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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Tue, 29 Dec 2009

Indian coupling with global risk aversion in 2009

I wrote a column in the Financial Express today about why Indian markets were swayed by global developments in 2009.

Indian markets in 2009 appeared to dance almost completely to the tune of global developments, reminding us of how strongly integrated we are with world financial markets.

Unlike China, the Indian economy does not depend so much on exports for its growth. Collapse of global trade in 2008 and early 2009 did impact sectors like textiles, diamonds and software services, but collapsing exports did not crush the whole economy because many other sectors thrived on domestic demand.

India’s tight coupling with global markets was not due to trade linkages, but to its dependence on foreign portfolio flows for risk capital. Over the last few years, more and more Indian investors have sold their shares in Indian companies largely to foreign investors (but also partly to Indian promoter groups seeking to increase their stakes).

Foreigners might have bought because they are more bullish about our country than we are, or because their global diversification makes them less concerned about India-specific risks. What is important is that Indian asset prices are now increasingly determined by foreign investors.

This dependence has three implications. First, when foreign portfolio flows reversed, as in late 2008 and early 2009, risk capital disappeared completely. A few companies with strong balance sheets were able to raise modest amounts of debt locally, but those with weaker balance sheets found that they could not raise money at all.

When the corporate sector talked about a liquidity crunch in early 2009, it was really bemoaning the lack of risk capital. Banking system liquidity was probably adequate by early 2009, but this liquidity was not risk capital that could meet the needs of cash-strapped businesses. It was the return of foreign risk capital in mid-2009 that saved the day for these companies.

The second implication of India’s dependence on foreign risk capital is that asset prices in India depend on global risk aversion as much or even more than on domestic sentiment. Capital inflows can ignite asset-price bubbles and outflows can prick the bubbles.

Many of us worried about asset-price bubbles in India in 2007, particularly in the stock markets and in real estate. This view can be debated, but if it is accepted, some of the air went out of these bubbles in 2008 and early 2009, and the bubbles might have been inflated again in the second half of 2009. They could deflate again if global risk appetite reverses in 2010.

The third implication of reliance on foreign risk capital is that equity portfolio flows have a strong effect on the exchange rate. Reserve accumulation by the central bank dampens currency appreciation but does not eliminate it completely. A regime of managed exchange rates creates difficulties for the conduct of monetary policy.

Despite all these problems, foreign risk capital (unlike debt capital inflows) brings huge benefits to the economy. Even in the extreme scenario where all inflows are sterilised in the form of reserves, capital inflows provide dramatic risk reduction for the economy as a whole.

This benefit was clearly visible in late 2008 and early 2009 when foreign investors sold shares at prices well below what they had paid only months earlier and converted the rupee proceeds into dollars at exchange rates much higher than the rate at which they had bought rupees when they came in.

Whenever foreign investors sell cheap after buying dear, they make a loss and India as a nation makes a profit. More importantly, we as a country make a profit precisely when the economy is not doing too well. This is a wonderful risk hedge that is worth all the costs that come with it.

Looking forward to 2010, it is quite likely that the ups and downs of global markets will be felt in India as well. Major downside risks remain in the global economy and the question is how well positioned we are to cope with their impact on India.

The Indian corporate sector has used the recovery of 2009 to repair balance sheets in a variety of ways. A lot of the rebuilding of balance sheets has been made possible by foreign risk capital.

Some companies have raised new equity in 2009 largely in the form of private placements and sales to strategic investors. Many companies that found themselves struggling to roll over short-term debt in 2008 have taken advantage of benign conditions in 2009 to refinance short-term debt with longer-term debt.

A few companies have also addressed the problem of busted convertibles. The recovery of 2009 enabled them to successfully exchange old convertibles that had uncomfortably high conversion prices for more viable instruments. The re-emergence of mergers and acquisitions activity also allowed some companies to carry out asset sales to rebuild their balance sheet strength.

As a result of all this, the Indian corporate sector is better positioned to face new challenges in 2010.

Posted at 12:48 on Tue, 29 Dec 2009     View/Post Comments (5)     permanent link

Wed, 23 Dec 2009

Letting large banks fail

I wrote a column in the Financial Express today about the reform legislation winding its way through the US Congress. I argue that the regulatory goal of making large banks failure proof will not be realized and that it is better to have a policy of letting even large banks fail.

Towards the end of 2008, US policymakers halted the panic phase of the global financial crisis with three simple words: “No more Lehmans.” In the short run, this statement could mean that there would be no more bankruptcies like Lehman – any large financial entity on the verge of failure would be simply bailed out. AIG was the first beneficiary of the new policy.

However, in the long run, the ‘No more Lehmans’ policy can only mean that there would be no more failures like Lehman. Either financial entities should be unimportant enough to be safely left to the bankruptcy courts when they fail, or they should be robust enough to make their failure extremely unlikely.

In this context, the US House of Representatives has passed a comprehensive 1,279-page Financial Reform Bill, but the Bill could change significantly before it is passed by the Senate and becomes law. How effective would this law be in eliminating Lehman-like failures?

First, the new US provisions (as well as the recent Basel proposals at the global level) impose higher capital requirements on financial institutions. While higher capital would reduce the chances of failure, it would not make failures so unlikely that governments can safely promise to bail out any large bank that slips through the cracks. Other elements of the new legislation are, therefore, designed to make it easier to let large institutions fail.

A second key part of the legislation extends the existing resolution mechanism for failed banks to systemically important non-banks and bank holding companies. Under the old law, Lehman could not have been resolved in this manner and while the banking part of Citigroup could have been resolved, the holding company itself (which owned many of the foreign subsidiaries) could not have been.

The new resolution mechanism makes it easier for the regulator to contemplate the failure of a large entity because the messy bankruptcy is replaced by a more orderly resolution process. There is also a provision for a bailout fund (Systemic Dissolution Fund) to facilitate the resolution process, but this fund is to be financed by contributions from the financial industry itself.

The problem with this proposal is that while it avoids bailing out shareholders of a large entity, it actually formalises the bail-out of their creditors through the systemic dissolution fund. It would, therefore, have the perverse effect of encouraging banks to become even larger to exploit this implicit guarantee from the government.

A third key element in the legislation is the reform of the OTC (over-the-counter) derivatives market. Lehman was not spectacularly large in terms of assets and liabilities. The systemic importance of Lehman (and even more so of AIG) came from OTC derivatives.

Lehman was a large dealer in OTC derivatives and AIG was a large counterparty for subprime-related credit default swaps. They were not too large to fail, but were described as too interconnected to fail. Reform of OTC derivatives is intended to prevent this kind of a situation from arising.

The straightforward solution to the OTC derivative problem is to move these derivatives to the exchanges where a central counterparty (the clearing house) collects margins from all participants and assumes responsibility for all trades. Lehman did have a portfolio of 66,000 contracts totalling $9 trillion of interest rate swaps cleared by LCH.Clearnet in London. LCH not only resolved the Lehman default without any loss, but also returned a large part of the margins that it had collected from Lehman.

To understand the difference with the OTC market, suppose that Lehman had sold $100 billion of a certain OTC swap to some parties and bought $90 billion of the same OTC swap from others. Its failure would force all its counterparties to terminate their $190 billion of Lehman deals and establish new contracts with other counterparties. When all these trades are done through an exchange, the clearing house would have to liquidate only the net position of $10 billion, and this is easier because of the margins that the clearing house has collected.

The US law tries to mandate clearing of standardised OTC derivatives, but the proposals are riddled with loopholes that threaten to make them ineffective. First, it does not mandate exchange trading; it only mandates clearing and that too if a clearing house accepts the concerned derivative for clearing. Second, many OTC derivatives lack price transparency and are therefore illiquid. Without a push towards transparency, many derivatives will simply be unacceptable for clearing. Third, minor changes in terms may make a derivative non-standardised and therefore not subject to clearing.

All in all, the 1,000-odd pages of complex provisions riddled with loopholes in this legislation will not make Lehmans sufficiently unlikely in future. I would suggest that ‘No more Lehmans’ is not the correct policy after all. True capitalism is about letting insolvent banks fail, however painful that might be.

Posted at 09:03 on Wed, 23 Dec 2009     View/Post Comments (2)     permanent link

Sun, 20 Dec 2009

How broken are the OTC markets?

The SEC has filed a complaint against the world’s largest inter dealer broker ICAP which dominates trading in US government securities and many other OTC markets. ICAP has settled the charges for $25 million and an undertaking to implement remedial action to be suggested by an independent consultant.

The charges are very serious:

It is depressing that charges of such seriousness are settled without an admission of guilt. The alleged actions shake the very foundations of market integrity and make one wonder whether OTC markets can be trusted at all.

Around the same time that I was reading this complaint, Rortybomb alerted me to a Bloomberg story of a few months ago about an investigation against Markit. The charges here are of a very different nature but they are disturbing in their own way. It is alleged that Markit agreed to provide price information to a clearinghouse only if the latter agreed to clear only trades that involved a dealer.

The question in my mind now is how badly broken are the OTC markets. Whenever, people describe the stock exchanges as casinos, my response is that even if many of the participants are only gambling, the stock exchange still performs the socially useful purpose of price discovery. OTC markets that do not provide transparent price discovery do not perform this function and are much closer to pure casinos. Those that distort the price discovery are worse than casinos.

Posted at 11:50 on Sun, 20 Dec 2009     View/Post Comments (2)     permanent link

Fri, 18 Dec 2009

Getting rid of cheques

The UK Payment Council this week announced a plan to abolish cheques in less than a decade. Actually, it is the clearing of cheques that would be closed on October 31, 2018, but that is as good as abolishing cheques themselves.

The report points out that “A number of countries including The Netherlands and Sweden have already largely or totally eliminated cheques. However volumes of paper credit payments in these countries remain significant. The cheque replacement programme in the UK would be going beyond these countries in aiming to modernise the payment system ...”

The usage of cheques in the UK peaked nearly two decades ago in 1990 and has been falling relentlessly since then. “Cheque use is in long-term, terminal decline.” The UK therefore proposes to shift remaining users of cheques to paperless channels (ATMs, mobile banking, internet banking and stored value cards) over the next decade and then get rid of cheques completely.

The report has a section on “cheque dependent consumers.” This group consists mainly of individuals with degenerative conditions and individuals living in care homes or with mobility problems. The main advantage of cheques is that they allow third parties to assist the user by filling up the cheque before the user signs the cheque. My own sense is that biometrics would be safer than reliance on a third party in such situations.

Interestingly, the report also discusses a few UK statutes which do not allow any alternative to paper payment – these include penalties for dog fouling, litter, releasing greenhouse gases and cigarette smoke.

Posted at 16:04 on Fri, 18 Dec 2009     View/Post Comments (1)     permanent link

Wed, 16 Dec 2009

Samuelson and finance theory

I found it surprising that most of the Samuelson obituaries do not refer to the impact that he had on finance theory. Along with Modigliani and Arrow, Samuelson was among the few mainstream economists who had an enduring impact on finance theory.

Indeed it appears odd that while modern finance theory is often regarded as the bastion of free market economics, it owes so much to Samuelson who was the dominant left wing economist of his era. By contrast, Samuelson’s great right wing rival, Milton Friedman, contributed very little to modern finance theory apart from his famous pronouncements on destabilizing speculation.

Samuelson more or less established the modern “martingale” concept of market efficiency (as opposed to the now largely discredited random walk model) in his landmark paper entitled “Proof that Properly Anticipated Prices Fluctuate Randomly.”

Samuelson also had a strong influence on option pricing through his doctoral student Robert Merton though Samuelson’s own work in this area is completely obsolete.

Above all, I think the mathematical approaches that Samuelson brought to economics were necessary prerequisites for modern financial economics to develop.

Posted at 12:36 on Wed, 16 Dec 2009     View/Post Comments (0)     permanent link

Tue, 08 Dec 2009

Principles based securities regulation

Cristie Ford has posted on SSRN an interesting paper on “Principles-Based Securities Regulation in the Wake of the Global Financial Crisis.” The paper argues that the Global Financial Crisis has not discredited principles based regulation.

According to Ford, what the crisis has done is to demonstrate that principles based regulation requires as much (and sometimes more) regulatory resources and trained staff as any other form of regulation. Principles based regulation “requires greater regulatory capacity in terms of numbers, resources, and expertise than has been allocated to it in some of the infamous examples of regulatory failure in the past two years – the failure of Northern Rock in the UK, and of the the SEC’s CSE Program”.

Principles based regulators also must have the ability to obtain transparent and reliable data directly, for otherwise, they effectively cede the field to the regulatees.

Ford also argues that regulators’ hiring decisions must be based not only on applicants’ relevant industry and legal expertise, but also with a view to whether applicants seem to have sufficient confidence and independence of mind.

Ford’s paper is an insightful analysis of the issues involved and is definitely worth reading.

Posted at 16:17 on Tue, 08 Dec 2009     View/Post Comments (0)     permanent link

Thu, 03 Dec 2009

Pirate stock exchanges and the origin of stock exchanges

Reuters has an interesting report on the stock exchange set up by Somali pirates to fund their activities. It is a fascinating story of how a stock exchange is operating in a near-barter economy. One of the shareholders got her “dividend” for contributing a grenade launcher which she received as alimony from her ex-husband.

The interesting thing is that this is exactly how finance began. Meir Kohn provides the following interesting description of the capital market before 1600 (page 13-14):

While landowners and governments could finance themselves with long-term debt, this option was generally not available to business: it lacked the security and the reliable cash flow required for a debt issue. On the other hand, business could promise substantial gains if things went well to compensate for the possibility of loss if things went badly. This potential for extraordinary returns did provide a basis for equity finance.

The fundamental problem of equity finance is to ensure equity-holders a fair return on their investment. Today, there exists a complex of institutional mechanisms to address this problem – accounting procedures and an accounting profession, legal protections, extensive reporting and analysis of financial information. Since none of these existed before 1600, equity finance had to rely on a simpler mechanism: wind up the business periodically, and divide up the proceeds among the shareholders. This procedure was possible, because business was largely commercial and did not require any substantial investment in fixed capital.

A few months ago, I wrote a post on ultra-simplified finance which revolved around equity markets. To see how powerful equity markets can be even when there is almost nothing else by way of a financial system, one has three choices:

  1. read Kenneth Arrow’s classic paper (“The role of securities in the optimal allocation of risk-bearing”);
  2. go back in time to the pre-industrial era;
  3. take a trip to Somalia.

Posted at 13:30 on Thu, 03 Dec 2009     View/Post Comments (1)     permanent link

Wed, 02 Dec 2009

Payment and Settlement Systems

I wrote a column in today’s Financial Express about payment and settlement systems in India in the context of the vision statement released by the Reserve bank of India

RBI recently released a vision statement for the payment systems in India for the next three years. The mission is “to ensure that all the payment and settlement systems operating in the country are safe, secure, sound, efficient, accessible and authorised.”

It is true that the payment system in India has made considerable progress in the last few years with the emergence of Real Time Gross Settlement (RTGS) system, National Electronic Fund Transfer (NEFT) system, implementation of core banking software in most large banks and rapid spread of the ATM network. With these developments, India is gradually moving away from antiquated paper-based payments to a modern payment system. The progress is slower than one would like, but it is progress all the same.

However, the global financial crisis in 2007 and 2008 has changed the way we look at the safety and soundness of payment systems, and the RBI vision statement does not reflect these new concerns and priorities at all. In fact, the document is characterised by a pre-crisis world view that makes it largely complacent about settlement system risks.

The first lesson from the crisis is that any payment or settlement system that settles in commercial bank money is simply unacceptable as a ‘safe, secure and sound’ system. During the crisis, credit default swap spreads on some of the largest banks in the developed world as well as in India rose to levels indicating serious concerns about their solvency.

This immediately brings up the horror scenario of every payment or settlement system: pay-ins take place into the settlement banks of these systems just before the settlement bank fails. In other words, the settlement bank fails after receiving the pay-in but before making the pay-outs.

Since the major securities and derivative settlement systems in India settle in commercial bank money, this horror scenario should be giving sleepless nights to the securities regulator and to the central bank. Unfortunately, the vision statement does not betray any such concern.

I think urgent steps should be taken to allow major settlement agencies like the clearing corporations of the stock exchanges, derivative exchanges, commodity exchanges, the Clearing Corporation of India and similar entities to make settlements in central bank money. Whether this takes the form of giving them a limited banking licence or of opening up the RBI’s payment system to systemically important non-bank entities is a matter of detail that need not bother us here.

The point is that we do not have a true delivery-versus-payment (DVP) system unless the payment happens irrevocably in central bank money. Before the crisis, it was possible to pretend that large banks are safe enough to allow settlement to happen in their books. After the crisis, the regulators would be irresponsible and delusional to accept this idea.

An even bigger problem exists in the settlement of foreign currency transactions where time zone differences preclude any true payment-versus-payment (PVP) settlement of these transactions. Herstatt Risk has really not been solved several decades after Herstatt Bank in Germany failed after receiving payments in its currency but before making payments in foreign currency.

The international community has come up with the idea of having a private bank (CLS Bank) handle the global settlement of foreign currency trades. This avoids banks having to take exposure on each other, but requires them to take exposure on CLS Bank and sometimes on a participant bank that provides access to CLS Bank.

The thinking was that a settlement and custody bank like CLS Bank cannot fail, but this is a delusion. During the 2008 global crisis, questions were raised about some US banks that were largely settlement and custody banks rather than lending banks. Moreover, even settlement and custody banks can suffer from acute operational risk as was demonstrated in a famous episode two decades ago in the US. As a member of the G20, India has an opportunity to argue for putting foreign exchange settlement on a sounder footing.

Many alternatives can be thought of. First is that the IMF could take on the responsibility of running foreign currency settlement not only because it holds all the currencies of the world, but also because it enjoys multilateral guarantees that would make settlement in IMF books a true PVP. The second possibility is that the world’s major reserve currencies (and currencies of invoicing) can be persuaded to run a 24/7 RTGS that eliminates the time zone problem.

The third solution, closer in line with the post-crisis philosophy of each country taking responsibility for risks within its territory, is for RBI to run a US dollar RTGS in Mumbai by taking advantage of its huge dollar reserves. In short, a lot needs to happen before we can say that “all the payment and settlement systems operating in the country are safe, secure and sound.”

Posted at 11:05 on Wed, 02 Dec 2009     View/Post Comments (2)     permanent link