Bankers and their Bonuses*

A very interesting article.

We analyse the role of financial sector workers in the huge rise of the share of earnings going
to those at the very top of the pay distribution in the UK. Rising bankers’ bonuses accounted
for two-thirds of the increase in the share of the top 1% after 1999. Surprisingly, bankers’
share of earnings showed no decline between the peak of the financial boom in 2007 and
2011, three years after the global crisis began. Nor did bankers’ relative employment position
deteriorate over this period. We discuss proposed policy responses such as transparency,
bonus “clawbacks”, numerical bonus targets and tax.

Bankers seem to be doing very well out of the crisis. And this was a well argued paper. For example: I quote:

In terms of policy, we begin by considering whether there is really any “problem” to be
addressed. If bankers are paid in a competitive labour market and simply rewarded for their
talent, there seems little reason for government intervention, at least on efficiency grounds.
However there seems to be substantial evidence of rents within the sector – a result of
imperfect competition or arising from the implicit and explicit guarantees and subsidies that
the sector receives from the government due to the “too big to fail” problem. We discuss
various policy options that seek to either remove the basis for these rents or to tax them ex
post. Finally, we note that on equity grounds, policy may seek to reduce the post-tax income
taken by those in the upper echelons of the income distribution – which implicitly targets
bankers given their prominence among high-earning workers. This has primarily taken the
form of higher marginal tax rates.

The authors argue that regulators are unable to remove the rental issue. Which is a curious argument to make but then in the absence of a truly global government with one currency, this issue will keep on happening as national regulators will keep on making suboptimal decisions based upon large banks presence in multi country jurisdictions. We have been here before, remember the Dutch and East India companies? They were also too big to fail. So I suspect and concur with the authors that the result will be to increase the marginal tax rates on the top earners. This can have unforeseen implications.

See for example what happened in France. Here’s one example:

Over 8,000 French households paid taxes topping 100% of their incomes, according to French Finance Ministry data. See Taxes on Some Wealthy French Top 100% of Income. You may scratch your head in disbelief. How is that possible?

Stateside, you might guess it was the alternative minimum tax. In France, it was a one-time 2011 levy on incomes for households with assets over 1.3 million euros ($1.67 million). 8,000 families paying 100% may seem a small number, but nearly 12,000 households paid more than 75%. The percentages sure do grate.

Or this:

Hollande's 75% supertax on the mega-rich is at the centre of another row after French football clubs said they would cancel all matches scheduled for the final weekend in November to protest at the levy.

The symbolic tax – a 75% tax on income exceeding €1m (£850,000)a year – has caused a headache for the Socialist government since it wasthrown out as unconstitutional by France's top court. To avoid the embarrassment of a major policy U-turn, ministers redrafted the tax earlier this year to shift the burden from individuals to employers – a legislative shimmy that has spooked football clubs, which famously pay vast salaries even to bit-part players.

Clubs say they are already under financial pressures and that the tax would spark an exodus of top players to rival leagues abroad, killing the domestic game. In spite of a poll showing that 85% of French people are in favour of the tax being applied to football clubs, the clubs decided to step up their protests.

this promises to be fun. Much more ink and excited electrons will flow below the bridge before this is settled.

How to Save American Finance from Itself

In a previous email Kannu, I told you that we are living in a complicated world which is getting even more complicated. The grand poobahs recognise this. Instead of simplifying they decide to add to complexity by adding giant rafts of regulation. Adding much more complexity. And that's just now. 

Here's an economics Nobel prize winner talking about his student who is the fed chief and asking for a more complex set of instruments to manage the economies and financial markets. And taking a gratuitous swing at hedgies. 

The result? Another crash is coming. Guaranteed. Before you are 25. So what can you do? Avoid debt son. As much as possible. Have your investments in good solid sectors and companies who will keep on operating despite downturns and crashes. Have a technical skill son that will always give you a job. Or if you are running a firm, then be in one which will always have demand. Keep an eye on your cash flow. Or marry a rich girl :) 

But the article is interesting from a macroeconomics perspective. It's people like these who will be running the world when you graduate and start looking for work or are working. It takes time for macroeconomic prescriptions to work it's way through the economy and hit individuals. So decisions taken today will impact you in 3-5 years time. 

I studied wave theory once. Ocean waves. The science is poorly understood even now. Which wave will just give you a ripple or give you a dunking or a great surf is difficult to know. The ocean interacts with temperature, wind, continental shelf topology, currents, gravitation, climate, seashore landscape in poorly understood ways. So what does a surfer do? Understand as much as possible. Be prepared. Take chances. 

Love

Baba. 

How to Save American Finance from Itself | New Republic
http://www.newrepublic.com/article/112679/how-save-american-finance-itself

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TODAY’S EDITION

Other stories from April 27, 2013

BOOKS APRIL 8, 2013

How to Save American Finance from Itself Has financialization gone too far?

BY ROBERT M. SOLOW

Central banking is not rocket science, but neither is it a trivial pursuit. Excellent books have continued to be written about the art and craft of central banking, from Walter Bagehot’s Lombard Street in 1873 to Alan Blinder’s Central Banking in Theory and Practice in 1998. Running a central bank is in one way a little bit like flying a plane or sailing a boat: much of the time standard responses and small adjustments will do just fine, but every so often a situation arises in which fundamental understanding, knowledge of history, and good judgment can make the difference between riding out the storm and crashing. There was no such person in charge in 1929, and the result was disaster. There was one in 2008.

In his earlier scholarly life, Ben Bernanke, the chairman of the Federal Reserve Board, had been a careful student of the general interaction between the financial system and the real economy and especially of its working out in the Great Depression of the 1930s. So he had done his homework. His decisive and innovative actions at the Fed saved our economy from free fall with a possibly catastrophic end. I once non-joked that Bernanke was the Captain Kirk of central banking: he had loaned where no man had loaned before. In a life before turning to government service, first as a member of the Federal Reserve Board, then briefly as chairman of the Council of Economic Advisers, and then returning to the Fed as chairman in 2006, Bernanke was a well-known and highly respected academic economist. (The reader should know that I was one of his teachers in graduate school at MIT, and have remained a friend.) My opinion is that, after a briefly hesitant start as Fed chairman, probably still under the considerable aura of Alan Greenspan, Bernanke rose admirably to a difficult occasion and has been generally right in his judgments and his decisions, and in his willingness and his ability to explain both.

In March 2012, George Washington University invited Bernanke to give four lectures as part of a course devoted to the role of the Federal Reserve in the economy. The lectures are now reproduced in book form, apparently from lightly edited transcripts. Each lecture ends with half a dozen questions from anonymous “students” and Bernanke’s answers. Some of the questions are smart, some less so, in which case Bernanke exhibits the professorial skill of seamlessly answering a slightly different question. We are not told anything about the audience. I imagine a lot of people wanted to hear about the Federal Reserve and the financial crisis from the chairman himself. It’s rather like hearing Admiral Nelson reminisce about the battle of Trafalgar.

The law of contradictions

What me boss said…

“As we rebuild the regulatory system we need to be wary of two traps — firstly, we should also be wary of using the phrase ‘never again’ — if we learn anything from history it is that we are destined to repeat mistakes whenever we believe that we have solved definitively the cause of the most recent crisis. Secondly, we have to avoid being over-prescriptive, as we cannot foresee every possible scenario.

These traps are seductive, pandering to the basic human desire for there to be meaning in life, for there to be some kind of order to show that fate is not capricious — ie, somehow we all get what we deserve. Indeed, it is a core objective of both political and economic systems to promote a comforting perception of predictability. Ever more today, society does not want to acknowledge unpredictability, particularly around economic outcomes — we want to believe an unwelcome outcome is the cause of failings that need both to be compensated and cause revisions to be made to the system to reinforce predictability and so restore confidence in the future.

This leads us to seek out definitive solutions to identified problems. But just because a solution is demanded of course does not mean there is a soluble problem. Many commentators would make this observation about the eurozone today. If only it were as simple as moving a toggle switch between ‘austerity’ and ‘growth’.

And there are many such conflicts challenging the restoration of growth:

· We want stability as well as growth, we promote economic growth as well as fiscal austerity;

· We want banks to lend more and also grow capital both in absolute and ratio terms;

· We want the banking system to have access to private capital at the same time as we debate the future shape and capitalization of its activities and restrain dividends;

· We want to see more competition in financial services but we don’t want to see the higher returns that would attract external private capital;

· We want to see fewer interdependencies without losing the benefits of scale;

· We continue to incent the banking system to lend ever more to governments and then agonise what happens if the same governments don’t/can’t pay;

· We want the system to respect market signals but then we don’t like what ratings agencies say;

· We want greater transparency but fret about how immediately markets react to events not yet able to be responded to a policy level;

· And finally, while we have made great strides in defining what we don’t want the system to do we have made less progress in determining what we want the system to look like when we are finished.

We continue to pose important questions which underpin many of the challenges in getting the financial system back to business as usual.

· For example; are there gaps in coverage? Shadow banking?

· Is the aggregate of all the measures both complete and in train duplicative or reinforcing? Who is responsible for ensuring this?

· Is there coherence between banking, insurance, pension fund and asset management regulation? Again whose responsibility is it to check this?

· Is there market capacity for the capital raising and funding assumptions being made?

· Does the understandable focus of national fiscal authorities towards limiting their contingent risk to domestic deposit bases risk unwinding many of the elements of globalisation of economic activity?

· If fiscal authorities don’t want the contingent risk of the banking system does anyone else and at what price?

· If a consequence is to unwind globalisation to some degree and establish a ‘home market’ bias — does this impact the availability and cost of financial services delivered to multinational groups?

· Does this change the competitive landscape between companies domiciled in Europe versus the US versus Asia? Does this matter?

· Does the public policy concern over systemically important institutions create a greater probability of stability because of their higher capital requirements and supervision or does it further concentrate activity into these institutions because of their elevated status; current experience suggests that in times of great uncertainty customers prefer the largest institutions.

· Does prospective bail-in of creditors change positively the probability of a future bank failure because of greater market led discipline or does it simply reallocate systemic losses away from the future income of society (through taxation) towards society’s current and future savings (via insurance and pension funds) — and if so have we deceived ourselves that we have achieved very much?

· And finally, is there too much focus on products, platforms, infrastructure, capital and liquidity because they can be defined and measured as opposed to focussing on behaviour which is much more difficult to pin down objectively?”

Daddy, you are more evil than I thought

This was a bit of a good post about a conversation that a Dad had with his son. Given that over the past couple of weeks, I have had similar ones with my son made this interesting.

I quote:

So, says my son asks you like nasty people to steal from poor investors, mutual funds (and he did not say pension funds for school teachers) so that you can join them in taking the loot by being a short-seller – and you don't want the regulators to do anything about it because there are more opportunities for you?
Sheepishly I confess yes.
And he says with a mixture of admiration and horror: “daddy you are more evil than I thought”.

Now there’s courage for you

Michael O’Leary, the boss of a low cost airline in Ireland says what he thinks. That its basically the state in the form of politicians and bureaucrats who are the enemies of innovation. The sheer irony that the European Commission had to setup a conference to talk about innovation. The stupidity of these morons is breath taking, which is why I don't have much hope for Europe, its currency or its future. Its a shitehole.

Guess what? He is the CEO of Ryanair, but the EU cannot pay for low cost air fares. And this is why I am paying my taxes for? WTF?

STOP SPENDING MY MONEY!

Watch the entire thing, see why these dinosaurs of the European Commission are extinct, moron and stupid. That is a good thing, but the only problem is that they will end up spending a wodge of my hard earned cash.

Another example of state going wild

First the video

1. SOMETHING must be done, why? Did regulation stop the black cabs or regulated minicabs stop the accidents? no

2. Regulation is demanded so that people can stop others popping in.

3. Note that nobody commented on the benefits of rickshaws, the low cost, convenience, etc.

4. You need ethics to drive a rickshaw? You are kidding me.

5. Where is the issue? why are people mumbling about this? The fact that I found this on the RMT union website indicates where this demand is coming from. The Union obviously want to stop competition, which is why they are upset.

6. Taxi costs in London are one of the highest in the world, see here. Guess where they are the cheapest, in Delhi, Mumbai, Cairo etc where there are alternatives to taxi’s and many have rickshaws. Bah, same old same old

Look at how British Investors are protected

Not. I feel gobsmacked. This is incredible. So many charities and bloody government departments and THIS is what they do when one determined man wants to report a suspicious dodgy website?

Show me the money and who owns it

Over the past couple of years, there has been a steadily rising crescendo of voices, initiatives, conferences and papers, all concentrating on enhancing and improving the regulatory framework around the banks so as to avoid another banking crisis. By and large, all of the initiatives and suggestions concentrate on the risk element of the bank’s portfolios. Whether they related to the portfolio being too big (too big to fail), having badly designed instruments (toxic debt and credit instruments), bad remuneration policies (the hoo haa over bonuses), separation of prop trading from deposit making (the Volker plan aka Glass Steagal v 2.0), to globally coordinated regulation to improved liquidity standards and the like. What has not been considered, at least the little bits that I have read, is the factor of bank corporate governance. Thankfully, a recent paper sheds some light on this issue.

The authors find that bank risk taking varies positively with the comparative power of shareholders within the corporate governance structure of each bank. Their sample has 279 publicly listed banks across 48 countries, so it’s pretty much a global study of the top banking firms in the world. In other words, you can pretty much take these outcomes to the bank (if you excuse the rather laboured pun) and generalise the results. The bank corporate governance is defined as relating to control rights and cash flow rights usually expressed in terms of one large shareholder having more than 10% of voting rights. If there is no single shareholder with more than 10% of voting rights, then it’s considered to be widely held. So what they find is that banks with a single large shareholder have a statistically significant greater bank risk and this is, surprisingly so, holding for all the 48 countries in the sample. No outliers at all. Policy implications are simple, regulators should also aim to get banks to diversify their shareholding, so that there is no single shareholder who manages to have banks hold greater risk than usual.

But then, there is a different angle to this. If the regulations are too onerous, then the utility value of holding a bank reduces because of increased capital requirements, and therefore existing owners can be tempted to increase risk to show greater returns. And the authors find that this behaviour is exacerbated when there is a single large shareholder in the bank. In other words, just increasing the requirement to hold more capital may not make the banking sector less risky if there are banks with large single shareholders. By how much you ask? The regression figures show that for widely held banks, for every 1 standard deviation increase in capital stringency, bank risk falls by 0.3 standard deviations, but increases by 0.1 standard deviations if the bank has a single large shareholder.

More worryingly, the authors find that capital requirements no longer have a robust direct link with banking stability and posit that this is due to the lack of attention paid to bank governance elements. Putting it in another way, it is crucial for regulators to factor in the bank governance elements in their analysis of the efficacy of proposed bank regulations. If they do not, then their attempts to reduce bank risk will be compromised at best and be ineffectual or even negative at worst.

Quite an interesting paper.

(Laeven Luc and Levine Ross, 2009, Bank Governance, regulation and risk taking, Journal of Financial Economics, 93, pp 259-275.

CFO or CEO: Who has most influence on earnings management?

Well, the previous idea was that earnings management was primarily driven by the CEO and therefore regulators around the world asked for the remuneration details of the CEO. But recently the SEC has started asking about the remuneration of the CFO as well, which in hindsight, makes perfect sense. After all, the CFO is the person who is actually managing the entire financial process which culminates in the production and propagation of the financial and earnings figures and announcement. A recent paper sheds some more light on this rather interesting and topical issue.

The authors cover the S&P 1500 firms for which CEO and CFO compensation data is available over the 1993 to 2006 period giving a total of 17542 firm years. They judge both cash pay and total pay, the latter including everything else such as option grants, incentive plans, etc. On an average, the CFO earns 1/3 of the CEO with an average equity incentive ratio of 11% for CFO’s compared to 24% for CEOs. Please bear in mind that 2002 saw the introduction of SOXA and the authors do include the impact of this on accounting treatments such as accruals management.

Prior to the introduction of SOXA, there is a positive association between the compensation of both CEO’s and CFO’s with accruals management. In other words, more the incentive, more are the accruals within the financial statements and the influence of the CFO is higher on the accruals management element compared to the CEO. The introduction of SOXA meant that active accruals management was dramatically reduced and there is no longer any relationship between the incentives to CFO and CEO and accrual management.

How about beating analyst forecasts? As you would know, analyst forecasts are extremely important in forming the market sentiments which drive how the market reacts post the earnings announcements. Similar to the above finding, the authors find that pre SOXA, CEO and CFO incentives are positively associated with the likelihood of reporting positive earnings surprises. They also find that greater the incentive, greater was the chance of an earnings surprise. In the post SOXA period, the equity incentives of the CEO is no longer positively associated with the likelihood of beating analyst forecasts. But surprisingly, the CFO is still highly influential in the likelihood of beating analyst forecasts.

The authors also some some additional tests and find:

We also find some weak evidence that earnings management incentives are strongest when the manager has compensation that is more sensitive to stock prices and the firm’s stock returns are more sensitive to accounting earnings.

In other words, the role played by the CFO is almost independent of the CEO at least in terms of accrual management, earnings management and general financial statements to the wider world. If I was a shareholder, I would peer at the CFO much more closely and if there is an element of equity incentive compensation to the CFO, then peer even more closely with a beady eye. I can see analyst models start to incorporate this as a factor. On the flip side, I am sure the CFO’s will be reading this and demanding more cash based compensation compared to stock based compensation. Not sure what the answer is, but it puts further pressure on the remuneration committee, the audit committee, the external auditors and regulators to make sure that the firms are presenting a true and fair picture of the accounts.

John(Xuefeng) Jiang,Kathy R.Petroni and Isabel Yanyan Wang, CFOs and CEOs:Who has the most influence on earnings management?, Journal of Financial
Economics, doi:10.1016/j.jfineco.2010.02.007

Interesting indeed.

Move to a free country and your firm will have lower cost of debt

Now here’s an interesting research paper which popped into my inbox. In short, the more the political rights, the more free the country, the level of property rights, free and fair elections, competitive political parties, important role played by opposition, minority group rights, a system of checks and balances across the legislature, judiciary and executive, etc, the lower are the costs of debt. To be precise, a one standard deviation in political rights is equivalent to an 18.6% decline in bond spreads. Now that is a serious chunk of change. The authors concentrate on Eurobonds and come up with the following main countries within their study: USA (799 issues), Japan (231 issues), Australia (214 issues), Germany (213 issues), and the U.K. (180 issues). India is also there which surprised me because the Indian bond market is generally anaemic but then the Eurobond market is slightly different. So what are the correlations like? Some very interesting results pop up:

 

	Log yield spread	Bond rating
Log yield spread	1
Bond rating	-0.65	1
Political rights	-0.25	0.3
SPI	0.08	-0.18
Freedom of the press	-0.31	0.37
Corruption	0.39	-0.46
Expropriation	0.33	-0.39
Creditor rights	-0.09	0.16
Log GDP/capita	-0.24	0.33
Sovereign rating	-0.34	0.42
Cross-list	0.03	0.02
Log total assets	-0.34	0.47
ROA	-0.13	0.06
Leverage	0.06	-0.05
Public	-0.46	0.48
Floating	0	0.08

Not going to go too deep into the analysis of each factor to each other and please bear in mind that correlations do not mean causality. But interesting results none the less. One can do couple of PhD's just on this :)

The researchers then do some rather complicated regression testing. One of their regressions is to analyse the joint impact of creditor rights and political rights on the bond yield spread. This is what they find out.

Pretty stunning visual results, eh? reduce the political and creditor rights and the surface starts to peak. And the gradient is pretty smooth, no lumps or bruises or troughs or peaks. The authors go about doing much more in terms of determining firm level impacts, checking cross listing implications, and other confusing things to me. So I am going to ignore them as the basic answer seems to be pretty clear. I quote 1 paragraph from their paper:

This paper examines the impact of country-level political rights on credit markets while controlling for legal institutions. Higher political rights are associated with significantly higher ratings and lower spreads for corporate bonds issued in both the Eurobond and the Yankee bond markets. A one standard deviation change in political rights is associated with an 18.6% decline in yield spreads on average; political rights impact international debt markets as much as creditor rights. We find that the interaction term between political rights and creditor rights is positively associated with yield spreads, thus, political rights and creditor rights partially act as substitutes.

We also consider the channels by which political rights impact bond markets. Freedom of the press appears to capture much of the effects of political rights, suggesting that part of the advantage of political freedom to credit markets may be due to greater information availability. Socio-political instability in the 25 years prior to the bond issue impacts the cost of debt, but does not capture the effects of political rights, suggesting that political rights are more important as a forward-looking measure of bondholder risk. Corruption and expropriation risk are also priced in bond yields; however, the effects of these variables appear to be more independent of political rights.

Now here’s the interesting take which I took away. Now that firms are becoming more and more globally footloose and capital becoming more and more aggressive, it is but natural that people will try to move these types of firms to countries which have more political rights so as to raise cheaper finance. On the other hand, think about what governments go about doing. They actually give tax benefits and a whole host of other benefits to attract FDI and capital. Here’s a silly thought. Instead of going about offering these kinds of tax breaks, why not try to improve the political rights? That will kill two birds with one stone, improve the society as well as attract firms. Neato, no?

How costly is the Sarbanes Oxley Act? Evidence on the effects of the act on corporate profitability

There is a tidal wave of regulation that is coming down the pipes from the various assorted regulators. There are 3 costs to this regulation to financial firms. The cost of implementing the change, the cost of of running the change and the opportunity cost related to the sum of the previous two costs. And believe you me, after having had about 15 years of experience of looking at regulatory change, they can mount up to a pretty penny. Seriously big pennies and I frequently doubt if this is actually making our lives better and safer. Stick to gold (just half kidding). What I also find very interesting is that these regulations are rarely followed by good costed business cases on the cost/benefits to be achieved. Its almost like an article of faith that more regulation is good. Period. No questions asked. Well, I am again not sure.

With that said, what about SOX? well, here’s a good interesting paper on it. Abstract:

The Sarbanes-Oxley Act (SOX) was intended to protect investors by improving the accuracy and reliability of corporate disclosures. However, critics have argued that the costs of SOX far outweigh its intended benefits. Prior studies based on stock-price reactions to SOX-related events document mixed evidence on the expected impact of SOX. In contrast, we provide evidence on the net realized costs of SOX by examining its impact on operating profitability. We find that average cash flows decline by 1.3 percent of total assets after SOX. These costs are more significant for smaller firms, for more complex firms, and for firms with lower growth opportunities. Annually, these costs range from $6 million for smaller firms to $39 million for larger firms. Further, we document that net SOX-related costs are not limited to one-time expenses associated with internal-control design and implementation. In aggregate, for the 1,428 firms in our sample, these costs amount to about $19 billion per year. Profitability is lower for up to four years post-SOX. To our knowledge, ours are the first estimates of the realized net costs imposed by SOX.

$19 billion per year with profits being impacted for 4 years. And no calculation of the compound nature of regulations which come from hundreds of regulators, in hundreds of markets. It is a heavy burden that society is placing on the financial institutions and I am yet to be convinced on a macro level that this is really thought through.

Bank Bosses: The law of unintended consequences

As Bloomberg reports,

Ten percent of candidates for senior management positions at Britain’s biggest financial companies withdrew their applications rather than learn whether they could pass an interview with the nation’s markets regulator.

Reynolds Porter said that some candidates drop out rather than challenge what may be an eventual FSA determination on whether someone is “fit and proper.” Appeals are public and the disclosure might damage a company’s reputation or the ability of the candidate to find another job.

“In the current environment no financial-services company would want to take the risk of being publicly accused of putting forward a supposedly sub-standard candidate,” said Jonathan Davies, a regulatory partner at Reynolds Porter. “There is a concern about just how much arm twisting the FSA is entering into to force companies into dropping their preferred job candidates.”

Now this is a pretty penny. I have further issues with this. If the FSA is actually interviewing candidates, then I am concerned about whether this is an examination driven bar? And why only for British Banks? And quite interestingly, the FSA is hiring a banker to interview other potential bankers for senior leadership positions. Look at the ranks of the FSA and you will find most if not all are also bankers. And what is the test?

The interviews test skills, behaviour, knowledge and expertise, including ethics.

I am really not sure about making all this public is a good idea. You can definitely injure a firm badly, not mentioning the personal injury to the candidate. We all know interviews are not good mechanisms for hiring people. And if I and rest of the world didn't see the damn crisis coming, how on earth will an interview tell you that I am good in managing crisis? weird or what?

An interesting analogy in the discussion about the future of financial regulation

The hills are alive – and have been for many moons now - with the ideas on how to regulate financial products. The most recent were the proposals by President Obama. On the whole they were of interest because they recognise the fragmented nature of regulation and how systemic risk is important. So in fact they do not propose to reduce the regulators, but rather to adopt the overall ‘Department of Homeland Security Model’, or if you will, create a super regulator to oversee all the hodge podge of regulators in the US. Curiously nobody is touching the Basel 2 framework (but more about that later on). The FSA is pushing for a liquidity management framework which, while being - in my opinion - conceptually and intuitively appealing, is practically a nightmare to implement and execute. The EU is also going towards the super regulator direction, but I am still not convinced that a super regulator is the answer. It all boils down to giving regulators more data and more coverage and this kind of credit crisis will not happen again. But the regulators already had all this data, coverage and people. If banks are already being labelled as "if they are too big to fail, they are too big", then why isn't the same question being asked of the regulator? If the financial world thinks that banks are too big to manage, what makes them think that a vastly bigger overarching regulator can oversee an entire group of these giant banks?

The BIS is currently going to through some serious debates about the future of regulation. In yesterday's annual report, they threw a wide net across this issue, but in particular, page 126 uses a very curious analogy which I thought was interesting enough to share.

I quote:

Balancing innovation and safety in financial instruments requires providing scope for progress while limiting the capacity of any new instrument to weaken the system as a whole. Balance can be achieved by requiring some form of product registration that limits investor access to instruments according to their degree of safety. In a scheme analogous to the hierarchy controlling the availability of pharmaceuticals, the safest securities would, like non-prescription medicines, be available for purchase by everyone; next would be financial instruments available only to those with an authorisation, like prescription drugs; another level down would be securities available in only limited amounts to pre-screened individuals and institutions, like drugs in experimental trials; and, finally, at the lowest level would be securities that are deemed illegal. A new instrument would be rated or an existing one moved to a higher category of safety only after successful tests – the analogue of clinical trials. These would combine issuance in limited quantities in the real world with simulations of how the instrument would behave under severe stress. Such a registration and certification system creates transparency and enhances safety. But, as in the case of pharmaceutical manufacturers, there must be a mechanism for holding securities issuers accountable for the quality of what they sell. This will mean that issuers bear increased responsibility for the risk assessment of their products.

Regardless of how great an analogy this is, it still opens up questions. Four major questions emerge:

1. Who will be the FDA (USA), EMEA (Europe) or MHRA (UK) to judge the safety of these "drugs"? The point is that the problem with the rating agencies is well known already. (would be good to give an example here, such as …. Etc to drive home the point)

2. Do the regulators have the capacity and capability to really judge these financial products?

3. How will the Basel 2 process be modified to cater for this as this is taking risk rating down to a seriously detailed level and will require far more standardisation than before.

4.Given that the speed of introducing new products into the financial markets is measured in terms of days for example in the OTC derivatives market, this kind of product based regulation will be equivalent to dropping a JCB full of boulders into the world financial system.

Much to think about...

The FSA shows its fangs despite global staff challenges

Finally the Financial Services Authority, the lead regulator of the United Kingdom, is starting to show its fangs. Good step but much more is required, I am afraid. I quote:

A record number of fines has been imposed by the City watchdog this year as it cracked down on consumer issues such as mortgage fraud and the mis-selling of payment protection insurance. Almost 50 penalties have been announced to date by the Financial Services Authority, more than twice as many as last year and half as much again as the previous record. Another heavy year of penalties is expected in 2009.

But this is the issue, the quality of the regulatory staff across the world is quite concerning. It is also not surprising, here's a simple bargain for you. Would you want to join a regulator when you could have been working for a bank at a higher salary? No. Here's what the head of the CBOE said about the SEC staff.

Financial illiteracy among junior staff at the US Securities and Exchange Commission made it easier for Bernard Madoff to operate his alleged $50bn fraud undetected, the head of the US’s biggest options exchange has warned.

Bill Brodsky, chief executive of the Chicago Board Options Exchange, said the scandal showed that inspector-level staff had not received enough training to enable them sufficiently to check for fraud.

“The people doing the examinations have no clue what the right questions are to ask,” he said in an interview with the Financial Times. “Going in and asking questions out of a manual doesn’t help you understand how a business works.”

Mr Brodsky said part of the problem at the SEC was that many of the staff at the regulator did not have the fundamental investment experience.

“They’re young, they very often don’t have any money and they’re not allowed to use these instruments themselves. How do they equip themselves to do a good job?

“How do you take kids out of college and get them to understand something they have no tangible connection to?”

Good questions, I am not sure if there are good answers to the regulatory conundrum but good people are required, no questions asked.

Technorati Tags: regulation,United Kingdom,USA

EU turning the screws on Iranian Bank

I have been talking about how USA is pressing down on the Iranian financial sector. You see, by choking off the flow of funds, a modern economy can be brought to its knees. And the constant American pressure is showing dividends (if you excuse the pun). I quote:

Bank Melli, Iran’s biggest commercial bank, is set to be banned from operating in the European Union under proposals in the final stages of discussion in Brussels.

And as the article quotes:

But Mr Levey said the financial sanctions, international warnings about the risk of money laundering and terror-financing in Iran, and related moves by international banks to scale down business with Tehran had had a big impact.

“It certainly has made the cost of financing [in Iran] to the extent that anyone has offered it at all, much more expensive,” he said.

Not that it will make a difference to Iran...

Technorati Tags: Iran,Sanctions,USA,Financial Institutions

German Monsters and Locusts

What is with these German ministers and financial markets? They all seem to keep on banging on about how bad the markets are, they are either locusts or they are monsters. Nice welcome there, folks, and that's the reason why several parts of the government run banking sector in Germany is in deep trouble. So what does that make the government? monstrous dung beetles? Curious, no?

Technorati Tags: Financial Institutions,Germany,Regulation

Cross-border M&As in the financial sector: Is banking different from insurance?

Well, the answer seems to be yes according to this research paper.

Dario Focarelli and Alberto Franco Pozzolo, Cross-border M&As in the financial sector: Is banking different from insurance, Journal of Banking & Finance Volume 32, Issue 1, , Dynamics of Insurance Markets: Structure, Conduct, and Performance in the 21st Century, January 2008, Pages 15-29.()Abstract: This paper investigates what factors might help explain the internationalisation strategy of banks and insurance companies, by comparing the determinants of cross-border M&As in the two sectors in a unified framework. The empirical analysis shows that between 1990 and 2003 the internationalisation of banks and insurance companies followed similar patterns. Distance and economic and cultural integration are important determinants for both the banks' and the insurance companies' expansion abroad. Comparative advantage also has a prominent role, the more so for banks. The evidence is less supportive of the view that cross-border M&As are more frequent between similar countries, as predicted by the new trade theory. Finally, and most interestingly, we find indirect evidence consistent with the hypothesis that implicit barriers to foreign entry are more important in explaining the behaviour of banks than that of insurance companies.

Technorati Tags: Financial Markets,Regulation,Financial Institutions

Foreign companies flee US bourses at record level

Remember what I said about regulation in the USA? Well, see one of the problems of that.

Read and weep!

A record 12.4% of foreign companies listed in New York have chosen to delist this year, as a committee of prominent academics and financiers endorsed by US Treasury Secretary Hank Paulson said the country's public equity market has continued to decline in competitiveness.

The number of delistings on the New York Stock Exchange has increased from 12 in 1997, 3.9% of all foreign listed companies, to 30 last year which was a rate of 6.6%, according to a new report entitled “The Competitive Position of the US Public Equity Market” by the Committee on Capital Markets Regulation.


All this to be taken with a grain of piquant salt!!!

Single EU Financial Services Regulator?

Well, in principle, I am ok with this and frankly, I would be surprised if we did not have a single EU financial regulator in say 10 years. But yes, slowly does it, financial regulations, when enacted in a rush, always throw up problems, and unfortunately at the time when you are least (politically, economically and financially) able to handle it (such as this spectacularly stupid and incompetently handled Northern Rock Crisis). But execution is KEY!

But we need to look at how MiFID has worked out, where there is flexibility, those locations have won. Many jurisdictions have no idea what they have implemented. Many financial institutions do not know what they are faced with and they are heading towards extinction if they do not change their business models. For those who think that this will not impact, see what London faced after the big bang. There are no british investment banks left but it is now a major financial centre. Similarly, most of the european countries will end up with sales offices while the production, engineering and major distribution centres will be in say Paris, London or elsewhere.

Read and resolve to fix this.

All this to be taken with a grain of piquant salt!!!

Innovation, Information, and Regulation in Financial Markets

Here is a very interesting speech on financial innovation, information and regulation. I keep on hearing about innovation these days. Whether its process innovation, technical innovation, financial innovation.... And I have to confess that I am puzzled. Because innovation for me is simply doing something better, cheaper, faster... And within the financial markets, we have been doing this since the year dot. And the current debate and discussion over innovation seems to be like it is a buzz word almost. You cannot manage innovation, it is there or it isnt there. So whenever we talk about innovation, be very specific. Are we talking device innovation? software innovation? reporting innovation? process innovation? cost innovation? relationship innovation? what?

But innovation does need to be managed as this speech says. It is long but very interesting, highly recommended to read the whole thing if you are worried about the state of financial markets.

Read and ponder.

Governor Randall S. Kroszner
At the Philadelphia Fed Policy Forum, Philadelphia, Pennsylvania
November 30, 2007
Innovation, Information, and Regulation in Financial Markets

Good afternoon. I am pleased to participate in the excellent annual Philadelphia Federal Reserve Policy Forum to discuss this year’s timely topic of innovations in financial markets. Innovations in financial markets have created a wide range of investment opportunities that allow capital to be allocated to its most productive uses and risks to be dispersed across a wide range of market participants. Yet, as we are now seeing, innovation can also create challenges if market participants face difficulties in valuing a new instrument because they realize that they do not have the information they need or if they are uncertain about the information they do have. In such situations, price discovery and liquidity in the market for those innovative products can become impaired.

In my remarks today, I would like to explore the role of information in the development of new financial products and then draw some lessons about risk management and regulation. In particular, I will examine the role that investment in information gathering, processing, and evaluating plays in supporting the price discovery process and how such investment can lead toward a tendency to greater standardization as markets for innovative financial products mature. Examples from both history and current experience will help to illustrate this tendency with respect to loan work-outs and restructurings. I will then conclude by considering how a regulatory approach that encourages transparency and sound risk management, such as Basel II, can be valuable in fostering a robust environment for the introduction of innovative financial products.

Experimentation and Learning in New Instrument Development
Typically, when a new product is being developed, there is an initial experimentation phase in which market participants learn a great deal about the product’s performance and risk characteristics. This phase involves gathering and processing information and modeling the performance of the product in various scenarios and under different market conditions. It may then take time for market participants to understand what, exactly, they need to know to value a product. During the early phases, a fair amount of due diligence is appropriate, given the greater uncertainty associated with innovative products. The investment in gathering, processing, and evaluating information then, as I will discuss, often leads to greater standardization of products and contract terms, which can enhance liquidity of products as their markets mature.

In the initial experimentation phase, the terms and characteristics of a new product are adjusted in response to market acceptance--or lack thereof. During this period, market participants are seeking and providing information so that they can properly value the product, judge its potential for risk and return, assess its market acceptance and liquidity, and determine the extent to which the risks of the product can be hedged or mitigated.

When a product’s track record is not well established, there should be a strong market demand for information in order to facilitate price discovery. Price discovery is the process by which buyers’ and sellers’ preferences, as well as any other available market information, result in the “discovery” of a price that will balance supply and demand and provide signals to market participants about how most efficiently to allocate resources. This market-determined price will, of course, be subject to change as new information becomes available, as preferences evolve, as expectations are revised, and as costs of production change.

In order for this process to work most effectively, market participants must utilize information relevant to value that product. Of course, searching out and using relevant sources of information--as well as determining what information is relevant--has its own costs. To underscore the last point, with new instruments, it may not even be clear exactly what information is needed for price discovery--that is, some market participants may not know what they do not know and they may therefore terminate the information-gathering stage prematurely, unwittingly bearing the risks and costs of incomplete information.

Price Discovery
Due diligence is an important part of the price discovery process. The due-diligence process allows market participants to “trust but verify” market-provided information through a range of activities, from assessing risks and exposures through stress-testing to assessing the enforceability of the contracts that define the legal relationship among originators, sponsors, investors, and guarantors. The due diligence is complemented by risk-management structures that allow participants to interpret, understand, and act appropriately in response to the information in the market.

Recently we have seen how a lack of information and inadequate due diligence and risk management have created problems in the market for certain structured finance products. Let me focus a moment on structured investment vehicles, or SIVs. SIVs have been created with a variety of terms and characteristics--for example, different underlying assets, different levels of liquidity support or guarantees, and various triggers that require the forced sale of assets or liquidation of the structure. Although SIVs or similar vehicles have existed for many years, many recent SIV structures involved a much higher level of complexity of the underlying credit risks, legal structures, and operations. This complexity--and the lack of information about where the underlying credit, legal, and operational risks resided--made these products more difficult and costly to value than many investors originally thought. Investors suddenly realized that they were much less informed than they assumed and, not surprisingly, they pulled back from the market.

We have seen similar problems in the subprime residential mortgage-backed securities market and the related derivatives markets. The lack of long historical data on the performance of these instruments, and their correlations with other assets and instruments, made it difficult to assess their overall risk-return profile, especially in times of stress. Moreover, in the subprime residential mortgage-backed securities market, many market participants were willing to proceed without conducting robust due diligence and without establishing appropriate risk-management structures and processes. They did not follow “trust but verify,” that is, they instead accepted the investment-grade ratings of these securities as substitutes for their own risk analysis. Ratings keyed to expected default or credit loss do not adequately capture the full range or magnitude of risks to which a product may be subject, including--as we have seen most dramatically--market liquidity risks. In addition, some originators may not have demanded sufficient information about the purchased assets underlying these structures and therefore may not have fully appreciated the credit risk of the assets and the consequential risk that the structures would come back on balance sheet when the assets defaulted.

When the problems in the subprime mortgage market began to emerge and delinquencies exceeded rating agency estimates and the defaults predicted by limited historical data, we had moved beyond our past experience with these instruments. Information was not readily available about the extent to which the economic context had changed, or even whether underlying loans would or could be modified to prevent default. When ratings were downgraded, investors lost confidence in the quality of the ratings and hence the quality of the information they had about subprime investments. Lack of information, a disrupted price-discovery process, and a stressed environment led to a reassessment of risk, not only in the subprime market but also in the residential mortgage market across the board.

Of course, this is not the first time that participants in a market for an innovative product have suffered losses. In the early 1990s, participants in the collateralized mortgage obligation (CMO) market and the markets for structured notes and certain types of interest rate derivatives did not have adequate information about the potential volatility and prepayment risk involved. Consequently, market participants did not appropriately model these risks and suffered significant losses when market interest rates rose sharply in the mid-1990s. As in the case of the residential mortgage-backed securities market today, the general market reaction was a flight away from these instruments. However, over time, the market was restored as market participants came to better understand the risks and as standardized methods were developed to measure the risks and model the value of these instruments under alternative scenarios. Increased information and standardized pricing conventions, such as the use of option-adjusted spreads, moved these instruments from the experimentation and learning phase to the phase of broad market acceptance.

When market participants realize that they do not have the information necessary for proper valuation of risks, the price-discovery process can be disrupted, and market liquidity can become impaired. A significant investment in information gathering, processing, and evaluation may be necessary to revive the price discovery process. This revival is likely to take time and the market may not look the same when it re-emerges.

Let me describe in a bit more detail the ways in which these investments will take place and hence why recovery of price discovery may be a gradual process. First, market participants will likely need to collect more-detailed data in a more systematic manner in order to better understand the nature and risks of the instruments and their underlying assets. Second, investments in enhanced systems to warehouse and model data related to these instruments will facilitate a better understanding of their risks, particularly under stress conditions. Third, investors need to ensure that they have the so-called human capital expertise--that is, the people--to understand, interpret, and act appropriately on the results of the modeling and analysis of the information gathered. The pay-off from these investments will be a greater understanding of risks and greater ability to value the instruments.

The Development of Greater Standardization in a Market
Another consequence of information investments is a tendency towards greater standardization of many of the aspects of an instrument, which can help to increase transparency and reduce complexity. As was demonstrated in the CMO market, as the market gains information about a product and develops a level of confidence in that information, the product tends to become increasingly standardized. Standardization in the terms and in the contractual rights and obligations of purchasers and sellers of the product reduces the need for market participants to engage in extensive efforts to obtain information and reduces the need to verify the information that is provided in the market through due diligence. Reduced information costs in turn lower transaction costs, thereby facilitating price discovery and enhancing market liquidity. Also, standardization can reduce legal risks because litigation over contract terms can result in case law that applies to similar situations, thus reducing uncertainty.

The benefits of the development of standardization for enhancing the liquidity of financial markets have a long history. One particularly clear example dates back to the development of exchange-traded commodities futures contracts in the mid-1800s. The standardization of the futures markets improved the flow of information to market participants, reducing transaction costs and fostering the emergence of liquid markets.

In the early days of the Chicago Board of Trade, in the mid-1850s, standardization took the form of creating “grades” or quality categories for commodities such as wheat, allowing for the fungibility of grains stored in elevators and warehouses, and breaking the link between ownership rights and specific lots of a physical commodity. Traders no longer needed to verify that a certain quantity of grain was of a sufficiently high grade because the exchange established a system of internal controls in the form of grain inspectors and a self-regulatory system to arbitrate disputes. The grain inspectors charged a set fee to certify the quality of the grain for any receipt traded at the board, a system with parallels to the mechanisms employed today by the rating agencies.1

In effect, standardization and related controls reduced traders’ information requirements and, thus, their transaction costs. In 1865, the Chicago Board of Trade standardized the delivery dates for the contracts, thus fostering the emergence of liquid markets in which traders could readily hedge the risk of price changes in the commodities and contracts. A final step toward standardization came years later with the adoption of the clearinghouse for the exchange as the common counterparty to all of the contracts traded on the exchange. With a central counterparty, the costs and uncertainties of failures and restructurings were significantly reduced, thereby reducing work-out costs and enhancing liquidity of the contracts traded on the exchange.2

The benefits of standardization can be realized not only on organized exchanges but also in over-the-counter markets. In more recent times, for example, the creation of the International Swaps and Derivatives Association (ISDA) master agreement for over-the-counter swaps and derivatives contracts has brought about the benefits of standardization while also allowing for product flexibility and customization. The ISDA master agreement provides standard definitions and a general outline for the contract but allows latitude in customizing terms. The master agreement also sets forth a template for workout procedures if a counterparty defaults, allowing parties to the agreement to adjust their risk-management strategies in light of the agreed-upon work-out process. This standardization reduces uncertainty about the instruments, which lowers transaction costs and facilitates price discovery and market liquidity.

The examples from the long- and more recent- past may hold some valuable lessons for how improvements in standardization could help to address some of the challenges in the subprime market. Uncertainty about the work-out process and the options that are available, for example, could be contributing to the difficulties in reviving price discovery and liquidity in the market for subprime residential mortgage-backed securities. Part of the valuation challenge is gauging the extent of the difficulties that borrowers will have in making payments and being able to stay in their homes given the reduction in house price appreciation--or actual declines in some areas--and the large number of interest rate resets coming on many adjustable-rate mortgages. From now until the end of next year, monthly payments for an average of roughly 450,000 subprime mortgages per quarter are scheduled to undergo their first interest rate reset. In addition, tightening credit conditions as reported in the Federal Reserve’s Senior Loan Officer Opinion Surveys on Bank Lending Practices suggest that refinancing may become more difficult.

Lenders and servicers generally would want to work with borrowers to avoid foreclosure, which, according to industry estimates, can lead to a loss of as much as 40 percent to 50 percent of the unpaid mortgage balance. Loss mitigation techniques that preserve homeownership are typically less costly than foreclosure, particularly when applied before default. Borrowers who have been current in their payments but could default after reset may be able to work with their lender or servicer to adjust their payments or otherwise change their loans to make them more manageable.

It is imperative that we work together as a financial services community to look for ways to help borrowers address their mortgage challenges, particularly for those who may have fewer alternatives, such as lower-income families. The Federal Reserve and other regulators have been active in encouraging lenders and servicers to take a proactive approach to work with borrowers who may be at risk of losing their homes. For example, the agencies have issued statements underscoring that prudent workout arrangements that are consistent with safe and sound lending practices are generally in the long-term best interest of both the investor and the borrower and have had numerous meetings with interested parties to foster the development and implementation of work-out arrangements.

Given the substantial number of resets from now through the end of 2008, I believe it would behoove the industry to go further than it has to join together and explore collaborative, creative efforts to develop prudent loan modification programs and other assistance to help large groups of borrowers systematically. I am not suggesting a one-size-fits-all approach, but a bottom-up approach designed to appropriately balance the needs of all parties. Getting to borrowers who have been making payments but are at risk of falling behind before they actually do become delinquent, for example, can help to preserve work-out and refinancing options.

Some industry participants and consumer groups have begun to work collaboratively to develop loan-modification templates, standards, and principles that can help to streamline the work-out and modification process. This can reduce transaction costs and potentially provide timely relief to a wider range of borrowers. A systematic approach to loan modifications would likely reduce some of the uncertainties in the market for such subprime mortgage-backed securities, helping to restore price-discovery and liquidity. This would help to ease the tightening of credit conditions in the market.

I am privileged to serve as a board member of NeighborWorks America, a national nonprofit that partners with the HOPE NOW Alliance. This alliance is developing ways to facilitate the flow of information between servicers and distressed borrowers and to work toward clarification of loan-modification procedures. Increased standardization and certainty could also benefit investors in the mortgage market by improving information flows and the price-discovery process, thereby improving market liquidity while at the same time helping to avoid foreclosures and promoting sustainable homeownership.

A Regulatory Environment That Encourages Sound Risk Management and Transparency
Recent market events have underscored the need for better market information about new products, robust due diligence to verify that information, and risk-management strategies to utilize the information in management decisionmaking. The supervisory agencies and the industry both are addressing the need for improved risk management in light of the market disruptions

The newly adopted Basel II capital framework for large internationally-active banking organizations, for example, is an important advance that encourages the types of investment in information I discussed earlier. The Basel II framework is comprised of three pillars. Pillar 1 requires information gathering and robust modeling techniques to better take into account the risks of different types of instruments and securities than under the traditional Basel I framework. It also provides incentives for more robust risk management in connection with certain higher-risk activities, such as securitization and other off-balance-sheet activities. Pillar 2 emphasizes the further stress testing and analysis of the data in conjunction with an ongoing evaluation of the institution’s capital adequacy in light of its risks through the internal capital adequacy assessment process. Pillar 3 reflects the need for better information through investments in data gathering and analysis that are reflected in enhanced public disclosures and regulatory reporting. More-comprehensive and more-transparent information allows investors to better understand the banking organization’s risk profile and thus reduces transaction costs and facilitates price discovery and market liquidity. The three pillars of Basel II promote precisely the three types of investment in information discussed earlier that facilitate the price discovery process.

In addition to supervisory initiatives, industry leaders’ efforts to influence the adoption of sound practices and codes of conduct can efficiently and effectively facilitate market-correcting behaviors. To this end, the industry is actively engaged in efforts to improve sound practices for risk management through improved stress-testing practices to cover contingent exposures, marketwide events, and potential contagion and enhanced due diligence and modeling for new products. As they look into the causes of the recent market disruptions and determine the appropriate response, both supervisory and industry groups are carefully analyzing the weaknesses in risk management and the lack of transparency in complex structures--and the implications of that lack of transparency for proper valuations.

Conclusion
The recent market disruptions have dramatically underscored the importance of gathering and analyzing information about innovative products. When the price-discovery process for a product is disrupted, both investors and sellers need to engage in a period of information gathering, processing, and analysis in order to re-establish a market price. This can be a gradual process and one that results in fundamental changes to the market for the product. Efforts underway by both supervisors and the industry should encourage improvements in risk analysis and management and, thus, price discovery. We are hopeful that our efforts to increase the standardization of loan-modification options and processes for subprime loans will help to provide more information to lenders, investors, homeowners, and communities faced with potential mortgage loan defaults while at the same time helping to provide more timely relief for borrowers in distress.


--------------------------------------------------------------------------------

Footnotes

1. See Randall S. Kroszner (1999), “Can the Financial Markets Privately Regulate Risk? The Development of Derivatives Clearing Houses and Recent Over-the-Counter Innovations,” Journal of Money, Credit, and Banking, vol. 31 (August), p. 600. Return to text

2. See Kroszner, “Can the Financial Markets Privately Regulate Risk?”, p. 601.

All this to be taken with a grain of piquant salt!!!