Reserve Bank of India
Sankt Ingen responds to my previous piece on this subject and asks what is it that the Debt Management Office can do that the RBI cannot do. Sankt Ingen thinks that I am arguing for fancy derivatives and similar stuff conjured up by bright young MBAs. No, what I would like to see is very low brow stuff.
In an institution like the RBI that does something as high brow as monetary policy and financial stability, the low brow job of peddling government bonds will never be treated with respect and seriousness. While the DMO whose sole job is to peddle those bonds will I hope do that with the same professionalism that an FMCG company brings to peddling toothpaste.
Yes, I mean that in all seriousness. The job of distributing government bonds to every nook and corner of the country is as much a matter of logistics, distribution and marketing as the selling of detergents and toothpastes. In India (and in many other countries), the system for distributing toothpastes is far superior to the system of distributing government bonds (and many other financial products).
Government bonds are a critical element of the asset allocation strategies of individuals, companies and institutions. It is a scandal that their effective distribution is restricted to a handful of elite institutions.
This lack of diversity of participants is a key factor in the underdevelopment of the government securities market in India. In equities, when domestic retail investors are selling, maybe domestic institutions are buying, and when both of them are selling, maybe foreign institutions are buying. One wishes that foreign retail could also participate and bring even greater variety to the market, but we do have reasonable diversity of players. We did not have this diversity in the late 1980s or early 1990s in Indian equities and the markets then lacked the resilience that they have now. At the slightest shock, the exchanges simply shut down the market to deal with the imbalance.
When I look at government securities market today, it is just banks (and LIC at the long end). All banks face the same liquidity shocks and markets can therefore easily become highly one sided. At a deeper level, banks are the wrong kind of buyers for long term government bonds because of the asset liability mismatch. The real reason why governments borrow from banks is the same as the reason why robbers steal from banks – that is where the money is easily available.
The government securities market today is not a market filled with investors, hedgers and speculators with diverse liquidity needs and different investment horizons. We have a crazy scheme of small savings that completely fragments the market by segregating retail investors in separate instruments altogether. Even the retail trading of government securities themselves is segregated from the inter bank market.
The biggest problem is that the RBI does not see investors in government securities as its customers at all – the banks are its wards and retail investors are just a nuisance to be segregated in a tiny and separate corner of the market. I wrote a paper on this five years ago.
I believe that with the right market design, India can and should aspire for a government securities market that is deeper and more liquid than that of the typical emerging market. I think in terms of the size of the economy, the outstanding stock of rupee government debt, the existence of a critical mass of financial intermediaries of reasonable sophistication and the abundance of finance talent in the country. Yet, the vibrancy that one sees in the equity market or the commodity derivatives market is lacking in the government bond market.
I hope that we will get a DMO with a low brow mandate of making government securities as easy to buy as toothpastes and detergents. I hope that such a low brow DMO will over a period of several years give us a deep and vibrant government securities market. This may be a misplaced hope, but hope is the last thing that I would like to lose. Anybody who hoped in the 1980s to see a well functioning equity market would have been dismissed as a day dreamer, but over two decades, this has indeed come about. Maybe we can repeat that miracle once again in the market for government securities.
Posted at 8:53 pm IST on Sun, 26 Jul 2009 permanent link
Categories: bond markets, regulation, sovereign risk
Debt Management Office and the Reserve Bank of India
I wrote a column in the Financial Express today about the reported views of the Reserve Bank of India on the establishment of a Debt Management Office in India.
I deliberately avoided mentioning monetary policy anywhere in the whole column, but focused on the implications for the government securities market and for borrowing costs.
The reported suggestion by RBI to postpone the establishment of a debt management office (DMO) is not a good idea. An independent DMO would help create a vibrant and dynamic government debt market, and would reduce the government’s borrowing cost in the long run.
It is worth remembering that the development of a vibrant government debt market is one of the few financial innovations that have changed the course of world history. Beginning with sixteenth century Holland, whose war for independence from the Spanish Empire was immensely aided by its superior debt market, it has been true that governments that have been able to borrow from willing lenders have prevailed over those that have had to rely on forced loans.
India is today at a stage in its economic and financial development where it needs to shift from relying on captive buyers of government securities (the modern day equivalent of forced loans) to creating a deep market of willing buyers for its debt. I see the DMO as an essential and valuable step in this direction.
When a private sector company issues securities, it goes to great lengths to assess investor appetite for different kinds of securities and tries to tailor its securities accordingly. It works with its investment bankers to improve the liquidity of its securities because it knows that higher liquidity ultimately reduces the cost of its borrowing.
Until the late twentieth century, governments around the world were insufficiently sensitive to these factors and often behaved in a distinctly investor unfriendly way. All that has changed with the creation of professionally managed debt management offices in country after country both in the developed world and in emerging markets.
These DMOs look at debt issuance exactly the way a corporate treasurer looks at corporate debt issuance. They have a mandate to borrow at the lowest possible cost, and they know that they can do this only by making their securities attractive to investors. DMOs around the world have worked on making the systems for issuing, trading and settling government securities much more investor friendly.
Partly as a result of this, government debt markets globally have evolved in depth, liquidity and sophistication. For too long, India has relied on the easy route of placing government securities with captive banks and insurance companies. The unfortunate side effect of doing this is that the development of government securities markets in India has been stunted.
Thanks to our fiscal profligacy, India has a large outstanding stock of government securities as a percentage of GDP. This large stock of debt provides a foundation for a very liquid and deep market. Unfortunately, this potential has not been realised.
Other than a few on “the run securities”, most government securities are hardly traded. Even the market for liquid “the run securities” securities lacks diversity of players. Government securities is largely an inter bank market. As a result, when there is a liquidity shock to the banking system, the government securities market becomes a one sided market. It lacks resilience – the ability of the market to quickly return to normalcy after a large shock.
A professionally managed DMO should change all this. In the long run, the establishment of a DMO with a clear mandate and accountability would help reduce borrowing costs for the government in many ways. Unlike the RBI or the Ministry of Finance, the DMO has only one function and a very well defined objective. This makes it easy to measure the performance of the DMO.
When one reads the audit reports evaluating the DMOs of some leading countries in the world, one is impressed by the clarity of discussion on factors like the maturity composition of debt that impact the borrowing cost of the government. In India by contrast, there is today no real accountability for the interest cost of the government, which is currently the single biggest item of government expenditure.
Apart from lower borrowing costs for the government, there are many other benefits from a liquid and well developed market for government bonds. The yield curve for “risk free” government securities is the benchmark for all other interest rates in the economy.
The lack of a reliable and robust yield curve in the Indian government securities market impedes the valuation and trading of other debt securities as well. In other words, a sophisticated government securities market is the first step to the creation of a vibrant corporate debt market.
I believe therefore that India should not waste any time in setting up a professionally managed DMO. What about the argument that this is the wrong time to do so because of the large borrowing programme this year? The savings pool in India is deep enough for the government to borrow enough to cover its fiscal deficit in the free market. No, we do not need “forced loans” – at least not yet.
Posted at 11:08 am IST on Thu, 23 Jul 2009 permanent link
Categories: bond markets, regulation, sovereign risk
Simplified Finance: Part III
In my last two posts on this subject, I talked about how a simplified financial sector would look like. Part I presented an ultra simplified financial sector with a payment system, a stock exchange, “narrow” insurance companies and practically nothing else. I argued that this system with no banks, no debt and no central banks would do a reasonably good job of supporting economic growth provided high levels of corporate governance could be enforced. Since that was unlikely to happen, Part II introduced long term corporate debt but still avoided banks. The difficulty here was that debt would not be available to smaller enterprises.
What happens when we introduce banks or bank like entities? To understand this we must recognize that corporate debt is already a derivative contract – because of limited liability, debt is economically the same as a put option on the assets of the company. If the value of the assets is less than the amount of debt, the company default and the assets belong to the creditors. This is economically equivalent to the shareholders selling the assets to the creditors at a price equal to the amount of debt. This is nothing but a put option. So the model of Part II had derivatives already though they were not described as such.
In part II, the toxicity of these derivatives was reduced by two means – first by allowing only long term debt and second by requiring this debt to be bought directly by individuals and not by financial intermediaries. The effect of this restriction would be to reduce the quantum of the debt and thereby reduce the amount of derivatives floating around in the economy. The low leverage also avoids the need for corporate hedging.
Once we introduce banks, we would also have to bring in short term debt since the assets and liabilities of the banks would be short term. The presence of banks as well as short term debt would encourage companies to take on higher levels of leverage to benefit from the interest tax shield. This makes corporate risk management essential.
More troubling is the risk management of the banks themselves. A bank is nothing but a CDO as I argued more than three years ago (see also this entry) – it is a portfolio of debt securities. The probability distribution of a credit portfolio is extremely skewed and fat tailed even if the values of the real assets are normally distributed. (Vasicek derived this so called normal inverse distribution way back in 1997). If the real assets themselves have fat tailed distributions and display non linear dependence patterns, the distribution of the credit portfolio is even more toxic. To manage the toxicity of this distribution, the bank has to use various risk management tools.
An economy with free floating exchange rates and interest rates must provide its banks (and leverage companies) with interest rate and currency derivatives. This presents us with a trilemma – (1) the economy can operate with fixed exchange rates and administered (repressed) interest rates or (2) it can run without banks and leveraged companies or (3) it can create derivative markets. In terms of financial innovation we cannot roll the clock back to the 1970s without also restoring the world economic order of the early 1970s
In all this, I have not talked about credit to individuals at all because it is possible to visualize a fairly advanced economy in which there is no consumer credit at all. It is possible to argue that the economic benefits of retail credit is quite small. Most of retail credit is for housing and as I argued in Part I, there is little economic reason for people to own the houses that they live. From the days when the suffrage was limited to those owning immovable property, home ownership has been a political question rather than an economic one. Most of the other consumer credit (credit cards and credit for consumer durables) is taken by those who are less than fully rational.
While economists talk about consumption smoothing, very little of consumer credit actually performs this function. The only important consumer credit in my opinion is the educational loan which allows investment in human capital. This is potentially as important as credit to businesses (which allows investment in physical capital), but as I argued in Part I, there are other equity like solutions to this problem as well.
A financial system without a mortgage market at all would not have encountered the crisis of 2007 and 2008 which have been rooted in the mortgage markets. But it would not have been immune to crises. Financial history teaches us that exposure to commercial real estate and to over-leveraged companies can create banking crises without any help from mortgages or from any other financial innovation.
In short, creation of banks and other pools of credit is the most toxic financial innovation ever but there might be good reasons for living with the consequences of this toxicity.
Posted at 9:34 pm IST on Tue, 21 Jul 2009 permanent link
Categories: post crisis finance
Loose fiscal plus tight monetary policy
I have a column in the Financial Express today on the dangers of combining loose fiscal policy with tight monetary policy.
The movement of equity and bond markets after the announcement of the budget is threatening to look like a re-run of early 2008 when falling stock markets and rising interest rates delivered a double whammy to the economy. Monetary policy needs to respond to this threat and avoid a similar double whammy now.
To recall what happened in early 2008, the stock market dropped by nearly 40% from mid-January to mid-July, while the 10-year government bond yield rose by over 180 basis points. The corporate sector found that both equity and debt were either unavailable or too expensive. With a lag, this funding squeeze had a highly negative impact on investment and on the broader economy.
The rise in interest rates at that time was due to the tight money policy followed by the RBI in response to double digit inflation caused by rising prices of food and oil. What nobody knew then, but is evident now is that the inflation of early 2008 was a transient phenomenon that was being killed by the global economic downturn. In retrospect, the tightening of interest rates was unnecessary.
The situation now has some similarities. The failure of the monsoon so far is causing fears of food price inflation. These fears would weigh on RBI and could induce it to keep monetary policy too tight. At the same time, the spending and borrowing programmes announced in the budget has caused long-term interest rates to rise. Interest rates would rise even further if RBI does not accommodate the borrowing through monetary easing.
Loose fiscal policy combined with a monetary policy fixated on inflation can cause interest rates to explode. In the US, in the early 1980s this was what happened when President Reagan embarked on a spending spree while the Federal Reserve under Paul Volcker declared war on inflation. The yield on long term US government bonds crossed 15% and shorter maturity yields rose even higher. This combined with the rising dollar (itself a result of the high interest rates) brought about a nasty recession in the US.
A recession induced by high interest rates is the last thing that India needs today when the economy is being kept afloat by a large fiscal stimulus. If we take away the support provided to the core sectors from government spending on infrastructure and the support provided to consumer durables by the sixth pay commission, the economy is in pretty bad shape. In this context, the fiscal stimulus is unavoidable and the only question is whether the central bank will accommodate the fiscal deficit through its monetary policy.
A lot of the discussion on the fiscal deficit in recent days has focused on the ‘crowding out’ of private borrowing by government borrowing. In today’s environment I worry more about private borrowing being crowded out by high interest rates, and fortunately monetary policy is a tool that can prevent this.
Many countries are running large deficits. The fiscal deficits of the US and the UK are much higher than ours as a percentage of GDP. The big difference is that in those countries, extremely loose monetary policy has worked in tandem with the fiscal policy. At extremely low interest rates, higher levels of government debt are sustainable simply because the cost of servicing the debt is low.
In India on the other hand, we have turned to fiscal policy long before exhausting the limits of monetary policy. This means that the government is undertaking huge borrowing at relatively high interest rates. The resulting high interest bill will only make the fiscal position worse in coming years.
In the event of a failed monsoon, tight monetary policy can control food price inflation by ensuring people run out of money before they run out of food. It is, however, much less painful for the broader economy to take advantage of our comfortable foreign exchange reserves and tackle food price inflation through aggressive imports.
Turning to the stock market, a modest decline in stock prices is not worrying. There is little point in propping up asset price bubbles when the economic fundamentals are as weak as they are today. What I find more worrying is the possible closing of the primary equity market that had begun to open up for Indian companies in May and June in the form of private placements.
There are signs that this window is closing again due to rising global risk aversion as well as changing risk perceptions about India. If this were to happen, then the corporate sector would be starved of risk capital as it tries to restructure and deleverage while grappling with the challenging economic environment. It is important to keep the primary market open for sound companies that are willing to raise equity at realistic valuations.
Posted at 10:55 am IST on Fri, 17 Jul 2009 permanent link
Categories: monetary policy
Lehman Risk, Segregation, Net Margins and Cash Margins
Lehman’s bankruptcy was a nightmare for those who had deposited margins with Lehman (particularly Lehman Brothers International Europe in London) for their derivative trades. Many of them ended up as unsecured creditors of Lehman and will have to wait for years to get back a few cents in the dollar. Margins deposited with Lehman US were protected by segregation rules which cannot be overridden by contract, but apparently many hedge funds chose to use LBIE in London to get higher leverage and signed away many of their rights.
Lehman risk is a significant risk for derivative exchanges because even when the risk containment processes of the exchanges work perfectly, the ultimate customer ends up with little or no protection at all. This is an important issue, but even after fruitful discussions with some UK lawyers on this matter, my understanding of the legal issues has been rather poor.
Now however we have access to a 158 page report submitted by derivative dealers to the New York Fed that is based on work by 13 lawyers from six countries on all the legal complexities involved in providing protection to ultimate customers. The report focuses on Central Counter Parties (CCPs) clearing CDS contracts but the principles are of broader application.
The key takeaways from the report are:
- In the event of a CM [Clearing Member] default, the two essential elements of the customer protection analysis are (i) the manner in which margin is provided and held, and particularly, the extent to which margin is segregated from the CM’s assets and recoverable by the customers (the “Segregation Analysis”) and (ii) the effectiveness of the CCP’s procedures for the transfer or novation of customer positions and related margin (the “Portability Analysis”).
- Collection by CCPs of the Gross Amount (rather than just the Net Amount) may enhance both the Segregation Analysis and the Portability Analysis.
- It is better for customers to grant a security interest in the securities provided as margin than to transfer the securities outright to the CM. By doing this they ensure that the margin would remain property of the customers. Proprietary claimants may have the ability (subject to tracing or other requirements) to recover their property ahead of unsecured creditors, on the ground that the property they deposited with the insolvent entity did not form part of the insolvency estate, but was merely held in a safekeeping or custodial capacity.
- For certain entity types of CMs, the posting of securities is preferable to cash from a customer protection standpoint.
- Holding margin away from an insolvent CM may be helpful to customers for several reasons.
- Where margin is held at the CCP or a third-party custodian, it is generally the case that, the more direct the contractual relationship between customers and the CCP or third-party custodian, the stronger the corresponding Segregation Analysis becomes. For instance, the notion that ownership of customer margin does not pass to the CM would be buttressed to the extent the CM were acting as agent vis-á-vis the CCP on behalf of customers (rather than as principal).
- Portability of positions and related margin is highly desirable, as it reduces the need for position close-outs and resulting transaction costs. Any transfer or novation of positions and related margin requires a willing transferee CM, but it is important to be able to effect the transfer legally without the consent of the insolvent transferor CM.
Finally, the report states upfront that “This Report does not address the risk of fraud, and assumes that the relevant CM has complied with its segregation and other obligations in respect of customer margin.”
Indian derivative exchanges use gross margins and enforce some degree of segregation of client assets, but I think that a lot can and needs to be done to improve customer protection against Lehman risk. I particularly like the idea of replacing cash margins with security interest in low risk securities.
Posted at 2:33 pm IST on Wed, 15 Jul 2009 permanent link
Categories: bankruptcy, crisis, risk management
Simplified Finance: Part II
In my earlier post (see Part I) on this subject, I talked about an ultra-simplified financial system that “has a payment system, a spot foreign exchange market, “pure” life insurance companies, an equity market and practically nothing else ... no banks, no central banks, no debt markets and no derivative markets.”
I did emphasize that my speculation was completely ahistorical. I did not perhaps make it clear that I also assumed fairly well developed legal systems and governance structures without which equity markets are a complete non starter. In early stages of economic and financial development, it is difficult to create equity markets that work. I have no quarrels with the claim (for example at the Lin roundtable) that stock exchanges are pre-mature at that stage of development.
Coming back to the minimalist design, the next thing that one would want to add would be a debt market. First a government bond market and second a corporate bond market.
I mentioned in my first post that the government bond market is as above all a concession to the practical reality of governmental profligacy. Many people that I talk to think of government bond markets as mechanisms that increase the asset allocation opportunities for investors and allow them to choose less risky portfolios if they like. I think that a lot of this is money illusion. Government bonds are in fact very risky because of the ever present threat of inflation and hyper inflation. The tail risk of bonds is greater than the tail risk of equities.
The introduction of government bonds does not by itself require the introduction of any other markets including interest rate derivatives. These derivatives are needed when you have leveraged financial institutions and in the minimalist design so far there are no such institutions.
Adding a corporate bond market is more complicated because it creates leveraged entities. It is difficult for leveraged entities to exist without derivative markets particularly commodity and currency derivatives. We could avoid this by having only long term corporate bond markets. The absence of financial institutions and short term debt markets would automatically limit the leverage of firms and then it may be possible to get by without derivative markets.
More troublesome is that adding corporate bonds without adding banks and other financial intermediaries would create a strong bias against small firms. It is easier for small firms to access equity markets than it is for them to access corporate bond markets. To level the playing field, it may be necessary to add bank like intermediaries that would lend to smaller enterprises. But once we add leveraged financial intermediaries, it is impossible to have a simplified financial system anymore as I shall discuss in the next part of this series.
Posted at 6:22 pm IST on Tue, 14 Jul 2009 permanent link
Categories: post crisis finance
UK proposal for consumer guidance in financial services
The UK has put out its proposals for financial regulation reforms, but many people expect the current government to lose the elections next year and believe that the new government will push regulations in a totally different direction.
The Governor of the Bank of England has been on a confrontational path with the government and some believe that he is already more concerned about his relationships with the next government than with the current one. He has been arguing for more powers to go with the Bank’s mandate for financial stability complaining that
So it is not entirely clear how the Bank will be able to discharge its new statutory responsibility if we can do no more than issue sermons or organise burials.
I thought therefore that the following passage in the government’s proposal was telling the governor to get on with his sermons and stop complaining.:
One of the existing key responsibilities of the Bank of England, which will continue to be a significant feature of its new role, is to analyse and warn of emerging risks to financial stability in the UK, principally by means of its Financial Stability Report, published twice-yearly. It is important that the Bank retains this independent voice, to warn publicly of risks facing banks and financial markets in the UK.”
What I found more interesting than all this petty politics is the set of suggestions on consumer education and protection:
- “While financial services and food are clearly very different classes of consumer products, there may be important lessons to be learned from food labelling for improving the transparency of financial products ... However, there is a risk that a voluntary scheme would not work – for products which would be rated as complex or expensive, there would be a strong incentive on providers not to provide a rating at all. The Government is therefore inclined to work towards a compulsory scheme.”
- “ The Government therefore invites views on the case for legislating to ... introduce some form of collective action through which consumers can enforce their rights to redress.” This looked exciting but the actual proposal is quite dull and very different from the US class action mechanism.
- The big ticket item in terms of cost is the money guidance service for “making impartial generic financial advice on a wide range of personal finance issues accessible to all.” The government estimates that over the next 52 years, the cost (present value) of providing this service will be £1.3 - 2.7 billion. It believes however that the benefits will be ten times as large. Personally, I think that the money made clear web site run by the FSA is a good service, but the proposals go far beyond a good web site: “ This service offers impartial help that consumers can trust, safe in the knowledge that Moneymadeclear advisors will never try to sell them anything. People can access the service in a way that suits them – through the website or by speaking to trained advisors on the phone or face to face, who can give information and support that is tailored to individuals’ needs and circumstances.” For this kind of service, the cost estimate appears ridiculously low.
One distressing element in the cost benefit analysis is the claim that arming the FSA with greater powers to curb short selling would bring benefits of up to £9 billion over the next ten years in present value terms. I think the upper bound here should be zero and the lower bound a large negative number.
Posted at 5:01 pm IST on Thu, 9 Jul 2009 permanent link
Categories: regulation
Governance of banks
I read two interesting pieces today about bank governance. First was John Kay’s column (“Our banks are beyond the control of mere mortals”) in the Financial Times in which he says that the top management of UK banks were people of exceptional ability:
... most of the people who sat on the boards of failed banks were individuals whose services other companies would have been delighted to attract ... Our banks were not run by idiots. They were run by able men who were out of their depth. If their aspirations were beyond their capacity it is because they were probably beyond anyone’s capacity.
The statement of Kay that I agreed with most was:
If you employ an alchemist who fails to turn base metal into gold, the alchemist is certainly a fool and a fraud but the greater fool is the patron.
Needless to say my understanding is that the true patron in this case was not the shareholder but the government.
Today, I also read a paper (“Subprime Crisis and Board (In-)Competence: Private vs. Public Banks in Germany ”) by Hau and Thum (hat tip FinanceProfessor). This paper tries to understand why during the current crisis, the losses at the large public sector banks in Germany were far worse than those of private sector banks. While the big three private banks (Deutsche, Commerzbank and Dresdner) have suffered quite badly, the losses (as a percentage of assets) of the large public sector banks (like Bayern LB, West LB and KfW) are truly dismal.
Hau and Thum do a painstaking job of going through the biographical data of each and every board member of each of the 29 banks in Germany with assets above € 40 billion and rating each of these 593 board members on 14 different indicators measuring three dimensions of competence – educational qualification, management experience and finance related experience. They first show that the board members of public sector banks fared badly on all these three dimensions. Next, their regression results show that performance of banks is strongly related to the finance experience of the board members. They conclude that the poor performance of the German public sector banks is due to their poor governance.
My only problem with this conclusion is that their first regression equation using just a dummy variable for state ownership has much higher explanatory power (R-square) than their later regressions using board competence measures. Unfortunately, they do not report any regressions containing both board competence and the ownership dummy. Therefore, we do not know whether board competence has any incremental explanatory power over and above that as a proxy for state ownership. The only light that they throw on this is a regression where they show that state ownership has only a small impact on executive compensation. They use this result to argue that state ownership is not the causal variable. But state ownership can affect performance in other ways – for example, by encouraging greater risk taking because of the implicit government support.
Posted at 5:29 pm IST on Wed, 8 Jul 2009 permanent link
Categories: banks, corporate governance
How far can finance be simplified? Part I
In the wake of the global financial crisis, there has been a lot of discussion about how finance became too complex and how it needs to be simplified. This led me to speculate on how far finance can indeed be simplified. This is a question that I would like to address in several parts as I use this blog to clarify my own thoughts. Caveat: my entire speculation is completely ahistorical – it is a clean slate design which ignores the existing institutional structure completely.
In this post, I describe an ultra-minimalist financial sector that has a payment system, a spot foreign exchange market, “pure” life insurance companies, an equity market and practically nothing else. In this ultra-minimalist model, there are no banks, no central banks, no debt markets and no derivative markets. The payment system would essentially be a retail version of a real time gross settlement system which in principle needs neither banks nor a central bank. It is essentially a piece of technological infrastructure and nothing more – a central depository for cash. Money could be fiat money or commodity money or anything else.
By pure life insurance, I mean first of all that the companies offer term insurance which unlike endowment insurance is not bundled with investment products. Secondly, level premiums would be replaced by rising (actuarially fair) premiums so that there is very little investment component in the insurance product. Finally, insurance would ideally be redesigned so that the life insurers take micro mortality risk (the cross sectional variation in mortality rates at a point in time) but not macro mortality risk (changes in life expectancy over time).
If we can make these changes, insurance companies become easy to run and easy to regulate. They simply become applications of the law of large numbers and involve vastly reduced risk taking over long horizons. Incidentally, I believe that macro-mortality risk is practically unhedgeable and uninsurable. Insurers can credibly claim to provide protection against this risk only by having recourse to a bail out by the state. Perhaps, it is ultimately beyond even the resources of the state to credibly insure against macro-mortality risk.
In the absence of debt, there are hardly any prudential regulations except possibly for the insurance companies. Financial regulation consists primarily of conduct of business regulators and consumer protection regulators.
How can a financial system operate without debt? Well, the Modigliani-Miller theorem says that lack of debt is not a serious problem for the corporate sector except that the tax advantage of debt is lost. One could assume that the government simply enacts a lower rate of corporate tax so that the elimination of tax deductible interest is revenue neutral to the state.
If there is no leverage of any kind, the need for derivative markets is vastly reduced. Corporate use of derivatives is principally to economize on equity capital. Since equity is the ultimate hedge of every conceivable (and inconceivable) kind of risk, if you have enough of equity, you can choose not to hedge anything at all and still you will not go broke. One could use a version of the Modigliani-Miller argument to show that corporate hedging is irrelevant unless it introduces deadweight losses like bankruptcy costs.
This is not the whole story because apart from corporate hedging we must also worry about optimal allocation of risk among individuals. I believe however that in the spirit of Arrow’s 1964 paper (“The role of securities in the optimal allocation of risk-bearing”), the equity markets span sufficient states of the world to permit a reasonable allocation of risk bearing among individuals. The practical consequences of not having a derivative market may not be much in a world without debt.
General insurance is essentially a substitute for derivatives and it too can be eliminated in this minimalist design. If corporations do not have debt and if individuals hold diversified portfolios of non human assets, then they can self-insure all forms of property risk. Insurance is required only for non diversifiable human capital which is why pure life insurance cannot be eliminated.
The Capital Asset Pricing Model would not hold because there is no risk free asset. I do not see this as a problem because we would still have the zero beta model of Black (1972) which is not significantly more difficult to use. (As an aside, if we focus on real returns instead of nominal returns, there is no risk free asset anyway. Inflation indexed bonds issued by the government are subject to significant default risk since the printing press is not sufficient to pay off these bonds.)
Passively managed mutual funds (exchange traded index funds for example) are nice to have because they allow individuals to achieve diversified portfolios very easily. But if the stock exchange allows shares to be traded in small lots, even small investors may be able to hold 25-40 stocks directly and obtain most of the gains of diversification. Exchanges could also allow basket trades in indices to achieve the same thing.
In the ultra-minimalist design there is no trade finance other than whatever trade credit one corporation chooses to extend to another out of its own resources. There are no letters of credit (which are actually highly complex credit derivatives!).
The absence of a debt market means that there are no mortgages. One possibility is that most houses are owned by corporations that rent it out to individuals. We do not need to own the homes that we live in any more than we need to own the offices that we work in. (See my post on this a year go.)Individuals would be able to obtain exposure to real estate by buying shares of these companies. (Another – less preferred – option is that people would live in rented houses in early stages of the life cycle and buy houses only later in life.)
One difficulty with the minimalist design is the lack of educational loans. Education would have to be financed through equity claims to an even bigger extent than it is today. Even today, the successful university that attracts lots of endowments essentially has an equity claim (an out of the money call option?) on the human capital of each of its alumni and the returns on this equity claim are used to subsidize (finance) a lot of the education.
I see two big problems with this ultra-minimalist design. First is that Jensen-Meckling pointed out in 1976 that the disciplining power of debt is useful in reducing the agency problems between the managers and the shareholders. We would therefore need very robust corporate governance frameworks (including a healthy market for corporate control) in a world without any debt. This would be a problem more for mature businesses that generate a lot of free cash flow.
Second is that under the assumption that governments are and will always be profligate, we need a government bond market. Theoretically also government debt can achieve some intergenerational transfers that would otherwise be difficult to accomplish, but I think this is less important than the practical reality of governmental profligacy.
In subsequent blog posts, I hope to extend the ultra-minimalist financial sector to allow for a corporate and government debt market increasing complexity one step at a time.
On the whole however, even the ultra-minimalist financial sector would be able to support a vibrant and modern economy. Clearly, it is the equity market that does the heavy lifting in this minimalist design by taking charge of both resource allocation and risk allocation.
Posted at 6:14 pm IST on Tue, 7 Jul 2009 permanent link
Categories: post crisis finance