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, 30 Nov 2010

Stock Exchange Ownership and Competition

I have a column in today’s Financial Express about a key committee report on ownership and competition in India’s stock exchanges.

The Jalan Committee appointed by Sebi has effectively recommended the back-door nationalisation of stock exchanges, clearing corporations and depositories (market infrastructure institutions or MIIs). If these recommendations are accepted, we will extinguish the essential spark of dynamism that has given India a world class equity market.

The Jalan report is permeated from beginning to end with the ideology of socialism and the command economy, but instead of overt nationalisation, it seeks to destroy private sector exchanges and other MIIs through a thousand small cuts. Let me list out just a few key elements of this strategy:

  1. The maximum profit that an exchange (or MII) can earn would be capped at a certain percentage of annual return on net worth of the previous year. Any excess over this would be transferred to the investor protection fund (IPF) or similar fund. The economic result of this would be that the existing equity capital of all exchanges would effectively become non-cumulative preference shares with a fixed rate of dividend, and the government (in the form of the IPF) would own the economic equity of the exchange.
  2. In keeping with the back-door nationalisation of the exchanges, it is proposed that their key executives should also be remunerated like bureaucrats—fixed salary with fixed annual increments, no variable pay and no form of stock options.
  3. The users of the market infrastructure (the members of the exchanges and clearing corporation) are prohibited from sitting on the board.
  4. Only public financial institutions and banks are allowed to become anchor investors in exchanges and other MIIs attenuating any residual chance of shareholder control.

The Jalan report also takes an essentially anti-competitive position in the field of exchanges and MIIs. The view taken is that there is sufficient competition already and that it would be undesirable to have more competition: “Sebi should have the discretion to limit the number of MIIs operating in the market, in the interest of the market and in public interest.”

There are two problems with this. First, the Indian MII industry (exchanges and depositories) is a near monopoly where the dominant players have been disciplined not by actual competition but by the threat of competition. In the jargon of the economists, it is a contestable market but not a competitive market. In this context, an attempt to limit new entrants will entrench the existing near-monopoly and remove the disciplining force of potential competition.

Historical experience tells us that we have got far better and cheaper telecommunications from competitive profit-seeking companies than from a monopoly state-run public utility. Competitive private players have given us cheaper and more convenient air travel than monopoly state players. It is the same story in industry after industry. The Jalan report is ignoring this overwhelming evidence from India and elsewhere, and propounding the belief that a cosy government-controlled monopoly or oligopoly would serve the market and the public interest better than a competitive industry structure.

The Jalan report seeks to limit competition by several means quite apart from the explicit limit on the number of exchanges and depositories. The regulated public utility model ensures that it is very unattractive for new entrants. Anybody seeking to challenge an entrenched incumbent faces a high chance of failure and the only incentive for entry is the prospect of large profit in case of success. The ceiling on profitability rules this out. Moreover, the new entrant would not be able to attract talented managers because of the inability to offer performance-based compensation.

As if all this were not enough, the proposed ownership norms rule out most strong strategic investors with deep pockets who have an incentive to enter the business. If only public financial institutions and banks are allowed to become anchor investors, the current incumbents are unlikely to be seriously challenged.

India, therefore, runs the risk of losing the competitive dynamism of the Indian equity markets. What is more tragic is that this is happening at a time when the stock exchange business in Asia is entering a period of regional, if not global, competition. The abortive bid by the Singapore Stock Exchange to buy the Australian Stock Exchange marked the first warning shot in this process. Asia is going to be one of the fastest growing equity markets in the world, and India’s world-class exchanges and depositories have a wonderful opportunity to occupy a pole position in this space.

At this critical juncture, when each exchange in Asia is deciding whether to be predator or prey in the emerging pan-Asian competition, the Jalan Committee is pushing India in the wrong direction. The recommendations, if implemented, would ensure that Indian exchanges never become pan-Asian institutions. Worse, Indian exchanges could even become completely unviable, if the business moves to exchanges outside India that may offer better service at more competitive prices.

Posted at 10:59 on Tue, 30 Nov 2010     View/Post Comments (2)     permanent link

Fri, 26 Nov 2010

Bailouts and thanksgiving

I wrote a column in Wednesday’s Financial Express arguing that bailout recipients seem to regard the bailout as an entitlement and are therefore unwilling to say ‘thank you’ let alone ‘sorry.’ This sense of entitlement aggravates the risk of moral hazard.

Warren Buffet’s open letter last week (NYT, November 17, 2010) thanking ‘Uncle Sam’ for bailing him out in 2008 serves to remind us that very few corporate leaders in the US or in India have been willing to say ‘thank you’ let alone ‘sorry’ after the global financial crisis and the ensuing bailout. Warren Buffet proudly says that “My own company, Berkshire Hathaway, might have been the last to fall,” but at least he admits that he too needed help.

By contrast, many corporate leaders around the world are busy creating a revisionist history of the crisis in which they can pretend that there was no serious problem with their companies at all. I do not think of the willingness to say ‘thank you’ or ‘sorry’ as a matter of politeness and courtesy. I view it instead as a measure of whether the recipient thinks of the bailout as an entitlement that he can look forward to in future or as a piece of good fortune that may or may not be repeated in future.

Warren Buffet’s letter describes the bailout as a correct policy but makes it clear that the bailout required a confluence of ideological disposition and technical competence in key decision makers. When recipients have this perspective, the moral hazard created by the bailout is attenuated.

While I disagree with the pro-bailout ideology of the Indian government (including RBI and other regulators) at the time, there is little doubt that the Indian crisis response was well thought-out, coordinated and implemented smoothly. Key recipients of this government bailout should be thankful to the government for this but, unfortunately, they seem to see the bailout as their right. Let us look at some examples of how this is leading to moral hazard.

Many debt-oriented mutual funds in India would have had to suspend redemptions but for the support provided by the government through the banking system. More than the mutual funds themselves, the corporate sector that had parked cash surpluses with these funds owe a big thank you to the government. For years, the corporate sector used these mutual funds as a tax sheltered vehicle to earn a high post-tax return on their cash surpluses.

Without the government bailout, these cash surpluses would have become illiquid and inaccessible at the time of the corporate sector’s greatest need. Moreover, the corporate sector would have taken large losses on their investments as the mutual funds tried to liquidate troubled assets into a risk-averse market.

This bailout encouraged moral hazard and within months corporate investors were pouring money back into liquid mutual funds believing that they would be protected if things go wrong. It is very disappointing that the government did not take the opportunity provided by the crisis to end the tax sheltered status of short-term mutual fund investments. Similarly, it is very unfortunate that the government did not impose a hair cut on impatient investors trying to redeem out of these funds at the height of the liquidity crisis.

Many Indian banks benefited from foreign exchange swaps extended by RBI during the crisis. When they were unable to roll over the foreign borrowing after the Lehman failure, and when their credit default swap spreads were trading at around 10% per annum, the RBI swaps were very attractively priced. Indian banks have therefore been in no hurry to subsidiarise their foreign branches.

Non-bank financial companies (NBFCs) owe a large debt of gratitude to the government for the lender of last resort (LOLR) support that they received at the peak of the crisis. Despite the fig leaf of providing the LOLR support through the banking system, the dividing line between banks and NBFCs was largely obliterated in those months.

The entire real estate sector owes a big thank you to the government for encouraging the banking system to restructure real estate loans during the crisis. More importantly, the sector benefited from the bailout of mutual funds and NBFCs, which were important sources of finance for them. Again the moral hazard engendered by this bailout is the main reason we have to worry about a real estate bubble so soon after the crisis.

The Indian corporate sector should also be grateful to the US Fed for unleashing a flood of dollar liquidity into the world after the Lehman failure. The resulting revival of capital flows into India in mid-2009 was instrumental in repairing damaged corporate balance sheets. There is no guarantee that conditions would be the same in the next crisis.

All these bailouts contributed to the relative mildness of the 2008 crisis in India, which has made the Indian private sector complacent. As a result, Indian managers are behaving less prudently than they ought to. That itself is a source of systemic risk. It would be far better if Indian corporate leaders emulated Buffet’s sense of humility and gratitude.

Posted at 16:10 on Fri, 26 Nov 2010     View/Post Comments (2)     permanent link

Mon, 15 Nov 2010

Why do Indian mutual funds intermediate inter-bank lending?

The Reserve Bank of India’s Report on Trends and Progress in Banking in India 2009-10 contains an interesting discussion on the inter-linkages between banks and debt mutual funds (Box IV.1 on page 64). As of November 2009, banks had invested Rs 1.3 trillion in debt mutual funds, but had also borrowed Rs 2.8 trillion from these funds – banks were thus net borrowers to the extent of over Rs 1.5 trillion. It appears that debt mutual funds are intermediating two kinds of flows in the debt market.

  1. Debt mutual funds were intermediating Rs 1.5 trillion of debt flows to the banks largely from the corporate sector.
  2. More interestingly, debt mutual funds were also intermediating Rs 1.3 trillion of interbank lending.

The RBI report describes the intermediation of interbank lending as follows:

When banks were arranged in a descending order by the amount of their net borrowings from MFs, public sector banks figured prominently at the upper end as major borrowers, while the new private sector banks along with SBI could be seen as major lenders to MFs.

The interbank money market is one of the oldest and most liquid markets in India. The repo market for secured lending is also well established with a central counterparty for risk mitigation, and has worked smoothly even during the turbulent periods of 2008. Why would there be a need for mutual funds to intermediate this market? Two possible reasons come to mind.

  1. The intermediation may be happening largely due to the tax advantages of mutual funds.
  2. The mutual funds may be intermediating the interest rate risk involved in investing in certificates of deposit issued by banks with several months of residual maturity, while allowing their own investors to redeem at any time. In the ultimate analysis however, this is an illusion because a mutual fund does not absorb risks, it only passes these risks on to its investors. Since the primary non-bank investors in a debt mutual fund come from the corporate sector, the question is whether the corporate sector has superior ability or willingness to assume this risk. I think the answer is no; in times of stress the corporate sector has been desperate to bail out of mutual funds. In 2008, it was left to the government to bail out the mutual funds themselves.

It appears to me that the whole system of artificial tax breaks to mutual funds has created economically useless layers of intermediation while also adding to systemic risk and fragility.

Posted at 08:22 on Mon, 15 Nov 2010     View/Post Comments (2)     permanent link

Tue, 09 Nov 2010

Mutual funds supporting their parents

Nearly three years ago, Ajay Shah sent out an email to a few of us about how the regulatory framework of a “first world country” would deal with possible conflicts of interest between a mutual fund and its parent company. At that time, it was too early in the global financial crisis for me to give the flippant answer that there are no first world countries any more – we are all third world countries.

The example that I gave then was that of UBS allegedly stuffing its own shares into its mutual fund and into the portfolios of wealth management clients and then voting them to win a proxy war against Martin Ebner way back in 1994. Holders of class N shares voting in favour of the UBS share unification proposal in that meeting were effectively voting to destroy the value of their own shares as Loderer and Zgraggen explained in an interesting paper (“When Shareholders Choose Not to Maximize Value: The Union Bank of Switzerland’s 1994 Proxy Fight”, Journal of Applied Corporate Finance, Fall 1999). Ideally therefore, portfolio investors should have sold all their class N shares ahead of the meeting.

But now there is an academic paper showing that Spanish mutual funds buy shares in their parent banks to prop up the share price after a significant fall (Golezyand and Marinz, “Price Support in the Stock Market”, SSRN, June 2010). The paper finds compelling evidence for such price support with careful econometrics that rules out alternative explanations like portfolio rebalancing into the banking sector, contrarian trading, timing skills or information-driven trading.

The authors point out that “Strictly speaking, price support activities by mutual funds are illegal, as the trades are not necessarily placed in the interest of the fund investors.” However they also believe that Spain is a country in which such crimes are not closely monitored and are not severely prosecuted.

Posted at 09:15 on Tue, 09 Nov 2010     View/Post Comments (0)     permanent link

Mon, 01 Nov 2010

Goodhart's law and leverage ratios

I am a strong believer in Goodhart’s Law which says that any measure begins to lose its usefulness when it is used as a regulatory target. The Basel Committee paper on “Calibrating regulatory minimum capital requirements and capital buffers: a top-down approach” released last week shows that this is quite true of the leverage ratio.

Table 2 on page 17 shows that if we exclude countries which had a leverage ratio requirement before the financial crisis, the leverage ratio does predict financial distress of banks. There is a large and statistically significant difference in the 2006 leverage ratios for banks that were stressed in the crisis of 2007/2008 and those that were not. However when these countries are included, the difference is smaller and is not statistically significant in most cases.

The Basle committee, which is now wedded to the idea of a leverage ratio, does not draw the conclusion that Goodhart’s Law is in operation. It refuses to even provide the only data which is truly relevant – the data for the countries which had a leverage ratio requirement pre-crisis. It is very likely that for these countries the leverage ratio would have been seen to be practically useless.

Posted at 14:07 on Mon, 01 Nov 2010     View/Post Comments (1)     permanent link