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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Tue, 29 Dec 2020

Disappointing Investigation Report on London Capital & Finance

Earlier this month, the United Kingdom Treasury published the Report of the Independent Investigation into the Financial Conduct Authority’s (FCA’s) Regulation of London Capital & Finance (LCF). I read it with high expectations, but must say I found it deeply disappointing. I take perverse pleasure in reading investigation reports into frauds and disasters around the world (so long as they are in English). Beginning with Enron nearly two decades ago, there have been no dearth of such high quality reports except in my own country where unbiased factual post mortem reports are quite rare. So it was with much anticipation that I read the report on LCF which involved a number of novel issues about the risk posed by unregulated businesses carried out by regulated entities. Unfortunately, the Investigation Report did not meet my expectations: instead of providing an unbiased and dispassionate analysis of what happened, it indulges in indiscriminate and often unwarranted criticism of the Financial Conduct Authority (FCA). In the process, the report very quickly loses all credibility.

The LCF debacle is described well in the report of the Joint Administrators under the Insolvency Act from which this paragraph is drawn. LCF was set up in 2012 as a commercial finance provider to UK companies. From 2013, the Company sold mini-bonds, with trading significantly increasing from 2015 onwards. LCF was granted “ISA Manager” status by the UK taxation authorities (HMRC) in 2017, and LCF started selling its mini bonds under this rubric. (The necessary requirements to qualify for ISA Manager status are fairly limited; it is not a rigorous application process; and ISA Managers are not routinely monitored by HMRC). About 11,500 bond holders invested in excess of £237m in LCF mini bonds. The vast majority of LCF’s assets are the loans made to a number of borrowers a large number of whom do not appear to have sufficient assets with which to repay LCF. At present the Administrators estimate a return to the Bondholders from the assets of the Company of as low as 20% of their investment.

It is evident from the above that the most important issue in the LCF debacle is a failure of regulation rather than supervision. In the UK, mini bonds (illiquid debt securities marketed to retail investors) are subject to very limited regulation unlike in many other countries. (In India, for example, regulations on private placement of securities, collective investment schemes and acceptance of deposits severely restrict marketing of such instruments to retail investors). To compound the problem, the UK allows mini bonds to be held in an Innovative Finance ISA (IFISA). ISAs (Individual Savings Accounts) are popular tax sheltered investment vehicles for retail investors. The UK has taken a conscious decision to allow these high risk products to be sold to retail investors in the belief that the benefits in terms of innovation and financing for small enterprises outweigh the investor protection risks. While cash ISAs and Stock and Share ISAs are eligible for the UK’s deposit insurance and investor compensation scheme (FSCS), IFISAs are not eligible for this cover. Many investors may think that ISAs are regulated from a consumer protection perspective, but the UK tax department thinks of approval of ISAs as purely a taxation issue. To make matters worse, the UK has had extremely low interest rates ever since the Global Financial Crisis, and yield hungry investors have been attracted to highly risky mini bonds especially when they are marketed to retail investors under the veneer of a quasi regulated product - the IFISA. After the LCF debacle, some regulatory steps have been taken to alleviate this problem.

The Investigation Report is concerned about supervision more than regulation, and here the key issue is the regulatory perimeter issue: when an entity carries out a regulated business and an unregulated business, to what extent should the regulators examine the unregulated business. There are some financial businesses like banking where there is intrusive regulation of the unregulated business (the bank holding company). But what should the regulatory stance be on small regulated entities that carry out very limited regulated businesses (for example, confined mainly to financial marketing)? The Investigation Report simply points to the regulatory powers of the FCA to look at the unregulated business, and blithely asserts that the FCA should have been doing this routinely. This is unrealistic and would confer excessive and unacceptable powers to the financial regulators that would make them overlords of the entire society. Imagine that the publisher of the largest circulation newspaper in the country also publishes an investment newsletter that could be construed as financial promotions and is therefore regulated by the financial regulators. Do we want the regulator to have the power to take some regulatory action because it does not like the editorial stance of the newspaper? If you think that I am insane to consider such possibilities, you should examine the criminal prosecution that German financial regulators launched against two Financial Times journalists for its reporting on the Wirecard fraud. The Investigation Report does not reveal any such nuanced understanding and therefore represents a missed opportunity to improve our perspective on such matters.

Since the issuance of mini bonds is itself not a regulated activity, the role of the FCA is mainly in the area of the marketing of the bonds by LCF as a regulated entity authorized to carry on credit broking and some corporate finance activities. I would have expected the Investigation Report to focus on whether the FCA monitored LCF’s marketing (financial promotions) adequately. The Investigation Report documents that FCA received a few complaints on this, and in each instance, the FCA required changes in the website to conform to the FCA requirements. In my understanding, it is quite common for regulators worldwide to require changes in the financial promotions ranging from the font size and placement of a statement to changes in wordings to more substantive issues. The question that is of interest is where did LCF breaches lie on this spectrum (some of them were clearly technical breaches) and how did the frequency of serious breaches compare with that of other entities of similar size that the FCA regulates. Unfortunately, the Investigation Report does not provide an adequate analysis of this matter, other than saying that repeat breaches should have led to severe actions including an outright ban on LCF. That is not how regulation works or is expected to work anywhere in the world.

But these two inadequacies of analysis are not the main grounds for my disappointment with the Investigation Report. What troubled me is the repeated instances of what struck me as prima facie evidence of bias. At first, I brushed these aside and kept reading the report with an open mind, but slowly, the indicia of bias kept piling up and I began to question the objectivity and credibility of the report. At every twist and turn, wherever there was a grey area, the Investigation Report unfailingly ended up resolving this against the FCA. In the process, the credibility of the report was eroded bit by bit. By the time, I reached the end, the credibility of the report had been completely destroyed.

One of the most glaring examples of apparent bias is the discussion about a letter purported to have been sent by one Liversidge to the FCA. The only evidence for this is the statement by Liversidge that he did post the letter. Detailed search of all records at the FCA failed to find any evidence that the letter was in fact received by the FCA. One of the first things that is taught in all basic courses on logic is that it is impossible to prove a negative statement (like the statement that the letter was not received) and that is essentially what the FCA quite honestly told the Investigation Team. The Investigation Report first states that whether this letter was received or not is not relevant to the Investigation. That should have been the end of the matter. But then it goes on to make the statement that “if it had been incumbent on the Investigation to have reached a decision on this point, it would have concluded on the balance of probabilities that the Liversidge Letter was received by the FCA”. This is unreasonable in the extreme: there is no evidence other than the sender’s testimony that the letter was sent at all (let alone received), while there is some evidence that it was not received. The balance of probabilities clearly points the other way.

The Report goes to great lengths to criticize the FCA for the extended timelines of the DES programme which attempted a very significant transformation in the structure, the governance, the systems, the processes, the risk frameworks of supervision at the FCA. This was initiated around end of 2016 or early 2017 with a target completion date of March 2018, but was concluded only by December 2018. Having been involved in exercises of this kind in many organizations, I think spending a couple of years to accomplish something like this is quite reasonable (In fact it strikes me as a rather aggressive timeline). The original timeline of March 2018 appears to me to have been utterly unrealistic. The Investigation Report suggests that the FCA should instead have resorted to some “quick wins, reviews or easy fixes”. I think this suggestion is utterly misguided. “Easy fixes” is precisely the kind of thing that an organization should not do under such conditions. I think it is to the credit of the FCA Board that it did not undertake such a stupid course of action.

Actually, the FCA discovered the fraud on its own from two different angles. First, LCF filed a prospectus with the FCA and the Listing Team had a number of serious concerns on this. Second, during the course of a review of an external database (only accessible to a limited group within the FCA and on strict conditions of use) concerned with another firm, the Intelligence Team found some information on LCF and immediately escalated the matter. While the Investigation Report commends these actions, it states that if other employees at the FCA had similar levels of expertise in understanding financial statements, they would have uncovered the fraud earlier. I was aghast on reading this. Expertise in financial statements is a highly sought skill that is in short supply in the market. That the FCA manages to hire people with that skill in some critical departments is great. To expect that people in the call centre or those running authorizations would have this skill is absurd. If people with such skills thought that they may be transferred to such postings, they would probably not join the FCA in the first place.

The Investigation Report finds fault with the FCA for giving LCF permissions to carry out regulated businesses that it did not in fact use. I do not find this unusual at all. To give an analogy, the objects clause in the corporate charter (Memorandum of Association) typically contains a lot of things that the company has no intention of undertaking; it includes these things because of the severe consequences of finding that the company does not have the power under its charter to do something that has suddenly become desirable. Similarly, a regulated business would often want to have a range of regulatory authorizations that it does not expect to use. All the more so because regulators often take an restrictive view of things and take companies to task for all kinds of technical violations. For example, a stock broker who provides only execution services might want to have an advisory licence to guard against the risk that some incidental service that it provides could be regarded as advisory. Similarly, an advisory firm might worry that a minor service like collecting a document from the customer and delivering it to a stock broker might be interpreted as going beyond purely advisory services. That LCF obtained a licence but did not carry out the regulated activity is not in my view a red flag at all. The Investigation Report makes a song and dance about this despite having observed one fact that demonstrates its triviality. The FCA created a system that produced an automated alert whenever a firm did not generate income from regulated activities. Because of the high volume of automated alerts that were created as a result of this, the FCA had to allow these alerts to be closed without review!

It is indeed distressing that this deeply flawed report is all that we will ever get on this episode which raises so many interesting regulatory issues of interest across the world.

Posted at 21:38 on Tue, 29 Dec 2020     View/Post Comments (0)     permanent link


Fri, 25 Dec 2020

The value of financial centres redux

When I started this blog over 15 years ago, one of my earliest posts was entitled Are Financial Centres Worthwhile? The conclusion was that though the annual benefits from a financial centre appear to be meagre, they may perhaps be worthwhile because these benefits continue for a very long time as leading centres retain their competitive advantage for centuries. At least, most countries seemed to think so as they all eagerly tried to promote financial centres within their territories. But that was before (a) the Global Financial Crisis and (b) the current process of deglobalization.

Yesterday, the United Kingdom finalized the Brexit deal with the European Union, and the UK government rejoiced that they had got a trade deal without surrendering too much of their sovereignty. There was no regret about there being no deal for financial services. The UK seems quite willing to impair London as a financial centre in the pursuit of its political goals. China seems to be going further when it comes to Hong Kong. It has been willing to do things that would damage Hong Kong to a much greater extent than Brexit would damage London. Again political considerations have been paramount.

Decades ago, both these countries looked at financial centres very differently. After World War I, the UK inflicted massive pain on its economy to return to the gold standard at the pre-war parity. In some sense, the best interests of London prevailed over the prosperity of the rest of the country. Similarly during the Asian Crisis when Hong Kong’s currency peg to the US dollar seemed to be on the verge of collapse, then Chinese Zhu Rongji declared at a press conference that Beijing would “spare no efforts to maintain the prosperity and stability of Hong Kong and to safeguard the peg of the Hong Kong dollar to the U.S. dollar at any cost” (emphasis added). The major elements of that “at any cost” promise were (a) the tacit commitment of the mainland’s foreign exchange reserves to the defence of the Hong Kong peg, and (b) the decision not to devalue the renminbi when devalations across East Asia were posing a severe competitive threat to China. In some sense, the best interests of Hong Kong prevailed over the prosperity of the mainland.

Clearly, times have changed. The experience of Iceland and Ireland during the Global Financial Crisis demonstrated that a major financial centre was a huge contingent liability that could threaten the solvency of the nation itself. Switzerland was among the first to see the writing on the wall; it forced its banks to downsize by imposing punitive capital requirements. Other countries are coming to terms with the same problem. Deglobalization adds to the disillusionment about financial centres.

Today, countries are eager to become technology centres rather than financial centres. How that infatuation will end, only time will tell.

Posted at 19:43 on Fri, 25 Dec 2020     View/Post Comments (0)     permanent link


Thu, 17 Dec 2020

BIS on Bank of Amsterdam: Pot calling the kettle black

Jon Frost, Hyun Song Shin and Peter Wierts at the Bank for International Settlements wrote a paper last month An early stablecoin? The Bank of Amsterdam and the governance of money which disparages past models of (proto) central banking and new incipient forms of central banking to conclude that the modern central bank is the only worthwhile model. They criticize the Bank of Amsterdam (1609–1820) for its flawed governance that led to its eventual failure, and extrapolate from that to dismiss newly emerging stablecoins which (according to Frost, Shin and Wierts) share the same governance problems. The authors think that, by contrast, modern central banks have the right governance structures and right fiscal backstops.

My biggest grouse with this paper is that if we want to criticize an institution that thrived for 170 years and survived for two centuries, we must compare it against an institution that has been successful for even longer. Unfortunately, I am not aware of even one major central bank today that has been successful for the last 100 years let alone 170 years:

It appears to me to be the height of hubris for an association of failed central banks and central banks that are too young to have experienced failure to point fingers at the Bank of Amsterdam whose track record for 170 years was far better than that of any of these banks. In fact, I think that the Bank of Amsterdam’s track record even at the point of failure was better than the stated goal of most central banks today. The best central banks currently target an annual inflation rate of 2%. Over a period of 200 years, this inflation rate will lead to a 98% loss of purchasing power: 200 years from now, a dollar would be worth only 2¢ in today’s money (1.02 − 200 ≈ 0.02). By contrast, at the point when the French revolutionary armies invaded the Netherlands in 1795, and the true state of the balance sheet of the Bank of Amsterdam was revealed, the money issued by the Bank of Amsterdam fell to a 30% discount to gold (Frost, Shin and Wierts, page 24). In other words, over the two centuries of its existence, the money issued by the Bank of Amsterdam lost only 30% of its value for an annual depreciation of less than 0.2% (1.0021609 − 1795 ≈ 0.7). At the point of failure, the performance of the Bank of Amsterdam was equivalent to an annual inflation rate one-tenth that of what the best central banks promise today.

If modern central bankers think that they are better than the Bank of Amsterdam (either in its heyday, or on average over its entire life including the point of failure), they need to introspect long and hard whether they suffer from excessive over confidence or amnesia.

Posted at 18:20 on Thu, 17 Dec 2020     View/Post Comments (0)     permanent link


Thu, 10 Dec 2020

Bankruptcy hardball and bank dividends

When I read the recent BIS working paper Low price-to-book ratios and bank dividend payout policies by Leonardo Gambacorta, Tommaso Oliviero and Hyun Song Shin, I was immediately reminded of the paper Bankruptcy hardball (Ellias and Stark (2020), Calif. L. Rev., 108, p.745) though that is not how Gambacorta, Oliviero and Shin analyse the issue.

Ellias and Stark documented the tendency of distressed firms to declare dividends or otherwise move assets out of reach of the creditors for the benefit of shareholders. This strategy which they called bankruptcy hardball is most closely associated with private equity owners.

As I reflected on the Gambacorta, Oliviero and Shin paper, it struck me that what makes bankruptcy hardball attractive is the high level of leverage rather than private equity ownership. If the assets are worth 100 and debt is 80% of assets (so that equity is 20%), then shifting 10 of assets to the shareholders reduces the value of debt only by 12.5% but increases the value of the shareholders by 50%. If debt is 90% of assets, then the same shift of 10 would be only a 11% loss to lenders but a 100% gain to shareholders. Since private equity is characterized by high leverage, the incentives are much greater in their case. On the verge of bankruptcy, it is true that the leverage would shoot up for all companies (as the equity becomes close to worthless), and it might appear that every firm can play hardball. However, the tactics are more likely to survive legal challenges when they are implemented at a time when the company appears to be solvent, and ideally years before a bankruptcy filing. So the greatest opportunity to play hardball is for those companies that have high levels of leverage in normal times when they are still notionally solvent but possibly distressed.

Apart from firms owned by private equity, there is another example of a business with high levels of leverage in normal times - banking. Banks typically operate with leverage levels that exceed that of typical private equity owned businesses. One would therefore expect banks to also play the hardball game - pay large dividends when they are distressed but still notionally solvent. And that is what Gambacorta, Oliviero and Shin find.

Their key finding is that banks with low Price to Book ratio (the ratio of the market price of the share to the book value per share) tend to pay higher dividends and this tendency becomes even more pronounced when the Price to Book ratio drops below 0.7. Price to Book has been associated with financial distress in the finance literature since the original papers by Fama and French. But the link is even stronger in banking where a low price to book ratio is often driven by the market’s belief that the asset quality of the bank is a lot worse than the accounting statements indicate. In other words, while for non financial companies, a low price to book reflects low profitability, for banks, it often indicates that book equity is overstated (due to hidden bad loans) and the capital adequacy of the bank is a lot worse than what the accounting statements suggest. Price to book is therefore an even more direct indicator of distress for banks than for non financial companies.

For a bank which is already highly levered and whose true leverage is even higher because of overvalued assets, dividends become an attractive device to transfer value to shareholders from creditors. The fact that the bank meets the capital adequacy standards set by the regulators (aided by overvaluation of assets) acts as a cover for the hardball tactic. The fact that many creditors (especially the depositors) are protected by deposit insurance means that creditor resistance is muted.

Gambacorta, Oliviero and Shin talk about the wider social benefits of curtailing dividends (increasing lending capacity), but there is a more direct corporate governance and prudential regulation argument for doing so. Regulators have already recognized the role of market discipline in regulating banks (Pillar 3 of the Basel framework). From this it is a short step to linking dividend and other capital distributions to a market signal (price to book ratio).

Posted at 17:46 on Thu, 10 Dec 2020     View/Post Comments (4)     permanent link


Sun, 23 Aug 2020

Negative beta stocks: The case of Zoom

One of the questions that comes up every time I teach the Capital Asset Pricing Model (CAPM) in a basic finance course is whether there are any negative beta stocks, and if so what would be their expected return. My standard answer has been that negative beta stocks are a theoretical possibility but possibly non existent in practice. Every time I have found a negative beta in practice, there was either a data error or the sample size was too small for the negative beta to be statistically significant. I would also often joke that a bankruptcy law firm would possibly have a negative beta, but fortunately or unfortunately, such firms are typically not listed. (The answer to the second part of the question is easier, if the beta is negative, the expected return is less than the risk free because it hedges the risk of the risk of the portfolio and one is willing to pay for this hedging benefit).

But now there is an interesting real life case of a negative beta stock: Zoom Video Communications, Inc. Not only is this a large company by market capitalization, but it is also a familiar company with so many online classes taking place on Zoom. During the Covid-19 pandemic, a plausible argument has been going round why Zoom should have a negative beta. The argument is that if the pandemic rages, the economy collapses while Zoom soars, and if the pandemic retreats, the economy recovers, and people go back to face to face meetings, and the Zoom boom is over.

Interestingly, the data supports this nice theory:

A better example of beta changing dramatically (going from around two to negative and then back to around two) within a few months without any change in the business mix of the company would be hard to find.

Negative betas may be a once in a 100-year event (the last global pandemic of comparable severity was in 1918), but the Zoom example illustrates the importance of estimating betas more carefully using shrinkage estimators and Bayesian methods as I explained in detail in a blog post ten years ago.

Posted at 17:37 on Sun, 23 Aug 2020     View/Post Comments (1)     permanent link


Mon, 06 Jul 2020

Bankruptcy and sovereign backstops during crises

During the difficult economic situation of the last couple of years in India, I have been emphasizing two things:

  1. Bankruptcy is a form of protection for firms that are unable to pay their debts on time, and not a punishment for past sins. As such, during bad times, we need a working bankruptcy law and not a suspension of the bankruptcy process. My blog post two months ago argued this in detail.

  2. Only the sovereign can absorb tail risks in crisis situations, and second loss instruments are the mechanism through which the government can provide this protection. I have proposed this several times during the last year: Recapitalizing the financial sector this April, Structuring the Yes Bank rescue this March and Real Estate and Infrastructure Resolution last September.

Last week, a leading US bankruptcy scholar, Adam Levitin, along with two co-authors published a white paper describing how the US government should respond to economic crises like Covid-19. (Adam Levitin’s book “Business Bankruptcy: Financial Restructuring and Modern Commercial Markets” is the best book on financial restructuring that I have seen).

When it comes to assisting large US firms, the core of Levitin’s proposal is a combination of bankruptcy restructuring and sovereign second loss backstop.

a capital injection in the form of preferred stock, conditioned upon the cancellation of existing common equity interests and dollar-matched conversion of unsecured debt to new common equity interests

This is a very simple bankruptcy regime: existing shareholders are wiped out, creditors become owners and therefore bear first dollar of loss, and the sovereign provides second loss protection through the preferred stock. If the company and its stakeholders do not like this standardized regime, they can resort to the normal bankruptcy process (Chapter 11) which works in the US even in crisis times like these (unlike in India).

Posted at 18:52 on Mon, 06 Jul 2020     View/Post Comments (0)     permanent link


Mon, 15 Jun 2020

Necro-bumped some old posts by mistake

Those of you who are following me on Twitter or Facebook might have observed some old posts of almost a decade ago pop up as new posts. This necro-bumping happened by mistake as I updated a large number of posts from 2005 to 2015 to change internal URLs to reflect a domain name change that took place some five years ago. I was informed that my Institute might choose not to retain the old domain name for much longer and that it was prudent to update the old links. I did not realize that the plugins that I use for linking my blog to Twitter and Facebook treat updated posts as new posts and post them as such. Those who rely on RSS and Atom feeds would not have seen any problem as these stone age tools are much smarter than the modern social media plugins.

The moment I realized what was happening, I disabled the Twitter and Facebook plugins before editing the rest of the posts, and re-enabled the plugin at the end.

Posted at 19:53 on Mon, 15 Jun 2020     View/Post Comments (0)     permanent link


Mon, 18 May 2020

Going concern assessment in the Covid-19 environment

My colleague, Prof. Sobhesh Kumar Agarwalla, and I wrote a piece in the Hindu BusinessLine last Friday about Going Concern assessment in the Covid-19 environment. We argue that:

Rather than leave it to the judgment of the management and auditors, it would be better if companies made assessments based on a common template of assumptions laid down by the regulators

The article is reproduced below:


The going concern concept requires that the financial statements of a company must normally be prepared under the assumption that the business will continue to operate and will not be liquidated. Therefore, the going concern value of a business is typically much higher than the breakup or liquidation value. However, this assumption has to be abandoned if there is significant doubt about the entity’s ability to continue as a going concern.

Management must make the going concern assessment based not only on information that exists on the balance-sheet date but events occurring after the balance-sheet date for conditions existing at the balance-sheet date (Ind AS 4). As Covid-19 was declared as a global pandemic by the WHO before March 31, 2020, the financial reports prepared for the financial year 2019-20 should reflect a post-Covid going concern assumption.

While the management is primarily responsible for the going concern assessment, the auditors are required to provide their opinion by applying professional judgment and professional scepticism based on the management’s representations and their independent assessment. A modified opinion is warranted if the management fails to recognise the financial impact of Covid-19 appropriately.

While assessing the going concern assumption, the management (and the auditor) will have to consider all available information and make reasonable estimates and judgments about current and future profitability and cash flows, liquidity and solvency issues like debt repayment schedules, borrowing and refinancing capabilities, asset valuation, financial conditions of key customers and suppliers, etc. (Ind AS 1).

Some of the factors are internal to the organisation, and the management is probably better placed than anybody else to assess these. However, neither the management nor the auditors have any particular expertise in making judgments about macroeconomic and public health factors like the lingering impact of Covid-19.

We believe that it would be dysfunctional to leave the post-Covid going concern assessment to the management and auditors. First, different companies (and auditors) will make different assumptions about the future evolution of the pandemic, and produce completely different financial assessments for companies whose economic position might be quite similar. Comparability of financial statement across companies would be fatally compromised.

Second, the preparation of financial statements and the conduct of the audit under the current environment is already quite challenging. There is no merit in wasting precious resources of both the management and the auditors on a useless debate regarding macro assumptions about which neither has any expertise.

Default assumptions

Investors and other users of financial reports would benefit from all companies making going concern assessments based on a common template of assumptions laid down by the regulators (including Ministry of Company Affairs, National Financial Reporting Authority, Reserve Bank of India, and Securities and Exchange Board of India).

Neither the management nor the auditors would be allowed to deviate from these default assumptions unless there is compelling evidence to the contrary. The management and the auditors would be shielded from liability for a wrong going concern assessment so long as this assessment was based on the default assumptions.

It might appear that we are asking the regulators to perform an impossible task of laying down default assumptions for the entire Indian business sector in an environment where the regulators themselves are overburdened and struggling to perform their normal functions. However, there are simple ways of setting the default assumptions: for example, the default assumption might be that while the first quarter of 2020-21 (April-June) has been more or less wiped out, there will be a V-shaped recovery and revenues for the remaining three quarters (July-March) will be similar to the corresponding period of 2019-20 with a possible adjustment for the historical annual growth rate.

If the regulators have enough time and information, they might lay down different recovery assumptions for certain sectors. For example, the tourism and travel industry may be subjected to a more pessimistic assumption.

Standard practices

Some analysts might think that our assumptions are too crude, simplistic and optimistic, but practices similar to what we recommend are, in fact, quite standard globally. Central banks performing a stress test of all banks under a common set of assumptions about macroeconomic shocks is standard practice across the world. On Covid-19 itself, we have already seen private contracts using an approach similar to what we recommend. For example, Live Nation Entertainment renegotiated its debt covenant so that the actual EBITDA of certain quarters of 2020-21 would be replaced by that of corresponding quarters of 2019-20.

Second, in times of crisis where financial stress is widespread, some degree of regulatory forbearance is a well-established policy response, and that principle justifies a lenient assumption. Finally, nobody knows for sure what will happen, and we have to just get on with life.

Moreover, if regulators are not satisfied with a simple assumption about a common recovery curve for the entire economy or different sectors, regulators can instead specify assumptions about macroeconomic factors like GDP growth, inflation rates, interest rates, unemployment, foreign exchange rates, industrial production, crude oil prices, household consumptions and savings rates, tax rates, economic reliefs, import policy, labour laws, government grants and concessions, and require each company to turn these macro forecasts into forecasts about its revenues and cash flows.

Another issue with the going concern test is that even if a company is balance-sheet solvent, it may be cash-flow insolvent because of lack of liquidity and access to financing. The regulators must also require companies to assume that the current accommodative monetary policy and central bank liquidity support policies would continue during the forecast horizon.

The central bank may also lay down additional assumptions to be used by financial institutions to deal with issues related to collateral valuation, debt covenant requirements, and initiation of bankruptcy proceedings.

Posted at 16:58 on Mon, 18 May 2020     View/Post Comments (0)     permanent link


Tue, 28 Apr 2020

Indian corporate bonds need a buyer and not a lender

The Reserve Bank of India (RBI) announced yesterday that it is setting up a Rs 500 billion Special Liquidity Facility for Mutual Funds (SLF-MF). This is basically a refinance window for banks that lend to mutual funds to help them handle redemption pressures in an environment where corporate bonds are both stressed and illiquid.

I believe that SLF-MF does not solve the real problem at all, because mutual funds by their very design need to liquidate assets to meet redemption. Unlike banks and hedge funds, mutual funds are not designed to use leverage: the Securities and Exchange Board of India (SEBI) Mutual Fund Regulations state:

The mutual fund shall not borrow except to meet temporary liquidity needs of the mutual funds for the purpose of repurchase, redemption of units or payment of interest or dividend to the unitholders:

Provided that the mutual fund shall not borrow more than 20 per cent of the net asset of the scheme and the duration of such a borrowing shall not exceed a period of six months.

Some mutual funds do talk and act as if the 20% limit allows them to borrow to juice up their returns or to speculate on prices rising in future. But the regulations are clear that this is not the intention, and any mutual fund that borrows for such speculative purposes is actually running a hedge fund in disguise. The proper use of borrowing is to deal with operational timing mismatches where a fund is not able to sell assets and realize the proceeds in time to meet the redemption needs.

Back in 2008, when the RBI launched a facility similar to SLF-MF during the Global Financial Crisis, I explained why mutual funds cannot borrow their way out of redemption trouble:

A mutual fund is very different from a bank. When a bank borrows to repay depositors, there is a capital cushion that can take losses on the assets side. When this capital is gone, the bank also needs to be recapitalized and cannot solve its problems by borrowing from the central bank. A mutual fund does not have any capital separate from the unit holders. This means that the only prudent way for a mutual fund to repay unit holders is by selling assets. If it borrows, then it is exposing remaining unit holders to leveraged losses.

The problem that the mutual fund industry faces today is in many ways worse than in 2008. Until Covid-19, open end debt mutual funds could offer redemption on demand to their investors because there was a liquid market for the bonds that these funds held in their portfolio. Now, the assets have become illiquid and hard to value while the investors are still able to demand instant liquidity. This mismatch can be solved only by some combination of two things: (a) the liquidity of the assets could be improved by a market maker of last resort, or (b) redemption could be restricted. The SLF-MF does neither of these, and merely postpones the problem till the maturity date of the borrowing.

Any financial crisis is ultimately resolved by allocating and absorbing losses. Everything else is a stopgap arrangement that merely postpones the day of reckoning. In times of crisis, there is sometimes merit in such postponement because it buys time for a more orderly loss allocation. But, whenever we kick the can down the road, we must ensure that by doing so we do not make matters worse in terms of making the losses bigger or making the ultimate loss allocation less fair or more difficult. The SLF-MF does not pass this test because it rewards those who redeem and penalizes those that remain in the fund (thereby incentivizing a run on all debt mutual funds):

What then are the solutions to the problems of the mutual fund industry today? I will first outline three solutions that I do not recommend:

My preferred solution is for the mutual fund industry itself to create the buyer of last resort with only limited support from the sovereign. It is guided by the principle that whenever we bail out the financial sector we do so not to help the financiers but to protect the real economy which depends on a well functioning financial sector. In these troubled times, the real economy cannot afford the loss of any source of funding. This is the same principle that guided my proposal earlier this month for a preemptive recapitalization of banks and non bank finance companies.

My proposal is similar to the US Fed’s Secondary Market Corporate Credit Facility mentioned above with one critical difference. Instead of the equity for the SPV coming from the government, it should come from the mutual funds themselves. When investors redeem from a mutual fund, and the fund is not able to sell bonds in the market, it can sell the bonds to the SPV at a fair value as determined by the SPV. The mutual fund will be required to contribute a percentage of the fair value as equity stake in the SPV and will receive only the balance in cash. If we follow the US and require 10% equity for the SPV, then a mutual fund selling bonds with a fair value of 100,000 to the SPV will have to contribute 10,000 towards the equity of the SPV. The SPV will use the equity of 10,000 to support 90,000 of borrowing from the RBI which allows it to pay 90,000 as the cash component of the purchase price to the mutual fund. The equity contribution of the mutual fund to the SPV has to come from the investors of the mutual fund. So an investor redeeming 100,000 from the fund would get 90,000 in cash and get the remaining 10,000 in the form of units representing the equity stake in the SPV.

This means that a large part of the credit risk of the bond remains with the redeeming investors as a whole. If the SPV ultimately realizes only 96% of the fair value of all the bonds that it bought, then its equity will come down to 6% from the original 10%. The redeeming unit holder will have got (a) 90,000 in cash and (b) shares in the SPV worth 10,000 originally, but worth only 6,000 when the SPV is wound down. The redeeming investor ends up with 96% of the original fair value of the bonds which matches the 96% ultimate realized value of the bonds. On the other hand, if the SPV realizes 103% of the fair value, then the original equity rises to 13% and the redeeming investor recovers 103,000 (90,000 in cash plus shares in the SPV worth 13,000).

Let me discuss some possible objections to the proposal:

Finally the proposal reflects a realistic evaluation of the current situation:

Posted at 19:09 on Tue, 28 Apr 2020     View/Post Comments (1)     permanent link


Thu, 23 Apr 2020

WTI crude futures in India

India’s commodity derivatives exchange, MCX trades crude oil contracts that mirror the WTI Futures contract traded at CME/NYMEX in the US. When the US contract settled at an unprecedented negative price this week (the seller had to pay the buyer to take their crude away), the Indian contract followed suit. Press reports state that brokers who had bought MCX crude futures suffered a loss of Rs 4.35 billion and have gone to court against the exchange’s decision to settle at a negative price.

I like to think that I have better things to do than take sides in this fight, but I also think that everybody involved in the Indian crude futures market has behaved recklessly. Since around mid-March, it has been clear that WTI crude in the US was experiencing extreme dislocation, and that highly perverse outcomes were likely, though nobody could have predicted the precise outcome. Prudent traders should have stopped trading the MCX crude oil futures in late March, and a prudent derivative exchange should have suspended trading in the contract in early April. The Securities and Exchange Board of India (SEBI) is currently overburdened with keeping the markets functional during Covid-19, but otherwise, they should have forced MCX to suspend the contract.

Unfortunately the Indian commodity derivatives ecosystem is borrowed lock, stock and barrel from the equity derivative ecosystem. Everybody thinks that a commodity is just another stock price ticker (to trade), another stock price chart (to do technical analysis) and another time series of prices (to compute VaR margins). People tend to forget that commodities are intensely physical, and, unlike stocks, do not come with limited liability. However much we may try to “financialize” and “virtualize” the commodity, its “physicality” never really goes away.

This will therefore be a long post discussing the gory details of crude oil (and WTI crude futures in particular) to explain why I think all parties involved in the MCX crude oil futures behaved recklessly this month.

Economic rationale for Indian crude oil futures

The biggest difference between a futures market and matka gambling is that the futures contract has an economic rationale: it helps economic agents to hedge risks that they are exposed to. Many entities in India are exposed to energy price risk and crude oil futures are useful to hedge that risk. Of course, the crude basket that India imports is closer to Brent crude than to WTI, but then MCX has an MOU with CME that gives them access to CME/NYMEX contracts, and that obviously determined their choice.

So long as WTI crude is highly correlated with Brent (and the Indian crude basket), the choice of underlying does not matter too much. In normal times, the correlation is high and the Indian crude oil futures serves a valuable hedging function. In abnormal times, this correlation can break down and then MCX/NYMEX WTI crude futures would cease to have an economic rationale, and its continued trading would become questionable.

Logistical constraints on WTI crude

Historically, it has been observed that there are occasions when logistical constraints create a big divergence between (a) Brent and the Indian crude basket and (b) WTI. The best known example of this was in 2011 when rising production of shale oil led to a glut of crude at Cushing, Oklahama (the delivery location for the WTI futures contract). At the peak of the dislocation in 2011, WTI crude fell to a discount of around $20 to Brent crude (in the pre-shale era, WTI traded at a premium reflecting its sweetness and lightness).

The critical difference between the two major global crude benchmarks is that Brent is a waterborne crude while WTI is a pipeline-delivered crude. Market forces will move waterborne crude from a region of excess supply to one of excess demand. There are relatively few constraints and frictions in this process of market equilibrium. Pipelines are much more rigid: they have limited capacity and fixed endpoints. A pipeline from point A to B is useless if stuff needs to be moved from A to C or from D to B. Even if the movement required is from A to B, the quantity might exceed the capacity of the pipeline and it would then of limited utility. The sea by contrast has practically unlimited transportation capacity and its directional preferences (winds and ocean currents) can be largely ignored in modern times.

The 2011 experience shows that when logistical constraints arise in landlocked WTI crude, its price diverges not just from Brent, but also from prices in the rest of the world, and indeed even from prices in the rest of the US. In the last decade, benchmarks like LLS and ASCI based on crude prices in the coastal US (Louisiana) have risen in importance. The other observation from 2011 was that refined petroleum products in the US tend to track Brent crude better than they track WTI crude when logistical constraints emerge on WTI. All of this means that WTI starts losing its economic rationale as a hedging instrument for Indian entities in such situations. The behaviour of Indian players in April 2020 needs to be evaluated against this background.

WTI Futures Contract

The WTI futures contract is physically settled: all positions outstanding at the expiry of the contract have to give/take delivery of WTI crude at Cushing, Oklahama which is a major pipeline hub of the US. The delivery procedure at CME/NYMEX reflects the rigidity of pipeline logistics:

Rolling out of WTI futures before expiry

What this means is that the only people who can afford to hold the May futures at expiry would be those who have lined up the pipelines and storage facilities at Cushing, Oklahama. Everybody else should trade out of the contract on or before the last trading session (either by closing the position or by rolling it into the next month contract). In fact, it is very risky to wait till the last trading session to exit the contract. If a buyer is trying to trade out of the contract, and other players know or suspect that the buyer does not have access to a pipeline/storage to take delivery of the crude, the sellers will try to take advantage of his predicament. The buyer’s only hope is to find a seller who does not have the crude to deliver and is equally eager to trade out of the contract. This means that prudent traders who want to square out should do so several days in advance when there is a lot of trading by hedgers and speculators who are not physical players in Cushing.

For example, USO (United States Oil), which is the largest crude oil ETF, typically starts rolling out of a contract two weeks before expiry and completely exits it one week before expiry. In fact, both the exchange and the regulator monitor large positions in the near month contract and encourage traders to reduce positions. They are much more relaxed about positions in the next month or more distant months.

The situation in March/April 2020

Early in March, when crude prices were falling due to Covid-19, Russia and Saudi Arabia held talks on cutting output to stabilize the price. When these talks failed, the Saudis (who are among the lowest cost producers in the world) responded by increasing output to crash prices and remind other oil producers of the perils of not cooperating with Saudi Arabia. In the meantime, demand collapsed as the Covid-19 situation worsened and there was a massive glut of oil worldwide. Prices fell far below what even the Saudis had anticipated, but all players hoped that the demand would bounce back as and when Covid-19 lockdowns were relaxed. The natural response was to store cheap oil so that they could be drawn down when prices rose in future.

By mid/late March, concerns were mounting that storage in Cushing was getting full. On March 19, 2020, Izabella Kaminska wrote in the Financial Times’ Alphaville blog that “in a scenario where there’s literally nowhere to put oil, it’s not inconceivable prices could go negative.” She also explained that some oilfields simply cannot be turned off during a short term glut: “temporary shutdowns pose the risk of them never being able to be revived at the same rates again.” So they would keep pumping crude even at negative prices. On March 27, 2020, Bloomberg reported that “In an obscure corner of the American physical oil market, crude prices have turned negative – producers are actually paying consumers to take away the black stuff.” The price was only 19 cents negative, and the grade of crude was a heavy oil that fetched only around $40 a barrel at the beginning of the year when WTI traded at around $60 (in April, this grade went much more negative). The importance of this Bloomberg report was that it confirmed that negative oil prices were not merely theoretical speculation.

Commodities do not come with limited liability

Many people find it counter intuitive that a commodity can have a negative price. However, the assumption of “free disposal” which is beloved of economics text book writers is not valid in the real world, and there are many examples of negative prices for commodities that are normally quite valuable. Before refrigeration became commercially available, it was quite common for fishermen to pay farmers to collect the day’s unsold fish catch and use it as manure. To understand the plausibility of the negative price, you need only imagine a bunch of fishermen trying to catch a night’s sleep with a boatload of rotting fish just outside their huts. Similarly, I have been told that restaurants often pay pig farmers to collect the waste food at the end of day and feed it to their pigs. On a more sombre note, the Bhopal gas tragedy was an unintended “free disposal” of a hazardous substance. The ultimate negative price of that “free disposal” bankrupted the company.

Please remember that crude oil is also a hazardous substance. Almost everywhere in the world, you would need an explosive licence to stock any significant quantity of it. Anybody who has seen images of oil spills at sea and the damage that it does to sea beaches knows that crude is an ugly and foul thing. Paying somebody to take this stuff from you is not at all unreasonable.

Physical versus Cash Settlement

Some people seem to think that the problems of WTI arise from the fact that it uses physical settlement while the Brent futures uses cash settlement. I have been arguing for more than 15 years that apart from transaction costs, there is no difference between cash settlement and physical settlement. The key difference between Brent and WTI is not in the futures market but in the spot market: one is waterborne and the other is pipeline-delivered. (The Brent physical market is in some ways even more out of reach of ordinary hedgers and speculators than WTI: the typical delivery is a ship load of 600,000 barrels. I described the Brent market in gory detail more than a decade ago and I am not masochistic enough to try and summarize that again.)

What about the theory that the Indian MCX futures is cash settled and therefore should not be subject to the travails of the NYMEX physically settled contract. This reminds me of the story about Medusa in Greek mythology: anybody who looked at Medusa would be turned into stone, but Perseus was able to slay her while looking at her reflection in the mirror. Myth is probably the most charitable word to describe the “Medusa” theory that the NYMEX contract was dangerous, but its reflection in the MCX mirror was safe.

What should Indians have done in early/mid April

First of all, anybody who was actually trying to hedge energy price should have run away from the May WTI futures contract as it was crystal clear that it would no longer provide any meaningful hedge of crude price risk or energy price risk in India.

Second, anybody who was in this contract purely as a speculator needed to understand that in early April, the WTI future was no longer a bet on crude; it was purely and simply a bet on storage space in Cushing. If storage remained available at Cushing, then the May future price could not fall too low. The floor for the price was the expected post Covid-lockdown price (proxied by the July/August futures prices) less the cost of storing crude for a few months. In mid April, this floor might have been estimated at around $15 a barrel. On the other hand, if storage got full, there was no floor on the futures price at all. The price could go negative, and if you did not exit the contract in time, the potential for a hugely negative price was clear as daylight. I would put it this way: when you went long WTI May futures in mid April, you were actually shorting Cushing storage space. Unless you had the discipline, attitude and nerves of a short seller, you should again have run away from this contract.

Third, any prudent broker should have stopped allowing their retail clients to trade this contract purely for risk management reasons. The only clients to whom this contract should have been made available were those with deep pockets and known integrity who could be counted on to pay up when things go wrong. Please remember that when prices can go from positive to negative, even 100% margins are inadequate as the loss exceeds the notional value of the position. This is another way of saying that the long crude position is actually a short storage position and there is no limit to the losses of a short position.

Fourth, if the exchange observed a sizeable open interest in this contract in early/mid April, it should have realized that market participants were ignoring one or more of the above three prudential principles. If market participants are reckless, they pose a risk to the exchange if they are unable to meet their obligations. Also, as mentioned above even 100% margins do not cover the worst case risk in this situation. Faced with this problem, I think the exchange should have done two things:

Posted at 21:10 on Thu, 23 Apr 2020     View/Post Comments (2)     permanent link


Thu, 09 Apr 2020

A new chapter in the Insolvency and Bankruptcy Code

When India adopted the Insolvency and Bankruptcy Code (IBC) in 2016, it was clear that it was a transitional, stopgap arrangement, and that after the urgent goals of the IBC were met, there would be a need for a more comprehensive and fairer law (I have blogged about this many times, most recently a year ago). Covid-19 has however accelerated this timeline and made it necessary to make urgent modifications in the IBC even before its old goals have been fully achieved.

The pressing goals that led to the enactment of the IBC were two:

  1. A bailout of the Indian financial sector (mainly the banking system) which was (and still is) reeling under a massive burden of bad loans. This goal was accomplished in part by expropriating operational creditors.

  2. Ousting dishonest promoters who had run their companies to the ground but who were allowed in the pre-IBC regime to remain in control of their businesses. This goal was accomplished by handing over control of the company to a committee of creditors who might not know how to run the business, but could at least keep the promoters out.

Covid-19 is leading to a drastically different situation where an even more pressing goal is coming to the fore: rebuilding businesses that have been devastated by the crisis. To accomplish this new overriding goal, we will have to rethink the mechanisms that the IBC created to achieve its original short term goals.

Expropriating operational creditors

As mentioned above, the bailout of the banking system was accomplished by expropriating the non financial (operating) creditors of the company. This expropriation was accomplished by two legal provisions:

It is amazing how such a massive expropriation was achieved without any resistance. The reason is that the financial sector was well organized, and the financial sector regulators as well as the sovereign itself (as the owner of a large part of the banking system) were all batting for them. Operational creditors were unorganized and were not even paying attention. It was only when home buyers realized that they were mere operational creditors of some insolvent real estate developers that they woke up and screamed; the backlash from this segment was so strong that home buyers had to be quickly accommodated by an explanation hastily grafted onto Section 2(8)(f) of the IBC. Other operational creditors continue to remain in the lurch.

Such an expropriation of operational creditors does not happen elsewhere in the world. Right now, for example, we are witnessing the bankruptcy of one of the largest electricity companies in the US, Pacific Gas and Electric Company (PG&E). The bankruptcy arose because of PG&E’s potentially massive liabilities from certain catastrophic wildlife fires allegedly caused by its equipment. The bankruptcy proceedings of PG&E are being driven by the wildfire victims (who, as tort creditors, would count as operational creditors under IBC), while the financial creditors have been relegated to the backseat.

The expropriation of operational creditors under the IBC will be a disaster in the aftermath of the Covid-19 crisis in India. The disruption caused by social distancing and subsequent lockdown means that most businesses are under acute stress, and are unable to pay their suppliers or their lenders. To prevent complete economic meltdown, we need companies to continue to sell on credit to their customers while old bills remain unpaid. That is the only way that the going concern value of these businesses can be preserved. The cruel twist of the IBC is that if the suppliers do so, the mega bank will come along and steal the entire going concern value that the operational creditors have created and preserved. There is an urgent need to give trade creditors their due to prevent a massive economic contagion in which firms that fail drag their suppliers down with them, and they drag their suppliers down and so on.

Committee of creditors

Until the IBC came along, Indian businesses were well protected from their lenders by mechanisms like the BIFR. There was consensus that this needed to be changed, and ousting dishonest promoters was an important goal of the IBC. The problem was that the Indian judicial system was and is plagued by excessive delays. It was therefore thought that putting the courts in charge will in effect leave the promoters in charge. So the IBC put a Committee of Creditors in charge of the company during the entire resolution process with a tight timeline to either find a buyer for the whole business or to liquidate it.

Since there was general agreement that many of the defaulting promoters were in fact dishonest, this arrangement made sense. A crooked management would be siphoning off money from the business at every opportunity, and ousting them would actually help preserve value even if the creditors or the resolution professionals that they hire were not very good at running the business.

Covid-19 changes this drastically because businesses will be failing for no fault of theirs. Often the incumbent management would not only be honest but also competent. Throwing them out is a stupid thing to do even for the creditors who are trying to maximize their take. In the extremely challenging post-Covid environment, it would take the most skilled management to rebuild the business. The idea that a bunch of people can do this with no knowledge at all of the industry in question is just laughable. The consequence of handing over the business to the committee of creditors would be a sure prescription for destroying all value. It would ruin not only the employees and other stakeholders but even the lenders themselves who would recover a pittance in a firesale of the assets at a time when other lenders are liquidating similar companies in the same industry.

Some people have suggested suspending the filing of insolvency petitions under the IBC for a few months to prevent such a perverse outcome. They forget that an insolvency petition actually protects the debtor because it carries with it a moratorium on enforcement of debt. Without such a moratorium, most companies will be swamped by enforcement actions by secured creditors. Moreover, without a moratorium, any default will allow counterparties to terminate contracts, and this would be the death knell of the business. What we need is a new chapter in the IBC that allows a Debtor in Possession (DIP) insolvency regime for companies that get into difficulty not due to mismanagement but due to external factors (economy wide or industry wide problems).

In other words, India needs a world class bankruptcy regime in short order. In the rest of the world, we see bankrupt airlines operating flights normally while a bankruptcy court is figuring out how to restructure its debt. Similarly, telecom firms file for bankruptcy while continue to serve their customers without interruption. Steel mills continue to run while the bankruptcy proceedings are going on. The reason this does not happen in India is that we designed a stopgap bankruptcy code which did not envisage any of this. The time has come to remedy this shortcoming.

The way forward

I think we need to quickly add a new chapter to the IBC that allows an insolvency resolution process with the following feature:

Initially, this chapter can be limited to Covid-19 bankruptcies, but over time, it could be extended to other “no-fault” bankruptcies.

Posted at 22:03 on Thu, 09 Apr 2020     View/Post Comments (0)     permanent link


Thu, 02 Apr 2020

A preemptive recapitalization of the Indian financial sector

Under normal conditions, we want financial firms to have enough capital to assure their survival. In the aftermath of Covid-19, we would want much more. We would want financial firms that are ready to lend to companies that seek to rebuild their businesses, and to individuals trying to rebuild their lives. We would not want financial firms that bunker down and try to conserve their capital because they are scared about their own survival.

If that is the goal, then India’s financial sector will need a large capital infusion for two reasons:

  1. At least since the ILFS meltdown, the financial sector has been under stress, and many firms, particularly, Non Bank Finance Companies (NBFCs) are vulnerable.

  2. The economic costs of the Covid-19 lockdown (and social distancing) is likely to lead to a rise in both corporate and retail loan defaults. Initial indications from China (which is just coming out of its lockdown) are suggestive of a 5% default rate in credit card loans, and the worst is probably yet to come. A similar phenomenon can be expected in retail loan portfolios worldwide, and India is unlikely to be an exception.

Needless to say, the sovereign is possibly the only source of capital for most NBFCs in the current environment. The government will have to inject capital across the board to NBFCs somewhat like the US did to the banks in 2008 under the TARP (Troubled Asset Relief Program). Indeed the breadth of the capital injection will have to be even broader because the goal is not to ensure that the NBFC survives, but that it has adequate capital to lend freely.

It is also necessary to ensure that this does not become a bailout of the existing shareholders of weak institutions. The broad outlines of such a scheme could be as follows.

The first step would be to determine the amount of capital injection. Starting with the December 2019 balance sheet, the new capital injection could be designed to bring the December 2019 capital adequacy ratio to a level of say 20% of risk weighted assets. This is designed to ensure that even large post Covid-19 loan losses would leave the NBFC with a capital adequacy of say 15% which would be adequate to support a significant expansion of the loan book.

Since an equity valuation is probably impossible under the current conditions, the government’s injection could take the form of redeemable convertible preference shares. The conversion terms would be set such that if conversion happens, the preference shareholder would end up with say 99% of the post conversion capital. In other words, the old shareholders would be diluted out of existence. This would effectively result in the outright nationalization of the NBFC. (Crisis period nationalizations are of course intended to be temporary with the eventual goal of sale, flotation or liquidation.)

But the NBFC could avoid this outcome by redeeming the preference shares two or three years down the line (when the economy and the markets have normalized). A pre-condition for such redemption would be an acceptable post redemption capital adequacy ratio. Hence in most cases, redemption would have to be financed by raising new equity capital at market prices. To incentivize an early redemption, the interest rate on the preference shares could be set at a spread of say 10% (1000 basis points) above the repo rate from the second year onward. The interest rate in the first year could approximate a modest spread over the NBFC’s estimated December 2019 borrowing cost.

The proposed instrument would clearly provide economic capital, but under current regulatory norms, it may not count as Tier 1 capital. If necessary, this gap between regulatory and economic capital could be bridged by regulatory forbearance.

I have focused on NBFCs because that is where the stress is most evident, but it is possible that some weak private sector banks would need the same treatment. The NPA crisis in the Indian banking system and the ILFS disaster have left India’s financial sector too weak to support the credit needs of the Indian economy, and the Covid-19 promises to make things a lot worse. India can ill afford a contraction of credit in these critical times, and decisive action is needed to preserve as much of the financial sector as possible.

Posted at 21:08 on Thu, 02 Apr 2020     View/Post Comments (0)     permanent link


Wed, 25 Mar 2020

Stock markets during lockdown

I have a piece in Bloomberg Quint today on this subject. Am reproducing this piece below.


India is in lockdown to halt the spread of Covid-19, and people are asking whether the stock markets should remain open. My answer is simple: the stock markets should remain open at least as long as the banks and ATMs are open; in fact, they should shut just before the online payment systems go down. There might be some short-lived extreme emergencies in which it would be appropriate to shut down the entire financial sector—including the markets and the payment systems—but right now, we are far from being there, and I hope we never get there. I would also emphasise that while extreme emergencies that warrant complete financial shutdown would likely be very short-lived, the current social distancing restrictions could be expected to last for several weeks if not months. A shutdown of the stock markets for such prolonged periods would be unnecessary and undesirable.

The fight against Covid-19 is all about restricting the movement and assembly of people to block the spread of the disease. Modern securities trading is completely electronic and does not need the movement of people or things..In purely technological terms, people should be able to trade stocks and bonds sitting at home without creating any risk of spreading the dreaded disease.It is true that regulators around the world have created stupid barriers to achieving the seamless remote trading that is technologically possible, but that only means that these obsolete and dysfunctional rules need to be changed. I will come to that in a moment.

This Moment, More Than Most, Needs Functioning Markets

Before getting into more details about how to keep the markets open, I turn to why we need a functioning stock market almost as long as the payment systems are running. We need to remember that even as many economic activities shutdown, both individuals and companies have bills falling due. For businesses, revenues have evaporated but expenses have not. They still need to pay rents, salaries, interest and utility bills. The organised workforce might be still receiving wages and salaries, but in the informal sector and for the self-employed, income has collapsed. Monthly expenses still have to be met from some source or the other. Individuals and businesses, therefore, need to draw down their liquidity reserves, liquidate assets and raise new debt to keep making payments as they fall due. The only alternative would be a sweeping moratorium on all debt servicing and bill payments. The world has not reached that point yet, though some countries might need to consider that at some future stage.

Equities and bonds—or mutual funds holding equities and bonds— are the assets that are being liquidated today to meet the bills. Over the last five years, a large amount of retail savings has flowed into equity and balanced funds through Systematic Investment Plans. Similarly, businesses will need equity markets to bolster their balance sheets; rights issues, preferential allotments, loan against shares might all have a role in keeping these companies afloat. The United States has been discussing a fiscal stimulus that includes a budget for the bailout of critical large businesses that are impacted by Covid-19, and India might also need similar measures. Such rescue packages also need a functioning stock market to price and calibrate such injections of taxpayer money.

While companies would be trying to borrow, the environment does not permit normal due diligence. Many lenders would rely substantially on information revealed in the equity markets because these markets are much more liquid than bond markets. Shutting down equity markets would indirectly shut down parts of the bond market also as information channels get blocked.

Over-Centralised Systems

Finally, let me turn to the regulatory obstacles to trading from home. These regulatory obstacles have arisen because global security regulators, beginning with the U.S. Securities and Exchange Commission, have been asleep at the wheel for the last two decades.Back in 2001, the 9/11 tragedy in New York demonstrated that stock markets had become so excessively centralised that the destruction of a small part of a single city forced the United States to shut down the entire national stock market. More than a decade ago, I blogged about a similar situation in India where local elections in Mumbai led to the shutdown of the stock markets nation-wide..Stock exchanges around the world have been obscenely profitable, and yet securities regulators have not forced them to invest sufficiently in business continuity.

In the case of the European Central Bank’s real-time gross settlement system Target2, the main site has a hot backup site with a synchronous copy in the live region, and, in addition, there is an asynchronous copy to two other sites in a separate testing region; all the four sites spread across three countries are permanently staffed. Compared with that, the business continuity planning of most stock exchanges across the world is a joke.

Securities regulators have made things worse by compliance requirements that encourage intermediaries to centralise key functions in a single geographic location. Regulators forgot that we must not create any single point of failure in systemically important securities markets. Keeping the markets open in difficult times like today will force the regulators to sweep out the whole cobweb of dysfunctional rules that stand in the way of a robust and resilient securities market infrastructure. When Covid-19 has passed into the history books, securities intermediaries should also be forced to rectify the deficiencies that come to light at their end during these troubled times.

Let us all hope that regulators in India will have the courage to keep the stock markets open and that the liquidity and price discovery in these markets will contribute their tiny little bit to help individuals and businesses to cope with the economic distress that is emerging today.

Posted at 12:40 on Wed, 25 Mar 2020     View/Post Comments (0)     permanent link


Sat, 07 Mar 2020

Structuring the Yes Bank rescue

I have been trying to wrap my head around the Reserve Bank of India’s draft scheme of reconstruction of the Yes Bank Ltd under which the government owned State Bank of India (SBI) intends to rescue Yes Bank by picking up a minority equity stake without first wiping out the equity shareholders. It is very hard to make a good estimate of the value of Yes Bank without a highly intrusive due diligence for which there is no time now. However, the working assumption has to be that while the deposits and senior debt are hopefully not yet impaired, the equity and junior debt could conceivably turn out to be worthless. Any rescuer would therefore legitimately demand that its capital infusion be senior to existing equity.

The obvious solution of using preference shares is not available because:

The next best solution would be to first wipe out the existing equity shareholders and then compensate them in one of the following ways:

To my mind, there are three compelling arguments for wiping out the existing shareholders:

  1. This protects the interests of the taxpayer who is indirectly paying for the bailout because the rescuer is a public sector bank.

  2. It avoids the counter intuitive outcome that Yes Bank’s AT1 bonds are wiped out, but the share capital is left intact.

  3. It would strengthen Pillar 3 of the Basel framework which aims to promote market discipline as an integral element of bank regulation. I complained a year and a half ago that the quiescent shareholders of Yes Bank had failed to discipline the management. It would be a good idea to send a clear signal to the shareholders that if they are too quiescent, they stand to lose everything.

Exotic financial instruments have a bad name these days, but as I wrote seven years ago, they have proved invaluable in designing rescue packages for the financial sector.

Posted at 20:16 on Sat, 07 Mar 2020     View/Post Comments (1)     permanent link


Fri, 21 Feb 2020

bZx attack translated into mainstream finance

A few days back, the cryptocurrency based Decentralized Finance (DeFi) platform bZx was subject to an attack/exploit/arbitrage in which the hacker made a gain of over $ 300,000 without investing any capital at all. There are a lot of detailed explanations of this attack from a crypto and smart contract perspective (the BzX Full Disclosure is quite good and Korantin Auguste’s description is even better).

My purpose here is to translate the entire set of operations into equivalent transactions in mainstream finance. I find that each individual element of the attack occurs quite commonly in mainstream finance. What is new is the ability to compose these together and execute them within seconds. What is also new is the ability to obtain unlimited leverage by eliminating information asymmetry.

Mainstream Equivalents

In terms of mainstream finance, the components of the attack are:

The Five Steps in the Actual Attack

The BzX Full Disclosure enumerates the five steps in the attack. In my explanation of these steps below, I will refer to ether (ETH) as cash because it is the native currency of the Ethereum blockchain in which all these smart contracts are executing. Similarly, I will refer to the token being traded – wrapped bitcoin (WBTC) – as the security. WBTC can be thought of as a bitcoin ETF that trades on the Ethereum blockchain and can therefore be managed by Ethereum smart contracts. The bitcoin underlying WBTC resides in its own different blockchain, and Ethereum smart contracts cannot transfer these underlying coins. WBTC solves this problem because it resides on the Ethereum blockchain. But it must be borne in mind that WBTC is far less liquid than bitcoin.

  1. Flashloans (Unlimited leverage with smart contracts): The crypto world is very close to the frictionless theoretical models of economics and finance in which a riskless arbitrage will attract unlimited amount of money. In the real world, there are various leverage constraints and other limits to arbitrage (Shleifer, A. and Vishny, R.W., 1997. The limits of arbitrage. The Journal of Finance, 52(1), pp.35-55.). If one thinks about it deeper, a riskless trade should be subject to a leverage constraint only in the presence of an information asymmetry. It should then follow that if we can find a way to eliminate the information asymmetry completely, then riskless arbitrage should support unlimited leverage.

    The world of smart contracts and immutable code in the crypto world provides an excellent example where we can see this phenomenon in action. The smart contract that makes this possible is the Flashloan which is described in the white paper (alternatively, you can take a look at this simpler explanation). In short, the flashloan borrower presents a smart contract that (a) executes the entire “arbitrage” and (b) repays the loan. This is a single atomic transaction that either succeeds completely or fails completely. The computer code simulates the entire transaction. If at the end, the loan repayment happens, then the transaction goes through and is broadcast on the blockchain. If the loan repayment does not happen, then the entire transaction is reverted – the state is restored to what it was earlier. The loan is not granted and the transaction does not happen.

    In the real world, you cannot give a loan for a factory, check whether the factory actually turns out to be profitable enough to repay the loan, and then undo both the granting of the loan and the construction of the factory if things do not work out. But if everything is virtual and on the blockchain, this is exactly what you can do.

    The attacker borrows cash of 10,000 ETH (roughly $ 2.5 million) using a flashloan. The fact that a completely unknown entity can borrow the equivalent of $ 2.5 million without any collateral and without any risk to the lender is one of the miracles made possible by the smart contracts of Decentralized Finance (DeFi).

  2. Compound Transaction (Security Borrow): In this step, the attacker deposits a little more than half of the cash borrowed in Step-1 as margin to support a security borrowing transaction to borrow 112 WBTC (worth roughly $ 1 million).

  3. Margin Trade or Trade A: The attacker deposits a little more than one-eighth of the cash borrowed in Step-1 to buy the security with 5:1 leverage. This is a huge whale-size trade in this market (recall that WBTC is an illiquid security) and there is only one liquidity provider that can meet this demand – a market-maker smart contract called Uniswap. This contract which is nicely explained in the Uniswap Whitepaper can always provide unlimited liquidity; but for large size trades, it offers absurdly distorted prices. Let me illustrate its algorithm using the example of market making between the US $ and Japanese ¥. Imagine that the market maker starts with $ 10,000 and ¥ 1 million and an exchange rate of $ 1 = ¥ 100. The smart contract uses a very simple formula to guide its operations. It multiplies $ 10,000 by ¥ 1 million to arrive at the product of 10 billion, and its sole goal in life is to keep this product of 10 billion unchanged during all the trading that it does. Suppose you went to this contract with ¥ 1,000 and asked it to give you dollars, it would give you $ 9.99 at an exchange rate of 100.1 ¥ / $ which is only a slight spread above the fair value of 100.1 ¥ / $ . At the end of this trade, the contract owns $ 9990.01 and ¥ 1.001 million, and the product is still 10 billion. Suppose instead, that you had gone to this contract with ¥ 10 million and asked it to give you dollars, it would have given you $ 9090.91 at the ridiculous exchange rate of 1,100 ¥ /$ . After this trade, the contract is left with $ 909.09 and ¥ 11 million and the product of these two is still 10 billion. This contract never declines a trade because it is too large. It simply distorts the price so much that it has enough money to pay out. The Uniswap market maker contract is designed to be used for small trades (say 1-2% of the available liquidity like the ¥ 1,000 trade, and not for trades of ¥ 10,000 let alone ¥ 10 million.

    But for the attacker, creating a distorted price was the goal and it succeeded in achieving this. It bought 51 WBTC at a price of around 110 as against the fair price of less than 40. This is where a bug in the margin trade contract came into play. The contract required 20% margin (5:1 leverage) and the code was supposed to compute the adequacy of the equity in the position by valuing the security (WBTC) using an external price feed. If it did that, the code would have seen that the trade has negative equity (of about -2,300 ETH or about $ 0.6 million). The 51 WBTC valued at the fair price of less than 40 would be only around 2,000 ETH which is less than half the 4,300 ETH borrowed in the margin trade (the purchase price is around 5,600 while the cash margin provided by the attacker was only 1,300).

    This is where the non recourse or limited liability nature of the margin borrow smart contract comes in. The critical point is that bZx does not have recourse to any other assets of the attacker (for example, its equity in the security borrow of Step-2). The attacker can simply walk away leaving bZx with the loss of $ 0.6 million in this contract. Of course, it loses the 51 WBTC lying in the contract, but that is what happens in any mainstream bankruptcy: you leave the assets behind and walk away from the debt.

  4. Dump the borrowed security (Trade B): This trade which is also with the Uniswap market maker smart contract allows the attacker to sell the 112 WBTC borrowed in Step-2 at an inflated average price of 61.4 which is more than 150% of the fair price. I do not understand why the attacker sells more than what it bought in the previous step. As a result of the suboptimal (?) sizing of this trade, the attacker makes a gain of only around $ 0.3 million as against the $ 0.6 million loss caused to bZx.

  5. Repay the flashloan: At this point, the attacker has enough cash to repay the flashloan of Step-1 despite the fact that over half of the proceeds of this loan are still locked up in the security borrow of Step-2. Indeed. the equity of the attacker in this security borrow (cash deposit less the value of the borrowed WBTC) is the profit of the attacker.

Conclusion

All the five steps listed above were completed in a few seconds (an Ethereum block is created every 15 seconds on average). What remains is to buy back WBTC to repay the security borrow (Step-2) and recover the cash trapped in that contract. The attacker is in no hurry to do that because it wants to minimize the impact cost of such a large trade. In a couple of days, this is done and the cash gains have been realized.

This shows that the problem with Decentralized Finance (DeFi) is not that the attacker is anonymous, nor that everything happens in a few seconds leaving others with no time to respond. The attacker’s gains are trapped in the security borrow for a couple of days. The difference with the real world is that DeFi has no provision for what in mainstream finance would be called piercing the corporate veil. In DeFi, there is no court to say that the owners of Step-2 and Step-3 are one and the same, and therefore the losses in the latter can be recovered from the gains in the other. In a blog post last year, I discussed the view of some scholars that mainstream finance itself takes limited liability too seriously, but DeFi seems to take the idea of limited liability to even greater dogmatic extremes.

To my mind, the vulnerabilities in mainstream finance and DeFi are broadly the same. In mainstream finance, smart lawyers find and exploit flaws in the legal code (legal terms of the contract): see for example, Matt Levine on Caesars Entertainment, on Hovnanian CDS and on McClatchy CDS. In DeFi, smart programmers find and exploit flaws in the software code. In both cases, the contracts behave differently from what they expected and get upset. For people on the outside with no stakes in the outcome, the exploitation of legal and software bugs are alike examples of intellectual creativity that can be admired, enjoyed or criticized.

Posted at 17:54 on Fri, 21 Feb 2020     View/Post Comments (1)     permanent link


Mon, 03 Feb 2020

European exchange trading hours and India

For three months now, European fund managers and banks have been pushing the London Stock Exchange (LSE) to reduce trading hours by delaying the market opening time by an hour and a half. The LSE began consultations on this in December and the comment period expired last week. The Investment Association (IA) which represents the fund managers and the Association for Financial Markets in Europe (AFME) which represents the banks, brokers and other market participants submitted a response to this consultation reiterating their earlier proposal.

They are quite blunt in their assessment that the overlap with the US trading hours must be preserved, but the overlap with Asia is unimportant:

The overlap between European and US market hours is clearly evident in better metrics on market quality and liquidity during the common hours, including tighter spreads, more liquidity and improved correlations. By contrast, overlap between London and Asia is invisible from a data/metrics-perspective in regards to European equities. Whilst in theory it has been talked about as being beneficial, in practice there is no discernible benefit.

If the proposal is accepted, India would be the only important Asian market with which London trading hours would overlap (unless Singapore or Hong Kong choose to extend their trading hours to overlap with London). Even for India, the overlap with London would drop to one hour or even half an hour unless India chooses to extend its trading hours (see Appendix 1 of the IA/EFMA proposal). I think India needs to analyse its market quality by time and decide whether to shift its trading hours by an hour or so by opening later and closing later to retain longer overlap with London at the cost of a shorter overlap with Singapore. IA/EFMA state:

We do not consider that a reduced availability of trading time affects other global jurisdictions when considering their large market capitalisation and the ability to transact in their markets.

But it would be stupid for India to simply accept this glib statement without its own analysis.

Posted at 21:29 on Mon, 03 Feb 2020     View/Post Comments (0)     permanent link


Mon, 27 Jan 2020

My 25% error rate

A month ago, in a blog post about the special open market operation (OMO) of the Reserve Bank of India (RBI), I expressed the view that while this was being described as an Operation Twist (purchase of long term bonds and sale of short term bonds), it would end up as a form of Quantitative Easing (QE) with more purchases and less sales. With four such operations now over, my prediction has a 25% error rate. In each of the four operations, the RBI purchased all the bonds (100 billion rupees face value) that it had notified. When it came to sales, the RBI’s acceptance rates were 68.25% (December 23, 2019), 85.01% (December 30, 2019), 100% (January 6, 2020) and 29.50% (January 23, 2020). So I was wrong about one of the four OMOs for an error rate of 25%. The RBI’s average acceptance rate for sales in these four operations works out to a little over 70% implying a net liquidity injection of almost 120 billion.

Posted at 19:58 on Mon, 27 Jan 2020     View/Post Comments (0)     permanent link


Mon, 20 Jan 2020

“Low for long” interest rates and retirement planning

Loose monetary policy after the global financial crisis has resulted in low interest rates that are also expected to remain low for a long time. A prudent person beginning a career today must therefore assume that over his or her life time, the average global real interest rate would probably be negative. By taking some risk, the return could be increased by harvesting the equity risk premium. Accounting for taxation and asset management costs, it would still be reasonable to assume that the realized post-tax weighted average rate of return would be close to zero. (A prudent person would not plan for the expected outcome but for an outcome in say the 10-25% lower tail.)

Rising life expectancy would imply that a person must plan for a post retirement life span roughly equal to the working life. For example, a person might work for 35 years from the age of 25 to 60, and then live for another 35 years till the age of 95. (Again, life expectancy does not have to be 95 because a prudent person would plan for the 10-25% tail outcome).

Some expenses may be lower post retirement, but medical and related expenses would be much higher (and these are rising much faster than inflation). The simplest assumption would be that average monthly expenses post retirement would be roughly equal to that before retirement.

The above assumptions lead to a very simple savings rule: you must save 50% of your income during your working life. The logic is straightforward:

  1. The assumption that the realized post-tax weighted average rate of return would be close to zero means that the discount rate is zero. In the absence of discounting, one can simply add incomes and expenses over one’s entire life span (time value of money – which is probably half of modern finance – becomes superfluous).

  2. The assumption that post retirement life span is roughly equal to the working life together with the assumption that average monthly expenses post retirement would be roughly equal to that before retirement means that total expenses during retirement are roughly equal to that during the working life.

  3. I assume that total lifetime income equals total lifetime expenses (no net bequests). Therefore working life expenses (being half of lifetime expenses) must be also half of lifetime income.

  4. Assuming that there is no non-investment income post retirement implies a savings rate of 50%.

If in addition, the prudent person is worried about a rising profit share in GDP and a possible secular decline in real wages as artificial intelligence destroys well paying jobs, then the savings rate in the early part of one’s career would have to be even higher.

Casual empiricism suggests that a 50% savings rate is far beyond what anybody plans for today. Several hypotheses suggest themselves:

  1. People are not actually risk averse and are planning for median outcomes and not for the 10-25% tail. This implies a significant minority of people will live out the last decades of their lives in poverty.

  2. People have adaptive expectations and because of high realized rates of return in the 20th century, they are excessively optimistic about rates of return going forward. If this is the case, even the median person could experience poverty in old age.

  3. The worry about “lower for longer”, secular stagnation, and the threat of artificial intelligence is just irrational pessimism, and, in fact, all is well with the world.

  4. Ultimately, the state will be forced to step in to provide support in retirement because in an ageing society, senior citizens have too many votes (and they do come out to vote). Since state support will probably be means-tested (and financed by heavy taxation), it is stupid to save too much.

  5. Climate change will end civilization as we know it long before our savings run out, and so retirement savings are the wrong thing to worry about.

  6. Society will decide that retirement is a luxury that we cannot afford, and we will all be working even with one foot in the grave.

Posted at 16:27 on Mon, 20 Jan 2020     View/Post Comments (1)     permanent link