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

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Thu, 25 Jun 2009

US fondness for ratings continues

Last week, I blogged about the US being an outlier in terms of its excessive use of ratings in its regulations. This fondness for credit ratings (particularly the highest rating) continues. Yesterday, the US SEC announced proposals for reforms of money market mutual funds. Reforms are clearly needed here – among the most scary consequences of the Lehman bankruptcy last September were the problems at the Reserve Primary Fund which saw its Net Asset Value drop below par.

SEC is eliminating the ability of the money market funds to hold 5% of their assets in “Second Tier” securities that have the second highest credit rating instead of the highest rating. This was of course one of the recommendations of the industry body (ICI) in its report of March this year. But even that report admitted that investment in second tier securities had nothing to do with the post Lehman crisis. Lehman had a Prime-1/A-1/F-1 short term credit rating (making it a first tier security) right up to its bankruptcy.

To my mind, this reform is indicative of regulatory capture. This is the kind of tiny change that has propaganda value for the fund management industry (“money market funds are safer than ever before”) while changing nothing substantive. If the SEC genuinely wanted to use ratings to make funds safer, it could have said that the issuer must also have a AAA/AA long term rating – Lehman was rated A long before its bankruptcy.

Actually, having something like 5% in second tier securities is not entirely a bad thing in that it reduces the skewness of the distribution. A portfolio of top rated securities can only experience downgrades and this produces a skewness towards the left. A small proportion of securities that can experience upgrades could make the distribution more symmetric.

The weighted average credit rating of a portfolio is more important than the minimum rating as a measure of credit risk. The current SEC rule does not distinguish between gradations within the highest rating category. A money market fund with a small amount of second tier securities and a lot of A1+/F1+ securities in its portfolio can have a higher weighted average credit rating than a fund which has no second tier securities at all. In the run up to its bankruptcy, Lehman had an A1/F1 rating and not an A1+/F1+ rating.

Finally, the best reform (something that a regulator captured by the industry would never dream of doing) is simply to prohibit stable (amortized) value completely. All funds should be required to operate a proper net asset value (based on market prices) that would fluctuate up and down so that investors do not get a false sense of security.

Posted at 16:40 on Thu, 25 Jun 2009     View/Post Comments (5)     permanent link

Mon, 22 Jun 2009

Rethinking SEBI Pricing Guidelines

I participated in a panel discussion on SEBI pricing guidelines on CNBC last week. Transcripts are here and video is here. Some excerpts from my comments:

I think this two-week, six-months averaging and all that is a bureaucrat’s paradigm. It completely ignores market reality. ... when the environment has changed you need to be able to price based on what the current reality is. You cannot price on a two-week average when current market realities are totally different. ... I think the entire pricing guidelines are based upon bureaucratic delusions and they must go at least for liquid stocks.

I repeated my earlier arguments (see here and here) that regulators must trust market prices at least for liquid stocks.

Posted at 10:54 on Mon, 22 Jun 2009     View/Post Comments (1)     permanent link

Fri, 19 Jun 2009

Obama's Financial Reforms and Rajan Committee

I wrote an article in today’s Financial Express comparing Obama’s proposals for financial regulatory reform in the United States with the Rajan Committee proposals in India. Obama’s speech is available here and the full report is available here. The Rajan Committee report is available here.

On Wednesday, US President Obama unveiled an 89 page blueprint for reforming financial regulation in the US in response to the financial crisis. The proposals have several striking similarities with the recommendations of the Raghuram Rajan Committee in India a few months ago.

Obama outlined the need for overhauling the regulatory structure very succinctly. He said that where there were regulatory gaps, regulators lacked the authority to take action and where there were overlaps, regulators lacked accountability for their inaction. The US and India face this problem of regulatory gaps and overlaps far more acutely than many other countries (like the UK, Singapore or Germany) which have a more streamlined regulatory architecture.

While recognising this problem, both the Obama and Rajan proposals make only incremental changes to the existing architecture and eschew more ambitious proposals to scrap the system altogether and start all over again. The reality is that even these proposals might test the limits of what is politically feasible.

Obama called for the creation of a Financial Services Oversight Council (FSOC) which is very similar to Rajan’s Financial Sector Oversight Agencies (FSOA) in terms of its composition and structure. Both bodies consist of the heads of all regulatory agencies and have a permanent secretariat. One difference is that the FSOC is chaired by the Treasury Secretary.

The much bigger difference is that Rajan’s FSOA was also to be the macro-prudential regulator for systemically important financial conglomerates and organisations. Under Obama’s proposals, the macro-prudential regulator for such conglomerates (unimaginatively called Tier 1 Financial Holding Companies) is the Federal Reserve Board. Arguments can be made in favour of both models. In the Indian case, the critical concrete question would be whether the RBI should be the macro-prudential regulator for the LIC or whether this role should be performed by all sectoral regulators meeting together.

Obama calls for the creation of a Consumer Financial Protection Agency (CFPA) whose role is very similar to that of the Office of the Financial Ombudsman (OFO) proposed by the Rajan Committee. The key difference is that the CFPA is vested with vast statutory powers while the OFO was conceived of as having much of the characteristics of a self-regulatory organisation. I believe that while there is merit in starting out with less formal statutory powers, the OFO should also move in the direction of the CFPA whose bite is as formidable as its bark.

On the markets, the corner piece of the Rajan report was the merger of the commodities derivatives regulator (FMC) into the securities regulator (SEBI). In the US too there were high expectations about merging the CFTC into the SEC, but Obama has stopped short of this.

Given the perception of the SEC today as a failed regulator (Bear Stearns, Lehman and Madoff), it is perfectly understandable that the President is reluctant to reward it with greater powers. The one regulator whose failures were even more egregious than that of the SEC – the OTS which regulated AIG – is proposed to be disbanded. Another infamous regulator – the OFHEO which regulated Fannie and Freddie – has already been replaced by the FHFA. In this context, the SEC should count itself lucky that it has been left largely intact.

In the long run, however, a merger of the CFTC into the SEC is inevitable and if Mary Shapiro’s attempts to reform the SEC succeed, we might not have to wait for the next crisis for this to happen. In India, the arguments for folding the FMC into Sebi are very strong and there is no need to wait at all.

Obama’s proposal (like the Rajan report) calls for moving most Over The Counter (OTC) derivatives towards centralised clearing and bringing them under the purview of the market regulators. This is absolutely necessary. Obama’s blueprint also states that key settlement and clearing agencies should have access to central bank accounts and facilities to reduce their dependence on banks. This is an extremely important issue in India as well where the dependence of securities clearing agencies like NSCCL and CCIL on commercial banks has become an unacceptable source of systemic risk.

Obama’s reforms recognise the importance of preserving vibrant financial markets. Obama rightly states that the role of the government is not to stifle the market, but to strengthen its ability to unleash creativity and innovation. The goal is to restore markets in which we reward hard work and responsibility and innovation, not recklessness and greed. He also says that the purpose of regulation is to allow markets to promote innovation while discouraging abuse, and to allow markets to function freely and fairly, without the risk of financial collapse.

These are important principles to keep in mind. The current global crisis has discredited the existing regulatory regime for financial markets; they have not discredited financial markets themselves.

Posted at 16:12 on Fri, 19 Jun 2009     View/Post Comments (0)     permanent link

Thu, 18 Jun 2009

Stocktaking on the use of credit ratings

Earlier this week, the Basel Committee (along with IOSCO and IAIS – the Joint Forum) published a report entitled “Stocktaking on the use of credit ratings” which documents the use of credit rating in banking, securities and insurance regulations in several major countries around the world. What struck me while reading the report is the fact that the US appears as an outlier in its pervasive use of credit rating in all aspects of its financial regulations.

Surprisingly, the UK uses credit ratings very little apart from what is mandated by Basel-II. In particular, the UK does not use credit ratings at all in determining what securities a regulated entity can or cannot invest in. (Just in case, one worries that somebody in the FSA might have made a mistake while checking boxes in the survey questionnaire, the report states categorically, “ the United Kingdom Financial Services Authority (UK FSA) noted that credit ratings are not used in any of its three financial sectors for asset identification.”)

For a country like India whose regulations use ratings quite extensively, this is an opportunity for a hard rethink. The current global crisis has shown that rating agencies can horribly wrong. More importantly, the crisis has reminded us that even when ratings measure idiosyncratic risk well, they are a poor signal of systemic risk.

Posted at 10:38 on Thu, 18 Jun 2009     View/Post Comments (4)     permanent link

Fri, 12 Jun 2009

Bankers’ pay and incentives

Much has been written about how (a) bankers’ pay is excessive and (b) the incentive created by these pay structures encourage risk taking. A lot of this discussion has treated bankers’ pay as a corporate governance problem without considering the special characteristics of banks. I was therefore delighted to read this paper by Bebchuk and Spamann which is like a breath of fresh air.

Bebchuk and Spamann point out that because of the excessive leverage of banks and the explicit and implicit support of the government, the shareholders are incentivized to support excessive risk taking. Therefore the standard corporate governance ideas of aligning the interests of managers with that of shareholders are useless when it comes to banking. They propose that regulators should step in and require that incentives be linked to the total value of the firm and not just the value of the equity.

Bebchuk and Spamann do not address the issue of bankers’ pay being excessive though that has a similar explanation. Deposit insurance and implicit government guarantees create the potential for huge rents in banking. The only way to extract these rents is by highly complex (and possibly deceptive) risk taking strategies that get past regulatory restrictions. Implementing these strategies therefore requires a great deal of expertise and skill which are in short supply. Therefore when shareholders try to extract rents by hiring smart people to implement complex risk taking strategies, most of the rents are in fact extracted by the managers themselves. To view this as a corporate governance problem is a mistake. It is a problem of government policy that encourages rent seeking.

Bebchuk and Spamann also correctly point out that the managers whose personal wealth has been destroyed by the collapse of their banks were not necessarily stupid or ex ante irrational. Ex ante, they could well have been responding correctly to the incentives that they faced and the probabilities that they estimated.

Posted at 16:11 on Fri, 12 Jun 2009     View/Post Comments (2)     permanent link