Prof. Jayanth R. Varma's Financial Markets Blog

Photograph About
Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma

Subscribe to a feed
RSS Feed
Atom Feed
RSS Feed (Comments)

Follow on:

Sun Mon Tue Wed Thu Fri Sat

Powered by Blosxom

Wed, 25 Dec 2019

Quantitative easing by any name is fine

Update: Rate hike of August 2017 corrected to rate cut.

In early November, I wrote a blog post arguing that the Reserve Bank of India (RBI) needs to consider some form of Quantitative Easing (purchase of long term bonds) to address the complete lack of monetary transmission from policy rate cuts to long term rates.

Last week, the RBI announced an open market operation (OMO) that was quickly labelled by market commentators as its version of Operation Twist:

On a review of the current liquidity and market situation and an assessment of the evolving financial conditions, the Reserve Bank has decided to conduct simultaneous purchase and sale of government securities under Open Market Operations (OMO)

The RBI offered to buy INR 100 billion of ten year bonds and sell the same amount of bonds of maturities less than one year. When this OMO was carried out on Monday, the RBI ended up buying the entire INR 100 billion of ten year bonds but it sold only INR 68 billion of short term bonds.

I think this is to be expected. In the current situation, the RBI can ill afford to allow any increase in yields even at the short end. If the RBI repeats the operation, I expect the results to be similar: full offtake of the long end purchase and much lower offtake of the short end sales. If the RBI wants to avoid the suggestion that it is doing any easing or any monetization of the fiscal deficit, we should not have any quarrel with the operation being called a Twist or a Special OMO or whatever. The important thing is get on with this in greater size or more frequently until the ten year yield drops 100-150 basis points below its August 2017 level. (While the OMO did reduce the ten year yield by about 25 basis points, this yield is still about 25 basis points higher than it was before the rate cut of early August 2017).

On the other hand, if the RBI stops with just this one operation, it would leave itself open to the insinuation that this was just a cosmetic attempt to help the banks window dress their balance sheets at the December quarter end.

Posted at 19:54 on Wed, 25 Dec 2019     View/Post Comments (0)     permanent link

Thu, 19 Dec 2019

New Zealand goes ahead on bank capital

A year ago, I wrote approvingly about New Zealand’s non-Basel-III approach to bank capital:

One of the dangers of international harmonization of financial sector regulation under the auspices of Basel, FSB and G20 has been the risk of a regulatory mono-culture. New Zealand located at the edge of the world and outside the Basel system is providing a good antidote to this.

Earlier this month, the Reserve Bank of New Zealand announced that it was going ahead with its proposal to raise capital requirements substantially. The only concession that it has made is in terms of allowing more instruments to count as capital. The ruthless focus on preventing banking crises is reiterated:

Banking crises cause not only harmful economic costs but also distressful social issues, such as the general decline in mental and physical health brought about by higher rates of unemployment. These effects are felt for generations.

New Zealand’s reliance on foreign banks for almost all of its banking needs is an interesting choice that many other countries could find worthy of emulation. The Global Financial Crisis highlighted one risk with this approach: bank losses elsewhere in the world could lead to a shrinking of bank credit within the country. While it might be tempting to react to this with a greater reliance on domestic banks, New Zealand is suggesting that you can simply protect your economy with higher capital requirements without worrying about the ownership structure.

I am inclined to think that steadily rising capital requirements for banks coupled with ever increasing reliance on deep financial markets may be the best way to manage the risk of financial crises.

Posted at 10:17 on Thu, 19 Dec 2019     View/Post Comments (0)     permanent link

Wed, 04 Dec 2019

Resolution of stock broking firms

The developments over the last week regarding Karvy highlight the urgent need for an operational framework for resolution of stock broking firms and smooth portability of positions in India. Almost two weeks back, the Securities and Exchange Board of India issued an order imposing various restrictions on Karvy Stock Broking Limited, but did not shut down the stock broker.

The order also froze the securities lying in the name of the stock broker on the ground that these securities actually belonged to the broker’s clients. Subsequently, these securities were transferred to the names of around 80,000 clients who had fully paid for the shares. Since the broker had pledged these securities with various bank and non bank lenders, these creditors appealed to the Securities Appellate Tribunal (SAT) which observed today that “a lot of water has flown under the bridge”, and it is not possible to reverse what has already been done.

In this blog post, I will however focus on the problems faced by the clients of Karvy. In its appeal to the SAT, Karvy complained that because of the SEBI restrictions it was unable to execute the instructions given by its clients (especially online clients) on the basis of the power of attorney that is normally used in these cases. On a direction from SAT, SEBI examined this matter but refused to make any concession, and stated that clients were free to issue paper transfer instructions or to fax them. Meanwhile, on Monday, the stock exchange “temporarily” suspended Karvy from its membership, and yesterday the SAT has refused to entertain an appeal against this action.

Clients are now stuck with a broker who has not been shut down or liquidated but is not functioning any more. It is not acceptable to say that the 1.2 million clients of Karvy can individually initiate the paper work to move their trading accounts to another broker. Contrast this with how the SIPC does this in the United States:

Shortly after the commencement of a liquidation proceeding, a SIPA trustee may transfer customer accounts to another solvent brokerage firm in what is called a “bulk transfer.” The bulk transfer can occur without the consent or participation of any customer, and may result in customers getting access to their property in a few days or weeks. (emphasis added)

It is also instructive to see how this process worked in the case of MF Global which is in many ways similar to the Karvy episode. The SIPC stated that in the MF Global case:

SIPC initiated the liquidation proceeding within hours of being notified by the SEC

The same day (October 31, 2011), there was a court order appointing a trustee to run MF Global:

ORDERED that … the SIPA Trustee, as appointed herein, is authorized to operate the business of MF Global Inc. to: (a) conduct business in the ordinary course until 6:00 p.m. on November 3, 2011, including without limitation, the purchase and sale of securities … and obtaining credit and incurring debt in relation thereto; (b) complete settlements of pending transactions, and to take other necessary and appropriate actions to implement the foregoing, in such accounts until 6:00 p.m. on November 7, 2011; and (c) take other action as necessary and appropriate for the orderly transfer of customer accounts and related property.

Within two days (November 2, 2011), the first set of bulk transfers covering about 50,000 accounts began.

There is an urgent need to create a statutory and regulatory structure to do all this in India, but I suspect that at a crunch, the regulators may be able to achieve some of these goals using existing statutes and by stretching the powers that they already have to protect the interests of investors. The even more urgent need in my view is to create the operational capability to implement this on the ground. It should not take more than a week to just put a brokerage firm into limbo.

Posted at 17:37 on Wed, 04 Dec 2019     View/Post Comments (1)     permanent link

Thu, 21 Nov 2019

Financial Markets and Monetary Transmission

In an blog post earlier this month, I argued that with a dysfunctional banking system impeding the transmission of monetary policy in India, the central bank must use the financial markets to achieve its goals. A blog post by the Federal Reserve Bank of New York yesterday shows that the markets are better at transmitting monetary policy even in the United States where the banking system is quite healthy. They show that the pass through from Fed rate changes to Money Market Mutual Fund yields is more than 90% (both before and after the global financial crisis) while the pass through to bank interest rates was less than 50% pre crisis and close to zero post crisis.

Posted at 22:02 on Thu, 21 Nov 2019     View/Post Comments (0)     permanent link

Thu, 07 Nov 2019

Does India need Unconventional Monetary Policy?

The Reserve Bank of India (RBI) has reduced its policy rate by 1.35% (135 basis points) during this calendar year, but that has provided little respite to the real economy. I think there are two issues here.

  1. First of all, this so-called 135 basis point cut is an exaggerated number because the base for this calculation is the high point of the policy rate of 6.50% in August 2018. At least in retrospect, it is clear that the rate hike in mid 2018 was a mistake which took too long to correct. (In this context, the MPC dissents of that period are fun to read). The more appropriate measure of the rate cut is therefore to ignore the aberration of mid 2018 and focus on the reduction from 6.00% in August 2017 to 5.15% currently to arrive at a number of 85 basis points. Of course, 85 basis points is not to be scoffed at, but my point is that thinking about 85 as if it is 135 has probably made the RBI reluctant to cut rates more aggressively. Had the RBI actually cut rates by 135 basis points from 6%, we would have reached 4.65% instead of 5.15%.

  2. Second is the stunning lack of monetary transmission: 10-year Indian government bond yields today are roughly where they were in August 2017 implying zero pass through of the 85 basis points cut in the policy rate. That is the most optimistic measure of monetary transmission because it focuses on risk free rates. Corporate borrowing is what is more relevant for capital investment in the economy, and here the situation is a lot worse because of a dysfunctional banking system that is unable or unwilling to lend for a variety of reasons.

As a result of this lack of monetary transmission, some people appear to have given up on monetary policy as a weapon to revive the economy. These people have started thinking that lower interest rates are simply pushing on a string, and that is better to rely on fiscal policy or supply side reforms. This in my view would be a cop out. Monetary policy has many other weapons still left in its armoury. After the Global Financial Crisis, when central banks in advanced countries found that they could not rely on interest rates because they had hit the zero lower bound, they did not give up. They used unconventional monetary policy that injected liquidity into the system and alleviated the credit crunch in the economy. The RBI should do the same if it thinks that policy rate cuts are not having an impact.

There is a lot that the central bank can do to push the 10-year government bond yield down by say 100-150 basis points to a level more consistent with the current state of the economy. First of all, the RBI could make a “lower for longer” commitment. It appears to me that the mistake of mid 2018 has dented the credibility of the central bank, and the markets are worried that as in 2018, policy rates could be raised again at the slightest pretext. Via the expectations channel, this fear would obviously stunt the monetary transmission to longer term rates. If the central bank could address this concern, and make a credible commitment that it would be more cautious in raising rates, 10-year yields would likely come down substantially. If jawboning the markets does not work, the central bank could simply buy enough long term government bonds to push the yield down to the desired level. Of course, such a policy is incompatible with an interest rate defence of the currency, and necessarily implies a willingness to let the rupee find its level.

What is even more pressing is the need to insulate the real economy from the debilitating effect of a dysfunctional banking system. The problem has been with us since the early 2010s, but for some time, the credit needs of the economy were met by near-banks (NBFCs). During the last year or so, the crisis in near-banks has shut down this channel and we are left with a dysfunctional financial sector (at least when it comes to credit). It is the responsibility of the central bank in situations like this to create mechanisms to maintain the flow of credit.

The RBI likes to acts through banks, but unfortunately, at this point of time, banks (and near-banks) are part of the problem and are definitely not part of the solution. The only feasible channel for maintaining credit flow today is the financial markets. I am convinced that the RBI should provide abundant systemic liquidity through the markets. Instead of complaining about the lack of deep bond markets, the RBI could use this as an opportunity to deepen these markets by acting as the market maker of first resort in a variety of credit markets and the buyer of last resort in key systemically important credit markets. The prime target for asset purchases by the central bank would be high quality residential mortgage backed securities and other securitization instruments, as well as senior tranches of Collateralized Loan Obligations (CLOs) that meet desired quality standards. The advantage of limiting asset purchases to pools of credit (and their tranches) is that it avoids charges of favouritism to individual borrowers. (The European Central Bank has been buying individual corporate bonds, but I doubt that Indian bond markets have the institutional maturity to make this possible.) When it comes to repo-lending, liquidity enhancement and market making, the RBI can target a far wider range of credit instruments.

Any measures that the RBI takes to promote financial markets would be welcome because India urgently needs to transition to a more market dominated financial sector for two reasons. First, Indian per capita income, GDP size and economic sophistication have all reached levels where it is natural for the financial sector to gradually shift from banks to markets. Second, the governance problems in banks and near-banks (whether in the public or private sector) have cast serious doubts about the viability of a bank dominated financial system in India at this point of time.

Posted at 19:28 on Thu, 07 Nov 2019     View/Post Comments (0)     permanent link

Mon, 23 Sep 2019

Real Estate and Infrastructure Resolution in India

Prof. Sebastian Morris and I have written a working paper on Real Estate and Infrastructure Resolution in India. We argue that real estate and infrastructure is at the centre of a vicious doom loop sketched in the figure below.

Problems in real estate and infrastructure debilitates the financial sector through rising non-performing assets. A dysfunctional financial sector further weakens the economy through credit tightening. A weak economy devastates Real Estate and Infrastructure through the demand channel.
Problems in real estate and infrastructure debilitates the financial sector through rising non- performing assets. A dysfunctional financial sector further weakens the economy through credit tightening. A weak economy devastates Real Estate and Infrastructure through the demand channel.

This vicious circle needs to be broken decisively, but merely bailing out the failing/ failed developers would only further crony capitalism. Our proposal uses the financial markets for price discovery and resource mobilization, and is based on the sovereign covering the left tail risk in infrastructure and real estate. The mechanism has the potential to revive these assets with the government earning a handsome return, while being fair to all stakeholders.

Our rationale for the sovereign to absorb the tail risks posed by the doom loop are:

This creates an opportunity for the sovereign to charge a fair insurance premium for providing tail risk cover, and thereby make a profit from the whole transaction in the long run. Our mechanism involves a second loss cover structure similar to the Maiden Lane transactions in the United States in the aftermath of the Global Financial Crisis.

We propose to use financial markets to discover fair prices of diversified pools of real estate assets. Diversified pools overcome problems of asymmetric information, and enable the use of standard valuation models like hedonic regression. More details are in the working paper.

Posted at 21:36 on Mon, 23 Sep 2019     View/Post Comments (0)     permanent link

Sat, 21 Sep 2019

Abstraction bias or bias bias?

Last month, Steven L. Schwarcz put out a paper, Regulating Financial Guarantors: Abstraction Bias As a Cause of Excessive Risk-taking, arguing that financial guarantors suffer from abstraction bias:

Financial guarantors commit to pay out capital only if certain future contingencies occur, in contrast to banks and other financial firms that pay out capital—for example, by making a loan—at the outset of a project. As a result, financial guarantors are subject to a previously unrecognized cognitive bias, which the author calls “abstraction bias,” that causes them to underestimate the risk on their guarantees.

Reading this paper reminded me of Gigerenzer’s paper (The Bias Bias in Behavioral Economics, Review of Behavioral Economics, 2018, 5: 303–336) arguing that:

[behavioral economics] is tainted by a “bias bias,” the tendency to spot biases even when there are none.

Let us look at the examples that Schwarcz presents of “abstraction bias”:

I got the feeling that Schwarcz picks up examples where there is significant tail risk that takes the form of a contingent liability. It is the tail risk that makes assessment and valuation difficult, but the author seems to think that it is all about abstraction instead.

Posted at 15:39 on Sat, 21 Sep 2019     View/Post Comments (0)     permanent link

Sun, 15 Sep 2019

Legal theory of finance redux

Six years ago, I blogged about Katharina Pistor’s Legal Theory of Finance, and observed that there seemed to be nothing novel about her claim that powerful institutions at the centre of the financial system tend to be bailed out while the small fry are allowed to die. But if one takes the politics out of the theory, the idea of the elasticity of law is an interesting insight. Pistor wrote:

Contracts are designed to create credible commitments that are enforceable as written. Yet, closer inspection of contractual relations, laws and regulations in finance suggests that law is … is elastic. The elasticity of law can be defined as the probability that ex ante legal commitments will be relaxed or suspended in the future

I was reminded of this when I read Emily Strauss’ paper Crisis Construction in Contract Boilerplate which describes how during the Global Financial Crisis, judges in the US interpreted a boilerplate contractual clause to reach a result clearly at odds with its plain language. She writes:

In the aftermath of the financial crisis, trustees holding residential mortgage backed securities sued securities sponsors en masse on contracts warranting the quality of the mortgages sold to the trusts. These contracts almost universally contained provisions requiring sponsors to repurchase individual noncompliant loans on an individual basis. Nevertheless, court after court permitted trustees to prove their cases by sampling rather than forcing them to proceed on a loan by loan basis.

While the reasoning of these decisions is frequently dubious, they gave trustees the leverage to salvage millions – even billions – of dollars in settlements from the sponsors who had sold the shoddy loans, reassuring investors that sponsors would be forced to stand behind their contracts. However, as the crisis ebbed, courts retrenched, and more recent decisions adhere to the plain language requiring loan-by-loan repurchase. I argue that the rise and fall of decisions permitting sampling reflect a largely unexpressed judgment that in times of severe economic crisis, courts may produce decisions to help stabilize the economy.

This phenomenon is in many ways quite the opposite of Pistor’s theory. The dubious decisions referred to above went against some of the largest banks in the world while benefiting a large and disparate group of investors. While Strauss describes this as an attempt to stabilize the economy, it appears to me to be more of fairness and pragmatism trumping the express terms of the contract. But, at a deeper level, Pistor is right: the law can be very elastic in a crisis.

Posted at 19:05 on Sun, 15 Sep 2019     View/Post Comments (0)     permanent link

Fri, 06 Sep 2019

Reserve Bank of India’s flip-flops on floating rate benchmarks

Earlier this week, the Reserve Bank of India (RBI) issued a circular asking banks to shift from internal to external benchmarks for pricing their floating rate loans. This is the latest in a series of flip-flops by the regulator on this issue over the last two decades:

These flip-flops reflect the failure of the central bank on two dimensions:

In the next few years, India needs to work on creating both a better banking system and better financial markets. One of the pre-requisites for this is that regulators should step back from excessive micro-management. For example, the RBI Master Directions require the interest rate under external benchmark to be reset at least once in three months while elementary finance theory tells us that if the floating rate benchmark is a 6-Months Treasury Bill yield, it should reset only once in six months. Either banks will refrain from using the six month benchmark (eroding liquidity in that benchmark) or they will end up with a highly exotic and hard to value floating rate loan resetting every three months to a six month rate. Neither is a good outcome.

Posted at 16:35 on Fri, 06 Sep 2019     View/Post Comments (0)     permanent link

Fri, 30 Aug 2019

No Easy Fixes for Limited Liability

US senator and presidential hopeful Elizabeth Warren (who also happens to be one of America’s most eminent bankruptcy scholars) has a proposal to make private equity firms liable for the debts of their portfolio companies by ending the limited liability protection that they currently enjoy. Another well known professor of bankruptcy law and financial regulation, Adam Levitin, has weighed in with an attack on the concept of limited liability itself.

Limited liability is a substantial, regressive cross-subsidy to capital at the expense of tort creditors, tax authorities, and small businesses. Limited liability is a relic of the underdeveloped financial markets of the Gilded Age and operates as an implicit form of leverage provided by law. But it’s hardly either economically efficient or necessary for modern business activity.

These extreme claims might have some basis in the Modigliani-Miller theory of corporate leverage, but Levitin does not substantiate them with serious evidence. In fact, the claims appear to be rhetorical in nature because Levitin goes on to say:

In any event the Stop Wall Street Looting Act rolls back limited liability solely for private equity general partners in a surgical manner such that doesn’t affect limited liability more broadly.

…, the problem with private equity isn’t limited liability per se. The problem is limited liability combined with other unique and unavoidable features of private equity. Limited liability plus extreme leverage means that there is a seriously lopsided risk/reward tradeoff that incentivizes excessive risk-taking.

The problem is that this limited excision of limited liability does not work in the presence of derivative markets because limited liability equity can be replicated by a call option. Owning the shares of a company with substantial debt is equivalent to holding a call option on the assets of the company with a strike price equal to the face value of the debt. This is essentially the Merton model of corporate debt (Merton, R.C., 1974. On the pricing of corporate debt: The risk structure of interest rates. The Journal of Finance, 29(2), pp.449-470.)

The converse is also true: it is impossible to ban derivatives without banning debt as I argued in a blog post a decade ago. Many proposals for fixing modern finance ignore the ability to replicate one instrument with another set of instruments.

Posted at 21:14 on Fri, 30 Aug 2019     View/Post Comments (0)     permanent link

Wed, 28 Aug 2019

When do algorithms violate the law

I enjoyed reading the judgement of the Federal Court of Australia on whether Westpac Banking Corporation’s computer operated home loan approval system (known as the automated decision system or ADS) violated Australia’s responsible lending laws. The judgement is fun to read, and that might itself be enough reason to read it since delightful court judgements are relatively rate. More importantly, this issue of evaluating algorithms for compliance is going to become increasingly important in the years to come.

The court threw out the case basically on the ground that the Australian Securities and Investments Commission (ASIC) had not done its homework well enough.

[ASIC] does not allege that the alleged defects in the ADS resulted in Westpac extending loans to any consumers who it ought to have found would be unable to meet their financial obligations under the credit contracts or who would be able to do so only in circumstances of substantial hardship. ASIC did originally make several such allegations in relation to specified loans but it abandoned these on the day before the trial commenced. This then is a case about the operation of the responsible lending laws without any allegation of irresponsible lending.

ASIC was claiming that Westpac’s ADS violated the responsible lending laws simply because the rules in the algorithm ignored some data or used imperfect measures for some variables. The court rejected this approach:

It is not enough to point to an individual rule in the ADS and to submit that it does not comply with Div 3. Westpac’s entire system (including manual assessment where referral is triggered) must be examined, and compliance with Div 3 gauged that way.

Of course, the Court is right on this point, and therein lies the challenge in regulating a financial world that is increasingly run on algorithms. It appears to me that financial sector regulators are by and large unprepared for this challenge.

Posted at 19:55 on Wed, 28 Aug 2019     View/Post Comments (0)     permanent link

Wed, 14 Aug 2019

Can India seize the Hong Kong opportunity?

As Hong Kong moves ever closer to a military denouement, India needs to think hard about the opportunity it could provide to its own fledgling offshore financial centre. Over the last several years, India has built the foundations for an offshore financial centre at GIFT City in Gandhinagar, Gujarat. A lot of physical infrastructure has been created, exemptions have been made from the normal exchange control regime, tax concessions have been provided, and some small beginnings have been made in offering offshore financial services. But the turmoil in Hong Kong presents opportunities of a vastly different order.

Is India willing to take the key steps that would make it an attractive option to businesses and individuals that may wish to relocate out of Hong Kong now or in the immediate future?

Posted at 16:56 on Wed, 14 Aug 2019     View/Post Comments (1)     permanent link

Tue, 06 Aug 2019

QE through unlimited buying of foreign equities

After the global financial crisis, central banks have done many things that were previously considered unthinkable, and Switzerland and Japan have probably been more radical than most others. But as the eurozone slips deeper and deeper into the quagmire of negative yields, the Swiss National Bank and the Bank of Japan are now at risk of being perceived as paragons of sound money.

The situation in the eurozone is so bad that the entire yield curve (all the way to 30 years) is negative in Germany and Netherlands, and it is possible that the ECB will be forced to push policy rates even deeper into negative rates. Both the Swiss franc and the Japanese yen have been pushed higher and even Bitcoin looks like a safe haven currency if you look only at a one week price chart.

The pioneers of monetary easing are reaching the limits of their existing unconventional policies, and will have to turn to something even more unthinkable. To compete with the frightening scale of European easing, Switzerland and Japan have to find an asset class that can accommodate almost unlimited buying without running into capacity constraints, creating excessive market distortions, or provoking a severe political backlash. I think at some point they will very reluctantly be driven to the conclusion that there is only asset class that fits the bill and that is global equities.

A portfolio of global index funds can absorb a few trillion dollars of central bank buying without too much disturbance. Political backlash would be muted for two reasons. First, by buying index funds instead of buying assets directly, they avoid getting involved in the sensitive issues of corporate governance and control. Second, every politician likes a rising stock market. Even America’s tweeter-in-chief who sees currency manipulators wherever he looks will probably tolerate a weaker yen if it takes the S&P 500 index to new highs.

Perhaps – just perhaps – falling global equities provide an opportunity for some ordinary investors to front-run the Swiss National Bank and the Bank of Japan before these central banks get into the game.

Posted at 18:08 on Tue, 06 Aug 2019     View/Post Comments (0)     permanent link

Fri, 26 Jul 2019

Big Tech 2019 = Big Finance 2005 = Big Risk?

That is the title of my post today in the sister blog on computing. In 2005, Big Finance was at the top of the world, but in 2008, it all came crashing down. It appears to me that Big Tech which enjoys a similar situation of dominance today also suffers from the same kind of hubris that destroyed Big Finance a decade ago. A change in fortunes could be as fast and as brutal as was the case with Big Finance a decade ago. Prudent risk management today demands that individuals and organizations take steps to protect themselves against the risk that one or more of the Big Tech companies would go bust or shutdown their services for other reasons.

Posted at 21:00 on Fri, 26 Jul 2019     View/Post Comments (0)     permanent link

Thu, 25 Jul 2019

A petty money dispute holds market to ransom

I am not a lawyer, and so it is with much trepidation that I write about a petty dispute that has been holding the Indian market to ransom. I venture to write only because I am convinced that the issue is not really about legal technicalities, and in any case the entire money dispute is quite petty and trivial compared to the broader issue of market integrity and the sanctity of key market infrastructure.

The facts of the dispute are well brought out in an order issued in May 2019 by the Securities Appellate Tribunal. The genesis of the dispute lies with a brokerage firm, Allied Financial Services, that allegedly stole about $50 million worth of its clients’ securities and pledged them as collateral with its Clearing Member, ILFS Securities, to support an options trade that they had done on the National Stock Exchange (NSE). On the strength of this collateral, ILFS Securities, deposited cash margins with NSE Clearing to support the trade done by Allied. After receiving complaints of fraud, the Economic Offences Wing (EOW) froze the collateral lying with ILFS Securities. When the time came to settle the trade, ILFS Securities asked for annulment of the trade. Even if the trade is annulled, ILFS would have to return the option premium and the benefit to them would be a only marginal reduction in the quantum of loss. ILFS Securities’ gain of probably $5-10 million would of course be the loss of the counter parties to the trade.

I deliberately call this a petty dispute because for some of the institutions involved, $5 million or even $50 million is quite likely a rounding error on their balance sheets. Even for the smaller entities, it is not by itself a bankruptcy threatening event. We are not talking about a poor investor whose lifetime savings could be wiped out by the dispute; we are talking about some big institutions which might be somewhat better off or somewhat worse off depending on which way the dispute is resolved. We are also not talking about recovering money from the alleged fraudster; the dispute is all about allocating the losses among different victims of the alleged fraud.

The tragedy is that as a result of this petty dispute, there has been a stay on the settlement of the trade. If not resolved soon, this settlement failure risks causing serious damage to the integrity and reputation of India’s largest stock exchange and its clearing corporation.

The core function of a stock exchange and its clearing corporation is to allow complete strangers to trade without doing any due diligence on each other. If you do an OTC trade or bilateral trade, you have to worry about whether your counter party is trustworthy. On the other hand, when you sell some shares on an exchange, you do not even bother to ask who was the buyer because it does not matter. The whole function of the exchange is to make that question (whom am I trading with) irrelevant and thereby create a national (or even global) market. OTC markets are a cosy club, while exchanges are open to one and all. At the centre of this magical transformation is the clearing corporation that becomes the counter party to all trades (novation) and thereby insulates buyer and seller from each other.

It is this core promise of the clearing corporation that has been called into question by the way this petty dispute has been allowed to fester and linger. A shadow has been allowed to fall on the sanctity of a key market infrastructure. I do not blame the judiciary for this tragedy because the judiciary adjudicates only issues that are brought before it. And it is the money dispute that has come before the judiciary because all the big and mighty entities involved have the wherewithal to hire the best lawyers to argue that this trivial dispute is the most important thing in the world.

The burden of preventing this tragedy lies primarily with the regulator who has the responsibility and mandate to draw the judiciary’s attention to the systemic issues and national interest involved in the smooth functioning of our market infrastructure. A $5 or even $50 million dispute should not be allowed to threaten the integrity of a $2 trillion stock market. As I said, I am not a lawyer, but I find it hard to believe that SEBI would not receive a patient hearing in the highest courts of the land if it made an earnest plea on its statutory duty to protect the investor interest and the public interest. Instead, it has confined itself to narrow legalistic arguments about who has the power to annul a trade and under what conditions. It has allowed the disputants to frame the debate instead of seeking to change the frame of the debate.

Posted at 16:06 on Thu, 25 Jul 2019     View/Post Comments (1)     permanent link

Thu, 11 Jul 2019

US wants to nurture single stock futures

Two decades ago, when India was trying to set up its equity derivatives market, the most contentious issue was that of single stock futures – market participants were keen on this product, while a large group of sceptics argued that the product did not exist in the US and was in fact confined to a handful of countries. It was also thought to be too similar to the indigenous system of rolling settlement known as badla which was somehow thought to be evil. The compromise was to begin with index futures and defer the launch of single stock futures. In reality, the single stock future was the first equity derivative to become successful in India, and then the earlier products picked up with a significant lag. India also became one of the largest single stock future markets in the world while also creating very liquid index futures, index options and single stock option markets. The Indian experience also demonstrated that each of these four markets catered to a different need. For example, my former doctoral student Sonali Jain in a recent paper, along with my colleagues, Sobhesh Agarwalla and Ajay Pandey and myself found that in India, single stock futures play the role that the options market plays in the US for informed trading around earnings announcements. This implies that single stock futures have some clear advantages over options in informed trading.

With this background, I found it quite amusing to read the joint proposal by the US Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) to reduce margins for retail investors in single stock futures (see press release and proposal). The US set up a single stock futures market a decade ago, but it remains tiny. The SEC is now very clear about its desire to promote the growth of this market:

The security futures market can provide a low-friction means of obtaining delta exposures, and relatively high margin requirements … may have played a role in restraining its development.

To the extent that the proposed reductions in margin requirements encourage significant growth in the security futures markets, it may, in time, improve price discovery for underlying securities. In particular, a more active security futures market can reduce the frictions associated with shorting equity exposures, making it easier for negative information about a firm’s fundamentals to be incorporated into security prices. This could promote more efficient capital allocations by facilitating the flow of financial resources to their most productive uses.

There is also a degree of anxiety about foreign markets that have stolen a march over the US in this product:

Lowering the minimum margin requirement also could enable the one U.S. security futures exchange to better compete in the global marketplace, where security futures traded on foreign exchanges are subject to risk-based margin requirements that are generally lower than those applied to security futures traded in the U.S.

To make things more interesting, there is also a public statement of dissent by one of the SEC Commissioners. I never thought that a day would come when it would be easier to obtain consensus between the SEC and the CFTC than to get consensus within the SEC. What is striking about this dissent is that it does not disagree with the goal of promoting single stock futures. Commissioner Jackson says:

So [stock futures] can provide a valuable price-discovery function in stock markets and give investors an important way to diversify.

But he is not convinced that reducing margins are the best way to accomplish this goal. He believes that there are many alternatives that could and should have been considered. As an example, he suggests that:

rather than asking us to lower margin requirements, an exchange could simply reduce the contract size for single-stock futures. … reducing contract size could also increase access to single-stock futures for the most popular securities and improve efficiency. … Indeed, one of the most liquid contracts in the world, the S&P E-mini Futures contract, is the product of cutting the classic S&P Futures contract in half.

To me, what is noteworthy is that, in two decades, the world has moved from frowning on single stock futures to trying to nurture them.

Posted at 12:23 on Thu, 11 Jul 2019     View/Post Comments (2)     permanent link

Tue, 02 Jul 2019

Deep fakes in finance?

For the last couple of years, I have been following the phenomenon of Deep Fakes with a mixture of cynicism and disinterest. It is only in the last few weeks that I have begun to worry that this is not something that concerns only a few celebrities, but could become a problem for the financial sector in general.

Last week, I read two things that brought the matter to focus. First was the news report about the fake French minister in a silicone mask who stole millions of euros from some of the richest men of Europe (h/t Bruce Schneier). The minister who was impersonated was quite impressed by the quality of the fake video: “They did a pretty good job. Unfortunately some people fell for it. They did a really good impression of my voice. But no-one can truly pass themselves off as me.”

The second was the following recommendation in the report of the Expert Committee on Micro, Small and Medium Enterprises set up by the Reserve Bank of India under the Chairmanship of Shri U K Sinha:

Presently the KYC process is manual and necessitates a physical presence, thus increasing costs and timelines in completing the required KYC processes. As an alternative to enabling e-KYC, the Committee recommends video KYC to be adopted as a part of digital financial architecture as a suitable alternative to performing a digital Aadhaar-based KYC process towards enabling non-physical customer onboarding. (Box XIV- Video Based KYC in Chapter 8)

It appears to me that we will see more of this: only a handful of Luddites will oppose the use of technology that saves cost and eliminates hassles. However, it is part of the folklore of digital security that you can pick any two of Secure, Usable and Affordable – you cannot get all three. Most market architectures would make the natural choice of Usable and Affordable and de-prioritize Security. Deep Fakes would thus emerge as a problem for mainstream finance over a course of time, but I guess it will (perhaps rightly) be treated as a cost of doing business.

Posted at 13:03 on Tue, 02 Jul 2019     View/Post Comments (0)     permanent link

Sat, 29 Jun 2019

The bankers, by contrast, moved on

I just finished reading Hassan Malik’s book Bankers and Bolsheviks: International Finance and the Russian Revolution (Princeton University Press, 2018) which is based on his PhD dissertation. I was struck by the close parallels between the excessive risk tolerance that we are seeing in the world today and the complacency and reaching for yield that Malik documents in international lending to Russia between 1906 and 1917.

In his final chapter, Malik describes the sorry fate of small French investors and Russian technocrats after the Russian default of 1918. He then concludes the book with the line that I have used as the title of this post:

The bankers, by contrast, moved on.

In that respect, not much changed between 1918 and 2008.

Posted at 18:15 on Sat, 29 Jun 2019     View/Post Comments (0)     permanent link

Sat, 22 Jun 2019

Allowing a corporate body to be a director

A few months back, Joseph Franco published a fascinating paper about a commoditized governance model adopted by a small minority of US mutual funds where the entire governance is outsourced to an unaffiliated entity that specializes in providing governance services. (Commoditized Governance: The Curious Case of Investment Company Shared Series Trusts (February 14, 2019). 44 J. Corp. L. 233 (2018) ; Suffolk University Law School Research Paper No. 19-7. Available at SSRN: Franco concludes that this model is merely an interesting curiosity:

Where a board’s role primarily involves organizational, rather than strategic, oversight of an underlying business, as in the fund industry, commoditized governance may prove attractive for at least some industry participants. In contrast, where a board’s role encompasses both organizational and strategic oversight of an underlying business, as is more commonly the case, commoditized governance will not be a successful governance model. Accordingly, and consistent with practical experience, commoditized governance will exist largely as an exceptional, rather than common, form of entity governance.

This discussion got me thinking about a related idea – would it make sense to let specialized unaffiliated corporate bodies (like LLPs, LLCs or private companies) to become independent directors of large companies? (I do not want to contemplate the recursion involved in letting the independent director be another listed company.)

The current model of allowing only individuals to become independent directors is not working well. First of all, most independent directors have quite meagre wealth, and so when things go wrong, investors can recover virtually nothing by suing the independent directors (They gain much more by suing the auditors or other gatekeepers). At the same time, prosecutors and regulators are very keen to punish the directors, and this keenness often depends more on the quantum of the loss and less on the degree of negligence of the director. This means that highly risk averse people would be reluctant to become independent directors. If the only people willing to serve on the board are those with a high degree of risk tolerance, then the companies that they govern would naturally tend to pursue high risk strategies as was well illustrated by the Global Financial Crisis of 2008.

Second, most independent directors lack the administrative and analytical support that is often needed to challenge management strategy at a fundamental level. Almost all independent directors can only envy the massive support that non independent directors (venture capitalists, private equity firms, activist investors, nominees of the lenders and representatives of controlling shareholders) get from their respective organizations. Unfortunately, these well endowed non independent directors are often more interested in looking after the interests of their respective constituencies, than the interests of the company itself or its shareholders as a whole.

The governance deficit that we observe in some of the largest companies in the US, in India, and elsewhere in the world, is symptomatic of these fundamental problems of the current model of relying on individuals to serve as independent directors. I think there is much to be gained by shifting to a model of incorporated independent directors. This will also make it easier to impose capital adequacy and skin in the game requirements. Valuation metrics in the financial services industry (for example, asset managers and rating agencies) suggest that a large incorporated independent director service provider would command a valuation of 5 – 10 times revenue. If independent directors are paid 0.5 – 1% of profits, and each incorporated independent director serves on boards of 30 – 100 large companies, then the independent directors of a company would probably have a combined valuation of twice the annual profits of a large company. That would represent a juicy litigation target for shareholders who suffer losses due to a governance failure (probably a more juicy target than the auditors). The large franchise value of the business would motivate these incorporated independent directors to exercise a high degree of diligence in performing their work, and would also make them highly sensitive to reputation risk. Would this not be a major improvement over the current system?

Posted at 15:47 on Sat, 22 Jun 2019     View/Post Comments (1)     permanent link

Thu, 13 Jun 2019

Bonds and loans

Banks give loans, while mutual funds buy bonds. Recent difficulties of Indian debt mutual funds in dealing with corporate defaults suggest, however, that these lines are quite blurred. Illiquid bonds are like loans in all but name, and then mutual funds start looking a lot like banks with all the attendant risks. Problems of this kind are not unique to India. The suspension of dealing in the LF Woodward Equity Income Fund run by one of the UK’s “star” fund managers raises similar questions about the difference between an equity mutual fund and a venture capital fund.

Both in the Indian and the UK situations, the core of the problem is that while regulators insisted on mutual funds investing in listed assets, “listed” does not necessarily mean “liquid”. The core premise of an open end mutual fund is that assets are sufficiently liquid that (a) no external liquidity support is needed and (b) a fair Net Asset Value (NAV) can be reliably computed. The problem is that many listed assets do not meet this requirement (and, on the contrary, some unlisted assets might).

In India, we have created a large debt mutual fund industry without paying enough attention to creating a liquid corporate bond market. The result is that much of what passes as bonds are loans dressed up in the legalese of bonds and listed on exchanges which collect listing fees but do not provide worthwhile liquidity.

More importantly, we have not encouraged the creation of a vibrant Credit Default Swap (CDS) market. A liquid CDS market would facilitate the flow of negative information about bonds (through shorting the CDS) and would thus hopefully provide early warning signals about impending downgrades and defaults. Currently, distressed bonds are often valued close to par right up to the date of default, and then they just fall off a cliff.

Unfortunately, regulators in India have been hesitant to allow markets that can speak truth to power, while being very happy to create a simulacrum of a corporate bond market.

Posted at 16:25 on Thu, 13 Jun 2019     View/Post Comments (0)     permanent link

Mon, 03 Jun 2019

Korean derivatives reforms come full circle

Back in 2011, South Korea embarked on a significant clampdown on retail participation in its equity derivatives market which is one of the largest in the world. The result of these measures was to effectively hand over the Korean derivatives market to foreigners. As for protecting retail investors from speculative misadventures, probably the only effect was to divert the speculative energies into bitcoin, exotic structured products and the like. It took the Koreans eight years to realize that the 2011 measures had basically thrown the baby out with the bathwater. Now they are pedalling back furiously and trying to bring Korean investors back into the market. The announcement last week by the Korean Financial Services Commission (FSC) reads like a mea culpa (if you read between the lines).

This episode holds a lot of lessons for India as well as we too have a host of would-be reformers who would love to clampdown on retail speculation in equity derivatives. There is every reason to believe that if they succeed, the results will be similar to that in Korea – the purported cure will be worse than the purported disease.

Posted at 13:26 on Mon, 03 Jun 2019     View/Post Comments (1)     permanent link

Tue, 02 Apr 2019

Blockchain in Finance

I have a perspectives piece in the current issue of Vikalpa about Blockchain in Finance. I have been teaching an elective course on the Blockchain for over three years now, and my approach has been to treat both mainstream finance and crypto finance with equal dollops of scepticism, cynicism and openness. That is what I do in this piece as well:

Blockchain – the decentralized replicated ledger technology that underlies Bitcoin and other cryptocurrencies – provides a potentially attractive alternative way to organize modern finance. Currently, the financial system depends on a number of centralized trusted intermediaries: central counter parties (CCPs) guarantee trades in exchanges; central securities depositories (CSDs) provide securities settlement; the Society for Worldwide Interbank Financial Telecommunication (SWIFT) intermediates global transfer of money; CLS Bank handles the settlement of foreign exchange transactions, a handful of banks dominate correspondent banking, and an even smaller number provide custodial services to large investment institutions. Until a decade ago, it was commonly assumed that the financial strength and sound management of these central hubs ensured that they were extremely unlikely to fail. More importantly, it was assumed that they were too big to fail (TBTF), so that the government would step in and bail them out if they did fail. The Global Financial Crisis of 2007–2008 shattered these assumptions as many large banks in the most advanced economies of the world either failed or were very reluctantly bailed out. The Eurozone Crisis of 2010–2012 stoked the fear that even rich country sovereigns could potentially default on their obligations. Finally, repeated instances of hacking of the computers of large financial institutions is another factor that has destroyed trust. When trust in the central hubs of finance is being increasingly questioned, decentralized systems like the blockchain that reduce the need for such trust become attractive.

However, even a decade after the launch of Bitcoin, we have seen only a few pilot applications of blockchains to other parts of finance. This is because cryptocurrencies (while being extremely challenging technologically) encountered very few legal/commercial barriers, and could therefore make quick progress after Bitcoin solved the engineering problem. The blockchain has many other potential finance applications – mainstream payment and settlement, securities issuance, clearing and settlement, derivatives and other financial instruments, trade repositories, credit bureaus, corporate governance, and many others. Blockchain applications in many of these domains are already technologically feasible, and the challenges are primarily legal, regulatory, institutional, and commercial. It could take many years to overcome these legal/commercial barriers, and mainstream financial intermediaries could use this time window to rebuild their lost trust quickly enough to stave off the blockchain challenge. However, whether they are successful in rebuilding the trust, or whether they will be disrupted by the new technology remains to be seen.

Blockchain is still an evolving and therefore immature technology; it is hard to predict how successful it would be outside its only proven use domain of cryptocurrencies. History teaches us that radically new technologies take many decades to realize their full potential. Thus it is perfectly possible that blockchain would prove revolutionary in the years to come despite its patchy success so far. What is certain is that businesses should be looking at this technology and understanding it because its underlying ideas are powerful and likely to be influential.

Posted at 13:01 on Tue, 02 Apr 2019     View/Post Comments (1)     permanent link

Thu, 28 Mar 2019

Learning from Crises

Last week, Anwer S. Ahmed, Brant E. Christensen, Adam J. Olson and Christopher G. Yust posted a summary of their research on how banks with leaders experienced in past crises fared in global financial crisis (GFC). Their conclusion is:

We find that banks led by executives and directors with past crisis experience had significantly higher ROA before and during the GFC, fewer failures during the GFC, lower risk-weighted assets in the GFC, less exposure to real estate loans both before and during the GFC, timelier loan loss provisions in the GFC, and more persistent earnings before and during the GFC.

There are two ways of looking at this result. At the micro level, organizations should try to recruit managers with such experience. More important in my view is the macro level implication: it is good for society to have a large pool of managers with past crisis experience. That would ensure that the entire financial system copes better with new crises. But for that to happen, we need crises (at least mild crises) to happen with some degree of regularity.

Already, a decade after the GFC, I think a whole generation of traders and bankers have entered the financial system who have no first hand knowledge of dealing with a crisis. All that they have seen is a financial market numbed by ultra loose monetary policy and policy-puts. Their experience so far is that large economic and geo-political shocks (Brexit or the US-China trade war) have very mild and transient effects on market prices and volatility. The complacency of this generation is probably balanced by the battle scarred veterans who dominate the senior ranks of most banks. But over a period of time, many of these crisis-experienced leaders will retire or leave. It is quite likely that when the next big crisis comes along, there will be a shortage of crisis experience in the trenches.

Outside of finance, it is well understood that preventing small crises is a bad idea: frequent small earthquakes are better than an occasional big one; periodic restricted forest fires are preferred to one rare but big conflagration, and so on. In finance, there is a reluctance to permit even small failures. Regulators and policy makers are rewarded for moving swiftly to “solve” mini-crises. The tragedy is that this leaves institutions, individuals (and even regulators) ill equipped to cope with the big crises when they come.

Posted at 15:01 on Thu, 28 Mar 2019     View/Post Comments (1)     permanent link

Thu, 14 Mar 2019

Inverting the intermediary theory of asset pricing

In the last few years, the intermediary theory of asset pricing has emerged as a single factor model of asset pricing that does as well as the standard four factor model and thus subsumes the size, value and momentum factors (Adrian, T., Etula, E., & Muir, T. (2014). Financial intermediaries and the cross‐section of asset returns. The Journal of Finance, 69(6), 2557-2596). The theoretical justification for this model is that since financial intermediaries are the marginal buyers of many assets, their marginal value of wealth is a more relevant stochastic discount factor than that of a representative consumer. Though the idea that leverage is a good proxy for marginal value of wealth strains credulity, the empirical results seem quite strong, and there is some case to be made that the shadow price of a leverage constraint is related to the marginal value of wealth.

I see two problems with this. First of all, the major risk factors (like Momentum, Value, Carry and BAB) have been demonstrated in two centuries of data (1799-2016) from across all major world markets (Baltussen, Guido and Swinkels, Laurens and van Vliet, Pim, Global Factor Premiums (January 31, 2019). Available at SSRN: It is evident that the structure of financial intermediation has changed beyond recognition over the last two centuries; for example, 19th Century giants like the Rothschilds operated with far lower levels of leverage than modern security dealers, and were in fact more principals than intermediaries. If the risk factors are solely due to intermediary leverage constraints, I would not expect to see such strong Sharpe ratios for the risk factors in the 19th Century data.

Second, there is a vertical split within the intermediary theory itself. He, Kelly and Manela presented a competing theory (Intermediary asset pricing: New evidence from many asset classes. Journal of Financial Economics, 2017, 126(1), 1-35) with drastically different results. I sometimes joke that Adrian, Etula & Muir (AEM) and He, Kelly & Manela (HKM) refute each other and so there is nothing more to be said. The first direct contradiction is that AEM find a positive price of risk for leverage, while HKM find a positive price of risk for the capital ratio (which is the reciprocal of leverage). Second, HKM get their nice results when they measure capital of the primary dealers at the holding company level unlike AEM who measure security dealer leverage at the unit level. Finally, AEM find book leverage to be more important, but for HKM, it is the market value capital ratio that is relevant.

I am veering around to the view that risk factors are not priced because of intermediary leverage constraints, but it is the other way around. Factor risk premiums have very long and deep drawdowns (for India, the drawdown plots are available at As Cliff Asness put it,

I say “This strategy works.” I mean “in the cowardly statistician fashion.” It works two out of three years for a hundred years. We get small p-values, large t-statistics, if anyone likes those kind of numbers out there. We’re reasonably sure the average return is positive. It has horrible streaks within that of not working. If your car worked like this, you’d fire your mechanic, if it worked like I use that word.

So it is easier to harvest factor premiums if you are gambling with other people’s money especially with a taxpayer backstop for extreme tail events. Since Too Big to Fail (TBTF) banks are ideal candidates for doing this, you could well see significant correlations between the factors and the capital/leverage of these banks, but these correlations might be very sensitive to the measurement procedures that you use. In short, perhaps, we need to invert the intermediary theory of asset pricing.

Posted at 16:15 on Thu, 14 Mar 2019     View/Post Comments (0)     permanent link

Sat, 09 Mar 2019

When do you sell your best businesses?

The traditional recipe for reducing the leverage of an over indebted business conglomerate is to (a) sell non core peripheral unviable businesses, and (b) focus on improving the cash flows of the core profitable businesses. Most companies tend to do this, at least after they have gone past the stage of denial and business as usual.

But there is an alternative view expressed most forcefully two decades ago by a senior Korean government official in response to a restructuring proposal submitted by the Daewoo group: you do not reduce debt by selling unviable business, you do it by selling profitable businesses. (This statement most probably came from the Korean Financial Supervisory Commission (FSC) then led by the no-nonsense Lee Hun Jai, but I am not now able to trace this quote though the tussle between Daewoo and the government was well covered in the international press.)

I do recall one company that sold its best business without any prodding from creditors or government: RJR Nabisco under the private equity group KKR. Way back in 1995, with the tobacco business in the doldrums (as a result of Marlboro_Friday and tobacco litigation), RJR sold a part of the more attractive food business in a public issue, and used the proceeds to pay off some of its humongous debt. Apparently, the reason for not selling off the entire food business was legal advice that this could expose the board members to liability for fraudulent conveyance. (Baker & Smith discuss this episode in some detail in Chapter 4 of their book on KKR – The new financial capitalists: Kohlberg Kravis Roberts and the creation of corporate value. Cambridge University Press, 1998).

There are two arguments in favour of the radical approach of selling your best businesses to reduce debt. The first is that deleveraging is often carried out under acute time pressure and it is the good businesses that can be sold quickly and easily. Dilly dallying over deleveraging can quickly take things out of the control of management, and potentially lead to the complete dismantling and liquidation of the group as happened to Daewoo. The second argument is that financial stress at the conglomerate level acts as a drag on the good businesses that might need capital to grow or might need strong balance sheets to retain customer confidence and loyalty. In times of financial stringency, the functioning of the internal capital markets within the conglomerate becomes impaired and the good businesses tend to suffer the most. When internal capital markets start prioritizing survival over growth, good businesses should be rapidly migrated to stronger balance sheets that can both preserve value and support growth.

Many business groups in India are today trying to deleverage in response to changes in the legal regime that empower creditors, but they are still focused on selling their bad businesses. The risk is that this may prove too little, too late. At least some of them should consider the heretical idea of selling their crown jewels.

Globally, perhaps the largest conglomerate that needs to evaluate the strategy of selling its best business is GE. The aviation business is the crown jewel that is at risk from the troubles in the conglomerate. A year ago, John Hempton explained why this business needs a pristine balance sheet: whoever buys a plane powered by a GE engine needs to be confident that GE will be around and solvent in 40 years to actually maintain that engine. Moreover, the business needs massive investment in research and development, and the ability of a struggling GE to do this might be questionable. John Hempton proposed an equity raising as the solution, but the window for that might be slipping away as the share price continues to slide.

In times of stress, companies need level headed managers who can take rational decisions without being swayed by a maudlin attachment to their crown jewels.

Posted at 18:13 on Sat, 09 Mar 2019     View/Post Comments (3)     permanent link

Thu, 07 Mar 2019

Ignoring operational risk

Operational risk has always been less glamorous compared to market risk, interest rate risk and credit risk which are all now dominated by sophisticated mathematical models and apparent analytical rigour. Regulators too are uncomfortable dealing with operational risk because of its judgemental nature. Yesterday, for example, the US Federal Reserve Board announced that the largest US banks would no longer be subject to the “qualitative objection” which was the rubric under which it dealt with operational risk (see pages 13-14 of the summary instructions).

The reality however is that in big financial institutions with large well diversified portfolios, most risk management failures involve operational risk. This was true for example of JP Morgan’s London Whale, of the Nirav Modi scam at Punjab National Bank, of Nick Leeson, and many other cases. Even in the Global Financial Crisis, many of the largest losses were due as much to operational risk as to systemic events (which is why some banks had much larger losses than others).

Chernobai, Ozdagli and Wang have a paper showing that operational risk is aggravated for large and complex institutions (Business Complexity and Risk Management: Evidence from Operational Risk Events in U.S. Bank Holding Companies (December 18, 2018). Available at SSRN). They show that operational risk increased significantly when the business complexity of banks increased and provide evidence that this results from managerial failure rather than strategic risk taking. A year ago, I wrote on this blog that

banks are so opaque that even insiders cannot see through the opacity when bad things happen … Even a very competent chief executive can be clueless about some activities in a corner of the bank that have the potential to bring down the bank or at least cause severe losses.

Ignoring operational risks for the largest and most complex banks because it is too qualitative and judgemental does not appear to me to be a very good idea.

Posted at 14:38 on Thu, 07 Mar 2019     View/Post Comments (0)     permanent link

Wed, 27 Feb 2019

Can a strong Gresham’s law make good money worthless?

Gresham’s law states that if good money and bad money are circulating simultaneously, everybody would hoard the good money and spend the bad money thereby driving the good money out of circulation. Essentially, the good money becomes a store of value, and the bad money becomes the medium of exchange. I am beginning to think that an even more perverse outcome is possible – the good money having ceased to be money can suddenly become nearly worthless (because the store of value function of the previously good money depended on its being money). This strong form of Gresham’s law came to my mind after reading Wiegand’s recent paper presenting a “prisoners’ dilemma” model of Germany’s adoption of the gold standard in the 1870s.

The story as Wiegand describes it is as follows. In the mid 19th century, a large bloc of countries led by France was on a bimetallic standard with both gold and silver being used as money at a fixed exchange rate. New discoveries in California and Australia brought new supplies of gold in the 1850s, leading to relative shortage of silver whose output grew slowly. While in 1849, annual production (by value) of gold was less than that of silver, in the 1850s and 1860s, gold output was 2-3 times that of silver. Gresham’s law operated as expected to cause hoarding of silver in the bimetallic world: the share of gold in the French currency in circulation rose from below 30% in 1849 to over 80% in the 1860s. As the proportion of gold in France approached 100%, the possibility emerged of silver simply ceasing to be money. But if silver was no longer money, its price would decline to its value in cutlery or jewellery (the first photographic rolls using silver halide came only in the 1880s). We know from 40-year old first generation currency crisis models (Krugman, P. (1979). A model of balance-of-payments crises. Journal of money, credit and banking, 11(3), 311-325.), that the transition from France being 90% on gold to 100% on gold would not be smooth, but would happen in a sudden speculative attack that demonitizes silver. My reading of Wiegand is that Germany acted like a mega George Soros in executing this speculative attack by shifting to a gold standard and dumping all its silver on world markets; soon everybody abandoned silver and its price collapsed. (In the French bimetallic standard, it took only 15.5 ounces of silver to buy an ounce of gold; currently it takes more than five times that many ounces of silver to buy an ounce of gold.) Wiegand’s “prisoners’ dilemma” model is that Germany was forced to act pre-emptively to prevent France from launching a similar speculative attack on Germany’s silver standard.

This is what I am calling the strong Gresham’s Law: in a world of competing monies, the good money would be destroyed by a sudden speculative attack if it undergoes excessive deflation. All successful moneys have been mildly inflationary over sufficiently long periods (Triffin’s dilemma also leads to the same insight).

On the other hand, it is well known that the bad (inflationary) money could also become worthless if inflation accelerates beyond a point (Bernolz has labelled this reverse of Gresham’s law as Thiers’ law). The two laws together imply that all moneys are likely to die over multi-century time frames because of the low probability of staying on the razor’s edge between being demonitized by (a) deflation (the strong Gresham’s Law) and (b) inflation (Thiers’ law) for such long periods of time. This is consistent with the historical evidence: the ultimate fate of every fiat money in human history beginning with 11th Century China seems to be to become worthless. Near worthlessness has also been the ultimate fate of every commodity money except gold (and who knows how long gold’s luck will last?).

This has implications for crypto currency money supply rules as well. Seared by an abundance of hyper inflationary episodes in the 20th Century, crypto currencies have been designed with a deflationary bias. Many of them have inbuilt rules that freeze the money supply after an initial period of gradual monetary emission. In the wake of the collapse of crypto currency prices in recent months, some are making their systems more deflationary. Commentators are interpreting the reduced rate of monetary emission under tomorrow’s Constantinople Upgrade in Ethereum as a move to increase its market price. The weak and strong Gresham’s Laws suggests that all this might be misguided. It appears to me that after the rapid appreciation of crypto currencies in 2017, the weak Gresham’s Law kicked in and crypto currencies ceased to be medium of exchange; they became mere stores of value as exemplified by the hodl meme. It remains to be seen whether the 2018 price collapse in crypto currencies is the beginning of the effect of the strong Gresham’s Law that could destroy these currencies. Counter intuitively, an increased rate of monetary emission might actually be the way to salvage these currencies. Models with multiple equilibria are indeed quite messy.

Posted at 21:51 on Wed, 27 Feb 2019     View/Post Comments (0)     permanent link

Sat, 23 Feb 2019

Convergence of insurance and derivatives

During the global financial crisis, it became fashionable to say that a CDS (Credit Default Swap) is insurance in disguise and should be regulated as such. My response used to be that (a) a lot of insurance is derivatives in disguise, (b) an LC (Letter of Credit) issued by a bank is a CDS in disguise, and (c) it might be better for both them to be regulated as derivatives with mark to market discipline and some pre/post trade transparency. Reinsurance for example is best thought of as put options on a portfolio of non traded or illiquid assets as I wrote in a blog post nearly 11 years ago.

More recently, I am beginning to think that a convergence of derivatives and insurance could happen as “parametric insurance” moves from a fringe idea to a mainstream insurance product. The common description of parametric insurance reads almost like a definition of a weather derivative:

Parametric insurance, …, provides coverage monies automatically upon the existence of certain objective weather-related parameters based upon a set formula. (Van Nostrand, J. M., & Nevius, J. G. (2011). Parametric insurance: using objective measures to address the impacts of natural disasters and climate change. Environmental Claims Journal, 23(3-4), 227-237.)

The parametric insurance literature talks a lot about “basis risk” which indicates convergence with derivatives not only in substance but also in terminology. More recently, proposals have emerged to move from digital call/put option payoffs (payout triggered by a variable such as rainfall amount, wind speed, or earthquake magnitude being observed to exceed a threshold) to more complex functional forms depending in non linear fashion on multiple indices (for example, Figueiredo, R., Martina, M. L., Stephenson, D. B., & Youngman, B. D. (2018). A Probabilistic Paradigm for the Parametric Insurance of Natural Hazards. Risk Analysis, 38(11), 2400-2414.) A traditional derivative structuring expert would be quite at home here.

Till now, parametric insurance has tended to be a niche product used for large transactions (often involving sovereigns or multilateral organizations). The derivatives analogy for this would be a transaction between two ISDA (International Swaps and Derivatives Association) counterparties. But that could change as well because FinTech (financial technology) players now see parametric insurance as an opportunity to break into the insurance space. They dream of using smart contracts and IOT (internet of things) to turn parametric insurance into a retail product. In some of these grandiose plans, a sensor in my home will inform the insurance company that it detected flood waters inside my home and the insurance company will automatically transfer the payout (or is it payoff?) to my bank account, and perhaps, all of this will happen on the blockchain. So we will have the equivalent of retail weather derivatives. I hope there will be a mark to market regulation somewhere.

Posted at 18:36 on Sat, 23 Feb 2019     View/Post Comments (2)     permanent link

Wed, 13 Feb 2019

Indian Bankruptcy Code: Morality play reaches a dead end

The Insolvency and Bankruptcy Code (IBC) introduced in India a couple of years ago was from the very beginning a morality play with a thin veneer of economic theory. With the passage of time, the veneer of economic theory has eroded, the morality play has become stronger and the functioning of the code has become progressively more divorced from economic reality.

Until the IBC came along, Indian businesses were well protected from their lenders by mechanisms like the BIFR which were the morality play of an earlier era that had become perverted over time. Originally designed to protect the interests of workers of distressed companies, these mechanisms ended up entrenching incumbent management, and leaving lenders helpless. Since a lot of the lenders were public sector banks, there was a strong political pressure to redress the balance. After a couple of attempts to empower the financial sector (Debt Recovery Tribunals and SARFAESI) proved inadequate, the IBC was introduced to redress the balance decisively.

In this morality play, the corporate sector were the villains, and the banks were the saints. The obvious solution was to hand over insolvent companies to the financial creditors. Of course, companies have operational creditors, but since these tend to be businesses which were classified as villains, a decision was taken to exclude operational creditors from the decision making. Morality was also the path of expediency as the new system also served as a backdoor bailout of the beleaguered financial sector.

Decades of studying finance have taught me that the world of finance is full of villains, but there are hardly any saints. In my first blog post on the Indian bankruptcy reform, I wrote that in the real world bankruptcy was “very much like the familiar scene in the Savannah where cheetahs, lions, hyenas and vultures can be seen fighting over the carcass”. There is no fairness in the jungle, and victory belongs neither to the one that hunted down the prey nor to the one in greatest need of food; victory typically goes to the most wicked of the lot. The story is the same when it comes to distressed debt around the world. Last month, Jared Ellias and Robert Stark wrote a fascinating paper entitled “Bankruptcy Hardball” which documented several episodes of such wickedness in the United States.

The sidelining of operational creditors was initially the most egregious morality play in the IBC and I wrote more than one blog post on this issue (here and here). Moreover, even the morality of this exclusion became suspect when it was realized that home buyers who had paid an advance to an insolvent builder would be operational creditors. Politically, it was impossible to club home buyers with other villainous operational creditors, and exceptions were made for them.

But there was more to come. Very soon, instances arose where the incumbent managements of the insolvent companies were potentially the highest bidders in the bankruptcy auction of their companies. Under the original IBC, they would have prevailed, and this might have been the best outcome from the point of view of maximizing the economic value of the lenders. But since the IBC was from inception a morality play, this could not be permitted. So the law was hurriedly amended to prevent them from bidding.

But this creates another problem. Originally, creditors were put in charge of the decision making because it was supposed to be a purely business decision. As the Bankruptcy Law Reforms Committee wrote in its report:

The evaluation of these proposals come under matters of business. The selection of the best proposal is therefore left to the creditors committee …

However, with the exclusion of tainted bidders, the choice of the best proposal is no longer one of economics, but one of theology. Some of the feverish debates in the courts on which bidders are tainted enough to be excluded reminds me of medieval scholastic debates about “How many angels can dance on the head of a pin?”. From an economic point of view, these debates are ridiculous. As the Roman emperor Vespasian said while imposing a tax on urine, Pecunia non olet (money does not stink). Morality plays tend to forget this principle.

By elevating morality above economics, the IBC is failing to live up to its promise. Instead, we see confusion reign paramount. We see distressed companies boasting of a respectable market capitalization while their debt trades at less than half of book value. We see bankruptcy remote vehicles delaying payment on their obligations after the parent group filed for insolvency. The time has come for us to deemphasize the morality play. It is time to hold our noses like emperor Vespasian, and get on with the ugly business of economics.

Posted at 22:16 on Wed, 13 Feb 2019     View/Post Comments (1)     permanent link

Thu, 07 Feb 2019

Covered Interest Parity yet again

I have blogged several times about how Covered Interest Parity (CIP) is not valid in the multi-curve discounting framework that is the standard in finance after the Global Financial Crisis. (My last post a couple of years ago argued that economists who still believe in CIP unreservedly are simply ignoring risk; earlier posts described the cross currency basis and the multi curve discounting framework).

Recently, I read a paper by Wong and Zhang that is perhaps the most lucid explanation that I have seen of the phenomenon of CIP violations and the emergence of a large cross currency basis. They are able to explain not only why the forward premium is not equal to the Libor differential, but also why the CIP violation persists when Libor is replaced by (near) risk free rates like OIS (Overnight Indexed Swaps) or repo.

Wong and Zhang point out that the Libor-OIS spread reflects two different things. First, Libor carries significant counterparty credit risk because it involves unsecured lending for a non trivial time period, while the overnight tenor of OIS reduces the credit risk to negligible levels. Second, Libor carries an exposure to funding liquidity risk because the lender has to fund the loan till maturity, while OIS involves only an exchange of interest cash flows without any principal funding.

The Cross Currency Basis Swap (CCBS) in its post-crisis form does not expose the counterparties to credit risk because of collateralization and variation margins. But it does involve funding liquidity risk (each party receives liquidity in one currency and gives up liquidity in another currency). Thus the CCBS spread reflects only one part of the Libor-OIS spread – the part that accounts for funding liquidity risk. The empirical results in the Wong and Zhang paper show that in some currencies, the Libor-OIS spread is dominated by credit risk while in other currencies (notably the US dollar) it is dominated by funding liquidity risk. As a result, a CIP violation is observed whether one measures the interest differential using Libor or OIS.

Of course, all this is consistent with the multi-curve discounting framework, but this analysis is probably a lot easier to understand.

Posted at 16:19 on Thu, 07 Feb 2019     View/Post Comments (0)     permanent link