Safe (or informationally insensitive) assets

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

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

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

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

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

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

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

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

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

 

Finance teaching and research after the global financial crisis revisited

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

 

The many different kinds of fixed exchange rate regimes

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

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

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

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

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

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

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

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

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

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

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

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

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

 

The risks in Indian dependence on foreign risk capital

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

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

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

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

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

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

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

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

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

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

 

RBS and ABN Amro Due Diligence

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

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

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

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

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

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

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

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

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

 

Examples of Currency Breakup

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

Argentina 2001-02

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

Ruble zone early 1990s

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

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

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

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

Pakistan/Bangladesh 1971

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

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

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

India/Pakistan 1947-48

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

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

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

Austro Hungarian Empire 1919

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

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

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

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

 

Book on SEBI Act

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

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

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

 

Mobile phones as Achilles heel of internet banking

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

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

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

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

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

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

 

European Banks as America’s Shadow Banks

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

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

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

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

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

 

Revisiting CME and LCH handling of Lehman default

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

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

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

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

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

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

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

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