Prof. Jayanth R. Varma's Financial Markets Blog

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

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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