I wrote a column
in the Financial Express today about the reform
legislation winding its way through the US Congress. I argue that the
regulatory goal of making large banks failure proof will not be
realized and that it is better to have a policy of letting even large
banks fail.

Towards the end of 2008, US policymakers halted the panic phase of the
global financial crisis with three simple words: “No more
Lehmans.” In the short run, this statement could mean that there
would be no more bankruptcies like Lehman – any large financial
entity on the verge of failure would be simply bailed out. AIG was the
first beneficiary of the new policy.

However, in the long run, the ‘No more Lehmans’ policy can
only mean that there would be no more failures like Lehman. Either
financial entities should be unimportant enough to be safely left to
the bankruptcy courts when they fail, or they should be robust enough
to make their failure extremely unlikely.

In this context, the US House of Representatives has passed a
comprehensive 1,279-page Financial Reform Bill, but the Bill could
change significantly before it is passed by the Senate and becomes
law. How effective would this law be in eliminating Lehman-like
failures?

First, the new US provisions (as well as the recent Basel proposals at
the global level) impose higher capital requirements on financial
institutions. While higher capital would reduce the chances of
failure, it would not make failures so unlikely that governments can
safely promise to bail out any large bank that slips through the
cracks. Other elements of the new legislation are, therefore, designed
to make it easier to let large institutions fail.

A second key part of the legislation extends the existing resolution
mechanism for failed banks to systemically important non-banks and
bank holding companies. Under the old law, Lehman could not have been
resolved in this manner and while the banking part of Citigroup could
have been resolved, the holding company itself (which owned many of
the foreign subsidiaries) could not have been.

The new resolution mechanism makes it easier for the regulator to
contemplate the failure of a large entity because the messy bankruptcy
is replaced by a more orderly resolution process. There is also a
provision for a bailout fund (Systemic Dissolution Fund) to facilitate
the resolution process, but this fund is to be financed by
contributions from the financial industry itself.

The problem with this proposal is that while it avoids bailing out
shareholders of a large entity, it actually formalises the bail-out of
their creditors through the systemic dissolution fund. It would,
therefore, have the perverse effect of encouraging banks to become
even larger to exploit this implicit guarantee from the government.

A third key element in the legislation is the reform of the OTC
(over-the-counter) derivatives market. Lehman was not spectacularly
large in terms of assets and liabilities. The systemic importance of
Lehman (and even more so of AIG) came from OTC derivatives.

Lehman was a large dealer in OTC derivatives and AIG was a large
counterparty for subprime-related credit default swaps. They were not
too large to fail, but were described as too interconnected to
fail. Reform of OTC derivatives is intended to prevent this kind of a
situation from arising.

The straightforward solution to the OTC derivative problem is to move
these derivatives to the exchanges where a central counterparty (the
clearing house) collects margins from all participants and assumes
responsibility for all trades. Lehman did have a portfolio of 66,000
contracts totalling $9 trillion of interest rate swaps cleared by
LCH.Clearnet in London. LCH not only resolved the Lehman default
without any loss, but also returned a large part of the margins that
it had collected from Lehman.

To understand the difference with the OTC market, suppose that Lehman
had sold $100 billion of a certain OTC swap to some parties and bought
$90 billion of the same OTC swap from others. Its failure would force
all its counterparties to terminate their $190 billion of Lehman deals
and establish new contracts with other counterparties. When all these
trades are done through an exchange, the clearing house would have to
liquidate only the net position of $10 billion, and this is easier
because of the margins that the clearing house has collected.

The US law tries to mandate clearing of standardised OTC derivatives,
but the proposals are riddled with loopholes that threaten to make
them ineffective. First, it does not mandate exchange trading; it only
mandates clearing and that too if a clearing house accepts the
concerned derivative for clearing. Second, many OTC derivatives lack
price transparency and are therefore illiquid. Without a push towards
transparency, many derivatives will simply be unacceptable for
clearing. Third, minor changes in terms may make a derivative
non-standardised and therefore not subject to clearing.

All in all, the 1,000-odd pages of complex provisions riddled with
loopholes in this legislation will not make Lehmans sufficiently
unlikely in future. I would suggest that ‘No more Lehmans’
is not the correct policy after all. True capitalism is about letting
insolvent banks fail, however painful that might be.

The SEC has filed a complaint
against the world’s largest inter dealer broker ICAP which
dominates trading in US government securities and many other OTC
markets. ICAP has settled the charges for $25 million and an
undertaking to implement remedial action to be suggested by an
independent consultant.

The charges are very serious:

• ICAP displayed thousands of fictitious trades designed to mislead
  other traders about the true state of the market; and
• ICAP brokers executed thousands of trades to liquidate
  ICAP’s positions against customer orders in violation of the
  stated workup protocol.

It is depressing that charges of such seriousness are settled
without an admission of guilt. The alleged actions shake the very
foundations of market integrity and make one wonder whether OTC
markets can be trusted at all.

Around the same time that I was reading this complaint, Rortybomb
alerted me to a Bloomberg
story of a few months ago about an investigation against
Markit. The charges here are of a very different nature but they are
disturbing in their own way. It is alleged that Markit agreed to
provide price information to a clearinghouse only if the latter agreed
to clear only trades that involved a dealer.

The question in my mind now is how badly broken are the OTC
markets. Whenever, people describe the stock exchanges as casinos, my
response is that even if many of the participants are only gambling,
the stock exchange still performs the socially useful purpose of price
discovery. OTC markets that do not provide transparent price discovery
do not perform this function and are much closer to pure
casinos. Those that distort the price discovery are worse than
casinos.

The UK Payment Council this week announced a plan
to abolish cheques in less than a decade. Actually, it is the clearing
of cheques that would be closed on October 31, 2018, but that is as
good as abolishing cheques themselves.

The report points out that “A number of countries including
The Netherlands and Sweden have already largely or totally eliminated
cheques. However volumes of paper credit payments in these countries
remain significant. The cheque replacement programme in the UK would
be going beyond these countries in aiming to modernise the payment
system …”

The usage of cheques in the UK peaked nearly two decades ago in
1990 and has been falling relentlessly since then. “Cheque use
is in long-term, terminal decline.” The UK therefore proposes to
shift remaining users of cheques to paperless channels (ATMs, mobile
banking, internet banking and stored value cards) over the next decade
and then get rid of cheques completely.

The report has a section on “cheque dependent
consumers.” This group consists mainly of individuals with
degenerative conditions and individuals living in care homes or with
mobility problems. The main advantage of cheques is that they allow
third parties to assist the user by filling up the cheque before the
user signs the cheque. My own sense is that biometrics would be safer
than reliance on a third party in such situations.

Interestingly, the report also discusses a few UK statutes which do
not allow any alternative to paper payment – these include
penalties for dog fouling, litter, releasing greenhouse gases and
cigarette smoke.

I found it surprising that most of the Samuelson obituaries do not
refer to the impact that he had on finance theory. Along with
Modigliani and Arrow, Samuelson was among the few mainstream
economists who had an enduring impact on finance theory.

Indeed it appears odd that while modern finance theory is often
regarded as the bastion of free market economics, it owes so much to
Samuelson who was the dominant left wing economist of his era. By
contrast, Samuelson’s great right wing rival, Milton Friedman,
contributed very little to modern finance theory apart from his famous
pronouncements on destabilizing speculation.

Samuelson more or less established the modern
“martingale” concept of market efficiency (as opposed to
the now largely discredited random walk model) in his landmark paper
entitled “Proof that Properly Anticipated Prices Fluctuate
Randomly.”

Samuelson also had a strong influence on option pricing through
his doctoral student Robert Merton though Samuelson’s own work
in this area is completely obsolete.

Above all, I think the mathematical approaches that Samuelson brought to
economics were necessary prerequisites for modern financial economics
to develop.

Cristie Ford has posted on SSRN an interesting paper on
“Principles-Based Securities Regulation in the Wake of the
Global Financial Crisis.” The paper argues that the Global
Financial Crisis has not discredited principles based regulation.

According to Ford, what the crisis has done is to demonstrate that
principles based regulation requires as much (and sometimes more)
regulatory resources and trained staff as any other form of
regulation. Principles based regulation “requires greater
regulatory capacity in terms of numbers, resources, and expertise than
has been allocated to it in some of the infamous examples of
regulatory failure in the past two years – the failure of
Northern Rock in the UK, and of the the SEC’s CSE
Program”.

Principles based regulators also must have the ability to obtain
transparent and reliable data directly, for otherwise, they
effectively cede the field to the regulatees.

Ford also argues that regulators’ hiring decisions must be
based not only on applicants’ relevant industry and legal
expertise, but also with a view to whether applicants seem to have
sufficient confidence and independence of mind.

Ford’s paper is an insightful analysis of the issues involved
and is definitely worth reading.

Reuters has an interesting report
on the stock exchange set up by Somali pirates to fund their
activities. It is a fascinating story of how a stock exchange is
operating in a near-barter economy. One of the shareholders got her
“dividend” for contributing a grenade launcher which she
received as alimony from her ex-husband.

The interesting thing is that this is exactly how finance
began. Meir Kohn provides the following interesting description
of the capital market before 1600 (page 13-14):

While landowners and governments could finance themselves with
long-term debt, this option was generally not available to business:
it lacked the security and the reliable cash flow required for a debt
issue. On the other hand, business could promise substantial gains if
things went well to compensate for the possibility of loss if things
went badly. This potential for extraordinary returns did provide a
basis for equity finance.

The fundamental problem of equity finance is to ensure
equity-holders a fair return on their investment. Today, there
exists a complex of institutional mechanisms to address this
problem – accounting procedures and an accounting profession, legal
protections, extensive reporting and analysis of financial
information. Since none of these existed before 1600, equity finance
had to rely on a simpler mechanism: wind up the business periodically,
and divide up the proceeds among the shareholders. This procedure was
possible, because business was largely commercial and did not require
any substantial investment in fixed capital.

A few months ago, I wrote a post
on ultra-simplified finance which revolved around equity markets. To
see how powerful equity markets can be even when there is almost
nothing else by way of a financial system, one has three choices:

1. read Kenneth Arrow’s classic paper (“The role of securities in the optimal allocation of
   risk-bearing”);
2. go back in time to the pre-industrial era;
3. take a trip to Somalia.

I wrote a column in today’s Financial Express
about payment and settlement systems in India in the context of the
vision statement released by the Reserve bank of India

RBI recently released a vision statement for the payment systems in
India for the next three years. The mission is “to ensure that
all the payment and settlement systems operating in the country are
safe, secure, sound, efficient, accessible and authorised.”

It is true that the payment system in India has made considerable
progress in the last few years with the emergence of Real Time Gross
Settlement (RTGS) system, National Electronic Fund Transfer (NEFT)
system, implementation of core banking software in most large banks
and rapid spread of the ATM network. With these developments, India is
gradually moving away from antiquated paper-based payments to a modern
payment system. The progress is slower than one would like, but it is
progress all the same.

However, the global financial crisis in 2007 and 2008 has changed
the way we look at the safety and soundness of payment systems, and
the RBI vision statement does not reflect these new concerns and
priorities at all. In fact, the document is characterised by a
pre-crisis world view that makes it largely complacent about
settlement system risks.

The first lesson from the crisis is that any payment or settlement
system that settles in commercial bank money is simply unacceptable as
a ‘safe, secure and sound’ system. During the crisis,
credit default swap spreads on some of the largest banks in the
developed world as well as in India rose to levels indicating serious
concerns about their solvency.

This immediately brings up the horror scenario of every payment or
settlement system: pay-ins take place into the settlement banks of
these systems just before the settlement bank fails. In other words,
the settlement bank fails after receiving the pay-in but before making
the pay-outs.

Since the major securities and derivative settlement systems in
India settle in commercial bank money, this horror scenario should be
giving sleepless nights to the securities regulator and to the central
bank. Unfortunately, the vision statement does not betray any such
concern.

I think urgent steps should be taken to allow major settlement
agencies like the clearing corporations of the stock exchanges,
derivative exchanges, commodity exchanges, the Clearing Corporation of
India and similar entities to make settlements in central bank
money. Whether this takes the form of giving them a limited banking
licence or of opening up the RBI’s payment system to
systemically important non-bank entities is a matter of detail that
need not bother us here.

The point is that we do not have a true delivery-versus-payment
(DVP) system unless the payment happens irrevocably in central bank
money. Before the crisis, it was possible to pretend that large banks
are safe enough to allow settlement to happen in their books. After
the crisis, the regulators would be irresponsible and delusional to
accept this idea.

An even bigger problem exists in the settlement of foreign currency
transactions where time zone differences preclude any true
payment-versus-payment (PVP) settlement of these
transactions. Herstatt Risk has really not been solved several decades
after Herstatt Bank in Germany failed after receiving payments in its
currency but before making payments in foreign currency.

The international community has come up with the idea of having a
private bank (CLS Bank) handle the global settlement of foreign
currency trades. This avoids banks having to take exposure on each
other, but requires them to take exposure on CLS Bank and sometimes on
a participant bank that provides access to CLS Bank.

The thinking was that a settlement and custody bank like CLS Bank
cannot fail, but this is a delusion. During the 2008 global crisis,
questions were raised about some US banks that were largely settlement
and custody banks rather than lending banks. Moreover, even settlement
and custody banks can suffer from acute operational risk as was
demonstrated in a famous episode two decades ago in the US. As a
member of the G20, India has an opportunity to argue for putting
foreign exchange settlement on a sounder footing.

Many alternatives can be thought of. First is that the IMF could
take on the responsibility of running foreign currency settlement not
only because it holds all the currencies of the world, but also
because it enjoys multilateral guarantees that would make settlement
in IMF books a true PVP. The second possibility is that the
world’s major reserve currencies (and currencies of invoicing)
can be persuaded to run a 24/7 RTGS that eliminates the time zone
problem.

The third solution, closer in line with the post-crisis philosophy
of each country taking responsibility for risks within its territory,
is for RBI to run a US dollar RTGS in Mumbai by taking advantage of
its huge dollar reserves. In short, a lot needs to happen before we
can say that “all the payment and settlement systems operating
in the country are safe, secure and sound.”

Back in 2007 and 2008, people were fond of arguing that the crisis
was due to highly complex financial instruments and that if finance
became boring, it would be a good thing. People even argued that
Islamic finance would be a good idea.

This week Dubai put an end to this talk by making it clear
that Dubai World would default on debt issued by its subsidiary Nakheel
Development Limited. The debt falls due in the middle of December, but
Dubai wants creditors to agree on a standstill till May while a
restructuring is worked out.

The interesting thing is that the instrument in question is an
Islamic bond – a Sukuk. The prospectus (available in the FT
Alphaville Long
Room) proudly refers to the “pronouncement dated 11 December
2006 issued on behalf of the Sharia Supervision Board of Dubai Islamic
Bank PJSC confirming that, in their view, the proposed issue of the
Certificates and the related structure and mechanism described in the
Transaction Documents are in compliance with Sharia principles.”
(page 34)

Of course, one can argue that there is really nothing Islamic about
modern Islamic bonds other than an opportunity for some religious
scholars to earn a living by issuing pronouncements on Sharia
compliance. But that itself is a warning that trying to legislate
simplicity in finance is often futile.

Modern corporate finance teaches us that money is made and lost on
the asset side of the balance sheet. To adapt a favourite statement of
the Austrian economists, losses occur when wrong investment decisions
are made. The defaults on the liabilities side of the balance sheet
only serve to announce and crystallize this loss. Last month, I blogged
about how bank losses from loans in the current crisis exceed losses
on securities. The default on the Sukuk reinforces this idea that
mis-allocation of capital produces losses regardless of the composition
of the liability structure.

At the EconLog blog, Bryan Caplan asks
why academic economists are not Bayesians. Caplan was talking about a
Bayesian approach to the validity of economic theories. Stephen Gordon
responded with a post
about why economists do not use enough of Bayesian econometrics. Both
questions are valid and should cause some introspection.

The issue is probably even more important in finance where key
parameters are estimated with such large confidence intervals that the
prior does not get washed out by the sample. In fact, I think that one
of the defining characteristics of finance as a discipline is that
first moments (for example, mean returns) are estimated very poorly
even with extremely large samples while second moments (variances) are
somewhat better estimated.

For example, Aswath Damodaran has an interesting paper last month
discussing the difficulties of estimating the Equity Risk Premium
reliably. Damodaran states bluntly that:

At the risk of sounding harsh, the risk premiums in academic
surveys indicate how far removed most academics are from the real
world of valuation and corporate finance and how much of their own
thinking is framed by the historical risk premiums they were exposed
to back when they were graduate students.

What Damodaran is really saying is that despite being exposed to
recent academic research using centuries of global stock market data,
the posterior distributions of most academics are still strongly
influenced by the prior distributions formed during their student
days. In such a situation, there is merit in making the prior
distribution quite explicit rather than leaving it implicit.

Classical statistics also involves priors; the tragedy is that in
that framework, there are only two kinds of priors:

1. Dogmatic priors which totally ignore what the data says, and arbitrarily
   set some parameters to zero or some other special value.
2. Diffuse (or improper) priors which impose no priors beliefs at all
   and leave everything to the data.

Bayesians can however use the more interesting priors which reflect
non trivial prior beliefs that can be overruled by the data.

At a different level, I think it is also essential to incorporate
Bayesian learning into theoretical models. Rational expectations
models are richer when they recognize that even with large samples,
posterior distributions could have large error variances.

In the popular imagination, the crisis in the global financial
markets in the last quarter of 2008 is identified with the collapse of
Lehman on September 15, 2008. However, many perceptive analysts believe
that it was not the collapse of Lehman itself, but the resulting
collapse on September 17 of the Reserve Primary Fund (a large money
market mutual fund) that was the real culprit. Finally, some
revisionists like John Taylor have argued that the panic started not
with the Lehman collapse but with the mishandling of the TARP
legislation later in September.

William Sterling has a nice paper
analyzing this issue relying on a broad index of financial conditions
covering money markets, bond markets and equity
markets. Taylor’s use of measures related to Libor was
controversial because at the time, people joked that Libor was the
rate at which banks did not lend to each other. I
like the more comprehensive measure chosen by Sterling.

Based on this index, all three views receive some support, but on
balance Sterling rightly concludes that the revisionist case is quite
weak. The financial conditions index fell 9.85 points when Lehman
collapsed, and fell a further 10.37 points when the Reserve Primary
Fund failed. If we regard these two as a single event, the fall in the
index over the three days was 20.76 points. But the biggest single day
fall was 11.77 points on the day that Congress rejected the first TARP
bill. (The index is constructed as a Z-score so that each point change
in the index can be regarded as one standard deviation move. Clearly,
all three days are extreme tail events).

The most intriguing thing in the paper is the 12.68 point rise in
the index on the day before a bailout plan for the
money market mutual funds was announced. This is the largest one day
change in the index in its entire history. It appears to me that this
is indicative of insider trading on a truly massive scale. If this
interpretation is correct, this insider trading would make Galleon
look like small change.