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, 26 Jan 2010

The Volcker rule

I wrote a column in the Financial Express today on the Volcker rule and other proposals of President Obama.

President Obama has proposed the ‘Volcker rule’ preventing banks from running hedge funds, private equity funds or proprietary trading operations unrelated to serving their customers. Simultaneously, he also proposed size restrictions to prevent the financial sector from consolidating into a few large firms. While this might look like unwarranted government meddling in the functioning of the financial sector, I argue that, in fact, free market enthusiasts should welcome these proposals.

Obama has chosen to frame the proposal as a kind of morality play in which the long-suffering public get their revenge against greedy bankers. While that might make political sense, the reality is that the proposals are pro free markets. To understand why this is so, we must go back to the moral hazard roots of the global financial crisis.

These roots go back to 1998 when the US Fed bailed out the giant hedge fund, LTCM. The Fed orchestrated an allegedly private sector bailout of LTCM, but more importantly, it also flooded the world with liquidity on such a scale that it not only solved LTCM’s problems, but also ended the Asian crisis almost overnight.

LTCM had no retail investors that needed to be protected. The actual reason for its bailout was the same as the reason for the bailout of AIG a decade later. Both these bailouts were in reality bailouts of the banks that would have suffered heavily from the chaotic bankruptcy of these entities.

Back in 1998, the large global banks themselves ran proprietary trading books that were also short liquidity and short volatility on a large scale like LTCM. A panic liquidation of LTCM positions would have inflicted heavy losses on the banks and so the Fed was compelled to intervene.

From a short-term perspective, the LTCM bailout was a huge success, but it engendered a vast moral hazard play. The central bank had now openly established itself as the risk absorber of last resort for the entire financial sector. The existence of such an unwarranted safety net made the financial markets complacent about risk and leverage and set the stage for the global financial crisis.

Those of us who like free markets abhor moral hazard and detest bailouts. The ideal world is one in which there is no deposit insurance and the governments do not bail out banks and their depositors. Since this is politically impossible, the second best solution is to limit moral hazard as much as possible.

If banking is an island in which the laws of capitalism are suspended, this island should be as small as possible, and the domain of truly free markets—free of government meddling and moral hazard—should be as large as possible. Looked at this way, the Volcker rule is a step in the right direction. If banks are not shadow LTCMs, then at least the LTCMs of the world can be allowed to fail.

The post-Lehman policy of extending government safety net to all kinds of financial entities amounted to a creeping socialisation of the entire global financial system. The Volcker rule is the first and essential step in de-socialising the financial sector by limiting socialism to a small walled garden of narrow banking while letting the rest of the forest grow wild and free.

What about the second part of the Obama proposal seeking to limit the size of individual banks? I see this as reducing oligopolies and making banking more competitive. Much of the empirical evidence today suggests that scale economies in banking are exhausted at levels far below those of the largest global banks, and there is some evidence that scale diseconomies set in at a certain level.

There is very little reason to believe that banks with assets exceeding, say, $100 billion are the result of natural scale economies. On the contrary, they appear to be the result of an artificial scale economy caused by the too-big-to-fail (TBTF) factor. The larger the bank, the more likely it is to be bailed out when things go wrong. It is therefore rational for a customer to bank with an insolvent mega-bank rather than with a well-run small bank.

This creates a huge distortion in which banks seek to recklessly grow to become eligible for the TBTF treatment. Well-run banks that grow in a prudent manner are put at a competitive disadvantage. This makes the entire financial sector less competitive and less efficient.

The Obama size restrictions will reduce the distortions created by the TBTF factor, and will make banking more competitive. One could argue that the restrictions do not go far enough because they legitimise the mega firms that already exist and only seek to prevent them from becoming even bigger. Nevertheless, it is in the right direction. It does not undo the damage that has already been done, but prevents further damage.

Posted at 14:27 on Tue, 26 Jan 2010     View/Post Comments (7)     permanent link

Thu, 21 Jan 2010

Computational and sociological analyses of financial modeling

I have been reading a number of papers that examine financial modeling in the context of the current crisis from a computational complexity and sociology of knowledge point of view:

I liked all these papers and learned a lot from each of them which is not the same as saying that I agree with all of them.

The paper that I liked most was Beunza and Stark which is really about cognitive interdependence and systemic risk. Their work is based on an ethnographic study of financial modeling carried out over a three year period at a top-ten global investment bank. Some of their conclusions are:

Using models in reverse, traders find out what their rivals are collectively thinking. As they react to this knowledge, their actions introduce a degree of interdependence ...

Quantitative tools and models thus give back with one hand the interdependence that they took away with the other. They hide individual identities, but let traders know what the consensus is. Arbitrageurs are thus not embedded in personal ties, but neither are they disentangled from each other.

Scopic markets are fundamentally different from traditional social settings in that the tool, not the network, is the central coordinating device.

Instead of ascribing crises to excessive risk-taking, misuse of the models, or irreflexive imitation, our notion of reflexive modeling offers an account of crises in which problems unfold in spite of repeated reassurances, early warnings, and an appreciation for independent thinking.

Implicit in the behavioral accounts of systemic risk is an emphasis on the individual biases and limitations of the investors. At the extreme, investors are portrayed as reckless gamblers, mindless lemmings, or foolish users of models they do not understand. By contrast, our detailed examination of the tools of arbitrage offers a theory of crisis that does not call for any such bias. The reflexive risks that we identified befall on arbitrageurs that are smart, creative, and reflexive about their own limitations.

Though the paper is written in a sociological language, what it most reminded me of was Aumann’s paper more than 30 years ago on “Agreeing to disagree” (The Annals of Statistics, 1976). What Beunza and Stark describe as reflexivity is closely related to Aumann’s celebrated theorem: “If two people have the same priors, and their posteriors for a given event A are common knowledge, then these posteriors must be equal.”

The Brigo et al paper is mathematically demanding as they take “an extensive technical path, starting with static copulas and ending up with dynamic loss models.” But it is very useful in explaining why the Gaussian copula model is still used in its base correlation formulation though its limitations have been known for several years. My complaint about the paper is that it focuses too much on the difficulties in fitting the Gaussian copula to observed market prices and too little on the difficulties of using it to estimate the impact of plausible stress events.

MacKenzie focuses on “evaluation cultures” which are broader than just models. They are “pockets of local consensus on how financial instruments should be valued.” He argues that “‘Greed’ – the egocentrically-rational pursuit of profits and bonuses – matters, but the calculations that the greedy have to make are made within evaluation cultures”. MacKanzie highlights “the peculiar status of the ABS CDO as what one might call an epistemic orphan – cognitively peripheral to both its parent cultures, corporate CDOs and ABSs.”

The Arora et al paper is probably the most mathematical of the lot. It essentially shows that an originator can put bad loans into CDOs in such a way that it is computationally infeasible for the investors to figure this out even ex post.

However, for a real-life buyer who is computationally bounded, this enumeration is infeasible. In fact, the problem of detecting such a tampering is equivalent to the so-called hidden dense subgraph problem, which computer scientists believe to be intractable ... Moreover, under seemingly reasonable assumptions, there is a way for the seller to ‘plant’ a set S of such over-represented assets in a way that the resulting pooling will be computationally indistinguishable from a random pooling.”

Furthermore, we can show that for suitable parameter choices the tampering is undetectable by the buyer even ex post. The buyer realizes at the end that the financial products had a higher default rate than expected, but would be unable to prove that this was due to the seller’s tampering.

The derivatives that Arora et al discuss are weird binary CDOs and my interpretation of this result is that in a rational market, these kinds of exotic derivatives would never be created or traded. Nevertheless, this is an important way of looking at how computational complexity can reinforce information asymmetry under certain conditions.

Posted at 12:40 on Thu, 21 Jan 2010     View/Post Comments (17)     permanent link

Wed, 13 Jan 2010

More on OTC derivatives

I have several comments by email on my blog post yesterday on OTC derivatives. This post responds to some of them and adds some more material on the subject.

One of the papers that I did not refer to in yesterday’s post was a paper by Riva and White on the evolution of the clearing house model for account period settlement at the Paris Bourse during the nineteenth century. Streetwise Professor linked to a conference paper version of this in his post while Ajay Shah pointed me to an NBER version of the same paper.

The account period settlement at the Paris Bourse was similar to the ‘badla’ system that prevailed in India until the beginning of this century. All trades during a month were settled at the end of the month so that the stock market at the beginning of the month was actually a one month forward market. At the end of the month, the settlement could be postponed for another month on paying the price difference and a market determined backwardation or contango charge. In fact, this system for trading individual stocks continued even after the introduction of stock index futures (CAC 40) in the Paris market. Crouhy and Galai, “The settlement day effect in the French Bourse,” (Journal of Financial Services Research, 1992) provide a good description of this market and explore the working of the cost of carry model in this market.

Coming back to Riva and White, they document the emergence of a clearing house model in which the Paris Bourse guaranteed all trades on the exchange. The bourse not only guaranteed settlement of trades between two brokers but also repaid the losses suffered by the defaulting broker’s clients (except during a period from 1882 to 1895). This clearing house guarantee was supported by a capital requirement for all brokers and by a guarantee fund, but not by any margins. The entire process seems to have been driven by the government and the central bank.

By contrast, the US futures exchanges introduced initial and variation margins well before they introduced the clearinghouse in 1883 as documented in the Kroszner paper that I mentioned in my post yesterday. The existence of margins eliminates most of the moral hazard problems that plagued the clearing house in Paris and required state intervention of some form or the other. The US thus saw a private ordering emerging without any involvement of the state.

India ran the ‘badla’ system in the nineteenth and through most of the twentieth century without any margins and without any clearinghouse guarantee. While France solved the risk problem in its usual dirigiste style and the US solved it using private ordering, India seems to be a case of state failure and market failure until the last decade of the twentieth century. In fact, the problem was solved only a few years before the abolition of ‘badla’ itself.

Now I turn to some other papers relevant to the regulation of OTC derivatives.

Viral Acharya and several coauthors have written extensively on the regulation of OTC derivatives, and I will mention two. Acharya and Engle have a nice paper that explains the key issues in the context of the proposed US legislation.

Acharya and Binsin have a conference paper explaining how an exchange is able to price counterparty risk better than the OTC market because it is able to see the entire portfolio of the counterparty. Streetwise Professor criticizes this on the ground that exchanges charge the same price to everybody and do not discriminate. I think this criticism is incorrect – exchanges do not discriminate in the sense that they apply the same risk model to everybody, but the standard SPAN type model is a portfolio model where the margin is not on an individual position but on a portfolio. The incremental margin requirement for any position thus depends on what else is there in the portfolio. Thus the risk is priced differentially.

The Acharya and Binsin paper must be read in conjunction with a paper by Duffie and Zhu who show that the efficiency gain from central clearing is best realized when there is a single clearing house for all derivatives and the gains may disappear if there are separate clearing houses for different products and even more so when there are competing clearing houses for the same product. This in my view is only an efficiency issue and does not detract from the reduction of systemic risk from the use of central clearing.

For those interested in data about the magnitudes involved in these markets in terms of risk and collateral requirements, a good source is an IMF Working Paper on “Counterparty Risk, Impact on Collateral Flows, and Role for Central Counterparties.” For more detailed information about the CDS market, there is an ECB paper on “Credit default swaps and counterparty risk”

Posted at 12:40 on Wed, 13 Jan 2010     View/Post Comments (0)     permanent link

Tue, 12 Jan 2010

Regulation of OTC Derivatives

Last month, the UK Financial Services Authority (FSA) and the Treasury put out a document entitled “Reforming OTC Derivative Markets: A UK perspective.” My one line summary of this document is that the UK does not wish to make any significant changes to the regulations of the OTC markets. A cynic would say that this is explained by the fact that London dominates the OTC derivative markets globally.

This month there was a nice paper by Darrell Duffie and two co-authors for the New York Fed advocating not just central clearing, but also encouraging the use of exchanges and electronic trading platforms, as well as post-trade price transparency. I like this report though the Streetwise Professor thinks that this is tantamount to socialist planning.

Streetwise Professor has been arguing in a series of posts on his blog that OTC markets have evolved naturally and must therefore represent an efficient outcome absent demonstrable externalities. This argument deserves serious consideration and is one to which I am sympathetic.

One of the early and clear enunciations of the private ordering argument is a paper over ten years ago by Randall Kroszner (“Can the Financial Markets Privately Regulate Risk?,” Journal of Money, Credit & Banking, 1999) which describes the historical evolution of exchange clearing in the last century and compares it to the development of the OTC markets. As I re-read this paper, I was struck by two statements in the paper.

This analysis provides one perspective on what went wrong during the crisis. First, the “regulation” provided by the rating agencies was an absolute disaster and the “mini derivatives exchange” run by the large derivative dealers turned out to be far less robust than the derivative exchanges.

At the same time, private parties have no incentive to move from the failed model to the robust model because the failed model now comes with the wrapper of a “Too Lehman-like To Fail” guarantee from the government. In the absence of this government guarantee, private ordering might have been relied on to do the right thing, but in its presence, things are different.

Posted at 14:45 on Tue, 12 Jan 2010     View/Post Comments (0)     permanent link

Mon, 11 Jan 2010

Currency in circulation

The Chief Cashier of the Bank of England, Andrew Bailey, gave a fascinating speech last month on various aspects of currency in circulation in the UK. The key point is that while cheques have been in terminal decline in the UK (see this blog post), cash has in recent years been growing not only in notional value, but even as a percentage of GDP.

Bailey thinks that people are increasingly using cash as a store of value (and not just as a medium of exchange) partly because of a lack of confidence in the banking system and partly because at near zero interest rates, the opportunity cost of holding cash is negligible. If people are indeed stuffing cash under their mattresses, it tells us how harsh the global financial crisis has been.

Another interesting point is about the quality of notes. In India, ATMs typically give out better notes than the bank branches do, but Bailey tells us that in the UK, it is the reverse. The new generation of ATM machines can dispense notes so soiled that a human teller would regard them as unfit to be dispensed. One almost hopes that India remains stuck in the old generation of easily jammed ATMs that give out relatively clean notes.

The most important point that Bailey makes is that “banknotes are central-bank money in a form that can be held by the public, in other words the retail equivalent of reserve accounts at the central bank.” I would like to push this point further – if technology allows electronic accounts to be maintained at near zero cost, should not the central banks provide electronic reserve accounts to all citizens? As India moves toward issuing a unique identity number to every citizen, would it not be nice for each such number to be linked to a no frills account at the RBI?

Why in other words should only the rich and powerful institutions have access to central bank money? When a variety of tax laws and money laundering laws attempt to prevent the use of central bank money in the form of cash, should they not then facilitate the use of central bank money in the form of electronic reserve accounts at the central bank?

The shocking thing in finance is that financial markets settlements do not reach the highest standards of DVP (delivery versus payment) – simultaneous and irrevocable payment in central bank money. If you go to a grocery shop, pay for your purchases in cash and walk out with your goods, the transaction conforms to the highest standards of DVP because cash is central bank money. In most financial markets on the other hand, we do not get this level of DVP because the settlement systems do not settle in central bank money. This is a shame.

Posted at 13:36 on Mon, 11 Jan 2010     View/Post Comments (2)     permanent link

Fri, 01 Jan 2010

Foreign Investment: Direct versus Portfolio

Ever since the Asian crisis, there has been a sort of consensus that foreign direct investment (FDI) is the best and most stable form of capital inflows while foreign portfolio flows (FII in Indian parlance) are more volatile and therefore less desirable.

Ever since the global crisis began, I have been reading a lot of financial history (starting with the last 500 years and slowly going further back). It now appears to me that the aversion to the volatility induced by portfolio flows is extremely short sighted.

In the long run, the volatility gets washed out and what counts is the average growth rate of the economy. The short term (high frequency) is all noise (volatility) while the signal (mean) is apparent only in long time series (low frequency). Lessons drawn from short time series of data are probably wrong.

Looking back at some of the major emerging markets of the nineteenth century (US, Canada, Australia and Argentina) puts things in a totally different perspective. I particularly enjoyed the discussion about nineteenth century US in Chapters 7 and 8 of Atack and Neal, (The Origin and Development of Financial Markets and Institutions; From the Seventeenth Century to the Present, Cambridge University Press, 2009).

Of all the big emerging markets of the nineteenth century, the US relied most on portfolio flows and Argentina relied the most on foreign direct investment. By 1890, the results of the different trajectories were quite apparent.

In the long run, the volatility of the growth rate is largely irrelevant; it is the average that counts. Despite frequent financial crises and corporate bankruptcies, the US grew faster. More importantly, it was also able (despite the damage inflicted by populist politicians like Andrew Jackson) to build a domestic financial system that ultimately made it less dependent on foreign markets and institutions.

Applying that historical lesson would suggest that India should remain friendly to foreign portfolio flows while developing domestic financial markets. We must simply learn to live with the volatility and occasional crises that come in their wake.

Posted at 13:37 on Fri, 01 Jan 2010     View/Post Comments (7)     permanent link