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?”

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.

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.

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.

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...

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

Capital Management - a tough one to follow

See this op-ed (quoted in full as its a bit complex!). I would like to comment a bit further on the last aspect which John Plender talks about and that is the risk management model and capital analysis aspects.

Now if I am trading complex derivatives (of whatever kind, FX, IR, Credit, Equities), I need to understand how it will move given various industry movements and internal characteristics. Also called as the Greeks. Now for quoted derivatives (either on an exchange or on broker pages), the risks are reasonably well understood and priced. But when you move into the exotics, then you are exposed to a new type of risk, that is called as the "model risk". In other words, the models that you are using to price the new instrument are based upon assumptions upon assumptions upon assumptions upon actual prices. So while you do do testing to a very large extent with loads of scenarios, you cannot test every eventuality.

And they blow exactly when you least want them to blow, when there are extreme market movements, where the normal relationships break down, the usual assumptions of liquid markets are blown, etc. etc. So that's one strand of the argument. The other strand is to pull in capital discipline. Now forget about the regulators. If you are expecting the regulators to manage your capital, you are already in deep doo doo.

It is so worrisome that so many financial institutions around the world do not have any capital discipline. When you are lending out your capital or putting your capital at risk on prop trading, how many actually kick the tires of the investment opportunity? And as it so happens, very few actually. They might evaluate that opportunity itself, but not the portfolio, not the overall bank risk, nothing. Even if they do the overall and underlying risk analysis, how many have tied their capital usage to the level of risks they bear? And final question, how many firms have actually withdrawn capital from individual desks or businesses on a frequency greater than monthly? In other words, how many banks monitor their risk adjusted capital usage on a daily or weekly basis and ACTUALLY ACTION on those figures? very few.

This is the reason why you have issues such as huge losses appearing out of thin air and people getting nervous, no capital management, no capital discipline, no balls to tell your trading and business MD's that if they run too big a risk, their capital will be withdrawn. If you dont, then you get chucked out of a job. Mind you, you get $150 million as a payoff, so perhaps there is something in this capital mismanagement malarkey!

Market insight: Basel is the root of the banking crisis
By John Plender
Amid high drama in bank boardrooms, the chief executives of Citigroup, Merrill Lynch and UBS have gone in short order. And with good reason, in the light of the huge losses these
men presided over in asset-backed securities.
Yet it is important to recognise, when considering any response to this continuing debacle, that the extreme nature of this financial cycle is partly the product of the very
regulatory systems that govern the operations of large financial institutions.
Likewise, executives’ behaviour has been a direct response to flawed incentive
structures in individual banks.
It was the 1988 Basel Accord that first created the opportunity for regulatory arbitrage whereby banks could shunt loans off the balance sheet. In effect, a new capital discipline designed to improve risk management had the unintended consequence of creating a parallel banking system whose lack of transparency explains the market seize-up since
August.
As the new “originate and distribute” model reduced the incentive for
banks to monitor the credit quality of the loans they pumped into collateralised
loan obligations and other structured vehicles, the Basel rules failed
adequately to highlight contingent credit risk. That is, when conduits and
structured investment vehicles (SIVs) ran into difficulties, credit risk started
to come back on to bank balance sheets, putting strain on bank capital.
Other forms of obfuscation were at work. Where conventional credit markets talked
about risk in terms of credit quality, defaults and ratings, derivative traders
in the shadow world of structured products employed far more esoteric language.
Yet while the cash and derivatives markets were linguistically and mentally at
odds, the fundamental risks were the same. If a company goes belly-up, the
credit event hurts in both places.
Within banks executive bonuses and other incentives have the effect of encouraging a perpetual dash for growth at ever-increasing risk. Why be prudent when you can bet the ranch in the knowledge that a losing bet pays so handsomely? The snag is that in banking, betting the
ranch increases systemic risk.
Note, too, that accountants have connived in the regulatory arbitrage game. After Enron, the accounting for off-balance sheet entities was supposedly tightened. Yet in practice banks have been carrying out the equivalent of sale or return transactions with their conduits and SIVs and booking profits up front regardless.
Then there are the analysts and shareholders. As with Marconi in the dotcom boom, Northern Rock was backed by an enthusiastic capital market chorus who cheered from the sidelines without grasping the risks in the bank’s funding model – although the euphoria this time
was not universal.
So what now? The Basel II regime, which takes effect in January, makes securitisation less attractive to banks and seeks to address contingent risk. Yet it is hard to believe it would have prevented the current mess. Basel II relies on the modelling techniques that led to the subprime
disaster. The new rulebook also depends heavily on the credit rating agencies in
whom investors have lost confidence.As for the evolution of executive pay
structures, there is little to inspire hope. The scale of the losses in the world’s biggest banks points to a failure on the part of bank boards on a monumental scale. That in turn raises the question of whether top executives, let alone non-executives, can really understand the risks being run in such large, complex institutions.
With executive compensation, nothing suggests that American committees have an appetite for addressing the crazy packages that create systemic problems. Nor does it seem likely that
lawmakers would want to introduce a statutory pay policy for the US boardroom.
If there is any good news, it is that market discipline will ensure that the more toxic structured products will not return. But nothing in the regulatory debate so far promises notably less extreme swings in the credit cycle. And the law of unintended consequences remains an ever-present threat.

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

Chi-X - the sneaky exchange

It is a well held truism in the banking and broking market that retail banking and exchange trading is generally very sticky. People tend not to move their current/savings account from the bank that they joined at university and will live with it for their lives. Despite it, many times, being a bad financial choice.

Similarly, exchanges are also pretty much sticky, moving trading away from an exchange to another exchange is very difficult and while it has happened before (Bund Futures taken away from LIFFE to Eurex), the history of exchanges is littered with failed attempts by exchanges to capture business from other exchanges. Eurex USA, Virt-X, Nasdaq Europe and a whole host of other examples lay testament to that fact.

But we now have this tiny exchange, called as Chi-X, run by Instinet. It has been very sneaky, and has managed to attract trading away from the big boys. For example, it has managed to have 44% and 29 %market share on Philips and ING in the end of August. It has also grabbed 10% of many very highly liquid German stocks, etc.

With MiFID barrelling down Europe's throat, Chi-X is positioned brilliantly. It promised a 10 times cheaper service and a 10 times faster trading opportunity compared to the big guys like LSE and NYSE Euronext. At end of the day, what market participants want is the best price formation process in the public eye at the lowest cost and at the fastest possible speed. In other words, you don't want the traffic policeman to become the bottleneck. So if he does become the bottleneck, the traffic is going to move away from your road to the road where the traffic policeman is the most efficient.

Life as the exchanges know it is going to (ex)change!

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