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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Wed, 23 Mar 2011

Finance teaching and research after the global financial crisis

I have a paper on “Finance teaching and research after the global financial crisis” (the paper is also available here). The abstract is as follows:

Finance has come in for a great deal of criticism after the global financial crisis of 2007 and 2008. Clearly there were serious problems with finance as it was practiced in the years before the crisis. To the extent that this was only a gap between theory and practice, there is a need for finance practice to go back to its theoretical roots. But there is a need to re-examine finance theory itself.

The paper begins with an analysis of what the crisis taught us about preferences, probabilities and prices, and then goes on to discuss the implications for the models that are used in modern finance.

The paper concludes that the finance curriculum in a typical MBA programme has not kept pace with the developments in finance theories in the last decade or more. While a lot needs to change in finance teaching, finance theory also needs to change though to a lesser extent. Many ideas that are well understood within certain subfields in finance need to be better assimilated into mainstream models. For example, many concepts in market microstructure must become part of the core toolkit of finance. The paper also argues that finance theory needs to integrate insights from sociology, evolutionary biology, neurosciences, financial history and the multidisciplinary field of network theory. Above all, finance needs more sophisticated mathematical models and statistical tools.

Posted at 21:41 on Wed, 23 Mar 2011     View/Post Comments (10)     permanent link

Tue, 15 Mar 2011

BCG Report on Organizational Reform of SEC

As required by Section 967 of the Dodd-Frank Act, the SEC engaged an independent consultant (Boston Consulting Group) to examine the internal operations, structure, and the need for reform at the SEC. The BCG report released last week covers four matters: organization structure, personnel and resources, technology and resources, and relationships with self-regulatory organizations.

The strength of the report is that it focuses on SEC as an organization rather than on regulatory philosophy or politics. We have known from several sources that there are serious organizational problems at the SEC. For example, Selling America Short by former SEC official, Richard Sauer, provides an insider’s perspective of the bureaucratic hurdles facing a committed SEC official. Markopolos of Madoff fame provides an even more riveting outsider’s perspective (see my blog post of two years ago).

I therefore looked forward to the BCG report which is based on nearly six months of work and more than 425 discussions with various people inside and outside the SEC. My main complaint against the report is that BCG appears to have accepted the views of the SEC senior management uncritically. This is quite normal in consulting assignments – a consultancy firm that does not align itself with the perspective of the client is unlikely to have many clients. In this case, however, it is not clear that the SEC is the client; arguably, the client is the US Congress if not the people of the US.

Consider for example, the excellent work that BCG has done in putting together Exhibit 4.1.1 on page 49. Essentially, BCG says that the SEC has too many layers and that many experienced and highly qualified professionals sit in the lower layers (layers six through eight of the organization. Equally disturbing is the finding (page 210-11) on the level of engagement of the workforce (the degree to which employees feel a bond to the organization and are motivated to give their best). Using data from a survey conducted by the US Government as well as their own data, BCG finds that SEC’s level of engagement is low compared to other private and public sector organizations.

If one combines this analysis with the insights from Markopolos and Sauer, the natural remedy is clearly a brutal delayering of the SEC that prunes out a lot of the dead wood at the upper managerial layers of the SEC and empowers the professionals who actually do the work. Unfortunately, a management consultant’s loyalties are to the senior managers and not to the professionals in layer eight.

The key conclusion of the BCG report is that the SEC needs a bigger budget and less interference from the Congress and the Government. The SEC Chairman of course welcomed the report enthusiastically.

Posted at 11:39 on Tue, 15 Mar 2011     View/Post Comments (1)     permanent link

Thu, 10 Mar 2011

Incredibly lax regulation of central counterparties

Regulators of central counterparties (CCPs) seem to have learned a very tiny lesson from the crisis – their standards for CCPs has moved from the laughable to the incredibly lax. The old standard (CPSS-IOSCO Recommendations for Central Counterparties, November 2004) said:

If a CCP relies on margin requirements to limit its credit exposures to participants, those requirements should be sufficient to cover potential exposures in normal market conditions. (Recommendation 4)

In a paper last year, I wrote:

This is like telling a car manufacturer that if a car has brakes, then the brakes should be sufficient to stop the car under normal driving conditions. The implication being that a car need not have brakes and even if they do, the brakes need not be designed to work on a slippery road.

The new standard (CPSS IOSCO Principles for financial market infrastructures: Consultative report, March 2011 ) is a tiny improvement:

A CCP should cover its credit exposures to its participants for all products through an effective margin system that is risk-based and regularly reviewed. ... Initial margin should meet an established single-tailed confidence level of at least 99 percent ... (Principle 6)

So, now the regulators have gotten around to accepting that the car should have brakes, but the regulation on the effectiveness of the brakes is still incredibly lax.

A confidence level of 99% implies that there would be a margin shortfall every six months. Even if we take into account other resources of the CCP, this is an unacceptably high failure rate for an institution as systemically important as a CCP. In banking regulation, 99% was the accepted level in 1996 (Market Risk Amendment), but this increased to 99.9% in Basel II (2004). For derivative exchanges, I have argued that the margin coverage should be set at 99.95%, so that margins coupled with other CCP resources would allow the CCP to reach an acceptable level of safety.

Posted at 16:07 on Thu, 10 Mar 2011     View/Post Comments (1)     permanent link

Wed, 02 Mar 2011

Ajay Shah on cross-border exchange mergers

Ajay Shah has written an elegant analytical blog post on the illusory cost savings from cross-border exchange mergers. In my view however, these mergers are as much about integration of capital markets as they are about cost savings.

Twenty years ago, India had around twenty exchanges spread across maybe twenty different states. Each exchange had its own clientele of listed companies and investors; India was divided into several regional capital markets. Then we witnessed a rapid integration of the Indian capital market in which two exchanges in Mumbai became national markets and the other exchanges became defunct.

I believe we are on the cusp of a similar integration of capital markets on a global scale. We will probably go from a hundred different exchanges in a hundred different countries to maybe ten (maybe fewer) global exchanges. The question is whether in this new game the Indian exchanges will end up like the BSE and the NSE that survived the consolidation or whether they will end up like the CSE and DSE that became defunct.

The MIFC report had a bold and wonderful vision of India being among the winners in the globalization of financial services. I fear that we are now abandoning this vision. Meanwhile globalization is picking up speed – this year’s budget has pulled down a couple of the few remaining barriers to de facto capital account convertibility.

Posted at 08:35 on Wed, 02 Mar 2011     View/Post Comments (1)     permanent link

Tue, 01 Mar 2011

Libya assets freeze: will other sovereigns start hiding assets?

I have been thinking about whether the moves by many countries to freeze Libyan assets could cause many sovereigns to start hiding their foreign assets (including assets held by foreign exchange reserves as well as sovereign wealth funds). First of all the asset freezes:

  1. The action began in Switzerland on Thursday (February 24). The text of the ordinance is in German, but the media release says:

    In order to avoid any misuse of state monies, the Federal Council decided today to block with immediate effect all assets in Switzerland of Moammar Gaddafi and those associated with him. The sale and any disposal of goods – in particular real estate – belonging to these persons are also prohibited with immediate effect. The Federal Council thus intends to take all the necessary steps to avoid any embezzlement of Libyan state assets that may still be in Switzerland. The corresponding ordinance will take effect today and will remain valid for three years.

    Apparently, most Libyan government assets were pulled out of Switzerland a couple of years ago because of a dispute between the two countries. So the impact of this freeze is minimal but it is of huge symbolic significance.

  2. The next day (Friday), the US followed up with a freeze very similar to the order used against Iran in 1979. The US order covers deposits with US banks outside the US, but in the case of similar sanctions back in 1986 (coincidentally against Libya itself) a UK court ordered the London branch of a US bank to release the assets and the US accepted this verdict.

    Some reports have suggested that the US was waiting to close down its embassy in Libya and bring most of its citizens back before doing the asset freeze on Friday. Similarly, it has been suggested that the UK had delayed action on a similar freeze while it tried to get its citizens back. This is important because the majority of Libyan foreign assets are probably in the UK.

  3. On Saturday, the UN Security Council passed Resolution 1970 requiring all UN member countries to freeze Libyan assets:

    [The UN Security Council] Decides that all Member States shall freeze without delay all funds, other financial assets and economic resources which are on their territories, which are owned or controlled, directly or indirectly, by the individuals or entities listed in Annex II ..., and decides further that all Member States shall ensure that any funds, financial assets or economic resources are prevented from being made available by their nationals or by any individuals or entities within their territories, to or for the benefit of the individuals or entities listed in Annex II ...

I recall that the 1979 US asset freeze against Iran had a dramatic and lasting impact on the investment of sovereign assets in the Arab world. Most Arab dollar deposits are today placed in non US banks in London or elsewhere out of reach of a US asset freeze. This is true though many of these nations are on friendly terms with the US and have no love lost for Iran. A significant part of Chinese holdings of US Treasury is also routed via London for possibly similar reasons.

The Libyan asset freeze poses far more serious challenges for sovereign asset managers, and could I think lead to even more dramatic changes. Most importantly, since countries other than the US (and in particular, Switzerland) are acting on this, it is hard to see where to park the money safely.

China did vote for the UN resolution: “Taking into account the special circumstances in Libya, the Chinese delegation had voted in favour of the resolution.” Yet it is arguable that in a post “Resolution 1970” world, Tiananmen Square might have led to much stronger action by many other countries. Surely, China has a veto in the UN Security Council, but I must point out that the Security Council records “Resolution 1970” as being welcomed by Libya:

IBRAHIM DABBASHI ( Libya) expressed his condolences to the martyrs who had fallen under the repression of the Libyan regime, and thanked Council Members for their unanimous action, which represented moral support for his people, who were resisting the attacks. The resolution would be a signal that an end must be put to the fascist regime in Tripoli.

Under this precedent, the veto is potentially useless during a period of intense internal turmoil when the country’s representative in the UN might have defected to the rebel regime.

Many countries other than China must also be wondering whether their assets are safe. Even India would remember the international sanctions that came after Pokhran II. Can India be absolutely confident that its assets outside India would be safe under all conditions?

It appears to me that the Westphalian sovereignty of the nation state is really dead. All sovereigns will have to start acting on this assumption, and trying to safeguard their foreign assets as best as they can. I suspect that this means that at least some part of sovereign wealth will have to be invested in assets whose ownership is opaque if not untraceable.

What might these assets be?

In short, sovereign fund managers who have been putting all their money in safe government bonds might have been focusing on the wrong risk. Assets with greater market risk and credit risk might have lower political risk particularly tail risk.

Posted at 08:07 on Tue, 01 Mar 2011     View/Post Comments (1)     permanent link