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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Wed, 29 Jul 2009

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 on Wed, 29 Jul 2009     View/Post Comments (5)     permanent link


Sun, 26 Jul 2009

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 15:23 on Sun, 26 Jul 2009     View/Post Comments (0)     permanent link


Thu, 23 Jul 2009

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 on Thu, 23 Jul 2009     View/Post Comments (4)     permanent link


Tue, 21 Jul 2009

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 21:34 on Tue, 21 Jul 2009     View/Post Comments (0)     permanent link


Fri, 17 Jul 2009

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 on Fri, 17 Jul 2009     View/Post Comments (2)     permanent link


Wed, 15 Jul 2009

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:

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 14:33 on Wed, 15 Jul 2009     View/Post Comments (0)     permanent link


Tue, 14 Jul 2009

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 18:22 on Tue, 14 Jul 2009     View/Post Comments (2)     permanent link


Thu, 09 Jul 2009

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:

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 17:01 on Thu, 09 Jul 2009     View/Post Comments (0)     permanent link


Wed, 08 Jul 2009

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 17:29 on Wed, 08 Jul 2009     View/Post Comments (1)     permanent link


Tue, 07 Jul 2009

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 18:14 on Tue, 07 Jul 2009     View/Post Comments (1)     permanent link


Sun, 05 Jul 2009

Incentives of regulators and supervisors

During the current global financial crisis, a lot has been written about the flawed incentives of those who run the banks. At the same time Kane has been writing a series of papers on the flawed incentives of regulators and supervisors.

Kane is of course well known in the finance literature for his seminal work starting three decades ago on regulatory competition, the action-reaction dynamic of financial innovation and regulation, and the evils of directed credit (“Good Intentions and Unintended Evil: The Case Against Selective Credit Allocation,” Journal of Money Credit and Banking, 1977, “Technological and Regulatory Forces in the Developing Fusion of Financial Services Competition” Journal of Finance, 1984 and “ Interaction of Financial and Regulatory Innovation” American Economic Review, 1988).

Kane’s work on the current crisis draws on the same ideas to develop a model of what he calls “subsidy induced crisis.” Some interesting passages from his papers on the current crisis:

[T]he principal source of financial instability is not to be found in the aberrant behavior of a few greedy individuals or in a sudden weakening of important institutions of a particular country at a particular time. Systemic financial fragility traces instead to a web of contradictory political and bureaucratic incentives that undermines the effectiveness of financial regulation and supervision in every country in the world. Weaknesses in supervisory incentives encourage modern safety-net managers not only to tempt financial institutions and their customers to overleverage themselves in creative ways, but also to close their own eyes to the unbudgeted costs of the loss exposures that excess leverage passes onto financial safety nets until it is too late for anyone to control the damage that results.

[T]echnological change and regulatory competition simultaneously encouraged incentive-conflicted supervisors to outsource much of their due discipline to credit-rating firms and encouraged banks to securitize their loans in ways that pushed credit risks on poorly underwritten loans into corners of the universe where supervisors and credit-ratings firms would not see them.

What the press describes as a “banking crisis” may be more accurately described as the surfacing of tensions caused by the continuing efforts of loss-making banks to force the rest of society to accept responsibility for their unpaid bills for making bad loans.

[T]he current crisis exemplifies not just the limits of market discipline, but the power of government-induced incentive distortions – and the limits of official supervision as commonly practiced.

Most importantly, references to ratings should be removed from all SEC and bank regulations, including Basel II. Government rules that rely on CRO ratings reduce investor incentives to conduct sufficient due diligence before making investments. At the same time, such rules reduce the accountability of government regulators and supervisors for neglecting their duty of oversight. By outsourcing due diligence to credit rating organizations, regulators shift the blame for the safety-net consequences of ratings mistakes away from themselves.

In government enterprises, decision-making horizons could be lengthened if employment contracts included a fund of deferred compensation that heads of supervisory agencies would have to forfeit if a crisis occurred within three or four years of leaving their office (Kane, 2002). Calomiris and Kahn (1996) show that such a system worked well in the 19th century Suffolk banking system, where claims to deferred bonuses were paid only after losses had been deducted. The public embarrassment of having to forfeit compensation would incentivize top supervisors to use market signals more efficiently and help them to resist political pressure to bail out zombie firms.

Giving more power to regulators without first improving their incentives will not fix anything important. One cannot improve the quality and effectiveness of government regulation and supervision merely by rewriting a few rules and mission statements. Even in countries whose markets are unsophisticated, good incentives and reliable information can produce effective regulation. That bad incentives generate misinformation and painful losses is the cumulative lesson that this and other crises impart.

[Credit rating organizations] claim only to be expressing an “opinion.” ... Whenever someone (say, a lawyer) collects a large fee for communicating his or her opinion to another party, the distinction between opinion and advice seems to break down.

Financial deregulation is often blamed for causing crises ... However, deregulation does not necessarily provide greater opportunities to shift private risk exposures onto the safety net. ... In principle, relaxing controls on interest rates, charter powers and portfolio structure promised to improve banks’ ability to foster economic growth and economic justice. But coupling deregulation with inadequate supervision of leverage and asset quality is a recipe for disaster ...

Authorities’ positive response to this competitive pressure has been labeled financial deregulation, but our ethical perspective makes it clear that the response is better described as desupervision.

Some of this resonates well with other perspectives that I have blogged about in the past. For example, my post about the panel discussion between Niall Ferguson, Nouriel Roubini, Jim Chanos and others as also the post on the paper by Bebchuk and Spamann on bankers’ pay and incentives.

Posted at 11:48 on Sun, 05 Jul 2009     View/Post Comments (0)     permanent link


Thu, 02 Jul 2009

Indian government clings to obsolete categories of financial intermediaries

As I read the Economic Survey presented by the Indian government today, I was struck by how the government is still clinging to obsolete categories of financial intermediaries. In Chapter 5 (paragraph 5.61), the government classifies financial institutions into (a) term lending institutions, (b) refinance institutions and (c) investment institutions.

This looks fine except that investment institutions refers to public sector insurance companies and not to mutual funds, venture capital funds or other true investment institutions. What is worse is that the private sector insurance companies are not included in this list but are discussed in a separate section on insurance companies.

The table on the next page (after para 5.64) is even more hilarious. The data on term lending institutions in this table includes SIDBI which is classified as a refinance institution in para 5.61. The table also includes a separate row for specialized institutions which includes a couple of venture capital companies but not all the SEBI regulated venture capital funds.

The entire classification is completely useless. During the mid 1990s, the entire category of financial institutions became increasingly anachronistic. However, more than a decade later, the government clings to this obsolete category.

Other countries have similar problems though perhaps not as ridiculous as this. In the US before the crisis, Countrywide was classified as a thrift but has now become part of a bank (Bank of America). Goldman Sachs was a Consolidated Supervised Entity (CSE) and has now become a bank holding company.

Even if we cannot bring sanity into our balkanized regulatory frameworks, can we not use sensible classifications when collecting and presenting statistical data?

Posted at 21:19 on Thu, 02 Jul 2009     View/Post Comments (0)     permanent link