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
jrvarma@iima.ac.in

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Wed, 21 Sep 2011

Siemens and the ECB

There have been a number of press reports about the German engineering giant Siemens parking € 4-6 billion of cash with the European Central Bank (ECB) in the form of one week deposits instead of leaving it with commercial banks (see, for example, here, here and here). Much of the commentary has emphasized the flight to safety motive for this move, but the reports also point out that the ECB pays a slightly higher interest rate on one week deposits than what the banks offer on longer term deposits. Assuming some tolerance for interest rate risk (the ECB rate could fall in future!), the move could also be justified purely as a pursuit of returns.

I would however like to ask the ultimate tail risk question (to which I have no answers) – is it reasonable to assume that there is no risk in depositing money with the ECB? The best analysis of the ECB’s solvency that I have seen is a piece by William Buiter written a couple of years ago (at his maverecon blog at the Financial Times several months before joining Citigroup as its Chief Economist). Much of the data in this is a little dated, but the analysis is illuminating all the same.

In his piece (entitled “Does the ECB/Eurosystem have enough capital?”), Buiter pointed out that the ECB has a leverage of 70:1 and even the consolidated balance sheet of the ECB and the Eurozone national central banks showed a leverage of 25:1. Buiter also noted that the asset side of the ECB balance sheet “includes a lot of rubbish”. And that was before it had started buying peripheral sovereign debt in a big way. Yet, Buiter concluded that all this “would not endanger the solvency of the Eurosystem, which has the present discounted value of current and future seigniorage income (the interest earned (or saved) by being able to borrow at a zero rate of interest through the issuance of currency and through mandatory reserve requirements).” Those who want a more elaborate theoretical treatment of seigniorage would find it useful to read his 2007 academic paper on the subject.

Buiter estimated that the capitalized value of the current and future stream of seigniorage would be 20 percent of Euro Area annual GDP. This capitalized value of seigniorage was according to Buiter sufficient to mark all the assets on the ECB’s entire balance sheet all the way down to zero and still leave it economically solvent.

One cannot ask for a more conclusive affirmation of solvency than this. But my question was about tail risk, and a tail risk scenario would include a possible euro zone break up. In that scenario, would the seigniorage income flow to the ECB or to the national central banks? And would those national central banks stand behind the ECB?

Posted at 18:17 on Wed, 21 Sep 2011     View/Post Comments (2)     permanent link


Tue, 20 Sep 2011

SEBI trading curbs when promoter fail to dematerialize their holdings

I was interviewed on CNBC TV18 today on the implications of the trading curbs imposed by the Securities and Exchange Board of India (SEBI) on companies whose promoters do not dematerialize all their shares. Even though the deadline is now only 10 days away, many of the largest companies in India including several state owned companies are not in compliance and could therefore face these curbs.

The principal points that I made in the interview were as follows:

The transcript of the interview as well as the video are available at the CNBC web site.

Posted at 16:51 on Tue, 20 Sep 2011     View/Post Comments (1)     permanent link


Thu, 15 Sep 2011

The UK Finish versus the Swiss Finish

The United Kingdom and Switzerland are the two large economies with global banking systems that are far larger than their own economies. Both of them have been worried about the risks that these outsized banking systems pose to their national solvency. They realize that if their banks were to behave as stupidly as the Icelandic banks did, they could face the same fate as Iceland.

A year ago, a Commission of Experts appointed by the Swiss government produced a report on dealing with “too big to fail” banks. A few days ago, an Independent Commission on Banking appointed by the UK government produced its report on improving stability and competition in UK banking.

Both reports have adopted a similar approach in terms of additional capital requirements. For their largest banks, the Swiss report recommended 19% capital consisting of 10% common equity and 9% contingent capital (CoCos). The UK report asks for 17% capital for a large ring-fenced retail banks and 20% for a large investment bank. Again 10% is equity but the balance can be in any form of debt that has “Primary Loss Absorbing Capacity” (PLAC). It is likely that a big part of the PLAC will be CoCos.

The Swiss finish for large banks kicks in for banks with assets of about 50% of Swiss GDP and the 19% capital level mentioned above is reached for their largest banks which have assets of about 300% of Swiss GDP. The UK requirements kick in for banks with Risk Weighted Assets (RWA) equal to 1% of UK GDP and reach the stated level of 17% for RWA of 3% of UK GDP. If we assume that RWA is about a third of total assets, then the 3% level for RWA would correspond to about 9% of UK GDP for total assets. Since UK GDP is about 4 times Swiss GDP, this would correspond to about 35% of Swiss GDP. In other words, the Swiss proposals are calibrated to catch just their two largest banks (UBS and CS), but the UK proposals are much broader. For universal banks which are essentially investment banks, the capital level of 20% is also marginally higher than the Swiss level of 19%. On balance, the UK is going a little beyond Switzerland.

The UK report would allow foreign owned investment banks to operate in London without being subject to the higher capital requirements applicable to UK banks on the assumption that the UK taxpayer would not have any significant exposure to such institutions. The report is really saying that the UK should make money by renting out office space in London to investment banks that may wreck the taxpayers of their home countries so long as the UK taxpayer is spared. “The fact that some other countries may implicitly subsidise their wholesale/investment banks does not make it sensible for the UK to do so.”

I personally believe that capital levels close to 20% are the right levels. The Rothschilds survived and prospered over two centuries of war and revolution in Europe because they had capital of this level or more (and that too as percentage of total assets and not risk weighted assets). High level of capital did not prevent the Rothschilds from becoming bankers to the world. The Modigliani Miller theorem in capital structure theory assures us that debt is cheaper than equity only because of the tax deductibility of interest. The tax advantage of debt essentially means that levered banks get a subsidy as a percentage of their total debt. If we do want to give tax breaks to the banks, it is better to give it to them as a percentage of assets so that it does not distort capital structure decisions.

The UK proposal goes far beyond the Swiss in another respect – the ring fencing of retail banks. In some respects, it goes beyond even the Glass Steagall Act let alone the Volcker Rule. Ring fenced retail banks are to be prohibited from providing any of the following services:

In another sense, the UK proposal is much milder than Glass Steagall. A ring fenced retail bank and an investment bank can be part of the same group provided the retail bank is independently capitalized and can continue to operate normally even if the investment bank fails and is put into liquidation.

I see some merit in this proposal, but I think it is less important than the requirement for higher capital.

Posted at 16:30 on Thu, 15 Sep 2011     View/Post Comments (0)     permanent link


Tue, 13 Sep 2011

Credit, money and sociopaths

Early in my career, I read Homer and Sylla’s A History of Interest Rates and learned that credit predates money and probably predates barter. As a finance professor I was thrilled to read a top notch economic historian like Richard Sylla say that finance predates economics: barter is economics, even money is economics, but credit is quintessential finance. No wonder that decades later I still love this book. In a blog post last year, I recommended Homer and Sylla as the one book on financial history that we should all read.

Of course, I did worry whether Homer and Sylla were right or were merely making a casual remark, but the other books that I read (for example, Polanyi, Trade and Markets in the Early Empires) confirmed the primacy of credit over money and barter. In the anthropological and sociological literature, there appeared to be a consensus on this issue.

So long as this account was confined to obscure books read only by a technical audience, there was no great controversy about it. But then, David Graeber wrote a book entitled Debt: The First 5,000 Years and more importantly talked about it in the widely followed economics blog Naked Capitalism. Austrian economists in particular were very upset with him and criticized him only to climb down subsequently. In his latest post at Naked Capitalism, Graeber provides a detailed description of how credit was transformed into money.

The post is worth reading in full especially the passage where Graeber writes that “Homo Oeconomicus ... is ... an almost impossibly boring person—basically, a monomaniacal sociopath who can wander through an orgy thinking only about marginal rates of return”. I entirely agree with this but in a way very different from what Graeber intends. The only way to succeed in finance is to assume that the other person is a monomaniacal sociopath; and that is true whether you are doing high frequency trading or negotiating with the people who borrowed your money years ago but are unwilling to repay it now. As for orgies, anybody who has seen a trading room (or read about it in books like Liar’s Poker) knows that such minor distractions do not impede the true sociopath’s ability to concentrate on making as much money as possible off the other person.

Posted at 19:37 on Tue, 13 Sep 2011     View/Post Comments (0)     permanent link


Tue, 06 Sep 2011

Importance of Financial Markets

After the global financial crisis, many people started thinking that financial markets are evil. So it is nice to see several papers in quick succession arguing that financial markets are more important than banks.

Asli Demirguc-Kunt, Erik Feyen, and Ross Levine presented a paper at a World Bank conference in June entitled “Optimal Financial Structures and Development: The Evolving Importance of Banks and Markets”. They present strong empirical evidence to show that as countries grow richer and become more sophisticated, they need markets more than banks. The optimal financial structure becomes more market based at higher levels of income. Deviations from this optimal structure lead to slower growth.

This month, Julien Allard and Rodolphe Blavy published an IMF working paper entitled “Market Phoenixes and Banking Ducks: Are Recoveries Faster in Market-Based Economies?” in which they argue that “market-based economies experience significantly and durably stronger rebounds than the bank-based ones” They go on to state that “because the financial structure of economies matters, structural policies to deepen financial markets so that they can effectively complement banking sectors are useful. This suggests that policies that would stifle the development of financial markets after the crisis would be misguided.” Of course, Allard and Blavy also emphasize that policy makers must enhance the stability of financial markets as well as reduce rigidities in the real economy.

Closed related is a paper by Stephen Cecchetti, M S Mohanty and Fabrizio Zampolli presented at the Jackson Hole Symposium late last month entitled “The real effects of debt”. Cechetti et al argue that “At moderate levels, debt improves welfare and can enhance growth. But high levels can be damaging.” For example, when corporate debt goes beyond 90% of GDP, it becomes a drag on growth. This appears to me to suggest that deepening of equity markets is more important than the development of banks beyond a certain stage of development.

Posted at 21:21 on Tue, 06 Sep 2011     View/Post Comments (5)     permanent link