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, 29 Nov 2013

Revisiting Fischer Black's deathbed paper

In 1995, Fischer Black submitted a paper on “Interest rates as options” when he was terminally ill with cancer. While publishing the paper (Journal of Finance, 1995, 50(5), 1371-1376), the Journal noted:

Note from the Managing Editor: Fischer Black submitted this paper on May 1, 1995. His submission letter stated: “I would like to publish this, though I may not be around to make any changes the referee may suggest. If I’m not, and if it seems roughly acceptable, could you publish it as is with a note explaining the circumstances?” Fischer received a revise and resubmit letter on May 22 with a detailed referee’s report. He worked on the paper during the Summer and had started to think about how to address the comments of the referee. He died on August 31 without completing the revision.

The paper contained an interesting idea to deal with the problem of negative interest rates – assume that the true or ‘shadow short rate’ can be negative, but the rate that we do observe is never negative because currency provides an option to earn a zero interest rate instead. Viewed this way, the interest rate can itself be viewed as an option (with a strike price of zero). What Black found attractive about this idea was that it made modelling easy: one could for example assume that the shadow rate follows a normal (Gaussian) distribution. Whenever the Gaussian distribution produces a negative interest rate, we simply replace it by zero. We do not need to assume a log normal or square root process just to avoid negative interest rates.

While interesting in theory, the model did not prove very popular in practice. But five years of zero interest rates in the US has changed this. Neither the lognormal nor the square root process can easily yield a persistent zero interest rate. Black’s shadow rate achieves this in a very easy and natural manner. More than the finance community, it the macroeconomics world that has rediscovered Black’s model. For example, Wu and Xia have a paper in which they show that macroeconomic models perform nicely even at the zero lower bound (ZLB) if the actual short rate is replaced by the shadow rate (h/t Econbrowser). The shadow rate has the same correlations with other macroeconomic variables at the ZLB as the actual rate has during normal times.

As I have mentioned previously on this blog, modelling interest rate risk at the ZLB is problematic and different clearing corporations have taken different approaches to the problem. Maybe, they should take Black’s shadow short rate more seriously.

Posted at 11:39 on Fri, 29 Nov 2013     View/Post Comments (0)     permanent link

Fri, 15 Nov 2013

Rakoff on financial crisis prosecutions

Judge Rakoff who is best known for rejecting SEC settlements against Bank of America and Citigroup for not going far enough, has come out with a devastating critique of the US failure to prosecute high level executives for frauds related to the financial crisis.

Rakoff points out that the frauds of the 1970s, 1980s and 1990s all resulted in successful prosecutions of even the highest level figures.

In striking contrast with these past prosecutions, not a single high level executive has been successfully prosecuted in connection with the recent financial crisis, and given the fact that most of the relevant criminal provisions are governed by a five-year statute of limitations, it appears very likely that none will be.

First of all, Rakoff dismisses the legal difficulties in prosecuting crisis crimes:

Rakoff thinks that there are three reasons why there have been no prosecutions:

  1. Prosecutors have other priorities –
    • the FBI’s resources were diverted to fighting terrorism;
    • the SEC was focused on Ponzi schemes and accounting frauds;
    • the Department of Justice was bogged down with the prosecution of insider trading based on the Rajaratnam tapes
  2. “[T]he Government’s own involvement in the underlying circumstances that led to the financial crisis ... [and] in the aftermath of the financial crisis ... would give a prudent prosecutor pause in deciding whether to indict a C.E.O. who might, with some justice, claim that he was only doing what he fairly believed the Government wanted him to do.”
  3. “The shift that has occurred over the past 30 years or more from focusing on prosecuting high-level individuals to focusing on prosecuting companies and other institutions.”

Rakoff is known for his strong views on the last point and he lays out the case brilliantly:

If you are a prosecutor attempting to discover the individuals responsible for an apparent financial fraud, you go about your business in much the same way you go after mobsters or drug kingpins: you start at the bottom and, over many months or years, slowly work your way up. Specifically, you start by “flipping” some lower or mid-level participant in the fraud ... With his help, and aided by the substantial prison penalties now available in white collar cases, you go up the ladder. ...

But if your priority is prosecuting the company, a different scenario takes place. Early in the investigation, you invite in counsel to the company and explain to him or her why you suspect fraud. He or she responds by assuring you that the company wants to cooperate and do the right thing, and to that end the company has hired a former Assistant U.S. Attorney, now a partner at a respected law firm, to do an internal investigation. ... Six months later the company’s counsel returns, with a detailed report showing that mistakes were made but that the company is now intent on correcting them. You and the company then agree that the company will enter into a deferred prosecution agreement that couples some immediate fines with the imposition of expensive but internal prophylactic measures. For all practical purposes the case is now over. You are happy ...; the company is happy ...; and perhaps the happiest of all are the executives, or former executives, who actually committed the underlying misconduct, for they are left untouched.

I suggest that this is not the best way to proceed. Although it is supposedly justified in terms of preventing future crimes, I suggest that the future deterrent value of successfully prosecuting individuals far outweighs the prophylactic benefits of imposing internal compliance measures that are often little more than window-dressing. Just going after the company is also both technically and morally suspect. It is technically suspect because, under the law, you should not indict or threaten to indict a company unless you can prove beyond a reasonable doubt that some managerial agent of the company committed the alleged crime; and if you can prove that, why not indict the manager? And from a moral standpoint, punishing a company and its many innocent employees and shareholders for the crimes committed by some unprosecuted individuals seems contrary to elementary notions of moral responsibility.

Rakoff concludes with a scathing criticism:

So you don’t go after the companies, at least not criminally, because they are too big to jail; and you don’t go after the individuals, because that would involve the kind of years-long investigations that you no longer have the experience or the resources to pursue.

After the series of frauds in the late 1990s and early 2000s in the US (Enron, Worldcom, Tyco and Adelphia), Europe (Lernout and Hauspie, Vivendi, ABB and KirchMedia) and India (Tata Finance), I wrote that: “ The US has shown that it can prosecute and punish wrong doers far more speedily than most other jurisdictions.”. I am not at all sure about this today.

Posted at 21:34 on Fri, 15 Nov 2013     View/Post Comments (1)     permanent link

Fri, 08 Nov 2013

Equity markets are different

Equity markets (specifically the market for large capitalization stocks) seem to be very different from other markets in that they are the only markets that are unconditionally liquid. The Basel Committee has officially recognized this – in their classification of 24 markets by liquidity horizons, the large cap equity market is the only market in the most liquid bucket. (Basel Committee on Banking Supervision, Fundamental review of the trading book: A revised market risk framework, Second Consultative Document, October 2013, Table 2, page 16)

There is abundant anecdotal evidence for the greater liquidity of large cap equity markets in stressed conditions – you may not like the price but you would not have any occasion to complain about the volume. For example, in India when the fraud in Satyam was revealed, the price of the stock dropped dramatically, but the market remained very liquid. In fact, the liquidity of the stock on that day was far greater than normal. During the global financial crisis, stock markets remained very liquid while liquidity in many other markets dried up. During the 2008 crisis, Societe General could unwind Kerviel’s unauthorized equity derivative position of € 50 billion in just two days.

There could be many reasons why large cap equity markets are indeed different:

At least some of these features can be replicated in other markets, and such replication should perhaps be a design goal.

Posted at 21:45 on Fri, 08 Nov 2013     View/Post Comments (0)     permanent link

Wed, 06 Nov 2013

Gorton defends opacity of the plutocrats

Gary Gorton has published a paper on “The development of opacity in U.S. banking” (NBER working paper 19540, October 2013). He writes that before the US Civil War:

... bank note markets functioned as “efficient” markets; the discounts were informative about bank risk. Banks at the same location competed, and the note market enforced common fundamental risk at these banks.

Then bank notes were replaced by checking accounts, the banks were taken over by rich men who kept the price per share high enough to keep it out of reach of most investors thereby effectively closing down the market for their stocks. Simultaneously,the clearing houses brought about a culture of secrecy so that depositors also knew little about the health of individual banks.

Gorton thinks that this shutdown of informative and efficient markets was a great thing for economic efficiency – a claim that I find difficult to believe.

On the other hand, the endogenous opacity that Gorton describes is completely analogous to the conclusion of another recent paper (“Shining a Light on the Mysteries of State: The Origins of Fiscal Transparency in Western Europe” by Timothy C. Irwin, IMF Working Paper, WP/13/219, October 2013) on the opacity of sovereign finances:

When power has been tightly held by a financially self-sufficient king, much information about government, including government finances, has remained secret. When power has been shared, either in democracies or sufficiently broad oligarchies, information on government finances has tended to become public.

Posted at 15:20 on Wed, 06 Nov 2013     View/Post Comments (0)     permanent link