When the UK government loses CDs containing name, addresses, date of birth, child benefit and national insurance numbers and bank details relating to 25 million people (40% of the population), we must ask the question whether governments can be trusted with financial information on a large scale.
A comment by a reader of the Times Online underscored the gravity of the problem:
Given the large number of government employees that clearly have access to these databases, if the administration and security systems in place allow for this kind of data to be burned onto an external removable disc, then it is inevitable that such data already has been (or will be) deliberately taken and sold to identity theft fraudsters by a modestly paid, unscrupulous civil servant (it is unfortunately naive to assume everyone is honest).
This is an issue that has largely been addressed in banks and other financial institutions who have historically held our private data, and who have measures in place to prevent such extraction of confidential data.
The idea of a “momentary blunder” or accidental loss seems to miss the real risk.
It is true that the private sector is a little better at handling data, but then the US telecom operators have shown that they are more than happy to part with data to the government even when the government requests the data illegally.
In the Indian context, I am worried about the huge amount of data that is being collected under the tax information network. Moreover, as India makes hesitant moves towards electronic payment systems, there seems to be a great deal of eagerness on the part of everybody including the tax authorities to collect and preserve all the transaction data. If somebody wants to do data mining on a few petabytes of data, that is fine, but who will ensure the safety of all the data? Whom can we sue if the data is lost or stolen?
Sat, 24 Nov 2007
- The Indian market certainly needs new derivatives products. Fixed income derivatives are the largest class of derivatives in the global derivatives exchanges and these products do not exist in Indian exchanges. Interest rate risk is the single biggest risk today both for households and for businesses and there is no exchange traded mechanism to deal with these risks. This is a very big problem for households who do not even have access to the inter bank OTC market for interest rate derivatives. With the large amount of floating rate home loans that households have on the liabilities side of their balance sheet and the large amount of fixed rate tax savings instruments that they have on the assets side, there is a clear economic need for accessible hedging mechanisms for households to cope with the huge interest rate risk that they are carrying. Similarly, with the $200,000 window for investments outside India, households will have a growing currency risk on their investment portfolio and there is a clear need for exchange traded hedging mechanisms. The existing OTC market provides risk management tools to business and denies them to households and this situation cannot be allowed to continue.
- The time has come for the regulator to move away from micro managing the design of specific derivative products and establish broad principles instead. Any product which meets minimum standards in terms of economic need and safeguards against market manipulation should be permitted. Competition in the marketplace should decide which products succeed and which fail. Regulators should stop pretending that they are wiser than the Markets.
Sun, 18 Nov 2007
The flurry of comments and discussion that followed Mervyn King’s interview to the BBC on November 6, 2007 have led me to the conclusion that the true lessons from Northern Rock are largely about deposit insurance and not about bank supervision.
Mervyn King’s interview about the handling of Northern Rock prompted a series of comments last week in the Financial Times by Philip Stevens, Willem Buiter and Martin Wolf. This has prompted me to revisit Northern Rock which I blogged about last month here and here. I am even more convinced than before that the Northern Rock episode does not reveal fundamental flaws with the model of unified regulation and separation of monetary policy from bank supervision. I also think that King’s decision to provide liquidity only at penal rates and against top class collateral was quite correct. Mervyn King said in his interview:
If you look at what the European Central Bank lent to banks through their auctions that they conducted, relative to the size of the banking system they lent an average of 230 million pounds per bank participating in their auctions. Northern Rock needed something closer to 25 billion, 100 times larger than the average amount which the European Central Bank was lending to banks through their auctions. The scale of the funding that was needed was staggeringly large.
So could we have had an auction that was sufficiently large that all the banks would have got 20 to 30 billion and Northern Rock wouldn’t have been noticed in that process? Well, that would have been an auction on a scale 50 odd times that which any other Central Bank had engaged in. And I’m absolutely convinced that the first question you would have asked on that day is: “What on earth must have happened to the entire British banking system to have merited an auction of that size?” We were doing this not to bail out the British banking system, which didn’t need bailing out, but actually to get money into one institution that needed it.
In my view, the lessons from Northern Rock are:
- In the age of television, even a small bank with retail deposits is systemically important. When television starts relaying images of depositor panic, there is a risk that investors worldwide are going to think that there is a problem with the entire banking system of the country in question. This means that the only politically feasible solution is to regard almost all retail deposits as de facto insured. The only question is whether the deposit insurance is ex ante or ex post. The realistic solution is a ceiling for deposit insurance approximately equal to the level of financial wealth at which financial regulators stop worrying about investor protection and treat the individual investor on par with institutional investors. In most developed countries, this would imply that the ceiling would have to be in the range of 1 to 5 million US dollars. To be non distortionary, such a large deposit insurance would not only have to be risk based but would also have to be funded by a tax on all bank deposits. The point is that the negative externality of banking is so large that it needs to be addressed with a large tax.
- There is a problem when a bank with some retail deposits has disproportionately large wholesale liabilities. Since wholesale lenders usually recognize a problem sooner than either retail lenders or regulators, uninsured wholesale liabilities are effectively senior to insured retail deposits. Thus wholesale lenders obtain the advantage of deposit insurance without paying for it. Therefore, regulators need to see liquidity management not as a problem for bank management, but as the primary mechanism by which uninsured wholesale lenders are prevented from free-riding on the deposit insurance provided to retail depositors. One way to make this happen is to make deposit insurance prohibitively expensive when wholesale liabilities become disproportionately large. This would have shut down Northern Rock long ago or forced it to become a pure wholesale operation. Either way, the problem would have been avoided.
Wed, 14 Nov 2007
I wrote an article in the Business Standard today arguing for the creation of an OTC equity derivative market in India.
I made the following points
- Competition between Over the Counter (OTC) markets and exchanges forces each market to lower costs and to adopt the best practices of the the other market.
- Standardized and highly liquid contracts are best traded in organized exchanges because of the enhanced transparency and lower systemic risk. However new contracts are often best incubated in OTC markets until they achieve a critical mass of liquidity and widespread participation at which point they can be moved to the exchange traded format. Long dated equity options are today best incubated in OTC markets.
- Exchanges should be allowed to introduce flexible options where market participants can choose parameters such as exercise prices, expiration date and type of expiration (American or European style) provided they trade the contracts in large blocks (say $10 million notional value). These flexible options are listed, margined and cleared like the standard options and therefore combine the flexibility of OTC options with the transparency and low systemic risk of exchange traded options.
- The Participatory Note (PN) or Offshore Derivative Instruments (ODI) market which the Foreign Institutional Investors (FIIs) have created outside India is essentially an OTC market in Indian equity derivatives. Indian regulations have driven this important market outside India and the result is a loss of liquidity for Indian markets, a loss of income for Indian financial services firms and a loss of access to OTC derivative markets for Indian securities and investment firms.
- To bring the PN/ODI market back to India, we need to do two
- The Securities Contract Regulation Act should be amended quickly to allow OTC equity derivatives in India. (Flexible options are a short term measure that avoids this statutory amendment).
- We must also establish a tax system for portfolio investment similar to that of the United States. The US does not tax “Portfolio Interest” income, capital gains on securities and income from derivative transactions (“Notional Principal Contract” income) earned by foreign investors. For too long, India has used the Mauritius double taxation agreement as an excuse for not doing something similar, but the Mauritius solution works only for investment in equities and not for investment through derivatives. The time has come to take Mauritius out of the loop altogether.
Tue, 13 Nov 2007
Earlier this year, I blogged about the problems created by the quiet period during public offerings of shares in the United States. The Lex column on “Quiet Periods” in the Financial Times yesterday raises the same issues and refers to the Blackstone example that I mentioned in my blog posting. Lex concludes by saying that the US Securities and Exchange Commission (SEC) should put the “onus on companies to talk rather than hide”. This is a very elegant way of putting it. Regulations must always impose a duty to disclose rather than a duty to keep quiet.