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, 24 Jun 2015

Revolving door and favouring future employers

Canayaz, Martinez and Ozsoylev have a nice paper showing that the pernicious effect of the revolving door (at least in the US) is largely about government employees favouring their future private sector employers. It is not so much about government employees favouring their past private sector employers or about former government employees influencing their former colleagues in the government to favour their current private sector employers.

Their methodology relies largely on measuring the stock market performance of the private sector companies whose employees have gone through the revolving door (in either direction) and comparing these returns with a control group of companies which have not used the revolving door. The abnormal returns are computed using the Fama-French-Carhart four factor model.

The advantage of the methodology is that it avoids subjective judgements about whether for example, US Treasury Secretary Hank Paulson favoured his former employer, Goldman Sachs, during the financial crisis of 2008. It also avoids having to identify the specific favours that were done. The sample size also appears to be reasonably large – they have 23 years of data (1990-2012) and an average of 62 revolvers worked in publicly traded firms each year.

The negative findings in the paper are especially interesting, and if true could make it easy to police the revolving door. All that is required is a rule that when a (former) government employee joins the private sector, a special audit would be carried out of all decisions by the government employee during the past couple of years that might have provided favours to the prospective private sector employer. In particular, the resistance in India to hiring private sector professionals to important government positions (because they might favour their former employer) would appear to be misplaced.

One weakness in the methodology is that companies which anticipate financial distress in the immediate future might hire former government employees to help them lobby for some form of bail out. This might ensure that though their stock price declines due to the distress, it does not decline as much as it would otherwise have done. The excess return methodology would not however show any gain from hiring the revolver because the Fama French excess returns would be negative rather than positive. Similarly, companies which anticipate financial distress might make steps (for example, campaign contributions) that make it more likely that their employees are recruited into key government positions. Again, the excess return methodology would not pick up the resulting benefit.

Just in case you are wondering what all this has to do with a finance blog, the paper says that “[t]he financial industry, ... is a substantial employer of revolvers, giving jobs to twice as many revolvers as any other industry.” (Incidentally, Table A1 in their paper shows that including or excluding financial industry in the sample makes no difference to their key findings). And of course, the methodology is pure finance, and shows how much information can be gleaned from a rigorous examination of asset prices.

Posted at 15:43 on Wed, 24 Jun 2015     View/Post Comments (1)     permanent link


Thu, 18 Jun 2015

On may versus must and suits versus geeks

On Monday, the Basel Committee on Banking Supervision published its Regulatory Consistency Assessment Programme (RCAP) Assessment of India’s implementation of Basel III risk-based capital regulations. While the RCAP Assessment Team assessed India as compliant with the minimum Basel capital standards, they had a problem with the Indian use of the word “may” where the rest of the world uses “must”:

The team identified an overarching issue regarding the use of the word “may” in India’s regulatory documents for implementing binding minimum requirements. The team considers linguistic clarity of overarching importance, and would recommend the Indian authorities to use the word “must” in line with international practice. More generally, authorities should seek to ensure that local regulatory documents can be unambiguously understood even in an international context, in particular where these apply to internationally active banks. The issue has been listed for further reflection by the Basel Committee. As implementation of Basel standards progresses, increased attention to linguistic clarity seems imperative for a consistent and harmonised transposition of Basel standards across the member jurisdiction.

Section 2.7 lists over a dozen instances of such usage of the word “may”. For example:

Basel III paragraph 149 states that banks “must” ensure that their CCCB requirements are calculated and publicly disclosed with at least the same frequency as their minimum capital requirements. The RBI guidelines state that CCCB requirements “may” be disclosed at table DF-11 of Annex 18 as indicated in the Basel III Master Circular.

Ultimately, the RCAP Assessment Team adopted a pragmatic approach of reporting this issue as an observation rather than a finding. They were no doubt swayed by the fact that:

Senior representatives of several Indian banks unequivocally confirmed to the team during the on-site discussions that there is no doubt that the intended meaning of “may” in Indian banking regulations is “shall” or “must” (except where qualified by the phrase “may, at the discretion of” or similar terms).

The Indian response to the RCAP Assessment argues that “may” is perfectly appropriate in the Indian context.

RBI strongly believes that communication, including regulatory communications, in order to be effective, must necessarily follow the linguistics and social characteristics of the language used in the region (Indian English in this case), which is rooted in the traditions and customs of the jurisdiction concerned. What therefore matters is how the regulatory communications have been understood and interpreted by the regulated entities. Specific to India, the use of word “may” in regulations is understood contextually and construed as binding where there is no qualifying text to convey optionality. We are happy that the Assessment Team has appreciated this point.

I tend to look at this whole linguistic analysis in terms of the suits versus geeks divide. It is true that in Indian banking, most of the suits would agree that when RBI says “may” it means “must”. But increasingly in modern finance, the suits do not matter as much as the geeks. In fact, humans matter less than the computers and the algorithms that they execute. I like to joke that in modern finance the humans get to decide the interesting things like when to have a tea break, while the computers decide the important things like when to buy and sell.

For any geek worth her salt, the bible on the subject of “may” and “must” is RFC 2119 which states that “must” means that the item is an absolute requirement; “should” means that there may exist valid reasons in particular circumstances to ignore a particular item; “may” means that an item is truly optional. I will let Arnold Kling have the last word: “Suits with low geek quotients are dangerous”.

Posted at 09:24 on Thu, 18 Jun 2015     View/Post Comments (1)     permanent link


Wed, 17 Jun 2015

Back from vacation

My long vacation provided the ideal opportunity to reflect on the large number of comments that I received on my last blog post about the tenth anniversary of my blog. These comments convinced me that I should not only keep my blog going but also try to engage more effectively with my readers. Over the next few weeks and months, I intend to implement many of the excellent suggestions that you have given me.

First of all, I have set up a Facebook page for this blog. This post and all future blog posts will appear on that page so that readers can follow the blog from there as well. My blog posts have been on twitter for over six years now and this will continue.

Second, I have started a new blog on computing with its own Facebook page which will over a period of time be backed up by a GitHub presence. I did not want to dilute the focus of this blog on financial markets and therefore decided that a separate blog was the best route to take. At the end of every month, I intend to post on each blog a list of posts on the sister blog, but otherwise this blog will not be contaminated by my meanderings in fields removed from financial markets.

Third, I will be experimenting with different kinds of posts that I have not done so far. This will be a slow process of learning and you might not observe any difference for many months.

Posted at 08:01 on Wed, 17 Jun 2015     View/Post Comments (1)     permanent link