Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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Thu, 22 Jan 2009

Open the books

I wrote a piece in the Financial Express today on the enhancements to corporate disclosure that are required in the aftermath of the Satyam fraud.

Ramalinga Raju was in jail two days after he confessed to a $1.5 billion fraud at Satyam and has remained there since then. By contrast, Bernie Madoff is still ensconced in his home more than a month after he confessed to a $50 billion fraud in the United States. Two days after the Raju confession, there was a new board of directors for Satyam taking charge of its assets and trying to preserve as much of shareholder value as possible. Meanwhile, Madoff has spent his time out on bail mailing a million dollars worth of jewellery as gifts to his friends and relatives, putting them beyond the reach of the investors whom he has defrauded.

On the whole then, the Indian government has done better than the low expectations that we have of our rulers, while the US has conformed to the images of crony capitalism that has characterised its bailout era.

But complacency would be a mistake on our part. Emerging markets are held to higher standards than developed markets, and it is essential to use Satyam as an opportunity to make a series of much-needed disclosure and governance reforms. The question to ask is not whether these reforms would have prevented Satyam; the relevant question is whether these reforms would help bolster investor confidence in the Indian corporate sector at a time when it has been badly shaken.

Much as the government might like to portray Satyam as an unfortunate exception, the fact is that most investors, both in India and abroad, think of it as symptomatic of the problems that could be lurking in many other leading Indian companies. Of course, companies will voluntarily increase their disclosure standards to signal that they have nothing to hide. But this by itself is not enough. Disclosure is most effective and useful to investors when it is carried out in a uniform way by many companies. This is where regulators have a role to play.

Increasing the quality of quarterly disclosures is very important. Satyam was, of course, subject to this requirement as a US listed company and it is conceivable that these disclosure requirements forced a confession in early January 2009 shortly before the results of the quarter ended December 2008 were to be unveiled. Absent the pressure of this disclosure requirement, it is not beyond the realm of possibility that the deception might have been kept up for another quarter till the year end in March 2009.

I have written in the past (FE, November 27, 2008) on the need to force companies to reveal the complete balance sheet and not just the income statement highlights on a quarterly basis. This needs to be pushed forward more rapidly. On the same lines, a more rapid move to international accounting standards is desirable. Certain key standards like AS 30 on financial instruments could be targeted for accelerated adoption and implementation.

Greater regulatory scrutiny of corporate disclosures is also essential. The Raghuram Rajan Committee on financial sector reforms (of which I was a member) has recommended that India should adopt a system of reviewing the accounting filings of companies on a selective or sample basis on the lines of what the SEC does in the US.

Equally important are measures to improve private sector scrutiny of corporate disclosures. In the US, the Edgar database of regulatory filings with its full text search capability and its XBRL based interactivity is a huge boon. It is difficult to see how private sector scrutiny of the kind carried out by footnoted.org could ever be done without Edgar. The dissemination of corporate disclosures by the exchanges and by Sebi on their websites does not come remotely close to what Edgar achieves in the US. We should make it a top priority to get our own Edgar style repository functional as quickly as possible.

I am also a proponent of combining regulatory review and private sector scrutiny in innovative ways. For example, a short seller who believes that there is something wrong with the accounts of a company should be able to demand a regulatory review by paying a fee to cover the regulator’s costs. Needless to say, the results of the review should be announced only publicly so that the short seller does not get any advance information. He would of course benefit from the price impact of the review findings on any pre-existing short positions.

I am invariably told that this scheme would be misused by people to embarrass their corporate rivals. My flippant response is that there is nothing wrong in harnessing corporate rivalry in such a constructive way to improve the credibility of corporate disclosures. More seriously, if a review leads to a clean chit, the public announcement of this would benefit the target company. This in itself would act as a disincentive against frivolous review requests by people endowed with deep pockets.

Posted at 07:03 on Thu, 22 Jan 2009     View/Post Comments (5)     permanent link


Wed, 21 Jan 2009

Basel is fighting the last war and that rather badly

The Basel Committee has put out a set of proposals for revising the Basel II capital requirements.

One of the things that Basel is now correcting is a discrepancy between the risk level of 99% that was laid down during the market risk amendment of 1996 to Basel I and the level of 99.9% that was laid down in Basel II in 2004 for the banking book. The proposed Guidelines for computing capital for incremental risk in the trading book require risk in the trading book to be measured at the 99.9% level and at a one year horizon. The Committee admits that:

Owing to the high confidence standard and long capital horizon of the IRC, robust direct validation of the IRC model through standard backtesting methods at the 99.9%/one-year soundness standard will not be possible. Accordingly, validation of an IRC model necessarily must rely more heavily on indirect methods including but not limited to stress tests, sensitivity analyses and scenario analyses, to assess its qualitative and quantitative reasonableness, particularly with regard to the model’s treatment of concentrations. Given the nature of the IRC soundness standard such tests must not be limited to the range of events experienced historically. The validation of an IRC model represents an ongoing process in which supervisors and firms jointly determine the exact set of validation procedures to be employed.

I think this is a futile attempt to preserve the 1990s era risk management technology (value at risk, linear correlations and normal distributions) embodied in Basel II. The only way to get to the 99.9% level in any plausible way is to use fat tailed distributions (say student with four degrees of freedom) explicitly and also to move to non linear dependence models (copulas); when one is doing all this, one might as well give up the theoretically discredited value at risk measure and move to a “coherent risk measure” like expected shortfall. Suggesting the use of stress tests as a way to arrive at the 99.9% standard is akin to changing the subject when you do not know what to say.

What I found even more troubling is the following statement in the other consultation document “Revisions to the Basel II market risk framework”

In addition, a bank must calculate a ‘stressed value-at-risk’ based on the 10- day, 99th percentile, one-tailed confidence interval value-at-risk measure of the current portfolio, with value-at-risk model inputs calibrated to historical data from a period of significant financial stress relevant to the firm’s portfolio. For most portfolios, the Committee would consider a 12-month period relating to significant losses in 2007/08 to be a period of such stress, although other relevant periods could be considered by banks, subject to supervisory approval. This stressed value-at-risk should be calculated at least weekly.

This document has been in the making for a longer period and perhaps reflects the Committee’s thinking at an earlier point of time – it still talks of 99% instead of 99.9%. That apart, what puzzled me is the belief that 2007-08 represented the ultimate in terms of financial stress. Since they say 2007/08 and not 2007/2008, it clearly refers to the financial year 2007-08 and excludes the severe stress in the second half of calendar year 2008.

More importantly, the idea that even calendar year 2008 is the ultimate in stress is debatable. There have been no sovereign defaults (ignoring Ecuador) while the big risk for 2009 and 2010 is certainly the possible default of a G7 sovereign and the related possibility of the break-up of the Eurozone. Risk managers who think that the worst is over in the current crisis are not worth their salaries today. I am shocked that the Basel Committee is encouraging this kind of shoddy thinking.

Posted at 08:21 on Wed, 21 Jan 2009     View/Post Comments (4)     permanent link


Sun, 18 Jan 2009

More on Siemens

I have not so far been posting links to my TV interviews though these days, videos and transcripts are often made available on the web sites of the TV channels. I am beginning to remedy that by posting links to the video and transcripts of an interview of January 15 on CNBC about the Siemens story that I blogged about two days earlier.

Some excerpts from the interview:

It doesn’t look fair at all – both the valuation and the entire manner in which it has been done. First of all, looking at the valuations, an IT firm being sold at six months of revenues looks quite absurd. We have the mainstream IT stocks trading at something like 2-3 times revenues, and this is half a year revenues, even by price earnings multiple, which looks very low about half of what mainstream companies sell at.

The other part of the problem is the process by which it is being conducted. The day Siemens announced that they were selling; they said nothing about the valuations, they said nothing about the financial performance of the subsidiary. Couple of days later, after all hell has broken loose, they come out with details about this and the information, which they disclose is even more troubling. It even gives an impression that the financial performance has actually been turned down – the revenues have fallen, the profit margin has collapsed and there is a situation in which somebody could give a low valuation to the stock.

The entire process looks really bad and when one looks at Satyam-Maytas, at least, on day one, they told us what the valuation was. Here on day one we were told nothing about the valuation, it is really troubling.

When you are talking about something which is really captive, the margin is entirely a function of transfer price. To believe that the kind of IT that Siemens does, they are really into relatively high value IT, and to believe that the profit margins are so low it strains credibility. Moreover, these are not third party prices; these are not arm’s length prices; these are internal transfer prices.

Posted at 16:15 on Sun, 18 Jan 2009     View/Post Comments (1)     permanent link


Tue, 13 Jan 2009

Siemens related party transaction

Two days after the Satyam fraud was announced, Siemens Limited, a 55% subsidiary of Siemens AG of Germany informed the stock exchanges that “the Board of Directors of the Company at its meeting held on January 09, 2009, has approved the divestment of its 100% stake comprising of 6,815,000 Equity Shares of Rs 10 each in its subsidiary Siemens Information Systems Ltd, Mumbai, to Siemens Corporate Finance Pvt. Ltd., a 100% subsidiary of Siemens AG, subject to receipt of all requisite consents, approvals.” In its press release, the company stated “This is pursuant to the change in structure of the global software business, where SISL businesses have also been aligned with the parent group. In the new model, SISL will serve as an internal software factory supporting the R&D and product development initiatives for business sectors globally. It will also focus on increasing its presence in the domestic market and continue to act as an offshore development centre for Siemens worldwide.”

The response of the stock market has been brutal: the stock fell almost 30% from Rs 298.00 to Rs 211.80 while the Nifty index fell by only 6% from 2920.40 to 2744.95. The press release does not mention anything about valuation or consideration, but clearly the market sees this as a valuable business being transferred to the dominant shareholder at a discount to its fair value. Investors are powerless here because unlike in the Satyam-Maytas case, here the parent company has a majority shareholding.

India should probably look at the UK model for dealing with such situations. Rule 6.1.4(3) of the UK listing rules, requires that a company that seeks listing of its equity shares in the UK should demonstrate that “it will be carrying on an independent business as its main activity.” In practice, rather than refusing to list an issuer that fails to satisfy this requirement, the UK regulator looks to see how a lack of independence will be managed. This means satisfying itself that an issuer that has a controlling shareholder is capable of carrying on its business independently of that shareholder.

For example, when the promoters of the Sterlite group in India listed their business in the UK as Vedanta Resources plc, the restrictions that they agreed to as a condition for listing included the following (Vedanta Resources plc, listing particulars, page 68-70):

Restrictions of this kind might have helped prevent the Siemens transaction provided they were coupled with a requirement that a related party transaction should be put to shareholder vote if say 10% of the shareholders so demand. The institutional investors with 25% shareholding would then have been able to demand a shareholder vote and then vote it down with Siemens AG unable to vote its shares.

Posted at 16:05 on Tue, 13 Jan 2009     View/Post Comments (2)     permanent link


Gold standard and Austrian economics

After I mentioned the gold standard in my last post on three centuries of UK interest rates, I received a number of comments relating to the gold standard and Austrian economics.

Mahesh asks about the advantages and disadvantages of going from a paper currency to the gold standard. I do not think of the gold standard as something to do with the physical commodity called gold; I think of it in terms of targeting the price level rather than the inflation rate.

Nowadays central banks target the inflation rate, not the price level. Suppose the initial price level was 100, the inflation target was 2% and actual inflation is 5%, then the central bank writes a suitably remorseful letter to the government explaining its failure to meet the target. In most cases, the government might accept and even endorse the explanation, though in the worst case, it may replace the head of the central bank. In either case, the inflation target for the next year would remain at 2%; the implied target for the price level at the end of the second year would be roughly 107 (105 plus 2% inflation).

Under the gold standard, essentially you are (implicitly) targeting the price level. In the above example, with desired annual inflation of 2%, the target price level at the end of two years is roughly 104. Since the price level at the end of the first year is already 105, implicitly the inflation target for the second year is -1%. High inflation in one year has to be compensated by deflation the next year. This is what we see during the gold standard era in the inflation graphs in my earlier post. During periods of war, there may be inflation for a few years, but this is acceptable if people believe that it will all be reversed in due course. You can even go off the gold standard temporarily if people believe you will come back to it.

Ideally in such a world, the detrended price level is a stationary process in econometric terms. In modern inflation targeting, the price level is a non stationary random walk (unit root process). For long term decisions, the reduction in volatility achieved by eradicating the unit root is huge.

The gold standard in practice also involved much lower inflation rates – most multi-decadal inflation rates are in the range of -½% to +½%. On a hedonic adjusted basis, this almost certainly implies persistent deflation, probably related to the inability of gold supply to keep pace with the growth of the global economy. I am not convinced that the trend rate of growth of the price level is hugely important so long as the detrended price level is a stationary process. If you worry about menu costs and money illusion, you may be less sanguine than I am.

In my view, the benefits of the gold standard had nothing to do with gold itself. I tend to regard gold as a (rational?) speculative bubble that has lasted five thousand years. The demonetization of silver in the late nineteenth century led to a collapse of the equally long lived (and equally rational?) silver price bubble. There is an ever present risk that the same could happen to gold one day. If the bimetallic ratio of 5-8 between gold and silver prices that prevailed for several millenia before the nineteenth century reflects the relative intrinsic worth of the two metals, gold could fall catastrophically. Of course, this might not happen in my lifetime nor in yours; that is why the bubble could be a rational speculative bubble.

Pravin asks whether inflation during the gold standard was due mainly to wars or government actions. Inflation could result not only from fiscal expansions but also from private sector credit expansions. Generically, I like to think of inflation in any one country under the gold standard as a deviation from purchasing power parity (PPP). Inflation would cause a departure from PPP, but since PPP asserts itself only over a period of a few years, this departure could persist for a short period, but in the medium to long term, the price level mean reverts to its old level.

Another complication is that even in a land with metallic money, one needs detailed historical evidence to determine whether the coins were accepted “by tale” or “by weight”. Until the nineteenth century, it was probably true that debased currency was accepted “by tale”, and therefore what appears to be silver (or gold) currency is actually fiat money.

As far as Austrian economics is concerned, I find Hayek, Schumpeter and Minsky to be most in accordance with my tastes. The gold standard is not to my mind among the more important ideas in Austrian economics. But then I am not an economist. I find that I am able to hold Keynesian, monetarist and Austrian ideas in my head almost simultaneously without getting a severe headache.

Posted at 07:53 on Tue, 13 Jan 2009     View/Post Comments (8)     permanent link


Mon, 12 Jan 2009

UK official interest rate at 315 year low

Last week, the UK reduced its interest rate to the lowest level ever in its 315 year history. I found this surprising since there is very little in terms of economic environment that the Bank of England has not seen in these three centuries. It is all the more puzzling when the interest rate graph is juxtaposed with a graph of inflation rates (see figures below).

BOE official rates

UK-inflation.png

It is interesting to see that negative inflation rates are quite common prior to the twentieth century. The average inflation rate was negative in the entire nineteenth century. But even in this period, while interest rates went down to 2% on several occasions, they never dropped to the 1.5% level reached last week.

What is also interesting is that for 103 years from 1719 to 1822, the Bank of England did not change its rate even once. England lost an empire in one continent while gaining an empire in another; it fought the Seven Years War and the Napoleonic wars; inflation rates ranged from +30% to -23%, but interest rates remained fixed at 5%!

Deflation was quite common in the eighteenth and nineteenth centuries, and apparently was not damaging to growth. Perhaps, there is something pernicious about fiat (paper) money that makes inflation and deflation so scary. Under the gold standard, the price level had a tendency to mean revert so that high inflation was followed quickly by deflation; therefore even 30% inflation did not create inflationary expectations, and even 20% deflation did not create deflationary expectations.

Posted at 07:47 on Mon, 12 Jan 2009     View/Post Comments (5)     permanent link


Thu, 08 Jan 2009

Satyam: old lies and new truth or new lie?

This is my fourth post on the Satyam fraud, and what I am concerned about in this post is the willingness of people to believe a liar’s confession blindly. To my cynical mind, the fact that a person admits to have been lying for several years is reason to suspect that what is put forward as the new truth might just be a new lie.

What makes me more suspicious is that the “confession” actually paints the most benign picture possible. What the Satyam Chairman is saying that he never siphoned any money from the company. While many people suspected that Satyam profits were diverted to group companies, the former chairman is saying that the profits were never there. He is also trying to paint the Maytas deal as a last ditch attempt to save Satyam instead of the other way around.

My question is why should we believe all this. How credible is the claim that an IT business with a blue chip client list was not profitable? How credible is the attempt to exonerate everybody else? Should we consider the possibility that the problems were in other group companies of the promoters and that Satyam lost everything while trying to bail them out?

The finance profession is supposed to train one to be skeptical and cynical about everything. The lack of sufficient skepticism and cynicism is itself a cause for concern as it suggests that markets are still too trusting.

Posted at 05:04 on Thu, 08 Jan 2009     View/Post Comments (13)     permanent link


Wed, 07 Jan 2009

Satyam and accounting regulation

In 2002 after the Enron debacle in the US, I wrote (sections 9.3.1 and 9.3.2 of this paper) that though the US system of review of accounting filings by the SEC did not work in the case of Enron and other frauds, it was still necessary for India to have a system of review of accounting filings. What I proposed (for the US as well as for India) was a system where short sellers could force regulators to review any specific filing by paying a fee. I even estimated the fee that should be charged.

In the same paper, I also argued that a credible body to oversee the audit firms in India is also needed.

The Raghuram Rajan Committee (of which I was a member) did recommend regulatory review and audit oversight in its report (see page 139-140). It also recommended the use of XBRL in all accounting filing to facilitate the system of regulatory reviews.

I think the world also needs to figure out ways of making auditing a more competitive industry. In my Enron paper, I argued that it should become easier to create new audit firms and for auditors to advertise directly to shareholders.

Nakedshorts points out that three of the big four audit firms (PricewaterhouseCoopers, Ernst & Young and KPMG) are potentially in the dock as auditors of the Madoff feeder funds in the US. (PricewaterhouseCoopers were also the auditors of Satyam). If the post Enron experience (the demise of Anderson) were to be repeated post Madoff with no regulatory forbearance, it is not inconceivable that a majority of the big four auditing firms would cease to exist in 2009. Stunning as that would be, it would not be more surprising than the disappearance of the majority of the Wall Street investment banks in 2008.

In this context, we need to fundamentally rethink the industry structure of the auditing industry. More competition is absolutely critical.

Posted at 10:01 on Wed, 07 Jan 2009     View/Post Comments (4)     permanent link


Saytam: why government needs to act now

In my last blog post, I briefly stated what the government needed to do:

What I did not do was to highlight the urgency of the first step:

I think this needs action today or at the very least within 24 hours.

Posted at 09:07 on Wed, 07 Jan 2009     View/Post Comments (3)     permanent link


Satyam requires government intervention

The fraud that has been disclosed in Satyam Computer Services Limited comes at a time when the Satyam board has lost all credibility. This requires extraordinary action. Only a new board can investigate the fraud and run the company until a general body meeting is held to elect a new board.

The company needs a new governance regime. One option is that the existing board meets for the sole purpose of co-opting a new set of directors and then the old board withdraws from the scene. The second option is for the government to step in. This is a fit case for section 398 and 401 of the Companies Act which give broad powers to the Company Law Board acting on an application by the government to make orders for “the regulation of the conduct of the company”s affairs in future ”.

I think this is also a fit case for an investigation under section 234(7) and 235 of the Companies Act.

Posted at 07:28 on Wed, 07 Jan 2009     View/Post Comments (2)     permanent link


Sun, 04 Jan 2009

44 years of inflation adjusted stock prices in India

real-stock-index-1965-2008.png

Above is a plot that I have put together of the real (inflation adjusted) stock price index in India from 1965 to 2008. The plot is on a log scale – each horizontal grid line represents a doubling of the real stock price.

I have divided the sample into three periods and it is obvious that all the action happens in the middle period from 1985 to 1994. On a point to point basis, practically the entire increase in real stock prices happens during this period.

The compound annual growth rates on point to point basis are: 0.57% (1965-1984), 18.95%(1985-1994) and 0.33% (1995-2008). Since point to point comparisons are misleading, I have also plotted exponential trend lines (straight lines on the log scale plot) for each of the three time periods. These trend lines also tell the same story of huge growth during 1985-1994 and tepid growth before and after. The compound annual growth rates from the trend lines are: 1.78% (1965-1984), 17.62%(1985-1994) and 6.39% (1995-2008).

This is not really surprising. Most of the movement towards a free market economy took place during the Rajiv Gandhi prime minister-ship in the mid/late 1980s and the Manmohan Singh finance minister-ship during the early 1990s. Since then, reforms have been at a glacial pace. India learned the wrong lessons from the Asian Crisis and seems to be learning the wrong ones again from the current crisis.

Notes on the data

Posted at 07:07 on Sun, 04 Jan 2009     View/Post Comments (3)     permanent link


Sat, 03 Jan 2009

India in a ZIRP world

I wrote a column in the Financial Express today about why Indian interest rates need to come down much more when the world interest rate is going down to zero.

While discussing the magnitude of interest rate cuts in India – the RBI cut repo rate and reverse repo rate by 100 basis points each and CRR by 50 basis points on Friday – we need to remember that the entire developed world appears to be converging to a zero interest rate policy (ZIRP). This is a completely unprecedented situation and points to interest rates much lower than what we are accustomed to seeing.

India is an open economy and even the capital account is quite open for all practical purposes. Indian interest rate policies are therefore strongly influenced by global interest rate. A comparison of the Indian repo rate and the US Fed Funds Target since 2000 shows that Indian tightening and easing follows US tightening and easing with a lag. Essentially, an open economy forces the RBI to follow what the “world central bank” does; and the only flexibility that it has is to delay its response by a few months.

Now, the US has pushed its interest rate down to virtually zero. Japan has also done the same, and the European Central Bank is also being dragged down that path much against its wishes by the sheer strength of global forces. In that situation, how low should Indian interest rates go?

plot of spread between the Indian repo rate and the US Fed Funds target

The plot above shows the spread between the Indian repo rate and the US Fed Funds target with key tightening and easing episodes demarcated on it. Because of the lag between US and Indian central banks, this spread fluctuates a lot.

For example, in July 2006, the US had completed its tightening cycle and India was still half way through its tightening cycle. The spread between the two rates fell to an abnormally low level of 1½% with the Fed Funds target at 5¼% and the Indian repo rate at 6¾%. Over the next nine months, India tightened by another 1% to 7¾% while the US rate remained unchanged at 5¼%. In April 2007, with both central banks having completed their tightening cycles, the spread was 2½% which can be regarded as a “natural” spread between the rates in the two countries reflecting differences in the respective inflation rates and other structural characteristics of the two economies.

In September 2007, the US began easing interest rates in response to the financial crisis. At that time, the crisis in the US appeared very remote to us, and India left rates unchanged for several months. Then earlier this year, the RBI raised interest rates by 1¼% to 9% in response to the inflation scare which gripped the country at that time. The spread between US and Indian rates rose to an extraordinary level of 7½% in October 2008.

Since then, India has been easing more sharply than the US and the spread came down to 6½% by the end of 2008. But this is still a very high spread. If we consider the April 2007 spread level of 2½% as a “natural” spread, then the Indian repo rate needs to come down to well below 3%.

That is a much steeper cut than what RBI has made. But even that might be an underestimate of what would be needed. The US has gone beyond zero interest rates to a regime of quantitative easing which pushes long rates down to low levels. Since it is not possible to make interest rates negative, quantitative easing achieves the same effect of negative interest rates by expanding the balance sheet of the central bank.

This means that to achieve the same spread against the “effective” (quantitative easing adjusted) interest rate in the US, Indian rates would have to come down even more. Similarly, European interest rates are lower than what they appear to be because the expansion of the ECB balance sheet has some of the characteristics of quantitative easing.

I believe that the RBI should cut its interest rates very rapidly to a level consistent with global interest rates for four reasons. First, the prospect of further cuts in rates in future makes long term government bonds a one way bet – they are today the most attractive asset for any bank on a risk adjusted basis. There is no point exhorting banks to lend when the central bank rewards “lazy banking” through the gradualism of its interest rate policy.

Second, India can afford a fiscal stimulus only if interest rates have first been brought down to very low levels. Otherwise, the weak fiscal capacity of the state is wasted on paying an excessive interest rate on its borrowings.

Third, the weakening of the currency caused by low interest rates is a stimulus that the economy needs very badly.

Finally, since many economists now project inflation at 2% or so by the end of this fiscal year, steep rate cuts are needed to prevent real interest rates from becoming excessive.

Posted at 02:20 on Sat, 03 Jan 2009     View/Post Comments (7)     permanent link


Fri, 02 Jan 2009

Fair value accounting

Earlier this week, the US Securities and Exchange Commission (SEC) released a 259 page study on mark to market accounting as required by the TARP related legislation. The study contains a lot of useful data about the extent of mark to market accounting in the US financial sector as well as the extent to which fair value accounting uses opaque valuation methods (Level 3, often called “mark to myth”).

The key takeaway is that for all the “modernization” of the financial sector that we read about, mark to market accounting covers less than half of all assets of the large financial firms. The percentage of assets where fair value changes impact reported profits is even lower at 25%. It is only the (erstwhile?) broker dealers who have practically all their balance sheet in fair value or in short term assets whose historical cost is practically the same as fair value. The insurance companies have a large percentage of fair value assets, but insurance is an industry where the valuation of liabilities matters more than the valuation of assets. For banks, less than a third of assets is at fair value.

The percentage of fair value assets which is in Level 3 is not too bad at around 10%. What I found more troubling is that around three-quarters of fair value assets are Level 2, leaving only about 15% for Level 1. This is a measure of how little of the financial sector assets are traded in exchanges or other liquid markets as opposed to opaque OTC markets. This is another respect in which the “modernization” of the financial sector has been much more limited than I would like.

The characterization of financial institutions as storehouses of illiquid and opaque assets is as true today as it was decades ago.

Posted at 09:14 on Fri, 02 Jan 2009     View/Post Comments (1)     permanent link


Thu, 01 Jan 2009

More on teaching finance

My last piece on teaching finance the hard way received a large number of interesting and valuable comments and I shall try to respond to them in this post.

Sahil is right that the quality of finance teaching leaves a lot to be desired. In my view, however, this is a result of the rapid growth of the financial sector in recent years. My simplistic way of looking at this is that if a fraction h of the people in a profession become educators and each educator can educate k people in a year, then the sustainable rate of growth of the profession is given by the product hk. In recent years, we have tried to grow the finance profession much faster than hk.

There are two ways to do this. First is to increase h by bringing in people who are not good educators. I recall a similar thing happened in the software field a few years ago. A programmer friend of mine went to an IT institute to enroll in a course, and they took him on as a faculty member instead. The second route is to increase k by reducing the depth and number of courses that a person is required to take before qualifying as a finance professional. Such an approach leaves the keen student thoroughly dissatisfied as Sahil explains in his comment.

As the growth rate of the financial sector slows down, I see this problem solve itself. It should now be possible for fewer (and hopefully better) teachers to teach in greater depth to smaller classes as I suggested in my last post.

I agree with Gaurav that Minsky is somebody that all finance professionals should have read. I recall reading Minsky before I had studied any serious finance and my impression is that this is a book that any serious student can read on his or her own and I doubt whether a course is needed on this. If at all it is to be taught, I think this is more economics than finance; perhaps, it should be taught along with a course on Austrian economics. (Yes, Paul Krugman thinks that “the Austrian theory of the business cycle is about as worthy of serious study as the phlogiston theory of fire”, but I do read the Austrian Economists’ blog).

Balu Kanchappa complains that finance case studies prepared at management schools have lot of bias in favour of institutions and context – the writers of the case studies focus more on ‘practice’ than ‘principles’. What the case writers do is less important than what happens in the class discussion. The case method is about applying theories to specific situations and so a large amount of detail is required. There is advantage in using cases from different geographies and different time periods so that students acquire the ability to apply broad principles to any context in which they might have to work.

Finance Guy takes issue with my reference to the mass market. What I had in mind was what I have described above as k. I was not talking about the quality of the students at all. There was a problem in the quality of the faculty (the expansion of h) and there was a problem in terms of the interest of the students in the subject. I do not think that there ever was a problem with the quality of the students. When I talked about the mass market, I was referring to the attempt to increase k by having broad brush courses that cover a large number of topics superficially. This makes it impossible to cover topics in depth.

At a personal level, I would also like to add that to a crass materialist like me, “mass” is not a pejorative term at all. Also, I have no desire to contribute to the production of “leaders”; in fact, my deep preoccupation with free markets is partly a rebellion against leadership of all kinds.

Both Finance Guy and Hemchand believe that there is a role for intuition and gut feeling in finance. This may or may not be true, but intuition is not something that can realistically be taught, and my post was about the teaching of finance. I was not and am not writing about what skills you need to succeed in finance.

Finally, I do not believe in the “infallibility” of models; on the contrary, the thing that I like most about models is that they describe their own fallibility and limitations explicitly and openly. And, I like to use models in the plural implying that there are several models each of which has a different restricted domain of applicability rather than one grand “theory of everything”.

Posted at 14:46 on Thu, 01 Jan 2009     View/Post Comments (1)     permanent link