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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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 13:22 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


Wed, 25 Dec 2019

Quantitative easing by any name is fine

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

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

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

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

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

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

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

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


Thu, 19 Dec 2019

New Zealand goes ahead on bank capital

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

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

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

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

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

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

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


Wed, 04 Dec 2019

Resolution of stock broking firms

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

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

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

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

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

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

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

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

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

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

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

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


Thu, 21 Nov 2019

Financial Markets and Monetary Transmission

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

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


Thu, 07 Nov 2019

Does India need Unconventional Monetary Policy?

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

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

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

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

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

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

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

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

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


Mon, 23 Sep 2019

Real Estate and Infrastructure Resolution in India

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

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

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

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

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

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

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


Sat, 21 Sep 2019

Abstraction bias or bias bias?

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

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

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

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

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

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

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


Sun, 15 Sep 2019

Legal theory of finance redux

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

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

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

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

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

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

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


Fri, 06 Sep 2019

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

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

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

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

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


Fri, 30 Aug 2019

No Easy Fixes for Limited Liability

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

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

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

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

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

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

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

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


Wed, 28 Aug 2019

When do algorithms violate the law

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

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

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

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

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

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

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


Wed, 14 Aug 2019

Can India seize the Hong Kong opportunity?

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

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

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


Tue, 06 Aug 2019

QE through unlimited buying of foreign equities

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

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

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

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

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

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


Fri, 26 Jul 2019

Big Tech 2019 = Big Finance 2005 = Big Risk?

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

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


Thu, 25 Jul 2019

A petty money dispute holds market to ransom

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

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

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

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

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

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

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

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


Thu, 11 Jul 2019

US wants to nurture single stock futures

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

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

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

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

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

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

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

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

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

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

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

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


Tue, 02 Jul 2019

Deep fakes in finance?

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

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

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

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

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

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


Sat, 29 Jun 2019

The bankers, by contrast, moved on

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

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

The bankers, by contrast, moved on.

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

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


Sat, 22 Jun 2019

Allowing a corporate body to be a director

A few months back, Joseph Franco published a fascinating paper about a commoditized governance model adopted by a small minority of US mutual funds where the entire governance is outsourced to an unaffiliated entity that specializes in providing governance services. (Commoditized Governance: The Curious Case of Investment Company Shared Series Trusts (February 14, 2019). 44 J. Corp. L. 233 (2018) ; Suffolk University Law School Research Paper No. 19-7. Available at SSRN: https://ssrn.com/abstract=3334701). Franco concludes that this model is merely an interesting curiosity:

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

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

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

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

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

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


Thu, 13 Jun 2019

Bonds and loans

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

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

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

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

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

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


Mon, 03 Jun 2019

Korean derivatives reforms come full circle

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

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

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


Tue, 02 Apr 2019

Blockchain in Finance

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

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

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

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

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


Thu, 28 Mar 2019

Learning from Crises

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

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

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

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

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

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


Thu, 14 Mar 2019

Inverting the intermediary theory of asset pricing

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

I see two problems with this. First of all, the major risk factors (like Momentum, Value, Carry and BAB) have been demonstrated in two centuries of data (1799-2016) from across all major world markets (Baltussen, Guido and Swinkels, Laurens and van Vliet, Pim, Global Factor Premiums (January 31, 2019). Available at SSRN: https://ssrn.com/abstract=3325720). It is evident that the structure of financial intermediation has changed beyond recognition over the last two centuries; for example, 19th Century giants like the Rothschilds operated with far lower levels of leverage than modern security dealers, and were in fact more principals than intermediaries. If the risk factors are solely due to intermediary leverage constraints, I would not expect to see such strong Sharpe ratios for the risk factors in the 19th Century data.

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

I am veering around to the view that risk factors are not priced because of intermediary leverage constraints, but it is the other way around. Factor risk premiums have very long and deep drawdowns (for India, the drawdown plots are available at https://faculty.iima.ac.in/~iffm/Indian-Fama-French-Momentum/drawdown.php). As Cliff Asness put it,

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

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

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


Sat, 09 Mar 2019

When do you sell your best businesses?

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

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

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

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

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

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

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

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


Thu, 07 Mar 2019

Ignoring operational risk

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

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

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

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

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

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