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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Thu, 25 Jul 2013

Legal theory of finance

The Journal of Comparative Economics (subscription required) has a special issue on Law in Finance (The CLS Blue Sky Blog has a series of posts summarizing and commenting about this work – see here, here and here). The lead paper in the special issue by Katharina Pistor presents what she calls the Legal Theory of Finance (LTF); the other papers are case studies of different aspects of this research programme.

Most finance researchers are aware of the Law and Finance literature (La Porta, Shleifer, Vishny and a host of others), but Pistor argues that “Law & Finance is ... a theory for good times in finance, not one for bad times.” She argues that though finance contracts may appear to be clear and rigid, they are in reality in the nature of incomplete contracts because of imperfect knowledge and inherent uncertainty. When tail events materialize, it is desirable to rewrite the contracts ex post. This can be done in two ways: first by the taxpayer bailing out the losers, or by an elastic interpretation of the law.

One of the shrill claims of the LTF is that legal enforcement is much more elastic at the centre while being quite rigid at the periphery. Bail out is also more likely at the centre. I do not see anything novel in this observation which should be obvious to anybody who has not forgotten the first word of the phrase “political economy”. It should also be obvious to anybody who has read Shakespeare’s great play about finance (The Merchant of Venice), and noted how differently the law was applied to Jews and Gentiles. It has also been all too visible throughout the global financial crisis and now in the eurozone crisis.

Another persistent claim is that all finance requires the backstop of the sovereign state which is the sole issuer of paper money. This is in some sense true of most countries for the last hundred years or so though I must point out that the few financial markets that one finds in Somalia or Zimbabwe function only because they are not dependent on the state. The LTF claim on the primacy of the state was certainly not true historically. Until the financial revolution in the Holland and later England, merchants were historically more credit worthy than sovereigns. Bankers bailed out the state and not the other way around.

Most of the case studies in the special issue do not seem to be empirically grounded in the way that we have come to expect in modern finance. I was not expecting any fancy econometrics, but I did expect to see the kind of rich detail that I have seen in the sociology of finance literature. The only exception was the paper by Akos Rona-Tas and Alya Guseva on “Information and consumer credit in Central and Eastern Europe”. I learned a lot from this paper and will probably blog about it some day, but it seemed to be only tangentially about the LTF.

Posted at 13:40 on Thu, 25 Jul 2013     View/Post Comments (0)     permanent link

Sun, 14 Jul 2013

Dubious legal foundations of modern finance?

I have been reading a 2008 paper by Kenneth C. Kettering (“Securitization and Its Discontents: the Dynamics of Financial Product Development”) arguing that securitization is built on dubious legal foundations – specifically there are possible conflicts with aspects of fraudulent transfer law. Kettering argues that securitization is an example of a financial product that has become so widely used that it cannot be permitted to fail, notwithstanding its dubious legal foundations.

I am not a lawyer (and Kettering’s paper is over 150 pages long) and therefore I am unable to comment on the legal validity of his claims. But, I also recall reading Annelise Riles’s book Collateral Knowledge: Legal Reasoning in the Global Financial Markets (University of Chicago Press, 2011), which makes somewhat similar claims. But her ethnographic study was focused on Japan, and when I read that book, I had assumed that the problems were specific to that country.

Posted at 21:55 on Sun, 14 Jul 2013     View/Post Comments (1)     permanent link

Sun, 07 Jul 2013

Non discretionary portfolio management

Last month, the Reserve Bank of India (RBI) released draft guidelines on wealth management by banks. I have no quarrels with the steps that the RBI has taken to reduce mis-selling. My comments are related to something that they did not change:

4.3.2 PMS-Non-Discretionary The non-discretionary portfolio manager manages the funds in accordance with the directions of the client. Thus under Non-Discretionary PMS, the portfolio manager will provide advisory services enabling the client to take decisions with regards to the portfolio. The choice as well as the timings of the investment decisions rest solely with the investor. However the execution of the trade is done by the portfolio manager. Since in non-discretionary PMS, the portfolio manager manages client portfolio/funds in accordance with the specific directions of the client, the PMS Manager cannot act independently. Banks may offer non-discretionary portfolio management services.

... Portfolio Management Services (PMS)- Discretionary: The discretionary portfolio manager individually and independently manages the funds of each client in accordance with the needs of the client. Under discretionary PMS, independent charge is given by the client to the portfolio manager to manage the portfolio/funds. ... Banks are prohibited from offering discretionary portfolio management services. (emphasis added)

I am surprised that regulators have learnt nothing from the 2010 episode in which an employee of a large foreign bank was able to misappropriate billions of rupees from high net worth individuals including one of India’s leading business families. (see for example, here, here and here).

My takeaway from that episode was that discretionary PMS is actually safer and more customer friendly than non discretionary PMS. After talking to numerous people, I am convinced that the so called non-discretionary PMS is pure fiction. In reality, there are only two ways to run a large investment portfolio:

  1. The advisory model where the bank provides investment advice and the client takes investment decisions and also handles execution, custody and accounting separately.
  2. The de facto discretionary PMS where the bank takes charge of everything. The fiction of a non-discretionary PMS is maintained by the customer signing off on each transaction often by signing blank cheques and other documents.

When you think carefully about it, the bundling of advice, execution, custody and accounting without accountability is a serious operational risk. One could in fact argue that the RBI should ban non-discretionary PMS and allow only discretionary PMS. Discretionary PMS is relatively safe because the bank has unambiguous responsibility for the entire operational risk.

The only argument for non-discretionary PMS might be if the PMS provider is poorly capitalized or otherwise not very reliable. But in this case, the investor should be imposing strict segregation of functions and should never be entrusting advice, execution, custody and accounting to the same entity.

Posted at 13:59 on Sun, 07 Jul 2013     View/Post Comments (4)     permanent link

Tue, 02 Jul 2013

Consumer protection may be a bigger issue than systemic risk

Since the global financial crisis, policy makers and academics alike have focused attention on systemic risk, but consumer protection is an equally big if not bigger issue that has not received equal attention. John Lanchester has a long (6700 word) essay in the London Review of Books, arguing that the mis-sold PPI (payment protection insurance) scandal in the UK was bigger than all other banking scandals – the London Whale, UBS (Adoboli), HBOS, Libor rigging and several others.

Lanchester argues the case not only because the costs of the PPI scandal could go up to £16-25 billion ($24-37 billion), but also because it happened at the centre of the banks’ retail operations and involved a more basic breach of what banking is supposed to be about. Interestingly, the huge total cost of the scandal is the aggregation of small average payouts of only £2,750 to each affected customer indicating that the mis-selling was so pervasive as to become an integral part of the business model itself.

Posted at 12:40 on Tue, 02 Jul 2013     View/Post Comments (0)     permanent link

Starred items from Google Reader

Updated: In the comments, Maries pointed me to Mihai Parparita’s Reader is Dead tools (see also here and here). Though Google Reader has officially shut down, it is still accessible, Mihai’s tools are still working, and I was able to create a multi-GB archive of everything that existed in my Google Reader. But the tools required to read this archive are still under development. So in the meantime, I still need my old code and may be more such code to read all the XML and JSON files in these archives.

With Google Reader shutting down, I have been experimenting with many other readers including Feedly and The Old Reader. Since many feed readers are still being launched and existing readers are being improved, I may keep changing my choice over the next few weeks. Importing subscriptions from Google Reader to any feed reader is easy using Google Takeout. The problem is with the starred items. I finally sat down and wrote a python script that reads the starred.json file that is available from Google Takeout and writes out an html file containing all the starred items.

Python’s json library makes reading and parsing the json file a breeze. By looking at some of the entries, I think I have figured out the most important elements of the structure. I am not sure that I have understood everything, and so suggestions for improving the script are most welcome.

Where the original feed does not contain the entire post, but only a summary, ideally I would like to follow the link, convert the web page to PDF and add a link pointing to the converted PDF file. This would protect against link rot. I tried doing this with wkhtmltopdf but I was not satisfied with the quality of the conversion. Any suggestions for doing this would be most welcome. Ideally, I would like to use Google Chrome’s ability to print a web page as PDF, but I do not find any command line options to automate this from within the python script.

Posted at 12:07 on Tue, 02 Jul 2013     View/Post Comments (2)     permanent link