Prof. Jayanth R. Varma's Financial Markets Blog

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

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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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