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. This blog is currently suspended.

© Prof. Jayanth R. Varma

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Wed, 27 Aug 2008

Catastrophe bonds to recapitalize banking system

Anil Kashyap, Raghuram Rajan and Jeremy Stein presented a fascinating paper at the Jackson Hole Symposium. This is my third post related to this symposium and yes, finally, the papers are available at the Kansas Fed website. The Buiter paper that I blogged about a few days ago after reading it on the WSJ website is also now available at the Kansas Fed website.

Kashyap, Rajan and Stein propose an instrument similar to a catastrophe bond which would automatically recapitalize the banking system when system wide losses cross a certain threshold. The starting premise of their paper is that the high level of leverage in banks is a rational response to governance problem of banks. If one accepts this premise, then their proposal for contingent capital makes a lot of sense. It gives banks capital to the banks when it is needed in the crisis, but does not give it to them in the boom when they might squander it.

It is a very clever idea, but I tend to be sceptical of the notion that there is something special about banks that exempt them from the Modigliani Miller arguments about capital structure. Rather I think Friedman was right in his statement in a different context that banks are not regulated because they are different, but banks are different because they are regulated. After all, many non bank financial firms run quite well with lower levels of leverage than banks, and the free banking era was also characterized by relatively low levels of leverage.

Kashyap, Rajan and Stein design their instrument very elegantly to deal with moral hazard problems at the level of the individual banks. My fear is that it will attract moral hazard on the part of the regulators. In fact, I think that their bond is best seen as non voting equity in a deposit insurance corporation. The governance implications of this are a nightmare.

Posted at 18:45 on Wed, 27 Aug 2008     View/Post Comments (0)     permanent link

Mon, 25 Aug 2008

Buiter on the central banks

Willem Buiter’s paper at the Jackson Hole Symposium castigating the major central banks of the world (and the Federal Reserve in particular) is worth reading in full (144 pages) even if one disagrees with what he has to say. I am surprised that as of today, I still cannot find the symposium papers at the web site of the Kansas Fed which organized the symposium, but the paper is available in the public section of the website of the Wall Street Journal.

Some people have been mis-characterizing the paper as dogmatically opposing central bank interventions on moral hazard grounds. That is not the impression that I got by reading the paper. The paper does accept that the central bank has to intervene in times of crises, but Buiter does oppose the particular forms that this intervention has taken.

Below are some interesting quotes from the paper:

Posted at 16:00 on Mon, 25 Aug 2008     View/Post Comments (0)     permanent link

Sat, 23 Aug 2008

Bernanke and his tag clouds

Paul Kedrosky’s Infectious Greed blog compares Bernanke’s speech at the Jackson Hole symposium this year with his speech at the same event last year. Using Wordle, Kedrosky produces nice tag clouds for the two speeches that highlight how sharply Bernnake’s concerns have moved from mortgage markets to the entire financial system.

I liked the Wordle tag clouds so much that I created one for my own blog which appears at the end of this post. The tag cloud confirms my description of the blog as being about financial markets.

Coming back to Bernanke’s speech, I found a few interesting things.

First, there was the sentence “The company’s failure could also have cast doubt on the financial conditions of some of Bear Stearns’s many counterparties or of companies with similar businesses and funding practices, impairing the ability of those firms to meet their funding needs or to carry out normal transactions.” This seems to vindicate those who have been arguing for quite some time now that the Bear Stearns rescue was a bail out of J P Morgan Chase. JPM had the largest derivative book by far of all the commercial banks and was a large counterparty of Bear Stearns.

Second, was the passage that has been widely quoted in the blogosphere: “A statutory resolution regime for nonbanks, besides reducing uncertainty, would also limit moral hazard by allowing the government to resolve failing firms in a way that is orderly but also wipes out equity holders and haircuts some creditors, analogous to what happens when a commercial bank fails.”

I wonder whether a new statutory framework is really necessary to achieve this. The monoline bond insurance companies have been able to negotiate cash settlement of the guarantees (which they had issued when they were AAA rated) at haircuts that reflect their current reduced credit worthiness. I would imagine that if Bear Stearns had not been bailed out, similar haircuts could have been negotiated with its counter parties as well. The Bear Stearns rescue was essentially a $29 billion loan under a second loss credit note collateralized by Bear Stearns assets. I do not see why the Fed could not have lent directly to Bear under a similar structure and adjusted the second loss trigger point to achieve any desired haircuts for the counter parties. I suspect that the alleged lack of legal frameworks is an excuse for lack of spine.

The Wordle tag cloud for my blog is shown below:

Wordle Tag Cloud for my

Posted at 14:12 on Sat, 23 Aug 2008     View/Post Comments (0)     permanent link

Fri, 15 Aug 2008

Faster rights issues in India

The Securities and Exchange Board of India (SEBI) has announced “changes in timeline [that] would enable a right issue to be completed within about 43 days as against about 109 days currently available for a rights issue.” It is indeed very creditable that SEBI has chose to attack the problem decisively rather than tinker at the edges.

Just to provide perspective, the ill fated rights issue of HBOS in the UK took almost three months (from late April to late July) to complete and during this period a 45% discount to the market price turned into a premium. After this experience, the UK is also attempting to bring this period down.

Posted at 11:36 on Fri, 15 Aug 2008     View/Post Comments (1)     permanent link