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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Fri, 21 Sep 2018

Indian banks: quiescent shareholders and activist regulators

The Indian central bank or other government agencies have been instrumental in effecting a change of management in three under-performing private sector banks (ICICI Bank, Axis Bank and Yes Bank) in recent months. While much has been written about the functioning of the boards and of the central bank, the more fascinating question is about the dog that did not bark: the quiescent shareholders of these banks. They have suffered in silence as these banks have surrendered the enviable position that they once had in India’s financial system. The void created by the wounded banking system in India is being filled by non bank finance companies. So much so that one of these non banks (Bajaj Finance) trades at a Price/Book ratio 3-4 times that of the above mentioned three banks and now boasts of a market capitalization roughly equal to the average of these three banks.

The question is why has this not attracted the attention of activist investors. One looks in vain for a Third Point, Elliott or TCI writing acerbic letters to the management seeking change. The Indian regulatory regime of voting right caps and fit and proper criteria has ensured that such players can never threaten the career of non performing incumbent management in Indian banks. The regulators have entrenched incumbent managements and so the regulators have to step in to remove them.

Incidentally, the securities regulator in India has been no better. It too has ensured that the big exchanges and other financial market infrastructure in India are immune to shareholder discipline, and over the last several years many of these too have performed far below their potential.

Indian regulators do not seem to understand that capitalism requires brutal investors and not just nice investors talking pleasantly to the management. Capitalism at its best is red in the tooth and claw.

Posted at 13:05 on Fri, 21 Sep 2018     View/Post Comments (0)     permanent link


Mon, 17 Sep 2018

The FED’s bite is worse than its bark

If any emerging market thought that the US Federal Reserve is a paper tiger whose bark is worse than its bite, the last few months have shattered that illusion. Already, the bite is hurting a lot more and the tiger still appears to be hungry and on the prowl.

The comparison below is actually biased in favour of a bigger effect for the bark because it focuses on the Fragile Five who were the worst sufferers during the barking phase. I have left out Argentina and China who have suffered only or mainly in the biting phase.

The FED’s bark (Taper Tantrum: April-July 2013)

The data is from Barry Eichengreen and Poonam Gupta, Tapering Talk: The Impact of Expectations of Reduced Federal Reserve Security Purchases on Emerging Markets. Following Eichengreen and Gupta, I have measured the exchange rate pressure by the percentage increase in the nominal exchange rate (units of domestic currency per US dollar), though ideally it should be the decline in the inverse of this number. Unlike Eichengreen and Gupta, I have simply added the percentage exchange rate change and the percentage reserve loss for a crude measure of the total effect. For a blog post, I am too lazy to weight the two measures by the inverse of their respective standard deviations (and I am also quite happy with improper linear models).

Depreciation Reserve Loss Total
Brazil 12.52 1.69 14.21
India 9.98 4.77 14.75
Indonesia 3.58 13.61 17.19
South Africa 8.96 5.42 14.38
Turkey 7.61 8.20 15.81

The FED’s bite (Ongoing since April 2018)

The following data is what I have been able to put together from easily available sources on the internet. The currency depreciation is from Yahoo Finance and covers the period from April 16, 2018 to September 13, 2018. The reserve loss is from end March (or mid April where available) to the latest date for which I could get data clicking through to the data links on the National Summary Data Pages (NSDPs) of the IMF’s Dissemination Standards Bulletin Board (DSBB). Except for Turkey, the data for the rest of the countries is not hopelessly out of date, and for Turkey, the reserve loss is totally swamped by its currency depreciation.

If you have better data, please free to provide that in the comments section.

Depreciation Reserve Loss Total
Brazil 22.22 0.26 22.48
India 10.46 5.90 16.36
Indonesia 8.02 6.35 14.37
South Africa 21.36 -0.00 21.36
Turkey 50.86 8.15 59.01

Posted at 16:14 on Mon, 17 Sep 2018     View/Post Comments (0)     permanent link


Sun, 09 Sep 2018

Self-serving self-censorship in a crisis

In a crisis, the only thing that is not censored or self-censored is the market (provided it has not been regulated out of existence or into meek submission). That is the lesson that we can learn from a rare candid admission from a well known columnist at one of the most respected financial newspapers in the world. In his latest “The Long View” column (link behind paywall) in the Financial Times yesterday (September 9, 2018) John Authers writes:

It is time to admit that I once deliberately withheld important information from readers. It was 10 years ago, the financial crisis was at its worst, and I think I did the right thing.

There was a bank run happening, in New York’s financial district. The people panicking were the Wall Streeters who best understood what was going on.

All I needed was to get a photographer to take a few shots of the well-dressed bankers queueing for their money, and write a caption explaining it.

We did not do this. Such a story on the FT’s front page might have been enough to push the system over the edge. Our readers went unwarned, and the system went without that final prod into panic.

There are many things going on here that are worth pointing out:

  1. If we go back to 2005 or 2006, the financial elite was as clueless as anybody else about the crisis that was round the corner.

  2. However, during (or even just before) the crisis, the financial elite had a pretty good idea of the most vulnerable entities in the system. I remember when I discussed the matter with smart finance people back in 2007 and 2008, we could all agree on which banks (both in India and globally) were at grave risk and which were sound. In retrospect, those judgements were largely correct. At the same time, outside of finance, this understanding was often lacking.

  3. This phenomenon was not peculiar to the global financial crisis of 2008, but was true in earlier crises like the Asian Crisis of 1997.

  4. Self censorship is the main reason why the common knowledge of the financial elite does not percolate to the general public. Many factors play a role here:

    • We all fear retribution from the state which can easily accuse the messenger of sedition or treason.

    • There is the risk of defamation suits from the affected entities which might not have enough money to repay their debt, but are never short of money to pay their lawyers.

    • Our views are often based on inferences rather than hard facts, and we shy away from making sweeping statements in public without objective data.

    • Like John Authers, we might worry that what we write might become a self fulfilling prophecy.

  5. But Authers’ story also points to a very uncomfortable fact, that our self censorship is self serving. We might hesitate to write about what we know, but we do not hesitate to act on that knowledge. Authers writes that he shuffled his money around so that he would not lose much if Citi failed. I recall that every company on whose board I served took preventive action to protect the company’s cash surpluses.

This means that, in a crisis, the general public cannot expect the elite (regulators, media, academics) to warn them or to tell them the truth. Meanwhile, the rich, powerful and well-connected are duly warned, and are able to protect themselves. Is it any wonder that the general public listens to wild rumours rather than to mainstream commentators?

There is one place where the public can learn the truth, and that is the financial markets. In the build up to the crisis, the markets are as complacent as everybody else. But during the crisis, the market is the fountain head of information. If I could make sensible judgements during 2008, it was only because I was tracking many different markets. Of course, one needs to know where to look: sometimes the most valuable information is in the spread between two arcane markets.

The governments and regulators know this very well and work overtime to ensure that the markets become uninformative. After Lehman failed, I had two blog posts on how successful government around the world had been in doing this (Towards a market only for buyers and More on market for buyers only).

Months before Lehman failed, I wrote this:

I believe that this crisis has shown the power and utility of financial markets. Policy makers have had at least a year of lead time to deal with the problems in the real economy. Without mark to market and without liquid ABX markets, the crisis would have become evident only when mortgages actually defaulted. By then it would have been too late to act.

It is difficult to persuade people about this in today’s context, but even today it is true that with all their imperfections and tendency to malfunction during crises, financial markets are the closest thing that we have to the crystal ball that reveals the future. Everything else is backward looking.

After reading Authers’ confession, I would add another clause to the last sentence: “Everything else is self-censored.”

Posted at 17:58 on Sun, 09 Sep 2018     View/Post Comments (0)     permanent link


Mon, 03 Sep 2018

Why does the Indian Government mandate proprietary software?

One of my pet peeves has been about the Indian government forcing citizens to buy or use proprietary software to enable them to perform their statutory obligations. Things have got better in some government departments, but worse in others.

In my opinion, it is a gross abuse of the sovereign powers of the state to compel a person to buy and use Windows in order to be a director of a company. Actually, I seriously considered resigning as Director rather than do this, but then that does not solve the problem as different departments of the government are moving in the same direction of e-filing with uncritical dependence on proprietary software.

No, we need to change incentives in the government to prevent the Indian state from becoming a marketing agent of powerful software companies. I think there are many arms of the government itself that can help bring about this change:

  1. Central Vigilance Commission (CVC): The CVC could declare that going forward, it would regard a government action that forces unwilling citizens to buy software from private companies as an act of corruption (on the ground that it provides a benefit to a private party and is also against the public interest). The reality is that the government outsources software development to large software developers who also act as authorized resellers for a large number of software product companies, and have every incentive to push the sales of these products on to their clients. This is fine when all these costs are evaluated as part of the total cost of the project during the bid evaluation. But when the government official allows the vendor to sell software to ordinary citizens using the coercive power of the state, that should count as an act of corruption. The CVC could allow existing applications to be grandfathered with a sunset clause, but it should not permit any new projects.

  2. Competition Commission: As explained in the previous point, the whole business of government software development involves giant software companies using their market dominance in the enterprise market to gain unfair and unlawful market power in the retail market using the coercive power of the state. The Competition Commission can and should investigate all authorized reseller agreements for such anti-competitive conduct.

  3. National Security Advisory Board: Widespread use of proprietary software in critical government applications can pose a threat to national security, and with the increasing threat of cyber attacks on India from some of its neighbours and other countries, this is also a reason for reconsidering the design of government applications like the MCA Portal. For example, under the so called Government Security Program the Microsoft Windows source code has been shared with Russia and China which are both associated with large scale state sponsored hacking activities. This means that when you and I use Windows, the hackers can see the source code, but you and I cannot. With open source software like Linux, the hackers can read the source code, but so can you and I. It is important that the national security apparatus in India takes these risks seriously and start advising other arms of the government to move away from proprietary software in citizen facing applications.

  4. Law Ministry: If rapid technological change and product obsolescence leads to Adobe going bankrupt and the Adobe Reader being discontinued, the government might find that it cannot read any of the PDF files that constitute the source documents for its entire database. Many people of my generation have old Wordstar files which are almost impossible to read because the Wordstar software is now defunct: truly desperate people do try to buy the old Wordstar diskettes on EBay and then try and find a disk drive that can read the diskettes. For those readers who are too young to remember, Wordstar was the undisputed market leader at its time, just as Adobe is today. The law ministry should recognize that storing critical source documents in a proprietary format is an unacceptable legal risk.

Until one or other of these branches of the government steps in and forces a redesign of citizen facing government applications, we will be doomed to pay money to rich multinationals to use insecure software to interact with our own governments.

Posted at 18:15 on Mon, 03 Sep 2018     View/Post Comments (0)     permanent link