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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Fri, 30 Dec 2011

RBS and ABN Amro Due Diligence

Earlier this month, the UK Financial Services Authority bowed to public pressure and published a massive (452 page) report on the failure of the Royal Bank of Scotland. This report has been much commented upon in the press and the blogospherre (yes, I am rather late to this party!), but I do wish to comment on what the report says about the due diligence involved in the ABN Amro acquisition:

Many readers of the Report will be startled to read that the information made available to RBS by ABN AMRO in April 2007 amounted to ‘two lever arch folders and a CD’; and that RBS was largely unsuccessful in its attempts to obtain further non-publicly available information. (Chairman’s Foreword, page 9)

The RBS Board was unanimous in its support for the acquisition. The RBS Board’s decision to launch a bid of this scale on the basis of due diligence which was insufficient in scope and depth for the major risks involved entailed a degree of risk-taking that can reasonably be criticised as a gamble. The Review Team reached this conclusion in the knowledge that had a fully adequate due diligence process been possible, the RBS Board might still have been satisfied with the outcome and decided to proceed. (Para 415)

In contested takeovers only very limited due diligence is possible. Management and boards have to decide whether the potential benefits of proceeding on the basis of limited due diligence outweigh the risks involved. Institutional investors are well aware of the limited nature of the due diligence possible in these circumstances, and have the ability to vote against approval of the acquisition if they consider the risks are too great. If the acquisition turns out to be unsuccessful, they can dismiss the board and management. (Para 441)

In most sectors of the economy, this market discipline approach remains appropriate because the downside risks affect only the equity shareholders. Banks, however, are different because, if a major takeover goes wrong, it can have wider financial stability and macroeconomic effects. The potential downside is social, not just private. (Para 442)

As a result, further public policy responses to the lessons of the ABN AMRO acquisition need to be considered. ... Establishing within this formal approval regime a strong presumption that major contested takeovers would not be approved, or would only be approved if supported by exceptionally strong capital backing, given that specific risks are created by an inability to conduct adequate due diligence. (Para 443)

I think this whole idea is misguided. Absent outright fraud, there is in fact not much that can be gained from invasive due diligence of a large public company. The FSA report itself admits that all the major risks of the acquisition were crystal clear without any due diligence. RBS made a conscious strategic decision to buy the ABN Amro business. They thought that the assets were of great strategic value, when in fact they were toxic. The problem was not one of lack of information; it was simply a wrong macro view of this business. A million lever arch folders and CDs would not have cured this problem.

If FSA thinks that an investment decision based on ‘two lever arch folders and a CD’ worth of due diligence is a gamble, then they must also argue that Warren Buffet’s bail out of General Electric and Goldman Sachs in 2008 (and of Bank of America this year) were gambles. I think this is wrong. Absent outright fraud, buying a large listed company after analysing only the public filings is perfectly prudent and legitimate. And, if the FSA thinks that banking is a sector where there is a preponderance of outright frauds, then that is an admission of total and complete regulatory failure – the regulators surely have access to all the lever arch files and CDs in the bank.

Only a check box ticking regulatory mindset can lead somebody to the silly idea that the quality of decision making can be measured by the volume of data that was processed. I am reminded of the great chess player Jose R. Capablanca who when asked how many moves he analysed before making his move replied “I see only one move ahead, but it is always the correct one.” When RBS looked at ABN Amro, they were fixated on one big move and that was a horribly wrong one. For that, they do deserve all the blame in the world, but let us not get unduly fixated about the ‘two lever arch folders and a CD’.

Posted at 14:54 on Fri, 30 Dec 2011     View/Post Comments (1)     permanent link

Thu, 15 Dec 2011

Examples of Currency Breakup

Since the prophets of gloom and doom are now talking openly of a possible breakup of the euro zone, I thought it would be useful to look back at some instances of breakup of currencies to see what really happens. I have chosen some examples based on my familiarity with them and describe them below in reverse chronological order. I think the examples are fascinating in their own right regardless of what one thinks about the prospects of the euro zone

Argentina 2001-02

Many analysts have drawn parallels between the current Greek crisis and the Argentine crisis of 2001. Therefore, my first example is the Argentine pesification of 2002. The process began in December 2001 with the corralito which froze all bank accounts for 12 months while allowing withdrawals of $250 a week for essential expenses. This led to riots that forced the resignation of the president. During the next two weeks, Argentina went through three interim presidents while also defaulting on its debt. In January 2002, interim president Duhalde announced an asymmetric pesification in which dollar denominated bank deposits were converted to pesos at 1.40 peso to the dollar while dollar denominated loans given by the banks were converted at 1.00 peso to the dollar. The government issued compensation bonds to the banks for the differential of 0.40 pesos, but at that time, the government was widely regarded as insolvent. The free market exchange rate was approximately 4 pesos to the dollar. The Argentine Supreme Court declared the corralito and the pesification unconstitutional. The government responded by impeaching two judges and forcing the resignation of two others. In October 2004, the Supreme Court ruled that pesification was legal. A good chronology of most of these developments can be found in Gutierrez and Montes-Negret (“Argentina’s Banking System: Restoring Financial Viability”, produced by the World Bank Office for Argentina, Chile, Paraguay and Uruguay, 2004).

Ruble zone early 1990s

Another example with similarities to the euro zone is the breakup of the ruble zone in the early 1990s after the collapse of the Soviet Union. While the overthrow of Gorbachev and the fall of the Soviet Union were political in nature, the breakup of the ruble zone was primarily due to economic reasons. After the collapse of the USSR, no change in monetary arrangements were made – the newly formed Central Bank of Russia (CBR) took over the old Soviet central bank (Gosbank) in Russia while Gosbank branches in the other countries became 14 independent central banks. However, all the printing presses were in Russia and so only the CBR printed rubles. The other countries relied on ruble notes and coins shipped from Russia by the CBR.

The old soviet system was based on a dual monetary circuit: enterprises could convert rubles in the bank (beznalichnye or non-cash rubles) into cash (nalichnye) only for specified purposes – chiefly the payment of wages, which were paid in cash. All inter-enterprise transactions were required to be in non cash (beznalichnye) rubles to facilitate central planning and control (see for example, William Tompson, 1997, “Old Habits Die Hard: Fiscal Imperatives, State Regulation and the Role of Russia’s Banks”, Europe-Asia Studies, 49(7), 1159-1185). This dual circuit continued in the post soviet ruble zone as well. The implication was that while the CBR had monopoly on cash rubles (nalichnye), other central banks could and did create non cash (beznalichnye) rubles.

Initially, the CBR continued the old soviet practice of accepting beznalichnye rubles of other ruble zone countries as payment for exports from Russia to these countries. So the central bank of Ukraine could lend beznalichnye rubles to a local bank which could lend them to a local factory which could use these to buy inputs from Russia. Effectively, Ukraine was paying for this stuff with rubles created by itself. This has striking similarities to how Germany has been lending to the rest of the euro zone through the ECB’s Target2 system.

At some point, the CBR decided that it would not accept beznalichnye rubles of other central banks. It also began printing new Russian rubles for use within Russia while printing old soviet rubles for shipping to other ruble zone countries. Finally, in 1993, the CBR unilaterally demonetized soviet era ruble notes and exchanged them for Russian rubles. The ruble zone was effectively terminated and the remaining 9 ruble zone countries (some countries had left even earlier) were forced to adopt their own currencies. Ultimately, the ruble zone broke up because Russia (or more precisely CBR) was not prepared to pay the economic price required for its continuation. A good discussion of the collapse of the ruble zone can be found in Abdelal’s paper (“Contested currency: Russia’s rouble in domestic and international politics”, Journal of Communist Studies and Transition Politics, 2003.)

Pakistan/Bangladesh 1971

My next two examples are closer home from the Indian subcontinent. In early 1971, Bangladesh declared independence from Pakistan, but the government-in-exile could return to the country and start functioning only nine months later. During this war of independence, Bangladesh continued to use the Pakistani currency without any change. Many people dealt with this incongruity by rubber stamping “Bangladesh” or “Joy Bangla” on these notes in English or Bengali. Images of these notes can be seen here and here.

Pakistan however took the stance that the war of independence was a civil war and that the notes circulating in Bangladesh were looted from the branches of the Pakistan central bank (State Bank of Pakistan) in East Pakistan (Bangladesh). It then declared that all note carrying the inscription “Bangladesh” or “Joy Bangla” or “Dacca” in any language would not be legal tender in Pakistan. It also proceeded to issue new currency notes in different colours and withdraw the old notes from circulation. (These events are described at the web site of the State Bank of Pakistan). This demonetization resulted in the paradoxical situation where the old Pakistan currency notes now circulated only in Bangladesh which was at war with Pakistan!

Even after winning the war of independence, Bangladesh retained the old currency for several months. The statute setting up the Bank of Bangladesh stated that “all Bank Notes, Coins and Currency Notes ... which were in circulation in Bangladesh [on December 16, 1971] shall continue to be legal tender”. Subsequently, Bangladesh printed new currency and exchanged the old notes.

India/Pakistan 1947-48

The other example from the subcontinent was the partition of undivided British India into India and Pakistan in August 1947. The two countries agreed that the Reserve Bank of India (RBI) would act as the central bank of Pakistan also for over a year (till September 1948). During this period, the government of India agreed to take two nominees of the Pakistan Government on the central board of the RBI. During this transition period, Indian notes were to remain legal tender in Pakistan, and the RBI was to issue notes overprinted with the inscription ‘Government of Pakistan’ in English and Urdu. During the transition period, these overprinted notes were to be the liability of the RBI, but not of the Government of India.

At the end of the transition period, the Government of Pakistan was to exchange the (non overprinted) Indian notes circulating in Pakistan at par and return them to India. The overprinted notes would become the liabilities of Pakistan. The division of assets of the Issue Department of RBI was to take place after the transition period. The division was to be based on the ratio of notes circulating in the two countries at the end of the transition period.

When the Kashmir dispute erupted later, the financial settlement between India and Pakistan broke down, and the RBI’s role as the central bank of Pakistan was terminated three months ahead of time. An excellent account of all these events can be found in Chapter 18 of Volume 1 of the RBI History. Images of Indian rupees overprinted with ‘Government of Pakistan’ in English and Urdu can be found here.

Austro Hungarian Empire 1919

I now move back from the Indian subcontinent to Europe for my final example – the breakup of the Austro Hungarian Empire in 1919. Richard Roberts (“A stable currency in search of a stable Empire? The Austro-Hungarian experience of monetary union”, History and Policy Paper 127, October 2011) provides an excellent discussion of this episode and its relevance for the euro zone. After the defeat of the Austrian Habsburg Empire at the hands of Prussia in 1866, Hungary threatened secession from the empire. The Compromise of 1867 was a constitutional treaty that recognised the sovereign autonomy of Austria and Hungary under a single monarch – the Austro-Hungarian Dual Monarchy. The two parts of the empire had separate parliaments and separate national debt, but there was a monetary union under the Austro Hungarian Bank (AHB). Like the European Central Bank (ECB) today, the AHB established a strong reputation for a policy of sound money. For a long period, the AHB was also able to rein in the fiscal profligacy which had been the hallmark of the Austrian Habsburg Empire.

Everything changed with the First World War. After its defeat in this war, the Austro-Hungarian Empire collapsed into five successor states – Czechoslovakia, Romania, Yugoslavia, Austria and Hungary. The peace treaties specified that the successor states should stamp Austro-Hungarian Bank notes circulating in their areas and then introduce their own notes. Successor state claims on the reserves and other assets of the Austro-Hungarian Bank was in proportion to the notes circulating in their territories. Stamping was done by affixing adhesive stamps or by rubber or metal stamps. Images of these stamped notes can be seen in the delightful paper by Keller and Sandrock (“The Significance of Stamps Used on Bank Notes”) and also at Wikipedia.

Stamping of notes to turn them into legal tender was a form of taxation and in some countries the tax rate was excessive. This created incentives for people to forge the stamps especially when the stamping was lacking in security features. The value of the stamped currency depended on the monetary policy followed in the various countries. This created incentives for unstamped AHB notes to be smuggled out of profligate countries for stamping in countries with more sound money. Reducing these substantial illicit cross-border flows required customs check points and deployment of army patrols.

The interesting thing about this episode was that out of the five successor states of the empire, only one (Czechoslovakia) was able to create a central bank with anything resembling the sound money attributes of the old AHB. Hungary for example went on to have one of the worst hyperinflations in world history.

Posted at 13:00 on Thu, 15 Dec 2011     View/Post Comments (3)     permanent link

Sat, 10 Dec 2011

Book on SEBI Act

Sumit Agrawal and Robin Joseph Baby sent me a copy of their book on the SEBI Act. I am not a lawyer, but I found the book well written and useful. To my knowledge, this is the first book giving detailed commentary on each section of the Act including judgements of the Securities Appellate Tribunal and the Courts. While the bare SEBI Act is only 33 pages, the commentary comes to 576 pages which is a measure of the extent of judicial precedents that have come up around the SEBI Act in the last two decades. (The length is not due to coverage of the regulations that SEBI has framed under the Act. The book hardly covers these regulations and therefore hopefully would not become obsolete too quickly.)

I wish they or others would write a companion volume covering the Securities Contract Regulation Act, Depository Act and relevant sections of the Companies Act that define the securities law in India.

My only quibble with the book is that as serving SEBI Officers, they tend to uncritically endorse the official SEBI stance regarding most of the disputed legal issues. This is however a minor matter because it is easy to take this with a pinch of salt, and even while taking sides, the authors do present both sides of the case.

Posted at 11:51 on Sat, 10 Dec 2011     View/Post Comments (1)     permanent link

Tue, 06 Dec 2011

Mobile phones as Achilles heel of internet banking

I am increasingly worried that mobile phones are emerging as the Achilles heel of internet banking.

The most frightening news is the key logging software installed by the telecom companies on millions of smartphones (hat tip Bruce Schneier). Every key stroke and every received text message is recorded by the Carrier IQ spyware which logs even what is entered into https web pages that use the secure socket layer (SSL).

The point is that our mobile is not ours in the same sense that our computer is ours. Our mobile belongs first and foremost to our telecom operator and only secondarily to us. This is true even if the mobile runs an open source operating system – the Carrier IQ spyware runs on Android smartphones. On the other hand, when I use a personal computer on which I have installed (say) Ubuntu Linux and I am careful about what software I install on it, the computer is mine in a very real sense.

Unfortunately, this mobile which is not truly ours is increasingly our passport in the cyberworld. When banks were forced to adopt two factor authentication, they chose the mobile phone as the second authentication tool. Most internet banking transactions today require an additional one time password sent to the registered mobile. This is a problem when nobody else regards the mobile as an important element of a person’s identity.

Consider for example this story from Malaysia (hat tip again to Bruce Schneier. The crooks installed spyware an online banking kiosk at a bank and retrieved usernames, passwords and even the transaction authorisation code (TAC) which is sent out by the bank to the registered handphones of online banking users. Then, using fake MyKad, police report or authorisation letters from the target customers, the crooks would report the customers’ handphones lost and applied for new SIM cards from the unsuspecting telecommunications companies. The only saving grace is that it took six crooks about nine months to steal about $75,000; the fraud is simply not scalable.

But then there are other methods of scaling this up. Professional call centres are emerging whose business is to extract sensitive information needed for bank fraud and identity theft from individuals.

Posted at 14:49 on Tue, 06 Dec 2011     View/Post Comments (2)     permanent link