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

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Mon, 26 Sep 2005

HealthSouth and Whistle Blower Protection

After the Enron debacle, the US enacted whistle blower protection into Section 806 of the Sarbanes-Oxley Act. Many companies around the world adopted whistle blower policies in accordance with the requirement of this law.

But much of this protection is quite useless if judges and prosecutors are insensitive to the organizational ground realities within which whistle blowers have to function. The verdicts in the HealthSouth case in the United States provide an excellent example of how things can go badly wrong. HealthSouth's founder Chairman and CEO was acquitted on all counts in June. A few other employees and former employees received mild sentences. As if to compensate for all these failures, the prosecution sought tough penalities against the whistle blower himself. Last week, the judge imposed the longest prison sentence in the case so far on the whistle blower Weston Smith!

Posted at 12:30 on Mon, 26 Sep 2005     View/Post Comments (2)     permanent link

Mon, 12 Sep 2005

Financial Development, Financial Fragility, and Growth

A recent IMF Working Paper by Norman Loayza and Romain Ranciere entitled Financial Development, Financial Fragility, and Growth ( tries to disentangle the short run and long run effects of financial development on economic growth.

In the process, the authors also seek to reconcile the apparent contradictions between two strands of the literature on the subject.

“On the one hand, the empirical growth literature finds a positive effect of financial depth as measured by, for instance, private domestic credit and liquid liabilities. On the other hand, the banking and currency crisis literature finds that monetary aggregates, such as domestic credit, are among the best predictors of crises and their related economic downturns. This paper accounts for these contrasting effects based on the distinction between the short- and long-run effects of financial intermediation.”

Essentially, Loayza and Ranciere measure financial development by the ratio of private credit to GDP. Using data for 75 countries from 1960 to 2000, they show that in the long run, a rise in this financial intermediation ratio increases economic growth. However, the short run effect is negative and this effect is several times the long term effect.

In their detailed analysis however the authors show that the short term effect is entirely due to the countries that have experienced a banking crisis. “In fact, for the non-crisis countries, the average short-run impact of intermediation on growth is statistically zero.”

This suggests that it is rather misleading to claim that financial development reduces economic growth even in the short term. First., while the title of the paper uses the term financial development and the text of the paper uses the term financial intermediation, the measure used is purely a measure of credit and ignores other financial claims. Second, the negative impact even in the short term is restricted to crisis countries where presumably the institutional structures required to support rapid credit growth were less well developed.

Posted at 07:51 on Mon, 12 Sep 2005     View/Post Comments (0)     permanent link

Tue, 06 Sep 2005

Transparency in Bond Trading

The FSA has put out a discussion paper on Trading transparency in the UK secondary bond markets ( This paper is in response to the possibility that greater transparency may be mandated under MiFID, the European Union’s Market in Financial Instruments Directive. MiFID currently imposes transparency obligation on the equity market but Article 65 requires the Commission to report on whether the pre and post-trade transparency obligations should be extended to transactions in bonds as well.

The FSA discussion paper provides a nice review of the academic literature on the role of transparency and also provides a comprehenseive description of the bond market in the UK. It is onstensibly neutral on whether more transparency is needed, but on closer reading it is clearly biased towards maintaining the status quo. It argues that the basic question to be asked before imposing a transparency obligation is whether there is a market failure that needs to be corrected. The problem is that market failure is too strong a word to describe the effect of opaque markets. Opaque markets may be unfair to classes of investors and may also be inefficient, but these do not probably rise to the level of market failure.

For example, the discussion paper while pointing out that post trade information is not publicly available observes that this information is available to those who subscribe to the services of various vendors. The point is that this may well be enough to prevent market failure but not sufficient to meet the regulator’s obligations regarding investor protection.

Posted at 18:42 on Tue, 06 Sep 2005     View/Post Comments (0)     permanent link

Thu, 01 Sep 2005

Henry Blodget’s Irreplaceable Exuberance

In the New York Times of August 30, 2005, Henry Blodget tries to justify some of the things that happened during the internet boom and bust of the late 1990s. Henry Blodget was a well known internet stock analyst of that era and his actions invited regulatory sanctions that cut short his career.

Blodget is not saying anything new when he says that “stock prices and strategic decisions are based on predictions, and predicting the future in an industry’s early days is hard”. What is more interesting is his point that “our exuberance helps build industries, however boneheaded it may later seem”.

This is true if we define exuberance as a temporary reduction in risk aversion. Such a reduction will lead to investments with higher expected returns and from the point of view of a risk neutral observer, this is more rational. Since we are always risk neutral about the past, posterity will be happy that those investments were made.

Unfortunately for him some of the investments that were made at that time were not justifiable even if we ignore risk aversion. Yet, it must be said that compared to some of the nonsense that Blodget wrote as an analyst, what he is writing now contains a grain of truth even when it is largely self serving.

Posted at 10:06 on Thu, 01 Sep 2005     View/Post Comments (0)     permanent link