Thu, 09 Feb 2012

Intra-day laxity: MF Global edition

I blogged two years back about the tendency in finance to be prudent at night but reckless during the day in the context of Lehman bankruptcy. A related phenomenon (compliant at night but trangressing during the day) is seen in the MF Global bankruptcy according to the preliminary trustee report released earlier this week:

The investigation to date has found that transactions regularly moved between accounts and that funds believed to be in excess of segregation requirements in the commodities segregated accounts were used to fund other daily activities of MF Global ... apparently with the assumption that funds would be restored by the end of the day. By Wednesday, October 26th, as the result of increasing demands for funds or collateral throughout MF Global, funds did not return as anticipated. As these withdrawals occurred, a lack of intraday accounting visibility existed, caused in part by the volume of transactions being executed ... (Paragraph 7, emphasis added)

Of course, I am not a lawyer, but it appears to me that such intra-day laxity is not consistent with the Commodity Exchange Act or the CFTC Regulations:

... all money, securities, and property received by such ... [futures commission merchant] to margin, guarantee, or secure the trades or contracts of any customer ... shall be separately accounted for and shall not be commingled with the funds of such commission merchant ... (Section 4d of the Commodity Exchange Act)

Each futures commission merchant shall treat and deal with the customer funds of a commodity customer or of an option customer as belonging to such commodity or option customer. All customer funds shall be separately accounted for, and shall not be commingled with the money, securities or property of a futures commission merchant or of any other person ... (CFTC Regulation 1.20)

... futures commission merchant ... [may add] to such segregated customer funds such amount or amounts of money, from its own funds or unencumbered securities from its own inventory, of the type set forth in §1.25, as it may deem necessary to ensure any and all commodity or option customers’ accounts from becoming undersegregated at any time. The books and records of a futures commission merchant shall at all times accurately reflect its interest in the segregated funds. (CFTC Regulation 1.23, emphasis added)

It would appear to me that the words “at any time” and “at all times” prohibit intra-day withdrawal “with the assumption that funds would be restored by the end of the day” as well as “lack of intraday accounting visibility”.

As an aside, it is interesting to note that after looking at 800 computer drives and 100 terabytes of data, the trustees still do not know where the money has gone

For three months the Trustee’s investigative team has worked to understand what happened during the final days of MF Global when cash and related securities movements were not always accurately and promptly recorded due to the chaotic situation and the complexity of the transactions. With these preliminary investigative conclusions in hand, the Trustee’s investigative team will analyze where the property wired out of bank accounts established to hold segregated and secured property ultimately ended up. (Paragraph 6)

The Trustee’s investigators, including the legal and forensic accounting teams, have conducted over 50 witness interviews, preserved secure access to thousands of boxes of hard copy documents, imaged over 800 computer drives, and are maintaining over 100 terabytes of data. (Paragraph 12)

Posted at 16:05 on Thu, 09 Feb 2012     View/Post Comments (0)     permanent link

Sun, 05 Feb 2012

Market microstructure: Limit orders and order flow

One of my favourite post crisis themes has been the idea that market microstructure has macro consequences. I touch upon this in my paper on post crisis finance (mentioned in my blog posts here and here). Two papers that I read last month are related to this theme.

Psy-Fi blog pointed me towards a paper by Linnainmaa showing that the under performance of individual investors’ portfolios can be attributed largely to their use of limit orders. When one looks at trades, it may appear that these investors were stupidly selling when the smart money was buying in response to good news. Linnainmaa’s point is that quite often, this apparent “selling” is not really active selling; their limit orders were simply being hit by the smart money. Looking at the totality of the orders of individual orders may show that these orders had no sell bias. What happens is that when the smart money is buying, the individual investors’ buy limit orders do not execute while their sell orders do.

If this is true, then one implication of this use of limit orders by uninformed traders is that the smart money is able to buy shares too cheap. The price does not move as much as it should have. This phenomenon may also be contributing to the well known momentum effect. This leads straight on to the second paper that I read recently (I do not recall to whom I owe a hat tip for this paper).

Beber, Brandt and Kavajecz published their paper “What Does Equity Sector Orderflow Tell Us About the Economy?” recently (the working paper version is available here). They not only show that the order flow into defensive sectors of the stock market forecasts recessions, but they go on to show that the order flow does a better job than prices or returns. One possible explanation of why order flow is more informative than prices is of course the phenomenon described by Linnainmaa – since uninformed limit orders absorb some of the impact of informed buying, the full information of these orders is not impounded in prices..

This is of course totally different from genuine equilibrium models with representative agents where prices are not only fully informative but also move with zero trading volume implying that order flows and trading volumes are totally uninformative (or rather totally irrelevant).

Posted at 21:49 on Sun, 05 Feb 2012     View/Post Comments (0)     permanent link

Thu, 26 Jan 2012

Safe (or informationally insensitive) assets

Gary Gorton and his co-authors have produced a large literature on what they calls safe assets (assets whose prices are informationally insensitive). They published two new papers this month on collateral crises and on the constant share of safe assets through the last half century. Their earlier papers on being slapped by the invisible hand and the run on repo are quite well known. The basic argument of this literature is that:

1. Safe assets serve an important social function
2. Safe assets are in short supply – the demand for these assets exceeds the stock of government securities and other obvious safe assets.
3. The shadow banking system is an important source of supply of safe assets
4. The shadow banking system and the safe assets that they create must be protected from “runs” in the same way that bank deposits are protected.

A more radical version of this idea can be found in a paper by Morgan Ricks which argues that only licensed money-claim issuers should be permitted to issue short term debt and that all this debt should then be explicitly insured by the government.

Much of what we know about the demand for safe assets come from the work of IMF economist Manmohan Singh (not to be confused with the Indian Prime Minister!). In a series of papers on the use of collateral in OTC derivatives, counterparty risk and central counterparties, collateral velocity, rehypothecation, and the reverse maturity transformation by asset managers, Singh and his co-authors have documented the need for safe assets in derivative markets and asset management.

What emerges from this discussion is that much of the demand for safe assets comes from sophisticated financial institutions and sovereign reserve managers. To my mind, this completely weakens the case for any form of subsidy for the creation of safe assets. The literature on participation in equity markets (which can be regarded as a proxy for risk taking in financial markets) demonstrates that participation is determined to a great extent by intelligence (Grinblatt et al), cognitive ability (Christelis et al), education (Cole and Shastry) and financial literacy (Rooij et al).

Most of the demanders of safe assets are big institutions (according to Manmohan Singh’s work), and one would expect them to possess a sufficient pool of intelligence, cognitive ability, education and financial literacy to be able to invest in risky assets. In some cases, portfolio risk may actually be lower if safe assets are replaced by equities. For example, Manmohan Singh explains how the security lending activities of asset managers creates a reverse maturity transformation – it converts the long term investment portfolio of households into a demand for short term assets (collateral). To the extent to which equities are correlated with each other, it is plausible that collateral in the form of stocks similar to those that are lent out might reduce risk. To the extent to which the borrower of the stocks is engaged in a “pair trade”, a natural supply of such collateral might exist.

I suspect that the demand for safe assets is better explained by a rational tradeoff between the costs and benefits of risk assessment (in a manner that bears some similarities to the rational inattention model of Sims). I therefore look at the huge demand for safe assets as a consequence of the moral hazard engendered by repeated bail outs of the financial sector. Even sophisticated investors may find it optimal not to make a serious risk assessment of any asset which has little idiosyncratic risks and is exposed only to systemic risks if the probability of such an asset (or rather its investors) being bailed out is quite high.

When one reads Gorton carefully, it becomes apparent that that the safe (or informationally insensitive assets) are not risk free – they are only free of idiosyncratic risk. Systemic risk is less subject to information asymmetry and therefore does not pose the problems that Gorton attributes to risky assets in general. But then the ability of the state to insure against systemic risk is highly suspect because if such an insurance is attempted in sufficiently large scale, the result is likely to be a sovereign debt crisis when the systemic risk event materializes. Capitalism to my mind is about accepting and dealing with failure, while the path that Gorton and Ricks are proposing is the path of socialism.

I see a similarity between the desire of the rentier class for safe assets and the desire of the working class for defined benefit pension plans. In both cases, the desire is to shift the risks to the taxpayers and thereby avoid the cognitive burden of making informed choices. In the case of the working class, society has over the last few decades rejected the demand for “informationally insensitive” pensions (defined benefit plans) despite the fact that lower levels of financial education might make the cognitive burden quite high for many of these people. I see no reason why the rentier class should receive a more favourable treatment.

Posted at 21:39 on Thu, 26 Jan 2012     View/Post Comments (0)     permanent link

Wed, 25 Jan 2012

Finance teaching and research after the global financial crisis revisited

Almost a year ago, I wrote a paper on finance teaching and research after the global financial crisis (see this blog post). A revised version of this paper has been published in the latest issue of Vikalpa. The only significant change in the published version is that the portion dealing with learning from related disciplines has been expanded and rewritten. Most of the other changes were only to improve readability and clarity. As always, comments and suggestions are welcome.

Posted at 16:54 on Wed, 25 Jan 2012     View/Post Comments (1)     permanent link

Thu, 19 Jan 2012

The many different kinds of fixed exchange rate regimes

In recent decades, economists have been increasingly focused on the de facto exchange rate regime using the ideas developed by Reinhart and Rogoff (2004) and by Frankel and Wei (1994). This approach of looking at the actual data is of course a huge advance over the naive approach of relying on official pronouncements. Intermediate approaches are also possible as exemplified in the IMF’s De Facto Classification of Exchange Rate Regimes and Monetary Policy Framework.

Obsessive contemplation of currency breakups (see my blog post last month) has made me more sensitive to the legal nuances of a fixed exchange rate regime, and I am beginning to think that looking only at the statistical properties of the exchange rate time series is not sufficient.

I have been thinking of three small but rich and highly successful jurisdictions which have today adopted a fixed exchange rate regime – Switzerland, Hong Kong and Luxembourg. The statistical properties of recent exchange rate behaviour in these three countries might be very similar, but the legal and institutional underpinnings are very different. A de-pegging event would play out very differently in these three cases.

1. Switzerland has temporarily pegged its currency (the Swiss franc) to the euro through an executive decision of its central bank. There is no statutory basis for this peg. Technically, the Swiss have put a floor (and not a peg) on the EUR/CHF exchange rate (Swiss francs per euro); but given the massive upward pressure on the franc, the floor is a de facto peg.

   Exiting this peg would be very easy through another executive decision of the central bank. The only real costs would be (i) the exchange losses on the euros bought by the Swiss central bank, and (ii) probably a modest loss of credibility of the central bank. I would imagine that a significant uptick in the inflation rate in Switzerland would be sufficient to cause the central bank to drop the peg and accept these costs.

2. Hong Kong’s peg to the US dollar is much stronger and longer. It has lasted a whole generation and is enshrined in a formal currency board system. Having survived the Asian crisis, the peg is regarded as highly credible. Yet, it would be very easy to change the peg or even to remove the peg completely. In fact, my reading of the statutes is that this could happen through an executive decision of the government without any changes in the law.

   Indeed, there is a significant probability that over the course of the next decade, the HK dollar would be unpegged from the US dollar and repegged to the Chinese renminbi. This change could happen quite painlessly and without any legal complications.

3. Luxembourg has adopted the euro as its currency. This means that leaving the euro and recreating its own currency would be a legal nightmare. The doctrine of lex monitae asserts that each country exercises sovereign power over its own currency, and that it is the law of that country which determines what happens when a currency is changed. This might appear to give enough leeway to the Luxembourg government to do whatever it wants.

   However, in a cross border contract, the other party would argue that the term “euro” in the contract did not refer to the currency of Luxembourg at all, but to the currency of the euro area as governed by various EU treaties. This argument may not help if the contract is governed by Luxembourg law because the local courts are likely to interpret lex monitae very broadly. But if the contract were governed by English law (as is quite common in international contracts), it is quite likely that the English courts would take the EU interpretation. Assuming that the UK remains a member of the EU, its courts might not have any other choice.

I am beginning to think that we tend to focus too much on the role of money as a medium of exchange or as a store of value. If we do this, it appears that all the three countries have surrendered their monetary sovereignty to an equal extent. But the role of money as a unit of account is extremely important. Of the three countries described above, only Luxembourg has (arguably) surrendered its sovereignty on the unit of account. This loss of sovereignty is the most damaging of all.

An alternate way of constructing the euro way back in 1999 might have been for Luxembourg to adopt its own new currency (say the Luxembourg euro) of which no notes would be printed, peg this currency to the euro issued by the ECB (the ECB euro) at 1:1, and declare the ECB euro to be the only legal tender in the country. From a medium of exchange or store of value point of view, this arrangement would be identical to what exists today because only ECB notes would circulate. But in Luxembourg law, under this alternate approach the ECB notes would just happen to be the legal tender for the Luxembourg euro which would just happen to be equal to the ECB euro. The Luxembourg euro would then be capable of being unpegged from the ECB euro at any time under the doctrine of lex monitae.

The problem as I see it is that technocrats always have a temptation to try and build something that cannot fail. The technocrats who created the euro therefore set out to create something irreversible and permanent. I think it is better to approach the matter with greater humility, and endeavour to build something that would fail gracefully rather than not fail at all.

Finally, there is a fourth small, rich and highly successful country – Singapore – which is also an important financial centre like the other three and has gotten by quite well without pegged exchange rates.

Posted at 13:22 on Thu, 19 Jan 2012     View/Post Comments (2)     permanent link

Mon, 09 Jan 2012

The risks in Indian dependence on foreign risk capital

Last month, the McKinsey Global Institute (MGI) published a 95 page report (The emerging equity gap: Growth and stability in the new investor landscape) arguing that over the next decade, there is likely to be a shortage of equity investors globally. This is based on two arguments:

1. Demographics and the regulatory aftermath of the financial crisis are reducing the demand for equities from investors in developed markets.
2. Global wealth is shifting to emerging market investors who have historically had less appetite for equity investment.

The second prong of this argument is clearly debatable. Had there been a think tank examining such questions in the nineteenth century, it too would have worried about the shifting of wealth from the UK (which was then the dominant source of risk capital for the world) to newer rivals. We do know with hindsight that with increasing wealth, the rising powers of the nineteenth century went on to become major sources of risk capital to the rest of the world. That could well happen again, but it will not happen unless today’s emerging markets create the preconditions for a vibrant equity market.

MGI is therefore on much stronger ground when it discusses the policy steps that emerging markets should take to develop their equity markets – strengthen the legal and regulatory foundations of equity markets; expand channels for households to access equity markets; and enable the growth of institutional investors. (pages 55-56).

All of this is of great relevance to India which has thrived during the last two decades on foreign risk capital. India has a large domestic savings pool and could perhaps at a crunch get by on only these savings. But two-third of household financial savings go into risk free assets like currency, deposits and small savings. Most of the remaining third goes into insurance and retirement funds which in turn invest a very large part of their resources in government bonds and other safe assets. Only around 1% of household savings go into equities. India may have nearly enough aggregate savings, but there is an acute shortage of risk capital.

Foreign portfolio capital has bridged this gap during the last two decades. Since these capital inflows exceed the aggregate savings shortfall, a part of the capital flows ends up as foreign exchange reserves which finance profligate governments in the developed world (and post 2008, this lending is far from being risk free).

Without foreign risk capital, it would have been impossible for the Indian private sector to come anywhere near the growth rates that it has achieved in the last two decades. But we must recognize that the reliance on foreign risk capital is a short term fix to the shortage of domestic risk capital. As we saw in 1998 and again in 2008, this dependence creates serious vulnerabilities. When foreign portfolio flows reverse, risk capital disappears and weak balance sheets cannot raise money at all. (Strong balance sheets can perhaps raise debt locally). Secondly, capital inflows can ignite asset price bubbles and outflows can prick the bubbles. Asset prices in India often depend on global risk aversion even more than on domestic sentiment.

It is true that Indian equity markets have been one of the great success stories of financial sector reforms (the contrast with the dismal state of the corporate bond market is particularly glaring). But we must not forget that even this success consists principally in the fact that foreign equity risk capital is largely intermediated through Indian markets (by contrast, the Indian corporate debt market moved offshore because of poor regulatory choices).

Creating a pool of domestic risk capital will take a long time and that is all the more reason why we must start soon. We will need a lot of things to get there – well developed and liquid markets, institutional support to facilitate easy access, sound regulatory regimes to provide investor protection and confidence, and finally investor education and awareness.

India would need to do all this in its own interest. What MGI is saying is that India (and other emerging markets) might be forced to do this even faster because the foreign pool of risk capital may be about to dry up.

Posted at 14:39 on Mon, 09 Jan 2012     View/Post Comments (1)     permanent link

Fri, 30 Dec 2011

RBS and ABN Amro Due Diligence

Earlier this month, the UK Financial Services Authority bowed to public pressure and published a massive (452 page) report on the failure of the Royal Bank of Scotland. This report has been much commented upon in the press and the blogospherre (yes, I am rather late to this party!), but I do wish to comment on what the report says about the due diligence involved in the ABN Amro acquisition:

Many readers of the Report will be startled to read that the information made available to RBS by ABN AMRO in April 2007 amounted to ‘two lever arch folders and a CD’; and that RBS was largely unsuccessful in its attempts to obtain further non-publicly available information. (Chairman’s Foreword, page 9)

The RBS Board was unanimous in its support for the acquisition. The RBS Board’s decision to launch a bid of this scale on the basis of due diligence which was insufficient in scope and depth for the major risks involved entailed a degree of risk-taking that can reasonably be criticised as a gamble. The Review Team reached this conclusion in the knowledge that had a fully adequate due diligence process been possible, the RBS Board might still have been satisfied with the outcome and decided to proceed. (Para 415)

In contested takeovers only very limited due diligence is possible. Management and boards have to decide whether the potential benefits of proceeding on the basis of limited due diligence outweigh the risks involved. Institutional investors are well aware of the limited nature of the due diligence possible in these circumstances, and have the ability to vote against approval of the acquisition if they consider the risks are too great. If the acquisition turns out to be unsuccessful, they can dismiss the board and management. (Para 441)

In most sectors of the economy, this market discipline approach remains appropriate because the downside risks affect only the equity shareholders. Banks, however, are different because, if a major takeover goes wrong, it can have wider financial stability and macroeconomic effects. The potential downside is social, not just private. (Para 442)

As a result, further public policy responses to the lessons of the ABN AMRO acquisition need to be considered. ... Establishing within this formal approval regime a strong presumption that major contested takeovers would not be approved, or would only be approved if supported by exceptionally strong capital backing, given that specific risks are created by an inability to conduct adequate due diligence. (Para 443)

I think this whole idea is misguided. Absent outright fraud, there is in fact not much that can be gained from invasive due diligence of a large public company. The FSA report itself admits that all the major risks of the acquisition were crystal clear without any due diligence. RBS made a conscious strategic decision to buy the ABN Amro business. They thought that the assets were of great strategic value, when in fact they were toxic. The problem was not one of lack of information; it was simply a wrong macro view of this business. A million lever arch folders and CDs would not have cured this problem.

If FSA thinks that an investment decision based on ‘two lever arch folders and a CD’ worth of due diligence is a gamble, then they must also argue that Warren Buffet’s bail out of General Electric and Goldman Sachs in 2008 (and of Bank of America this year) were gambles. I think this is wrong. Absent outright fraud, buying a large listed company after analysing only the public filings is perfectly prudent and legitimate. And, if the FSA thinks that banking is a sector where there is a preponderance of outright frauds, then that is an admission of total and complete regulatory failure – the regulators surely have access to all the lever arch files and CDs in the bank.

Only a check box ticking regulatory mindset can lead somebody to the silly idea that the quality of decision making can be measured by the volume of data that was processed. I am reminded of the great chess player Jose R. Capablanca who when asked how many moves he analysed before making his move replied “I see only one move ahead, but it is always the correct one.” When RBS looked at ABN Amro, they were fixated on one big move and that was a horribly wrong one. For that, they do deserve all the blame in the world, but let us not get unduly fixated about the ‘two lever arch folders and a CD’.

Posted at 14:54 on Fri, 30 Dec 2011     View/Post Comments (0)     permanent link

Thu, 15 Dec 2011

Examples of Currency Breakup

Since the prophets of gloom and doom are now talking openly of a possible breakup of the euro zone, I thought it would be useful to look back at some instances of breakup of currencies to see what really happens. I have chosen some examples based on my familiarity with them and describe them below in reverse chronological order. I think the examples are fascinating in their own right regardless of what one thinks about the prospects of the euro zone

Argentina 2001-02

Many analysts have drawn parallels between the current Greek crisis and the Argentine crisis of 2001. Therefore, my first example is the Argentine pesification of 2002. The process began in December 2001 with the corralito which froze all bank accounts for 12 months while allowing withdrawals of $250 a week for essential expenses. This led to riots that forced the resignation of the president. During the next two weeks, Argentina went through three interim presidents while also defaulting on its debt. In January 2002, interim president Duhalde announced an asymmetric pesification in which dollar denominated bank deposits were converted to pesos at 1.40 peso to the dollar while dollar denominated loans given by the banks were converted at 1.00 peso to the dollar. The government issued compensation bonds to the banks for the differential of 0.40 pesos, but at that time, the government was widely regarded as insolvent. The free market exchange rate was approximately 4 pesos to the dollar. The Argentine Supreme Court declared the corralito and the pesification unconstitutional. The government responded by impeaching two judges and forcing the resignation of two others. In October 2004, the Supreme Court ruled that pesification was legal. A good chronology of most of these developments can be found in Gutierrez and Montes-Negret (“Argentina’s Banking System: Restoring Financial Viability”, produced by the World Bank Office for Argentina, Chile, Paraguay and Uruguay, 2004).

Ruble zone early 1990s

Another example with similarities to the euro zone is the breakup of the ruble zone in the early 1990s after the collapse of the Soviet Union. While the overthrow of Gorbachev and the fall of the Soviet Union were political in nature, the breakup of the ruble zone was primarily due to economic reasons. After the collapse of the USSR, no change in monetary arrangements were made – the newly formed Central Bank of Russia (CBR) took over the old Soviet central bank (Gosbank) in Russia while Gosbank branches in the other countries became 14 independent central banks. However, all the printing presses were in Russia and so only the CBR printed rubles. The other countries relied on ruble notes and coins shipped from Russia by the CBR.

The old soviet system was based on a dual monetary circuit: enterprises could convert rubles in the bank (beznalichnye or non-cash rubles) into cash (nalichnye) only for specified purposes – chiefly the payment of wages, which were paid in cash. All inter-enterprise transactions were required to be in non cash (beznalichnye) rubles to facilitate central planning and control (see for example, William Tompson, 1997, “Old Habits Die Hard: Fiscal Imperatives, State Regulation and the Role of Russia’s Banks”, Europe-Asia Studies, 49(7), 1159-1185). This dual circuit continued in the post soviet ruble zone as well. The implication was that while the CBR had monopoly on cash rubles (nalichnye), other central banks could and did create non cash (beznalichnye) rubles.

Initially, the CBR continued the old soviet practice of accepting beznalichnye rubles of other ruble zone countries as payment for exports from Russia to these countries. So the central bank of Ukraine could lend beznalichnye rubles to a local bank which could lend them to a local factory which could use these to buy inputs from Russia. Effectively, Ukraine was paying for this stuff with rubles created by itself. This has striking similarities to how Germany has been lending to the rest of the euro zone through the ECB’s Target2 system.

At some point, the CBR decided that it would not accept beznalichnye rubles of other central banks. It also began printing new Russian rubles for use within Russia while printing old soviet rubles for shipping to other ruble zone countries. Finally, in 1993, the CBR unilaterally demonetized soviet era ruble notes and exchanged them for Russian rubles. The ruble zone was effectively terminated and the remaining 9 ruble zone countries (some countries had left even earlier) were forced to adopt their own currencies. Ultimately, the ruble zone broke up because Russia (or more precisely CBR) was not prepared to pay the economic price required for its continuation. A good discussion of the collapse of the ruble zone can be found in Abdelal’s paper (“Contested currency: Russia’s rouble in domestic and international politics”, Journal of Communist Studies and Transition Politics, 2003.)

Pakistan/Bangladesh 1971

My next two examples are closer home from the Indian subcontinent. In early 1971, Bangladesh declared independence from Pakistan, but the government-in-exile could return to the country and start functioning only nine months later. During this war of independence, Bangladesh continued to use the Pakistani currency without any change. Many people dealt with this incongruity by rubber stamping “Bangladesh” or “Joy Bangla” on these notes in English or Bengali. Images of these notes can be seen here and here.

Pakistan however took the stance that the war of independence was a civil war and that the notes circulating in Bangladesh were looted from the branches of the Pakistan central bank (State Bank of Pakistan) in East Pakistan (Bangladesh). It then declared that all note carrying the inscription “Bangladesh” or “Joy Bangla” or “Dacca” in any language would not be legal tender in Pakistan. It also proceeded to issue new currency notes in different colours and withdraw the old notes from circulation. (These events are described at the web site of the State Bank of Pakistan). This demonetization resulted in the paradoxical situation where the old Pakistan currency notes now circulated only in Bangladesh which was at war with Pakistan!

Even after winning the war of independence, Bangladesh retained the old currency for several months. The statute setting up the Bank of Bangladesh stated that “all Bank Notes, Coins and Currency Notes ... which were in circulation in Bangladesh [on December 16, 1971] shall continue to be legal tender”. Subsequently, Bangladesh printed new currency and exchanged the old notes.

India/Pakistan 1947-48

The other example from the subcontinent was the partition of undivided British India into India and Pakistan in August 1947. The two countries agreed that the Reserve Bank of India (RBI) would act as the central bank of Pakistan also for over a year (till September 1948). During this period, the government of India agreed to take two nominees of the Pakistan Government on the central board of the RBI. During this transition period, Indian notes were to remain legal tender in Pakistan, and the RBI was to issue notes overprinted with the inscription ‘Government of Pakistan’ in English and Urdu. During the transition period, these overprinted notes were to be the liability of the RBI, but not of the Government of India.

At the end of the transition period, the Government of Pakistan was to exchange the (non overprinted) Indian notes circulating in Pakistan at par and return them to India. The overprinted notes would become the liabilities of Pakistan. The division of assets of the Issue Department of RBI was to take place after the transition period. The division was to be based on the ratio of notes circulating in the two countries at the end of the transition period.

When the Kashmir dispute erupted later, the financial settlement between India and Pakistan broke down, and the RBI’s role as the central bank of Pakistan was terminated three months ahead of time. An excellent account of all these events can be found in Chapter 18 of Volume 1 of the RBI History. Images of Indian rupees overprinted with ‘Government of Pakistan’ in English and Urdu can be found here.

Austro Hungarian Empire 1919

I now move back from the Indian subcontinent to Europe for my final example – the breakup of the Austro Hungarian Empire in 1919. Richard Roberts (“A stable currency in search of a stable Empire? The Austro-Hungarian experience of monetary union”, History and Policy Paper 127, October 2011) provides an excellent discussion of this episode and its relevance for the euro zone. After the defeat of the Austrian Habsburg Empire at the hands of Prussia in 1866, Hungary threatened secession from the empire. The Compromise of 1867 was a constitutional treaty that recognised the sovereign autonomy of Austria and Hungary under a single monarch – the Austro-Hungarian Dual Monarchy. The two parts of the empire had separate parliaments and separate national debt, but there was a monetary union under the Austro Hungarian Bank (AHB). Like the European Central Bank (ECB) today, the AHB established a strong reputation for a policy of sound money. For a long period, the AHB was also able to rein in the fiscal profligacy which had been the hallmark of the Austrian Habsburg Empire.

Everything changed with the First World War. After its defeat in this war, the Austro-Hungarian Empire collapsed into five successor states – Czechoslovakia, Romania, Yugoslavia, Austria and Hungary. The peace treaties specified that the successor states should stamp Austro-Hungarian Bank notes circulating in their areas and then introduce their own notes. Successor state claims on the reserves and other assets of the Austro-Hungarian Bank was in proportion to the notes circulating in their territories. Stamping was done by affixing adhesive stamps or by rubber or metal stamps. Images of these stamped notes can be seen in the delightful paper by Keller and Sandrock (“The Significance of Stamps Used on Bank Notes”) and also at Wikipedia.

Stamping of notes to turn them into legal tender was a form of taxation and in some countries the tax rate was excessive. This created incentives for people to forge the stamps especially when the stamping was lacking in security features. The value of the stamped currency depended on the monetary policy followed in the various countries. This created incentives for unstamped AHB notes to be smuggled out of profligate countries for stamping in countries with more sound money. Reducing these substantial illicit cross-border flows required customs check points and deployment of army patrols.

The interesting thing about this episode was that out of the five successor states of the empire, only one (Czechoslovakia) was able to create a central bank with anything resembling the sound money attributes of the old AHB. Hungary for example went on to have one of the worst hyperinflations in world history.

Posted at 18:30 on Thu, 15 Dec 2011     View/Post Comments (3)     permanent link

Sat, 10 Dec 2011

Book on SEBI Act

Sumit Agrawal and Robin Joseph Baby sent me a copy of their book on the SEBI Act. I am not a lawyer, but I found the book well written and useful. To my knowledge, this is the first book giving detailed commentary on each section of the Act including judgements of the Securities Appellate Tribunal and the Courts. While the bare SEBI Act is only 33 pages, the commentary comes to 576 pages which is a measure of the extent of judicial precedents that have come up around the SEBI Act in the last two decades. (The length is not due to coverage of the regulations that SEBI has framed under the Act. The book hardly covers these regulations and therefore hopefully would not become obsolete too quickly.)

I wish they or others would write a companion volume covering the Securities Contract Regulation Act, Depository Act and relevant sections of the Companies Act that define the securities law in India.

My only quibble with the book is that as serving SEBI Officers, they tend to uncritically endorse the official SEBI stance regarding most of the disputed legal issues. This is however a minor matter because it is easy to take this with a pinch of salt, and even while taking sides, the authors do present both sides of the case.

Posted at 17:21 on Sat, 10 Dec 2011     View/Post Comments (0)     permanent link

Tue, 06 Dec 2011

Mobile phones as Achilles heel of internet banking

I am increasingly worried that mobile phones are emerging as the Achilles heel of internet banking.

The most frightening news is the key logging software installed by the telecom companies on millions of smartphones (hat tip Bruce Schneier). Every key stroke and every received text message is recorded by the Carrier IQ spyware which logs even what is entered into https web pages that use the secure socket layer (SSL).

The point is that our mobile is not ours in the same sense that our computer is ours. Our mobile belongs first and foremost to our telecom operator and only secondarily to us. This is true even if the mobile runs an open source operating system – the Carrier IQ spyware runs on Android smartphones. On the other hand, when I use a personal computer on which I have installed (say) Ubuntu Linux and I am careful about what software I install on it, the computer is mine in a very real sense.

Unfortunately, this mobile which is not truly ours is increasingly our passport in the cyberworld. When banks were forced to adopt two factor authentication, they chose the mobile phone as the second authentication tool. Most internet banking transactions today require an additional one time password sent to the registered mobile. This is a problem when nobody else regards the mobile as an important element of a person’s identity.

Consider for example this story from Malaysia (hat tip again to Bruce Schneier. The crooks installed spyware an online banking kiosk at a bank and retrieved usernames, passwords and even the transaction authorisation code (TAC) which is sent out by the bank to the registered handphones of online banking users. Then, using fake MyKad, police report or authorisation letters from the target customers, the crooks would report the customers’ handphones lost and applied for new SIM cards from the unsuspecting telecommunications companies. The only saving grace is that it took six crooks about nine months to steal about $75,000; the fraud is simply not scalable.

But then there are other methods of scaling this up. Professional call centres are emerging whose business is to extract sensitive information needed for bank fraud and identity theft from individuals.

Posted at 20:19 on Tue, 06 Dec 2011     View/Post Comments (1)     permanent link

Wed, 23 Nov 2011

European Banks as America's Shadow Banks

Hyun Song Shin delivered the Mundell-Fleming lecture at the IMF Annual Research Conference earlier this month. This very interesting lecture argues that European banks essentially constitute the US shadow banking system.

While there has been much discussion of how the US has been relying on capital flows from Asia, there is little mention of Europe as a financing source. This is because Europe is not a significant source of net capital flow for the US – after all, Europe has a roughly balanced current account, and is not therefore a source of capital. The picture changes when one looks at gross capital flows instead of net capital flows. This is because European banks borrow dollars in the US and lend the dollars back in the US. This too is well known because it was a major source of distortions in the dollar Libor market and in the currency swap market (see for example, my blog post from April 2008 on this issue).

What makes Shin’s paper important is his demonstration that the sheer scale of this gross flow is much bigger than most people imagined. At least, it is an order of magnitude larger than what I thought it was. In fact, he shows that for a brief period in 2007 and early 2008, the total dollar assets of non US (largely European) banks exceeded the total assets of US commercial banks.

As a result, European banks while not being important sources of net capital, were hugely important sources of liquidity and credit transformation in the US financial system. They created liquid and apparently safe assets out of illiquid and risky loans to US borrowers, and they did this mostly through the shadow banking system (securitization and repos). As Shin points out, this is hugely important in the context of the European crisis. The ongoing deleveraging by European banks could be painful for the US financial system even if none of the big European banks fail.

I am tempted to think of the US as a giant CDO (collateralized debt obligation). China (and the rest of Asia) own the super-senior and senior pieces (Treasury and Agency paper) while Europe holds the equity piece. Much of the complacency about the US financial position is based on the idea that Asia cannot find another home for its money and so the super-senior piece will continue to find buyers. When all else fails, the US Federal Reserve has also provided buying support for this piece through its QE (quantitative easing) programmes. However, the real challenge in selling the CDO is in selling the equity piece because this piece has no natural buyer, and the only buyer in town might be delevering itself out of existence.

Posted at 16:18 on Wed, 23 Nov 2011     View/Post Comments (0)     permanent link

Tue, 15 Nov 2011

Revisiting CME and LCH handling of Lehman default

A year and a half ago, I had a blog post comparing how CME and LCH.Clearnet coped with the Lehman default. I raised a number of questions and concluded by saying that:

In the context of the ongoing debate about better counterparty risk management (including clearing) of OTC derivatives, I think the regulators should release much more detailed information about what happened. Unfortunately, in the aftermath of the crisis, it is only the courts that have been inclined to release information – regulators and governments like to regard all information as state secrets.

While regulators have still not been too forthcoming, considerable new information has become public since then. Somehow I did not get around to revisiting this issue until I received a comment on my blog post a few days ago from Risk Dude saying:

LCH utilized excess margins from other products to auction the IRS book under margin. So it’s a bad comparison.

This comment appears to be quite correct. The best material that I have read on the subject is the book by Peter Norman entitled The Risk Controllers: Central Counterparty Clearing in Globalised Financial Markets, (Wiley, 2011). Chapter 2 of the book deals exclusively with the Lehman bankruptcy, and Norman quotes a personal conversation with the LCH.Clearnet Chief Executive, Liddell in which Liddell says:

We always thought that a common default fund would be the main benefit from being a multi-asset CCP. ... In fact, the big and far more valuable discovery during Lehman was that the initial margin in each market was completely fungible. ... There were inverse correlations with prices moving one way in some markets, another way in others. As we managed to liquidate some of the portfolios more quickly than others, it meant that the margin that was left after some had been liquidated was available to cover risk somewhere else. That was a massive, massive benefit. ... it meant we had a much bigger cushion all the time. ... We didn’t have the same sort of urgent need to get rid of everything straight away.

Norman also explains that over the same weekend that Lehman failed, the energy futures exchange, ICE, was to move all its positions from LCH.Clearnet to ICE Clear Europe. On Sunday evening around 7 pm, the FSA, LCH.Clearnet and ICE Clear agreed to defer this move. This meant that during the liquidation of Lehman position, the ICE positions (and more importantly, the associated margins) were also available to LCH.Clearnet and this was a big benefit.

Once again, I hope that regulators will disclose more details about what happened during those dark days.

Posted at 14:20 on Tue, 15 Nov 2011     View/Post Comments (0)     permanent link

Mon, 07 Nov 2011

Unifying initial and maintenance margins

The bankruptcy of MF Global prompted CME Clearing to temporarily unify maintenance and initial margins (h/t Kid Dynamite). I would argue for a permanent abolition of the distinction between these two margins.

Initial margin is the margin that market participants must pay when they initiate a position while the maintenance margin is the level at which the margin must be maintained subsequently. I believe that this distinction is quite silly. The whole purpose of daily mark to market is to ensure that every day begins on a clean slate. There is absolutely no difference between a position initiated yesterday and a position initiated today because yesterday’s losses and gains have already been settled in cash. To pretend otherwise is a delusion. CME Clearing stated in its notice that:

Maintenance margins are set to provide appropriate risk management coverage. Initial margins are set to provide an additional buffer against future losses in the account.

In these troubled times, no one can argue against additional buffers, but the idea of applying buffers selectively to some positions is absurd. The situation becomes even more ludicrous when we consider a large portfolio of positions where new positions do not necessarily correspond to new risks.

In the days when fund transfer was slow and painful, it made sense for customers to deposit extra margins to avoid the hassle of managing daily cash inflows and outflows. This is no longer relevant with today’s electronic payment systems. In any case, that should be a matter for the individual customer to decide. There is little merit in the clearing corporation micro-managing the cash management policies of its customers.

CME Clearing is absolutely right in saying that “Maintenance margins are set to provide appropriate risk management coverage.” It should stop with risk management and leave cash management to market forces.

I am quite disturbed by the statement from CME Clearing that “This is a short term accommodation to maintain market integrity and provide temporary relief to customers whose accounts have been disrupted by this event.” One expects risk managers at clearing corporations to be ruthless and uncompromising on protecting the clearing corporation from risks. Words like accommodation and relief should not be part of their vocabulary at all. Instead CME Clearing should have said that since it is illogical for customers to pay a higher margin merely because their positions have been transferred from MF Global to another clearing member, they are permanently unifying their margins.

Posted at 19:28 on Mon, 07 Nov 2011     View/Post Comments (0)     permanent link

Sun, 06 Nov 2011

Pricing of cheques and electronic payments

India seems to be now moving to a system where it costs the originator more to make an electronic payment than to issue a cheque. This is dysfunctional because the cheque imposes costs both on the receiver and on the payment system (the paying bank, the collecting bank and the clearing house). Of course, in a free market, banks are free to levy charges as they deem fit and charges do vary significantly across banks in India. What is interesting is (a) that the resulting market equilibrium is so perverse, and (b) that this perversity is a recent phenomenon.

In the past, many banks were not charging for electronic payments through the National Electronic Fund Transfer (NEFT) system operated by the Reserve Bank of India. Recently, more and more banks seem to be introducing charges at the maximum permitted rate of Rs 5 per outbound electronic transfer for small transactions. By contrast, most banks charge only about Rs 2 per cheque leaf, and the first 20-30 cheques per year are typically free.

This means that it may now be advantageous for many retail consumers to issue cheques instead of using NEFT for inter-bank transfers within the same city. This privately optimal decision does however have a huge negative externality. The cost to the paying and collecting bank of processing this cheque might be about Rs 50 each, and there are costs elsewhere in the system (for the payee who has to deposit the cheque and for the clearing house which has to process it).

What I would like to know is whether this pricing decision is optimal for the individual banks. Perverse as the end result is, the pricing can be rational for individual banks if customers sophisticated enough to use NEFT are assumed to be relatively price insensitive. In that case, the customers continue to use NEFT and the bank simply pockets another source of revenue. The alternative hypothesis is that the costing and transfer pricing system in many banks is badly broken. In that case, the costs of processing paper cheques is not fully reflected in the pricing decision, while the cost of the electronic transfer is a transparent out of pocket cost (the fee charged by NEFT). A naive cost-plus-pricing system does the rest of the mischief. It would be interesting to figure out which hypothesis is closer to the truth.

In either case, the problem can be solved by a Pigovian tax on cheques.

Posted at 20:29 on Sun, 06 Nov 2011     View/Post Comments (3)     permanent link

Fri, 28 Oct 2011

Does it make sense to hedge DVA?

This blog post is not about whether CVA/DVA accounting makes sense or not; it is only about whether it makes sense to hedge the DVA. Modern accounting standards require derivatives and many other financial assets and liabilities to be stated at fair value. Fair value must take into account all characteristics of the instrument including the risk of non performance (default). CVA and DVA arise out of this fair value accounting.

CVA or Credit Value Adjustment accounts for the potential loss that the reporting entity would incur to replace the existing derivative contract in the event of the counterparty’s default (less any recovery received from the defaulting counterparty). It obviously depends on the probability of the counterparty defaulting and on the recovery in the event of default. More importantly, it also depends on the expected positive value of the derivative at the point of default – if the entity owes money to the counterparty (instead of the other way around), the counterparty’s default does not cause any loss.

DVA or Debit Value Adjustment is the other side of the same coin. It accounts for the possibility that the reporting entity itself could default. One could think of it as the CVA that the entity’s counterparty would need to make to account for the default of the reporting entity. It accounts for the potential loss that the counterparty would incur to replace the existing derivative contract in the event of a default by the reporting entity (less any recovery received from the reporting entity). It can also be thought of as the notional gain to the reporting entity from not paying off its liability in full. The DVA depends on the probability of the reporting entity defaulting, the recovery in the event of default, and the expected negative value of the derivative at the point of default.

DVA can also be applied to any liabilities of the reporting entity that are accounted at fair value and not merely to derivatives, but the logic is the same.

The application of CVA and DVA in valuing assets and liabilities on the balance sheet is perhaps the only logical way of applying fair value accounting of assets and liabilities in which non performance risk is material. But the accounting standard setters took another fateful and controversial decision when they mandated that changes in CVA and DVA be included in the income statement instead of letting it go straight to the balance sheet as a part of Other Comprehensive Income. As I said at the beginning, this blog post is not about the merits of this accounting treatment; I mention the accounting rules only because these rules create the motivation for the management of financial firms to try and hedge the CVA and DVA.

Hedging the CVA is relatively less problematic as it only increases the resilience of the firm under conditions of systemic financial stress. Counterparty defaults are somewhat less threatening to the solvency of the entity when there are hedges in place even if there could be some doubts about whether the hedges themselves would pay off when the financial world is collapsing. What I find difficult to understand is the hedging of the DVA.

The DVA itself is a form of natural hedge in that it produces profits in bad times. It is when things are going wrong and the world is worried about the solvency of the reporting entity that the DVA changes produce profits. One could argue that the profits are notional, but there is no question that the profits arise at the point in time when they are most useful. Hedging the DVA would imply that during these bad times, the (possibly notional) DVA profits would be offset by real cash losses on the hedges. A position that produces losses in bad times is not a good idea. Such positions have to be tolerated when they are intrinsic to the business model of the entity. What baffles me is why anybody would willingly create such wrong way risks purely to hedge an accounting adjustment.

The Modigliani Miller argument in capital structure theory (home made leverage) can be extended to hedging decisions (home made hedging) to say that hedging is irrelevant except when it solves a capital market imperfection. Bankruptcy costs are a major capital market imperfection that can make it advantageous to undertake hedging activities that reduce the chance of bankruptcy. In this framework, the only hedges that make sense are the ones that hedge large solvency threatening risks. The DVA hedge is the exact opposite. It produces large cash losses precisely at the point of maximum distress. For example, this Wall Street Journal story says that Goldman Sachs implements a DVA hedge by selling credit default swaps on a range of financial firms. The trouble with this is that these hedges will produce large cash losses when many other financial firms are all in trouble, and this is likely to coincide with troubles at Goldman Sachs itself. Far from mitigating bankruptcy risks, the hedges would exacerbate them.

The only way this makes sense is if investment banks think that losses during systemic crises can be pushed on to the taxpayer. If this assumption is correct, then DVA hedges work wonderfully to socialize losses and privatize gains!

Posted at 21:55 on Fri, 28 Oct 2011     View/Post Comments (2)     permanent link

Sun, 16 Oct 2011

St. Petersburg, Menger and slippery infinities

In the twentieth century, St. Petersburg became Petrograd, then Leningrad and finally went back to being St. Petersburg. The St. Petersburg paradox named after this city also seems to have been running around in circles during the last three centuries. The latest round in this long standing paradox has been initiated by a mathematics professor who is coincidentally named Peters. Way back in 1934, Menger proved that a generalized version of the St. Petersburg paradox invalidates all unbounded utility functions. Prominent economists like Arrow and Samuelson have accepted this conclusion. In a paper entitled Menger 1934 revisited, Peters argues that Menger made an error that has remained undiscovered during the last 77 years.

The original version of the St. Petersburg game involved a fair coin being tossed until the first time a head appears. If this happens at the n'th toss of the coin, the payoff of the game is 2^n–1. The probability of this event is 2^-n and therefore this event contributes 2^n–1 2^-n = 1/2 to the expected payoff of the game. Summing over all n yields 1/2 + 1/2 + ... and the expected payoff from the game is therefore infinite.

Bernoulli’s 1738 paper from which the paradox obtained its name argued that nobody would pay an infinite price for the privilege of playing this game. He proposed that instead of expected monetary value, one must use expected utility. If utility of wealth is logarithmic in wealth, then the expected utility from playing the game is not only finite, but is also quite small.

Menger’s contribution was to consider a Super St. Petersburg game in which the payoff was not 2^n–1 but exp(2^n–1). Essentially, taking logarithms of this payoff to compute utility yields something similar to the payoff of the original St. Petersburg game, and the offending infinity reappears. Menger’s solution to this generalized paradox was to require that utility functions must be bounded. In this case, there is no monetary payoff that yields very high utilities like 2^n–1 for sufficiently large n.

Peters argues that there is an error in Menger’s argument. The logarithmic function diverges at both ends — for large x, ln(x) goes to infinity, but for small x (approaching zero), ln(x) goes to minus infinity. Suppose a player pays a large price (close to his current wealth) for playing the Super St. Petersburg game. Now if heads comes quickly, the players’s wealth will be nearly zero and the utility would approach minus infinity. The crux of the Peters’ paper is the assertion: “Menger’s game produces a case of competing infinities. ... the diverging expectation value of the utility change resulting from the payout is dominated by the negatively diverging utility change from the purchase of the ticket.” Therefore, the ticket price that a person would pay for being allowed to play this game is finite.

I agree with Peters that even for the Super St. Petersburg game, a person would pay only a finite ticket price if the utility function is logarithmic or is of any other type that has a subsistence threshold below which there is infinite disutility. It appears to me however that a slight reformulation reintroduces the paradox. If we do not ask what ticket price a person would pay, but what sure reward a person would forego in order to play this game, the infinite disutility of the ticket price is kept out of the picture, and the infinite utility of the payoff remains. In other words, the certainty equivalent of the Super St. Petersburg game is infinite. Peters is right that a person with logarithmic utility would not pay a trillion dollars to play the game, but Menger is right that such a person would prefer playing the Super St. Petersburg game to receiving a sure reward of a trillion dollars. Peters’ contribution is to make us recognize that these are two very different questions when there is a “competing infinity” at the other end to contend with. But Menger is right that if you really want to exorcise this paradox, you must rule out the diverging positive infinity by insisting that utility functions should be bounded.

Peters also makes a very different argument by bringing the time dimension into play. He argues that the way to deal with the paradox is to use the Kelly criterion which brings us back to logarithmic functions. Peters relates this to the distinction between time averages and ensemble averages in physics. I think this argument goes nowhere. We can collapse the time dimension completely by changing the probability mechanism from repeated coin tossing to the choice of a single random number between zero and one. The first head in the coin toss can be replaced by the first one in the binary representation of the random number from the unit interval. Choosing one random number is a single event and there is no time to average over. The coin tossing mechanism is a red herring because it is only one way to generate the required sample space.

Of course, there are other solutions to the paradox. You can throw utility functions into the trash can and embrace prospect theory. You can correct for counterparty risk (Credit Value Adjustment or CVA in modern Wall Street jargon). You can argue that such games do not and cannot exist in a market, and financial economics need not price non existent instruments.

I am quite confident that three hundred years from today, people will still be debating the St. Petersburg paradox and gaining new insights from this simple game.

Posted at 14:27 on Sun, 16 Oct 2011     View/Post Comments (0)     permanent link

Thu, 13 Oct 2011

Is there a two tier inter bank market in India?

Update October 13, 2011:

After I posted this yesterday, the RBI published the results of the Reverse Repo auction yesterday showing that there was no money parked with the RBI yesterday. Possibly, the top tier banks are also now cash deficit in the aggregate, and they do not have any surplus to deposit with RBI. Or perhaps, the two tier market is de-tiering. I do not know.

Original post (October 12, 2011):

In a well functioning inter bank market, cash surplus banks lend to cash deficit banks and only the aggregate cash surplus or deficit of the banking system is absorbed by the central bank’s liquidity operations (repo or reverse repo). In a two tier market, there is a top tier of healthy banks that lend to and borrow from each other, but this tier refuses to lend to the second tier of banks whose financial health is suspect. In such a market, if the top tier banks in the aggregate have a cash surplus, they would not lend it to the second tier banks, and would instead park the surplus with the central bank. If the second tier banks have a cash deficit, they would be borrowing from the central bank because they are unable to borrow from anybody else. The central bank would thus be partially supplanting the inter bank market. A two tier market is of course better than a complete seizure of the inter bank market where there is no inter bank market at all and all cash surpluses are parked with the central bank which on-lends it to the deficit banks. After 2008, this progression from a normal inter bank market to a non existent one is well known and understood.

What I am worried about is whether there is a two tier inter bank market in India today. Since the end of last month, we have been seeing the odd situation of some banks parking cash with the RBI at 7.25% while other banks are borrowing from the RBI at 8.25%. If there is no tiering of the banking system, this does not make sense. The surplus bank could lend to the deficit bank at 7.75% and both banks would be better off. The surplus bank would earn ½% more than what the RBI pays, while the deficit bank would reduce its borrowing cost by ½%. That this is not happening suggests that the surplus bank does not have confidence in the solvency of the deficit banks and prefers a safe deposit with RBI. Put differently, there are some banks who are able to borrow only from the central bank as other banks are unwilling to lend to them.

When I started observing this phenomenon at the end of September, my first reaction was that it was due to the distortions caused by the half yearly closing on September 30. When it lasted beyond that, I thought that this was just the effect of the holiday season (Durga Puja and Dussehra). But all that is now over and still the phenomenon persists. Are some bankers worried about the solvency of their fellow bankers?

Posted at 10:41 on Thu, 13 Oct 2011     View/Post Comments (10)     permanent link

Wed, 05 Oct 2011

Basel III: The German (or rather Sinn) Finish

I have blogged about the Swiss Finish and the British Finish that add (or threaten to add) large layers of capital requirements for banks on top of the Basel III minimum. Now, one of Germany’s most influential economists, Hans-Werner Sinn, has come out with proposals that are equally far reaching. My impression is that the German political establishment has been opposed to higher capital requirements, but this could change if the peripheral sovereign crisis necessitates a large bail out of German banks. So Sinn’s proposals are interesting:

After the Basel III system for bank regulation, a Basel IV system is needed in which the risk weights for sovereign debt are to be raised from zero to the level for mid-sized companies.

Common equity (core capital plus balance-sheet ratio) is to be increased by 50% with respect to Basel III.

Sinn does not elaborate on these points which come at the fag end of a long list of (highly controversial) recommendations on how to rescue the euro. There is therefore some ambiguity about what exactly he means. Basel III demands common equity of 4.5% plus a capital conservation buffer of 2.5% plus an extra capital requirement of up to 2.5% for Global Systemically Important Banks (G-SIBs) plus a counter cyclical buffer of up to 2.5%. This leaves us with a range of 7% to 12%. If we take the mid point of 9.5% (for example, a big G-SIB at a point in the business cycle where the counter cyclical buffer is zero) and apply a 50% increase to this, we end up at 14.25%. Since Basel III also requires non equity capital of 3.5%, the total capital requirement would be 17.75%. This is a little below the Swiss and British finish in the aggregate, but it has more of higher quality (equity) capital.

Sinn’s proposal for increasing risk weights is also effectively an increase in bank capital requirements. I am quite in agreement with the idea that we should not distinguish between sovereign exposures and corporate exposures when it comes to risk weights. Other classes of assets with low risk weights (for example, exposures to central counter parties) also need to be revisited. Sinn’s proposal attacks the risk weight problem in another way by applying a 50% increase to the balance sheet leverage ratio which essentially measures the ratio of capital to unweighted assets. Basel III requires a minimum leverage ratio of 3% (assets can be 33 times capital); if this ratio is pushed up to 4.5%, assets will be limited to 22 times capital. For the leverage ratio, Basel III uses tier one capital; it is not clear whether Sinn wants this to be entirely in the form of equity capital.

Basel III was in some ways a victory for the big global banks (though they are still trying to water it down to whatever extent they can), but it appears to me that the real battle lies beyond Basel III. And perhaps, the banks are gradually losing this battle. So many different groups of people coming at it from different perspectives are ending up with very similar banker-unfriendly numbers on minimum bank capital.

Posted at 14:17 on Wed, 05 Oct 2011     View/Post Comments (4)     permanent link

Wed, 21 Sep 2011

Siemens and the ECB

There have been a number of press reports about the German engineering giant Siemens parking € 4-6 billion of cash with the European Central Bank (ECB) in the form of one week deposits instead of leaving it with commercial banks (see, for example, here, here and here). Much of the commentary has emphasized the flight to safety motive for this move, but the reports also point out that the ECB pays a slightly higher interest rate on one week deposits than what the banks offer on longer term deposits. Assuming some tolerance for interest rate risk (the ECB rate could fall in future!), the move could also be justified purely as a pursuit of returns.

I would however like to ask the ultimate tail risk question (to which I have no answers) – is it reasonable to assume that there is no risk in depositing money with the ECB? The best analysis of the ECB’s solvency that I have seen is a piece by William Buiter written a couple of years ago (at his maverecon blog at the Financial Times several months before joining Citigroup as its Chief Economist). Much of the data in this is a little dated, but the analysis is illuminating all the same.

In his piece (entitled “Does the ECB/Eurosystem have enough capital?”), Buiter pointed out that the ECB has a leverage of 70:1 and even the consolidated balance sheet of the ECB and the Eurozone national central banks showed a leverage of 25:1. Buiter also noted that the asset side of the ECB balance sheet “includes a lot of rubbish”. And that was before it had started buying peripheral sovereign debt in a big way. Yet, Buiter concluded that all this “would not endanger the solvency of the Eurosystem, which has the present discounted value of current and future seigniorage income (the interest earned (or saved) by being able to borrow at a zero rate of interest through the issuance of currency and through mandatory reserve requirements).” Those who want a more elaborate theoretical treatment of seigniorage would find it useful to read his 2007 academic paper on the subject.

Buiter estimated that the capitalized value of the current and future stream of seigniorage would be 20 percent of Euro Area annual GDP. This capitalized value of seigniorage was according to Buiter sufficient to mark all the assets on the ECB’s entire balance sheet all the way down to zero and still leave it economically solvent.

One cannot ask for a more conclusive affirmation of solvency than this. But my question was about tail risk, and a tail risk scenario would include a possible euro zone break up. In that scenario, would the seigniorage income flow to the ECB or to the national central banks? And would those national central banks stand behind the ECB?

Posted at 18:17 on Wed, 21 Sep 2011     View/Post Comments (2)     permanent link

Tue, 20 Sep 2011

SEBI trading curbs when promoter fail to dematerialize their holdings

I was interviewed on CNBC TV18 today on the implications of the trading curbs imposed by the Securities and Exchange Board of India (SEBI) on companies whose promoters do not dematerialize all their shares. Even though the deadline is now only 10 days away, many of the largest companies in India including several state owned companies are not in compliance and could therefore face these curbs.

The principal points that I made in the interview were as follows:

• It is necessary to eliminate physical shares completely to deal with the risks of fraud. I argued this point at length in an article that I wrote in January.
• However, the measure introduced by the regulator is highly problematic because it penalizes the company and all its shareholders for a failure on the part of its promoters. The trading curbs reduce the liquidity of shares for innocent shareholders who have already dematerialized their shares.
• The logic of the SEBI measure is presumably that the trading curbs hurt the promoters so much that they would comply with it. I argued that this is incorrect. In a rising market, the trading curbs slow down the rise in the share price of the affected company by slowing down price discovery and making it harder for speculators to buy the stock. This presumably hurts the promoters. But this effect is completely symmetric – in a falling market, the slowing of price discovery supports the stock price. The stock price does not fall as much as it otherwise would because speculators find it difficult to short sell the stock. It is conceivable that some promoters will delay dematerialization precisely to activate the trading curbs.
• It is distressing that the government is not dematerializing its shares in state owned companies. I argue that the Comptroller and Auditor General (CAG) should be worried about the potential for fraud and theft and should insist on dematerialization.
• If neither the regulators nor the promoters blink in this game of chicken, the Indian stock market could be severely affected. Impeding price discovery in a large number of index stocks would create serious problems for the index derivative market as well.
• If the regulator really wants the promoters to fall in line, it is much better to say that physical shares will not be entitled to voting rights or to dividends until they are dematerialized.

The transcript of the interview as well as the video are available at the CNBC web site.

Posted at 22:21 on Tue, 20 Sep 2011     View/Post Comments (1)     permanent link

Thu, 15 Sep 2011

The UK Finish versus the Swiss Finish

The United Kingdom and Switzerland are the two large economies with global banking systems that are far larger than their own economies. Both of them have been worried about the risks that these outsized banking systems pose to their national solvency. They realize that if their banks were to behave as stupidly as the Icelandic banks did, they could face the same fate as Iceland.

A year ago, a Commission of Experts appointed by the Swiss government produced a report on dealing with “too big to fail” banks. A few days ago, an Independent Commission on Banking appointed by the UK government produced its report on improving stability and competition in UK banking.

Both reports have adopted a similar approach in terms of additional capital requirements. For their largest banks, the Swiss report recommended 19% capital consisting of 10% common equity and 9% contingent capital (CoCos). The UK report asks for 17% capital for a large ring-fenced retail banks and 20% for a large investment bank. Again 10% is equity but the balance can be in any form of debt that has “Primary Loss Absorbing Capacity” (PLAC). It is likely that a big part of the PLAC will be CoCos.

The Swiss finish for large banks kicks in for banks with assets of about 50% of Swiss GDP and the 19% capital level mentioned above is reached for their largest banks which have assets of about 300% of Swiss GDP. The UK requirements kick in for banks with Risk Weighted Assets (RWA) equal to 1% of UK GDP and reach the stated level of 17% for RWA of 3% of UK GDP. If we assume that RWA is about a third of total assets, then the 3% level for RWA would correspond to about 9% of UK GDP for total assets. Since UK GDP is about 4 times Swiss GDP, this would correspond to about 35% of Swiss GDP. In other words, the Swiss proposals are calibrated to catch just their two largest banks (UBS and CS), but the UK proposals are much broader. For universal banks which are essentially investment banks, the capital level of 20% is also marginally higher than the Swiss level of 19%. On balance, the UK is going a little beyond Switzerland.

The UK report would allow foreign owned investment banks to operate in London without being subject to the higher capital requirements applicable to UK banks on the assumption that the UK taxpayer would not have any significant exposure to such institutions. The report is really saying that the UK should make money by renting out office space in London to investment banks that may wreck the taxpayers of their home countries so long as the UK taxpayer is spared. “The fact that some other countries may implicitly subsidise their wholesale/investment banks does not make it sensible for the UK to do so.”

I personally believe that capital levels close to 20% are the right levels. The Rothschilds survived and prospered over two centuries of war and revolution in Europe because they had capital of this level or more (and that too as percentage of total assets and not risk weighted assets). High level of capital did not prevent the Rothschilds from becoming bankers to the world. The Modigliani Miller theorem in capital structure theory assures us that debt is cheaper than equity only because of the tax deductibility of interest. The tax advantage of debt essentially means that levered banks get a subsidy as a percentage of their total debt. If we do want to give tax breaks to the banks, it is better to give it to them as a percentage of assets so that it does not distort capital structure decisions.

The UK proposal goes far beyond the Swiss in another respect – the ring fencing of retail banks. In some respects, it goes beyond even the Glass Steagall Act let alone the Volcker Rule. Ring fenced retail banks are to be prohibited from providing any of the following services:

• any service which is not provided to customers within the European Union (EEA);
• any service which results in an exposure to a non-ring-fenced bank or a non-bank financial organisation, except those associated with the provision of payments services where the regulator has deemed this appropriate;
• any service which would result in a trading book asset;
• any service which would result in a requirement to hold regulatory capital against market risk;
• the purchase or origination of derivatives or other contracts which would result in a requirement to hold regulatory capital against counterparty credit risk; and
• services relating to secondary markets activity including the purchase of loans or securities.

In another sense, the UK proposal is much milder than Glass Steagall. A ring fenced retail bank and an investment bank can be part of the same group provided the retail bank is independently capitalized and can continue to operate normally even if the investment bank fails and is put into liquidation.

I see some merit in this proposal, but I think it is less important than the requirement for higher capital.

Posted at 22:00 on Thu, 15 Sep 2011     View/Post Comments (0)     permanent link

Tue, 13 Sep 2011

Credit, money and sociopaths

Early in my career, I read Homer and Sylla’s A History of Interest Rates and learned that credit predates money and probably predates barter. As a finance professor I was thrilled to read a top notch economic historian like Richard Sylla say that finance predates economics: barter is economics, even money is economics, but credit is quintessential finance. No wonder that decades later I still love this book. In a blog post last year, I recommended Homer and Sylla as the one book on financial history that we should all read.

Of course, I did worry whether Homer and Sylla were right or were merely making a casual remark, but the other books that I read (for example, Polanyi, Trade and Markets in the Early Empires) confirmed the primacy of credit over money and barter. In the anthropological and sociological literature, there appeared to be a consensus on this issue.

So long as this account was confined to obscure books read only by a technical audience, there was no great controversy about it. But then, David Graeber wrote a book entitled Debt: The First 5,000 Years and more importantly talked about it in the widely followed economics blog Naked Capitalism. Austrian economists in particular were very upset with him and criticized him only to climb down subsequently. In his latest post at Naked Capitalism, Graeber provides a detailed description of how credit was transformed into money.

The post is worth reading in full especially the passage where Graeber writes that “Homo Oeconomicus ... is ... an almost impossibly boring person—basically, a monomaniacal sociopath who can wander through an orgy thinking only about marginal rates of return”. I entirely agree with this but in a way very different from what Graeber intends. The only way to succeed in finance is to assume that the other person is a monomaniacal sociopath; and that is true whether you are doing high frequency trading or negotiating with the people who borrowed your money years ago but are unwilling to repay it now. As for orgies, anybody who has seen a trading room (or read about it in books like Liar’s Poker) knows that such minor distractions do not impede the true sociopath’s ability to concentrate on making as much money as possible off the other person.

Posted at 19:37 on Tue, 13 Sep 2011     View/Post Comments (0)     permanent link

Tue, 06 Sep 2011

Importance of Financial Markets

After the global financial crisis, many people started thinking that financial markets are evil. So it is nice to see several papers in quick succession arguing that financial markets are more important than banks.

Asli Demirguc-Kunt, Erik Feyen, and Ross Levine presented a paper at a World Bank conference in June entitled “Optimal Financial Structures and Development: The Evolving Importance of Banks and Markets”. They present strong empirical evidence to show that as countries grow richer and become more sophisticated, they need markets more than banks. The optimal financial structure becomes more market based at higher levels of income. Deviations from this optimal structure lead to slower growth.

This month, Julien Allard and Rodolphe Blavy published an IMF working paper entitled “Market Phoenixes and Banking Ducks: Are Recoveries Faster in Market-Based Economies?” in which they argue that “market-based economies experience significantly and durably stronger rebounds than the bank-based ones” They go on to state that “because the financial structure of economies matters, structural policies to deepen financial markets so that they can effectively complement banking sectors are useful. This suggests that policies that would stifle the development of financial markets after the crisis would be misguided.” Of course, Allard and Blavy also emphasize that policy makers must enhance the stability of financial markets as well as reduce rigidities in the real economy.

Closed related is a paper by Stephen Cecchetti, M S Mohanty and Fabrizio Zampolli presented at the Jackson Hole Symposium late last month entitled “The real effects of debt”. Cechetti et al argue that “At moderate levels, debt improves welfare and can enhance growth. But high levels can be damaging.” For example, when corporate debt goes beyond 90% of GDP, it becomes a drag on growth. This appears to me to suggest that deepening of equity markets is more important than the development of banks beyond a certain stage of development.

Posted at 21:21 on Tue, 06 Sep 2011     View/Post Comments (5)     permanent link

Wed, 31 Aug 2011

Can too much capital be risky?

An IMF working paper by Perotti, Ratnovski and Vlahu (PRV) published earlier this month argues that higher bank capital may not only fail to reduce risk taking, but may have an unintended effect of enabling banks to take more tail risk without the fear of breaching the minimal capital ratio in non-tail risky project realizations. PRV argue that the traditional minimum capital requirement must be supplemented with a maximum capital requirement (realistically, in the form of special attention devoted to banks with particularly high capital) in order to assure that they are not taking tail risk.

The key driver of this result is that, in the PRV model, banks choose between a relatively safe investment and a risky project which has both tail risk and non tail risk. Even though tail risk can be passed on to the government through explicit and implicit bail out, the non tail risk is borne by the bank. Banks facing high levels of non tail risk would rationally hold higher capital to protect themselves from the corrective actions imposed by the regulators when minimum capital levels are breached. In the PRV model, this high level of capital tells the regulator that the bank is bearing a large amount of tail risk as well.

In reality, banks can choose not only between safe assets and risky assets, but also between tail risk and non tail risk. For example, a bank which lends against a residential mortgage bears a significant amount of non tail risk and experiences volatility in earnings requiring capital even in normal situations. As against that, consider a bank that provides liquidity support to a special investment vehicle (SIV) that borrows short term and invests in senior and super senior tranches of a mortgage securitization. In normal times, the SIV earns a nice carry with virtually no risk because the senior tranches are unlikely to default except in systemic crisis events. However, the SIV faces catastrophic tail risk because of the high leverage. The liquidity support provided by the bank to the SIV transfers this tail risk to the bank. In normal times, the SIV produces no losses at all, and the bank produces smooth and predictable earnings with negligible losses. In times of systemic distress, the bank would take large losses, but the bank would rely on a tax payer bail out for coping with this tail risk. A rational bank would therefore set aside negligible capital for its SIV exposure because its non tail risk is low.

By setting up a model in which tail risk and non tail risk are embedded in the same project, the PRV paper does not capture the true risk profile of too big to fail (TBTF) banks that manufacture tail risk to monetize their TBTF status.

Posted at 17:21 on Wed, 31 Aug 2011     View/Post Comments (1)     permanent link

Mon, 29 Aug 2011

Safe assets as Giffen goods

Updated: corrected reference to absolute risk aversion instead of relative risk aversion and added a reference for the usage of the term return free risk.

The increased demand for US Treasuries after their credit rating was downgraded led some analysts to ask whether these assets are Giffen goods. The classic example of Giffen goods are staple foods like bread or potatoes where a rise in price depletes the spending power of the poor so much that they are no longer able to afford meat or other expensive food and are forced to consume more of the cheaper food. This means that the demand rises as the price rises – the income effect increases the demand of the inferior good so much that it outweighs the substitution effect of the higher price.

Can this happen with investment assets? For an investor trying to protect her capital, a rise in risk (without any change in the rate of return) of the safest asset is effectively an increase in the price of capital preservation. The idea is that a rise in risk of the safe asset consumes so much of the risk budget of the investor that she can no longer afford too much of the riskier asset. She therefore is forced to shift more of her portfolio into the safer asset. At a qualitative level, the story sounds plausible.

For a more rigorous analysis consider a portfolio choice model with two uncorrelated assets which we shall call the safer asset and the riskier asset. The following results can then be proved:

1. In a pure mean-variance optimization framework, the safer asset can never be a Giffen good. An investor who had a positive allocation to the safer asset will reduce his allocation if its risk rises.
2. In a more general expected utility setting, the safer asset can be a Giffen good. An investor who had a positive allocation to the safer asset could under certain conditions allocate even more to that asset when its risk rises.

I have written up a complete mathematical demonstration of the mean variance result for those who are interested. The intuitive reason for this result is actually quite simple. In a mean variance framework, the optimal portfolio consists of two components (a) the minimum variance portfolio which minimizes risk without any regard for return, and (b) a zero investment purely speculative portfolio of long positions in high return assets financed by short positions in low return assets. The allocation to the speculative portfolio is proportional to the risk tolerance (reciprocal of the Arrow Pratt measure of relative risk aversion) of the investor. An investor with zero risk tolerance holds only the minimum variance portfolio. As the risk tolerance increases, the investor blends the minimum variance portfolio with more and more of the speculative portfolio.

Now if the risk of the safer asset rises, its weight in the minimum variance portfolio necessarily declines. The weights of the two uncorrelated assets in the minimum variance portfolio are proportional to the reciprocals of the variances of the two assets and so a rise in variances reduces the weight.

So an investor with zero risk tolerance will necessarily reduce his holding of the safer asset when its risk increases. What about other investors? What will happen to the short positions that they hold in the safer assets through the speculative portfolio? Increasing the risk of the safer asset makes this short position riskier and all risk averse investors will therefore reduce this position by buying the safer asset. The question is whether this can outweigh the sale of the safer asset via the minimum variance portfolio?

Clearly this can happen if and only if the risk tolerance is very high. We can show that at such high levels of risk tolerance, the initial total position in the asset would have been short. Such an investor is not increasing his long position; he is only reducing his short position. This is not a Giffen good situation at all. Moreover, with short sale restrictions, the initial position in the safer asset would have been zero and it would just remain zero.

So in a mean variance framework, the safe asset is never a Giffen good. As one thinks about it, this result is being driven by the fact that in this framework, the risk aversion is being held constant in the form of a fixed tradeoff between risk and return. This does not allow the income effect to play itself out fully. The principal mechanism for a Giffen phenomenon is likely to be a rapid rise in risk aversion as wealth declines.

So I shift to an explicit expected utility framework using a logarithmic utility function with a fixed subsistence level: U(x) = log(x – s). This functional form is characterized by rapidly increasing risk aversion as the subsistence level s is approached. I consider an up state and a down state for the terminal value of the safe asset u₁ and d₁ with probabilities p₁ and q₁=1 – p₁ respectively. Independently of this, the riskier asset also has two states u₂ and d₂ with probabilities p₂ and q₂=1 – p₂ respectively. The investor invests w₁ in the safer asset and w₂ = 1 – w₁ in the riskier asset. Expected utility is therefore given by:

p₁ p₂ log(w₁ u₁+ w₂ u₂ – s) +p₁ q₂ log(w₁ u₁+ w₂ d₂ – s) +q₁ p₂ log(w₁ d₁ +w₂ u₁ – s) +q₁ q₂ log(w₁ d₁+ w₂ d₂ – s)

The optimal asset allocation is determined by maximizing this expression with respect to w₁. I did this numerically using this R script for specific numerical values of the various parameters. Specifically, I set:

s = 0.8, u₁ = 1.01, d₁ = 0.99, u₂ = 5.00, d₂ = 0.70, p₁ = p₂ = 0.50.

In keeping with the spirit of the times, the expected return on the safer asset is zero – instead of a risk free return, it represents return free risk. For these parameters, the weight in the safer asset is 81%. If we now reduce d₁ to 0.90 (increasing the risk and reducing the return of the safer asset), the weight in the safer asset rises to 82%. Alternatively, if we change d₁ to 0.85 and u₁ to 1.15 (increasing the risk and leaving the return unchanged), the weight in the safer asset rises to 85%. The absolute risk aversion in the low wealth scenario rises from 7.4 when d₁ = 0.99 to 15.7 when d₁ = 0.90 and even further to 37.3 when d₁ = 0.85. This is what drives the higher allocation to the safe asset. The safer asset is truly a Giffen good.

Posted at 09:01 on Mon, 29 Aug 2011     View/Post Comments (0)     permanent link

Mon, 22 Aug 2011

More on Law, Madoff, Fairness and Interest Rates

Last year, I blogged about a US bankruptcy court ruling which said that the net claim that a Madoff investor could make in court was for the total of all amounts invested less all amounts withdrawn. Somebody who invested $10 million in 1988 and withdrew $10 million in 2007 would be deemed to have got back his investment and would have no claims in the bankruptcy court. This ruling completely ignores the time value of money.

Grant Christensen, has written a detailed paper explaining the legal position regarding allocating losses in securities frauds, particularly Ponzi schemes like Madoff. Apparently, the bankruptcy courts “have a great deal of leeway when it comes to ratifying different methods to determine loss and allocate assets.” While the net investment method used by the court in the Madoff case is the most popular method, it is not the only method that is legally sustainable. The rescission and restitution method subtracts only the withdrawal of principal and does not subtract any interest or dividend that was withdrawn. Apparently, “appellate courts have expressed a clear preference for the rescission and restitution method over the net investment approach.”

Quite frankly, I have not been able to understand the mechanics of the various methods discussed in the Christensen paper. The economic difference, if any, between the rescission and restitution method (from civil law) and the loss to the losing victim method (based on criminal law) is not explained at all. The paper focuses on the legal foundations for various methods. I do know that some of the readers of my blog are lawyers and if they can throw light on this in the comments, that would be most helpful.

From what I have been able to understand, the alternative methods are based on accounting definitions of interest and principal. These would then be based on the promised rate of return which would be unrealistically high. Finance theory would suggest that the rate of return on a risk free asset (or a low risk asset) might be more appropriate. Alternatively, the average return earned by the Ponzi operator on the actual invested assets could be considered. For a successful Ponzi scheme, the cash inflows from new investors would exceed the cash outflows to withdrawing investors. This surplus cash would hopefully earn some return and this realized rate of return could be used as the discount rate.

Posted at 15:51 on Mon, 22 Aug 2011     View/Post Comments (0)     permanent link

Sun, 07 Aug 2011

HKEx Clearing House Risk Management Reforms

Last month, the Hong Kong Exchanges and Clearing Limited (HKEx) released a 73 page consultation paper on risk management reforms at the clearing house. Now, HKEx is nobody’s idea of best practices in risk management – this was after all the clearing house that needed a government bail out after the crash of 1987. Even today, the cash equities market of HKEx collects only mark to market margins and not initial margins – only the futures market collects initial margins. But, the HKEx consultation paper goes far beyond what most other exchanges have done and provides much needed transparency on the issue of clearing corporation risk management.

I have long argued that the international standards (the CPSS-IOSCO Recommendations for Central Counterparties, 2004) issued jointly by the BIS Committee on Payment Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) are woefully inadequate. They only allow even the worst run clearing houses to claim to be compliant with global standards. Even the consultative report issued by CPSS-IOSCO earlier this year still falls well short of what is needed for such a systemically important entity as a clearing house.

What HKEx has done is to (a) explain (and strengthen) its stress testing procedures, (b) publicly admit that its guarantee fund is inadequate and (c) set out the process by which this guarantee fund will be built up to acceptable levels.

HKEx also states clearly that while some exchanges treat “margins” as a pooled resource, HKEx does not want to go down that path. It wants only the contributions to the guarantee fund to operate as a pooled resource. In other words, in case of a default, the exchange will have access to the margins of the defaulting member and the guarantee fund contributions of both defaulting and non defaulting members, but not the margins of the non defaulting members. Some exchanges are permitted under their bylaws to use even the margins of the non defaulting members. I believe that the HKEx is right in taking this “non-pooled upfront margin + pooled default fund” approach. In practice, if an exchange taps the margins of the non defaulting members, the market place would regard it as a default by the clearing house regardless of what the bylaws might say.

In conformity with Hong Kong’s well known plutocratic traditions, HKEx proposes:

To ensure long term sustainability and scalability of funding to support these changes and to mitigate any higher funding requirements for CPs that may detract from the markets’ competitiveness, we are keen to work with the HKSAR Government and the regulator in establishing a RMF which is funded by the SFC, HKEx and the market in equal proportion. The model is based on the principle that all key stakeholders, including the market players, the CCP and the regulator will support the stability of the securities and derivatives markets.

While reformers are struggling to avoid having to bail out the finance industry when things go badly wrong, HKEx is seeking a bailout in advance. We can see very clearly the moral hazard created by the 1987 bail out of HKEx.

Posted at 18:19 on Sun, 07 Aug 2011     View/Post Comments (1)     permanent link

Sun, 24 Jul 2011

Two curves and non deliverable interest rate swaps

I have blogged about the importance of two curve discounting in valuation of swaps (here and here), and I have separately blogged (here, here, here and here) about the growing offshore market in rupees and other emerging Asian currencies. But it was an alert reader of the blog who pointed out to me a very interesting connection between the two. The instrument that lies at this intersection is the non deliverable interest rate swap (NDIRS). This is like the non deliverable forward (NDF) market in that it is cash settled in US dollars and operates out of reach of the local regulators. But the underlying product is an interest rate swap rather than a forward contract. The two parties agree to exchange a floating interest rate for a fixed interest rate in rupees or renminbi or other emerging market currency. However, the contract is non deliverable and is therefore cash settled in US dollars without any cash flows in the underlying currency.

The issue is about valuation of the swap and the complexity arises because in India and in many other emerging markets, the OTC derivative market runs without collateralisation. As I explained in my earlier blog post, this means that the valuation depends on the funding cost of the counter parties involved. The problem affects the valuation of the swap even at inception (particularly when the yield curves are quite steep), but the problem is most acute and clearly understood for a swap which has moved into or out of the money some time after inception.

For example, consider a hedge fund that entered into a five year swap agreeing to pay a fixed rate of 5.25% and received floating. After some time, suppose that the swap rate has moved to 5.75%. The hedge fund can now lock in a risk free profit of 0.50% per year for the next five years by entering into another swap in which it receives fixed at today’s rate (5.75%) and pays floating. The net effect of the old swap and the new swap is that the floating legs cancel and the hedge fund simply receives 0.5% fixed for the next five years. The question that arises is what should the hedge fund receive if it wants to unwind the two offsetting swaps and simply pocket the entire profit upfront instead of letting the profit trickle in over five years.

The simple and obvious answer of course is that the hedge fund should receive the present value of the annuity of 0.50% a year. The tricky part is to agree on the discount rate for determining this present value. If the hedge fund goes to a local bank that funds itself largely in the onshore market, the answer would clearly be a discount rate based on the onshore interest rates. On the other hand, if the hedge fund goes to a foreign bank that funds itself largely in the offshore market (borrowing US dollars and swapping into rupees or renminbi), then the discount rate would be based on the all-in (swapped) cost of the offshore borrowing. This latter cost of funds is given by the cross currency swap rates (where a US dollar floating rate is swapped for fixed rate in rupees or renminbi).

In countries with capital account convertibility, there is not too much of a difference between the onshore swap yield curve and the cross currency swap curve because of covered interest parity (CIP). But CIP is clearly not applicable to rupees and renminbi! The cross currency swap rate for currencies like renminbi can actually be negative because of the wall of money wanting to speculate on the appreciation of the currency. Even if things do not get that bad, the gap between the two curves can be several percentage points. Swap valuation using the cross currency swap rate is a form of two curve discounting – the forward rates come from the onshore swap market and the discount rates come from the cross currency swap market.

Smart hedge funds know all about this and choose the banks carefully when unwinding trades. It would clearly like a low discount rate when unwinding a winning trade and a high discount rate when unwinding a losing trade. A bank that watches the hedge fund do this probably feels frustrated, but in fact, the bank is not being cheated at all as the unwind is done at the rate offered by the bank. What the hedge fund is doing is to arbitrage between the onshore and offshore markets with their different interest rates.

All this assumes that the banks are smart and know what their funding costs are. While this may be true of the most sophisticated banks, it is certainly not true for all banks. Some banks may also not be fully clear about the difference between average cost of funds and marginal cost of funds. A foreign bank that funds 90% of its rupee balance sheet in local currency deposits and borrowing may think that its cost of funds is the onshore rate. But if it depends on offshore borrowing for the incremental growth of the balance sheet, it may still be true that its marginal cost of funds (which is all that is relevant for valuation and pricing) is actually the offshore rate. Some banks surely get this wrong.

The lesson in all of this is that the non deliverable market is quite a big mess and there is plenty of scope for supplanting this to a great extent with an onshore cash settled exchange traded currency derivative and interest rate derivative market. Without compromising on capital controls, these exchange traded markets would improve transparency and would move the market (and associated high paying jobs) onshore.

Posted at 19:55 on Sun, 24 Jul 2011     View/Post Comments (0)     permanent link

Fri, 15 Jul 2011

Indian uncollateralised derivative markets

An article by Christopher Whittall in the International Financing Review (IFR) about the difficulties in valuing uncollateralised derivatives is of great relevance to Indian OTC swap markets. Christopher Whittall explains in his article that “Unsecured trades now present a serious valuation headache”. FT Alphaville follows up on this story and highlights the problem: “... pricing even the most basic (uncollateralised) swaps is now very complex. ... traders just flat refuse to enter into any detail about how they price uncollateralised derivatives nowadays — hardly a positive thing for a market that is regularly accused of being like a black box. ”.

Over the last few years, the two curve discounting model which discounts cash flows using the OIS curve (see my blog post of last year) has emerged as the market standard for valuing collateralised swaps. This technique is not applicable for uncollateralised swaps, and in fact there is no “market” valuation for these swaps because the value depends on the cost of funds of the two parties via the Credit Value Adjustment (CVA) and Debt Value Adjustment (DVA).

Deus ex Machiatto puts the matter succinctly:

A vanilla derivative is a collateralized one under the standard CSA these days (cash collateral in the same currency, daily MTM, daily margin). Anything else is exotic, because it involves an exotic collateral option.

All this is important for Indian OTC swap markets because the market runs largely without collateralisation. While these swap deals are governed by the standard ISDA (International Swaps and Derivatives Association) documentation, most Indian banks do not sign the Credit Support Annex (CSA) that deals with collateralisation. We have tended not to worry too much about the Indian OTC swap market because it is dominated by plain vanilla interest rate swaps. What Whittal and Deus ex Machiatto are saying is that this view is incorrect. Effectively, these are all exotic derivatives because of the lack of collateralisation. I believe that this is correct and the matter needs urgent regulatory attention.

There are three main ways to set things right:

• Indian OTC markets can move towards collateralised swaps. This is simple as it only requires Indian banks to sign the CSA under standard ISDA documentation.
• We can move one step further towards the post crisis global regulatory consensus and adopt central clearing of the OTC swaps. The Clearing Corporation of India (CCIL) already has the ability to clear OTC derivatives. Of course, moving more risks into CCIL would make it even more systemically important than it already is, and regulators would need to be extra vigilant about this concentrated risk.
• The most radical solution is to move more of the markets towards exchange trading and clearing. There is a great deal of experience with this both in the equity markets and in currency futures and there is the added benefit of price and trade transparency.

I believe that it is necessary to move quickly along one or more of these alternative paths to mitigate the risks in this market.

Posted at 13:31 on Fri, 15 Jul 2011     View/Post Comments (2)     permanent link

Sat, 09 Jul 2011

The Formula That Killed Wall Street is Alive and Well

The Gaussian Copula which used to be the standard model for valuing CDOs has been described as the The Formula That Killed Wall Street. After the crisis, several alternatives to the Gaussian copula have become popular for CDO valuation.

But there are many other areas where Gaussian copulas still hold sway. Last month, the Basle Committee on Banking Supervision published Operational Risk Supervisory Guidelines for the Advanced Measurement Approaches. The paper notes that the most common method of dealing with dependence in modelling operational risk is by use of copulas; and “Of the banks using Copulas, most (83%) use a Gaussian copula.” In addition about 17% of banks, used a correlation matrix which is even worse than a Gaussian copula.

Faced with this clearly unsatisfactory situation, the BCBS pushes back against this in the mildest possible way:

Assumptions regarding dependence should be conservative given the uncertainties surrounding dependence modelling for operational risk. Consequently, the dependence structures considered should not be limited to those based on Normal or Normal-like (eg T- Student distributions with many degrees of freedom) distributions, as normality may underestimate the amount of dependence between tail events. (para 229)

Not only is the Gaussian copula alive and well, the regulators do not seem to feel any sense of urgency in changing this state of affairs.

Posted at 22:26 on Sat, 09 Jul 2011     View/Post Comments (3)     permanent link

Thu, 07 Jul 2011

The political economy of selling gold reserves

For those of us in India who lived through the economic crisis of 1991, one of the images seared into our memory is that of the plane taking off from Mumbai to London filled with gold to be pledged for an emergency loan. This helped create a broad consensus among politicians and bureaucrats to do whatever it takes to solve the crisis and bring back the gold. Almost two decades later, that episode still influences the thinking of policymakers. I believe that it played some role in the government's decision last year to buy some gold in the IMF gold auction.

Similarly, one of the enduring images of the Asian crisis of 1997 is that of Korean citizens depositing their gold with the government so that the country could pledge this gold for badly needed loans. The Korean people took ownership of the problem and became determined to overcome the crisis.

I was reminded of all this when I read an article in Time (originally published in Die Welt) pointing out that both Greece and Portugal are sitting on billions of dollars of gold reserves even while they are being bailed out by the EU and the IMF.

It appears to me that when countries receive help before they have exhausted their own resources, the moral hazard is exacerbated. Moreover, commitment to painful reforms is likely to be very weak. During the Asian crisis, the IMF was accused of being too harsh. The reality is that while the IMF medicine was bitter (in a few cases, unnecessarily so), it was successful in creating dynamic economies that could put the crisis behind them.

Responding to the criticism that it was subjected to after the Asian crisis, the IMF seems to have turned from a purveyor of bitter medicine to a dispenser of sugar coated placebos. The EU is even less willing to take any harsh action. This is most unfortunate, and I believe years from now, peripheral Europe would wish that they had a sterner taskmaster.

Posted at 13:07 on Thu, 07 Jul 2011     View/Post Comments (4)     permanent link

Tue, 28 Jun 2011

Banking index option spreads during the crisis

Kelly, Lustig and Nieuwerburgh have written an NBER Working Paper (Bryan T. Kelly, Hanno Lustig, Stijn Van Nieuwerburgh, “Too-Systemic-To-Fail: What Option Markets Imply About Sector-wide Government Guarantees”, NBER Working Paper No. 17149, June 2011) explaining banking index option spreads during the global financial crisis in terms of the effect of sector-wide government guarantees:

Investors in option markets price in a collective government bailout guarantee in the financial sector, which puts a floor on the equity value of the financial sector as a whole, but not on the value of the individual firms. The guarantee makes put options on the financial sector index cheap relative to put options on its member banks. The basket-index put spread rises fourfold from 0.8 cents per dollar insured before the financial crisis to 3.8 cents during the crisis for deep out-of-the-money options. The spread peaks at 12.5 cents per dollar, or 70% of the value of the index put. The rise in the put spread cannot be attributed to an increase in idiosyncratic risk because the correlation of stock returns increased during the crisis.

I am not convinced about this because the “No more Lehmans” policy implied a guarantee on individual firms and not merely on the sector as a whole. I propose an alternative explanation for the counter intuitive movement of the index spread based on the idea that the market knew the approximate scale of subprime losses but did not know which banks would take those losses. What securitization had done was to spread the risk across the whole world and nobody knew where the risk had ultimately come to rest. However, the total amount of the toxic securities could be estimated and the ABX index provided a market price for what the average losses would be on these securities. In the macabre language that was popular then, the market knew how many murders had taken place, but did not know where the bodies were buried. The interesting implication of this model is that when a “body” (large loss) turns up in one place (bank X), that immediately reduces the chance that a “body” would turn up elsewhere (bank Y) because there were only a fixed number of “bodies” to discover. The fact that bank X has a huge loss reduces the losses that other banks are likely to suffer because the total scale of losses is known.

A simple numerical example using the Black Scholes model would illustrate the application of this idea to the basket-index put spread. I consider a banking sector with only two stocks A and B each of which is trading at 100. Assuming equal number of shares outstanding, the index is also 100. Consider a put option with a strike of 85 with a volatility of 20% and for simplicity an interest rate of 0 (we are in a ZIRP world!). The put option on each of the two stocks is priced at 2.16 by the Black Scholes formula. Since the two stocks are identical the price of a basket of options (half an option each on each of the two stocks) is also 2.16. To value the index put at the same strike, assume that the correlation between the two stocks is 0.50. The standard formula for the variance of a sum implies an index volatility of 17.32% and using a lognormal approximation and the Black Scholes model, the index option is priced at 1.49. The basket-index put spread is 2.16 - 1.49 = 0.67.

Consider now the crisis situation and assume that the correlation rises to 0.60 but nothing else changes. The stock option prices are unchanged, but the higher correlation raises the index volatility to 17.89% and the index put is now worth 1.63. The basket-index put spread declines to 0.53. During the crisis the actual data shows that the spread rose instead of declining as correlations rose. This is the puzzle that Kelly et al are trying to solve.

I now solve the same puzzle using the “where are the bodies buried” model. In this framework, the simple Black Scholes diffusion is supplemented by a jump risk representing the risk that a “body” would be discovered in one of the banks. Assume for simplicity that there is only “body” to be discovered and that the discovery of that “body” would reduce the value of the affected stock by 25%. As far as the index is concerned, there is no uncertainty at all. One of the stocks goes to 75 and the other remains at 100 (though we do not know which stock would be at which price) and so the index drops to 0.50 x 75 + 0.50 x 100 = 87.50. Assuming the same correlation (0.6) and volatility as before the index put option price rises from 1.63 to 4.98 because the put option is now much closer to the money.

As far as either of the two stocks is concerned, the position is more complicated. There is a 50% chance that a “body” turns up at that bank in which case the stock would trade at 75; there is also a 50% chance that there is no “body” in that bank in which case its stock should trade at 100. Let us make the reasonable assumption that the 50% objective probability is also the risk neutral probability. Before we know where the “body” is buried, the stock price of either bank would be 0.50 x 75 + 0.50 x 100 = 87.50. Note the interesting negative dependence in the tail, if a “body” is discovered in one bank, its price would fall from 87.50 to 75, but the price of the other bank would rise from 87.50 to 100.00 because it is now clear that there is no “body” there.

Option valuation in this situation can no longer use Black Scholes because of the jump risk. Adapting the basic idea of the Merton jump model, we can value this put as follows. If the stock price jumps to 100, the Black Scholes put option price would be 2.16 as computed earlier. But if the price jumps to 75, the Black Scholes put price rises dramatically to 12.58 (the put is now actually in the money). Since the risk neutral probabilities of these two events are 50%, the value of the stock option (before we know where the “body” is buried) is 0.50 x 2.61 + 0.50 x 12.58 = 7.37. The basket-index put spread is now 7.37 - 4.98 = 2.39.

The “where are the bodies buried” model produces a rise in the basket-index put spread from 0.67 to 2.39 without any government guarantees at all. At the same time, the basket-index call option spread shows very little change – this is what Kelly et al found in the actual data as well.

We can elaborate and complicate this basic model in many ways. Of course, there can be more than two banks, they may be of different sizes, there may be more than one “body” to be discovered, the number of “bodies” may be uncertain, the effect of a “body” on the stock price may also be uncertain (random jump size). None of this would change the essential feature of the model – a negative tail dependence between the various bank stock prices.

The key purpose of the model is to demonstrate the pitfalls of using correlation to measure dependence relationships when it comes to tail risk. The dependence in the middle of the distribution (the diffusion process) can be large, positive and rising while the dependence in the left tail is becoming sharply negative. This is the phenomenon that Kelly et al seem to be ignoring completely.

Posted at 19:32 on Tue, 28 Jun 2011     View/Post Comments (5)     permanent link

Fri, 24 Jun 2011

Sending internet banking passwords by mail

I have observed banks in India use several different ways to send internet banking passwords to their customers, but from a security point of view all these methods are totally unsatisfactory:

• Some banks send the username and password in two separate envelopes by ordinary mail usually with a time gap of a couple of days. The mailer is so designed that the password cannot be read (at least by the naked eye) without tearing it open. The only security here is that even if one of the envelopes is stolen or tampered with, the account is not compromised. Customers love this method because it is the most hassle free and simple mechanism. Banks like this because it allows them to centralize password issuance at a central location where it is easier to control operational risk. Moreover, because of centralization, it is possible to generate and print passwords only as needed. Since printed passwords do not have to be stored for long periods, the risk of their being compromised by insiders is reduced. However, this method of password dissemination also poses the biggest security risk at the customer end. Any person staying in the same house has the opportunity to take possession of both the username and the password; the account is then completely compromised.
• A less common variant of the above method is one where the bank requires the customer to send a signed acknowledgement of having received the password before activating the internet banking facility. This is a powerful security measure, but to make the process more convenient, these banks typically allow the acknowledgement to be sent by fax or email (scanned image). This makes the method useless because it is quite trivial to scan a signature from some other document and superimpose it on the scanned image of the acknowledgement form.
• Some banks (particularly public sector banks) require the customer to come to the bank in person to collect the username and password. Customers (especially the younger generation to whom a bank means an ATM and not a branch) hate this because they are today accustomed to getting everything sitting at home. The direct security risk is low in this method, but there are severe operational risks. Thousands of envelopes containing usernames and passwords are stored for long periods of time in hundreds of branches across the country. If even one pair (of usernames and passwords) is compromised, a rogue employee might be able to arrange matters in such a way as to assign this pair to a vulnerable account (an account with a large balance that is monitored infrequently). Moreover general bank staff in the branches are not particularly sensitive to password security. Sharing of password between different staff members is quite rampant in many branches and there is often a culture of not taking security precautions seriously. Some bank staff are themselves not aware of the nuances of internet banking and often give wrong instructions to customers. All of these increase security risks.

Many people think that these security risks are trivial and unavoidable. Subconsciously, they think that the bank must anyway store the password somewhere to verify the password that the user types in. But this is wrong. Computers never store user passwords at all – at least they are not supposed to do so. What is stored is a secure cryptographic hash of the password from which the password cannot be recovered with any reasonable amount of computational effort. When a user tries to log in, what happens is that the computer applies the same secure cryptographic hash to the password that the user typed in. If this hash matches the stored password hash, the computer accepts the password as correct and carefully erases (from its own memory) the password that it just read in from the user. Good software programmers are so paranoid about this that before they read the password that a user is typing in, they take care to lock the memory location into RAM (for example, by using mlock in unix) so that during the few milliseconds that the plain text password exists in the computer’s memory, this password is not accidentally written to the hard disk when the operating system manages its virtual memory.

Looking at things with this background, it appears to me that any system in which a password exists in plain text printed form even for a few minutes (let alone several days) is an unacceptable and intolerable level of security risk.

There is also a very simple solution to the problem. The most secure way of sending a password to the customer is not to send the password at all! This requires that the bank should not generate the password in the first place. If the user generates the password, then there is no need to send the password to him at all. This thought occurred to me when I was examining the process of applying for a PAN number online (A similar process is used for online filing of income tax returns also.). This process addresses the same problem that the bank faces – a PAN number cannot be allotted without receiving signed documents in physical form:

1. The applicant fills the form online and submits the form.
2. The system displays an acknowledgement which contains a unique 15-digit acknowledgement number.
3. The applicant prints the acknowledgement, affixes the photograph, signs it, attaches relevant documents and mails it to the PAN Service Unit.
4. At the PAN Service Unit, the 15-digit acknowledgement number provides the link between the physical records and the online application to enable processing of the application.

This process can be adapted to the internet banking password problem as follows. The customer applies for internet banking online and chooses a password. As usual, the system stores a a secure cryptographic hash of the password but does not enable the online banking facility at this stage. The system generates an acknowledgement number and lets the customer print out an application form which includes this acknowledgement number. The customer mails this form duly signed to the bank. After the bank verifies the signature and other documents, it simply enables the password that the user has already generated. At all times, this password is known only to the user; neither does the bank records this password on paper nor does it store the password electronically in plain text.

Posted at 14:23 on Fri, 24 Jun 2011     View/Post Comments (10)     permanent link

Tue, 14 Jun 2011

Cryptic RBI announcement on banknote numbering

The Reserve Bank of India issued a cryptic press release yesterday saying:

With a view to enhancing operational efficiency and cost effectiveness in banknote printing at banknote presses, it has been decided to issue, to begin with, fresh banknotes of Rs 500 denomination in packets, which may not necessarily all be sequentially numbered. This is consistent with international best practices. Packets of Banknotes in non-sequential number will, as usual, have 100 notes. The bands of the packets containing the banknotes in non-sequential number will clearly be superscribed with the legend, “The packet contains 100 notes not numbered sequentially.”

The confusion comes from the three phrases “enhancing operational efficiency and cost effectiveness in banknote printing”, “to begin with”, and “international best practices” each of which gives a different idea of what this is all about. My very limited understanding of the subject is that there are three reasons for non sequential numbering of currency notes:

1. The most important and best known is the checksum or security reason seen principally in euro banknotes. The euro banknote contains a checksum and therefore every packet of freshly printed notes is non sequentially numbered – ignoring the factors below, consecutive notes in a packet are nine numbers apart: Z10708476264 would be followed by Z10708476273. This would truly be consistent with “international best practices”, but this can be ruled out because the press release clearly says that only some packets will have non sequential numbers.
2. The second is the replacement note reason which arises when there are defects while printing a sheet of notes. The defective note is removed and is replaced with a replacement note which usually has a different number in a totally separate replacement note series (for example, star series in India). This is ruled out because it would not be consistent with the phrase “to begin with”. Star series notes were introduced in India five years ago. The annual policy statement for 2006-07 stated:

   Currently, all fresh banknote packets issued by the Reserve Bank contain one hundred serially numbered banknotes. In a serially numbered packet, banknotes with any defect detected at the printing stage are replaced at the presses by banknotes carrying the same number in order to maintain the sequence. As part of the Reserve Bank’s ongoing efforts to benchmark its procedures against international best practices, as also for greater efficiency and cost effectiveness, it is proposed to adopt the STAR series numbering system for replacement of defectively printed banknotes. A ‘star series’ banknote will have an additional character, viz., a star symbol * in the number panel and will be similar in every other respect to a normal bank note and would be legal tender. Any new note packet carrying a star series note will have a band on which it will be indicated that the packet contains a star note(s). The packet will contain one hundred notes, though not in serial order. To begin with, star series notes would be issued in lower denominations, i.e., Rs.10, Rs.20 and Rs.50 in the Mahatma Gandhi series. Wide publicity through issue of press advertisements is being undertaken and banks are urged to keep their branches well informed so as to guide their customers.

3. The third reason that I am aware of is the column sort. This too arises from defective sheets. The defective sheets are first cut into columns and the “good” columns are cut into notes and packed into bundles which will not be sequentially numbered because of the missing “bad” columns. It does enhance “operational efficiency and cost effectiveness in banknote printing”. It is of course internationally common simply because DeLaRue uses it, and they print notes for many countries around the world. But in light of the developments last year, DeLaRue is not exactly a paragon of “international best practices”.

So what exactly does the RBI mean in its cryptic press release? I fail to see the need for “constructive ambiguity” when it comes to the numbering of banknotes. Any comments that would clarify my understanding of this would be welcome.

Posted at 16:16 on Tue, 14 Jun 2011     View/Post Comments (1)     permanent link

Mon, 13 Jun 2011

Levin-Coburn Report and Goldman Risk Management

The Levin-Coburn report (prepared by the staff of the US Senate Permanent Subcommittee on Investigations) came out while I was on vacation and I finished reading it (nearly 650 pages) only now. In the meantime, the findings of the report have been discussed and analyzed extensively in the press and in the blogs. I will therefore focus on what the report tells us about risk management in a large well run investment bank.

Even as the crisis unfolded, we knew that Goldman was among the few firms that sold and hedged their mortgage portfolio and limited their losses. The Levin-Coburn report gives us a ringside view of how this process actually works. Of course, it is ugly, but it is also fascinating. Three examples stand out:

• Even before one starts selling off problematic assets or hedging them, the first step would obviously be to shut down the purchase of more such assets. In reality, this is very difficult to do. When Goldman is half way through putting together a pool of assets to be put into a CDO, it has two choices – (a) it can abort the process and try and sell the underlying mortgages or securities, or (b) it can complete the pool and sell the CDO (securities). Which works better for Goldman depends on how quickly the situation is expected to deteriorate as well as the comparative liquidity and depth of the two markets. The report (pages 535-36) describes a decision taken late night on a Saturday to choose alternative (a) for the Anderson CDO, but this is reversed and alternative (b) is finally chosen. There is also an interesting discussion about the mark to market/model accounting under the two alternatives.
• A tail risk hedge has very little VaR (value at risk) until the tail risk materializes; at this point when it becomes profitable, it also becomes highly risky. For example, the report (page 419-24) describes Goldman’s $9 billion short position in AAA rated tranche of an ABX index. When the short was put on, the index was trading close to par and the volatility was negligible. The tail risk if the index were to rise even further was also small – $80 million if the tranche traded at zero spread to Treasuries. The VaR was so small that nobody bothered too much about it even while monitoring the VaR of the mortgage portfolio very closely. But in mid 2007 as the index started falling, the highly profitable short position also became increasingly risky and began contributing a large VaR. Goldman had to unwind this profitable trade to bring down the VaR. This illustrates the power of the mark to market framework – since past profits are already embedded in the carrying value of the assets, any reversal in market direction shows up as a loss for the day and not as a reduction of past profits.
• When you analyze a portfolio of short and long positions in closely related assets some of which (say on the long side) are highly illiquid while some others (say on the short side) are reasonably liquid, it is awfully difficult to measure the risk of the position. It is even more difficult to decide the optimal amount of the short position (hedge). Reading the report, one finds that Goldman did a tolerable job of this in a very turbulent environment only by cutting across organizational boundaries (vertically and horizontally) and involving top management in what would under normal conditions be regarded as operational decisions.

In short, implementing a risk mitigation strategy was extremely hard even though (a) Goldman had the right view on the market, and (b) it was willing to place its self interest far above that of its “customers” in executing its desired trades.

Finally, anybody who thinks that investment banks like Goldman would give them a fair deal should read the gory details of how Goldman dumped toxic securities (Hudson, Anderson and Timberwolf) on investors around the world to protect/further its own interests. There have been many press reports about these shady deals, but the wealth of detail in the report (page 517-560) is much more than what I have seen elsewhere. The Abacus deal which led to the record $550 million settlement with the SEC appears much less sinister in comparison.

Posted at 17:40 on Mon, 13 Jun 2011     View/Post Comments (1)     permanent link

Sat, 04 Jun 2011

RBI Report on Financial Holding Companies

I participated in a panel discussion on CNBC-TV18 about the recent report of an RBI Working Group on Financial Holding Companies (FHCs). The transcript and video are available at the CNBC-TV18 web site. I made four points:

1. The global financial crisis has shown that we need a funeral plan for our largest financial conglomerates. The FHC model makes it easier to deal with the failure of a part of a conglomerate. The failing subsidiary can be wound up leaving the rest of the conglomerate intact. In the current model, the failing business unit may own other healthy business and they all go down if the parent unit is resolved.
2. It is natural that a report by the Reserve Bank would recommend that the FHC should be regulated by the RBI in line with the central bank’s mandate regarding financial stability. I am sure there will be a lot of debate on that. It is perfectly possible that this could move up to the financial stability development council or something like that. The competencies required to regulate FHCs probably does not exist in the Indian regulatory space today, and if we are going to build those capabilities, then it it probably make sense to create them in a regulatory collegium like the FSDC.
3. A big advantage of the FHC model does is that the FHC does not have any operations on its own – it does nothing other than own share in each of the operating subsidiaries. Each operating subsidiary can be independently regulated by its own sectoral regulator. The only thing that you need to do at the FHC is consolidated prudential supervision of the conglomerate. That is a lot easier to do than consolidated supervision of an entity, which is also an operating financial company.
4. Businesses houses that set up banks should be subject to the FHC regime. If a manufacturing company chooses to own a bank or a systemically important insurance company or asset manager then the financial regulators have interest in the solvency and in the governance of the parent manufacturing company itself. The regulation of the corporate holding company will essentially be in terms of how much leverage it can have and in terms of what are the minimum governance standards. If a manufacturing company does not like that then it should not get into the financial sector.

Posted at 17:36 on Sat, 04 Jun 2011     View/Post Comments (0)     permanent link

Wed, 01 Jun 2011

When is an algorithm not an algorithm?

An algorithmic description becomes a mere description and not an algorithm when you ask the US SEC and CFTC to interpret the term. Section 719(b) of the Dodd-Frank Act mandated a study on algorithmic description of derivative contracts in the following terms:

The Securities and Exchange Commission and the Commodity Futures Trading Commission shall conduct a joint study of the feasibility of requiring the derivatives industry to adopt standardized computer-readable algorithmic descriptions which may be used to describe complex and standardized financial derivatives.

The algorithmic descriptions defined in the study shall be designed to facilitate computerized analysis of individual derivative contracts and to calculate net exposures to complex derivatives. The algorithmic descriptions shall be optimized for simultaneous use by— (A) commercial users and traders of derivatives; (B) derivative clearing houses, exchanges and electronic trading platforms; (C) trade repositories and regulator investigations of market activities; and (D) systemic risk regulators.

When the SEC and CFTC published their joint study in April, they redefined the mandate of the study completely as follows:

Section 719(b) of the Dodd-Frank Act requires that the Commissions consider “algorithmic descriptions” of derivatives for the purposes of calculating “net exposures.” An algorithm is a step-by-step procedure for solving a problem, especially by a computer, which frequently involves repetition of an operation. Algorithmic descriptions, therefore, would refer to a computer representation of derivatives contracts that is precise and standardized, allowing for calculations of net exposures. While it is conceivable to represent derivatives as algorithms – by reflecting the steps necessary to calculate net exposures and other analysis as computer code – such an approach would be very difficult given the divergence of assumptions and complex modeling needed to calculate net exposures. Accordingly, the staff have interpreted “algorithmic descriptions” to mean the representation of the material terms of derivatives in a computer language that is capable of being interpreted by a computer program.

This is truly astounding. The Commissions clearly understood that they were flagrantly violating the express provisions of the law. They are brazenly telling the lawmakers that they will do not what the law asks them to do, but what they find it convenient to do. If only the entities that the SEC regulates could do the same thing! Imagine the SEC telling companies that they need shareholder approval for certain matters, and the companies brazenly saying that since calling shareholder meetings is very difficult, we will “interpret” shareholder approval to mean board approval. What the two commissions have done is no less absurd than this.

The Dodd-Frank Act explicitly states “The study shall be limited to ... derivative contract descriptions and will not contemplate disclosure of proprietary valuation models.” This is important because for many complex derivatives, there are no good valuation algorithms. Dodd-Frank is not bothered about valuation, it is talking about the payoffs of the derivatives. I do not understand what is so difficult about describing derivative payoffs algorithmically. The Church Turing thesis states (loosely speaking) that everything that is at all computable is computable using a computer algorithm (Turing machine). Since derivative payoffs are clearly computable, algorithmic descriptions are clearly possible.

A year ago, I blogged about an SEC proposal to require algorithmic description for complex asset backed securities:

We are proposing to require that most ABS issuers file a computer program that gives effect to the flow of funds, or “waterfall,” provisions of the transaction. We are proposing that the computer program be filed on EDGAR in the form of downloadable source code in Python. ... (page 205)

Under the proposed requirement, the filed source code, when downloaded and run by an investor, must provide the user with the ability to programmatically input the user’s own assumptions regarding the future performance and cash flows from the pool assets, including but not limited to assumptions about future interest rates, default rates, prepayment speeds, loss-given-default rates, and any other necessary assumptions ... (page 210)

The waterfall computer program must also allow the use of the proposed asset-level data file that will be filed at the time of the offering and on a periodic basis thereafter. (page 211)

The joint study does not reference this proposal at all. Nor does it give any clear rationale for dropping the algorithmic requirement. Interestingly, last week, the Economist described a typo in a prospectus that could cost $45 million:

On February 11th Goldman issued four warrants tied to Japan’s Nikkei index which were described in three separate filings amounting to several hundred pages. Buried in the instructions to determine the settlement price was a formula that read “(Closing Level – Strike Level) x Index Currency Amount x Exchange Rate”. It is Goldman’s contention that rather than multiplying the currency amount by the exchange rate, it should have divided by the exchange rate. Oops.

It is exactly to prevent situations like this that algorithmic descriptions are needed. By running a test suite on each such description, errors can be spotted before the documentation is finalized. Clearly, the financial services industry does not like this kind of transparency and the regulators are so completely captured by the industry that they will openly flout the law to protect the regulatees.

Posted at 21:31 on Wed, 01 Jun 2011     View/Post Comments (5)     permanent link

Fri, 01 Apr 2011

Am on vacation

I am on vacation during most of April and May 2011. There will be no posts during this period. I shall try to moderate comments during this period, but there are bound to be delays.

Posted at 12:31 on Fri, 01 Apr 2011     View/Post Comments (3)     permanent link

Wed, 23 Mar 2011

Finance teaching and research after the global financial crisis

I have a paper on “Finance teaching and research after the global financial crisis” (the paper is also available here). The abstract is as follows:

Finance has come in for a great deal of criticism after the global financial crisis of 2007 and 2008. Clearly there were serious problems with finance as it was practiced in the years before the crisis. To the extent that this was only a gap between theory and practice, there is a need for finance practice to go back to its theoretical roots. But there is a need to re-examine finance theory itself.

The paper begins with an analysis of what the crisis taught us about preferences, probabilities and prices, and then goes on to discuss the implications for the models that are used in modern finance.

The paper concludes that the finance curriculum in a typical MBA programme has not kept pace with the developments in finance theories in the last decade or more. While a lot needs to change in finance teaching, finance theory also needs to change though to a lesser extent. Many ideas that are well understood within certain subfields in finance need to be better assimilated into mainstream models. For example, many concepts in market microstructure must become part of the core toolkit of finance. The paper also argues that finance theory needs to integrate insights from sociology, evolutionary biology, neurosciences, financial history and the multidisciplinary field of network theory. Above all, finance needs more sophisticated mathematical models and statistical tools.

Posted at 21:41 on Wed, 23 Mar 2011     View/Post Comments (9)     permanent link

Tue, 15 Mar 2011

BCG Report on Organizational Reform of SEC

As required by Section 967 of the Dodd-Frank Act, the SEC engaged an independent consultant (Boston Consulting Group) to examine the internal operations, structure, and the need for reform at the SEC. The BCG report released last week covers four matters: organization structure, personnel and resources, technology and resources, and relationships with self-regulatory organizations.

The strength of the report is that it focuses on SEC as an organization rather than on regulatory philosophy or politics. We have known from several sources that there are serious organizational problems at the SEC. For example, Selling America Short by former SEC official, Richard Sauer, provides an insider’s perspective of the bureaucratic hurdles facing a committed SEC official. Markopolos of Madoff fame provides an even more riveting outsider’s perspective (see my blog post of two years ago).

I therefore looked forward to the BCG report which is based on nearly six months of work and more than 425 discussions with various people inside and outside the SEC. My main complaint against the report is that BCG appears to have accepted the views of the SEC senior management uncritically. This is quite normal in consulting assignments – a consultancy firm that does not align itself with the perspective of the client is unlikely to have many clients. In this case, however, it is not clear that the SEC is the client; arguably, the client is the US Congress if not the people of the US.

Consider for example, the excellent work that BCG has done in putting together Exhibit 4.1.1 on page 49. Essentially, BCG says that the SEC has too many layers and that many experienced and highly qualified professionals sit in the lower layers (layers six through eight of the organization. Equally disturbing is the finding (page 210-11) on the level of engagement of the workforce (the degree to which employees feel a bond to the organization and are motivated to give their best). Using data from a survey conducted by the US Government as well as their own data, BCG finds that SEC’s level of engagement is low compared to other private and public sector organizations.

If one combines this analysis with the insights from Markopolos and Sauer, the natural remedy is clearly a brutal delayering of the SEC that prunes out a lot of the dead wood at the upper managerial layers of the SEC and empowers the professionals who actually do the work. Unfortunately, a management consultant’s loyalties are to the senior managers and not to the professionals in layer eight.

The key conclusion of the BCG report is that the SEC needs a bigger budget and less interference from the Congress and the Government. The SEC Chairman of course welcomed the report enthusiastically.

Posted at 17:09 on Tue, 15 Mar 2011     View/Post Comments (1)     permanent link