Can governments be trusted with financial data?

When the UK government loses CDs
containing name, addresses, date of birth, child benefit and national
insurance numbers and bank details relating to 25 million people
(40% of the population), we must ask the question whether governments
can be trusted with financial information on a large scale.

A comment
by a reader of the Times Online underscored the
gravity of the problem:

Given the large number of government employees that clearly
have access to these databases, if the administration and security
systems in place allow for this kind of data to be burned onto an
external removable disc, then it is inevitable that such data already
has been (or will be) deliberately taken and sold to identity theft
fraudsters by a modestly paid, unscrupulous civil servant (it is
unfortunately naive to assume everyone is honest).

This is an issue that has largely been addressed in banks and other
financial institutions who have historically held our private data,
and who have measures in place to prevent such extraction of
confidential data.

The idea of a “momentary blunder” or accidental loss
seems to miss the real risk.

It is true that the private sector is a little better at handling
data, but then the US telecom operators have shown that they are more
than happy to part with data to the government even when the government
requests the data illegally.

In the Indian context, I am worried about the huge amount of data
that is being collected under the tax information network. Moreover,
as India makes hesitant moves towards electronic payment systems,
there seems to be a great deal of eagerness on the part of everybody
including the tax authorities to collect and preserve all the
transaction data. If somebody wants to do data mining on a few
petabytes of data, that is fine, but who will ensure the safety of all
the data? Whom can we sue if the data is lost or stolen?

New Derivative Products in India

Yesterday, the Financial Express published an interview
with me on the proposal by
SEBI earlier this month to launch new derivative products. I made two
main points:

• The Indian market certainly needs new derivatives products. Fixed
  income derivatives are the largest class of derivatives in the global
  derivatives exchanges and these products do not exist in Indian
  exchanges. Interest rate risk is the single biggest risk today both
  for households and for businesses and there is no exchange traded
  mechanism to deal with these risks. This is a very big problem for
  households who do not even have access to the inter bank OTC market
  for interest rate derivatives. With the large amount of floating rate
  home loans that households have on the liabilities side of their balance
  sheet and the large amount of fixed rate tax savings instruments that
  they have on the assets side, there is a clear economic need for
  accessible hedging mechanisms for households to cope with the huge
  interest rate risk that they are carrying. Similarly, with the
  $200,000 window for investments outside India, households will have a
  growing currency risk on their investment portfolio and there is a
  clear need for exchange traded hedging mechanisms. The existing OTC
  market provides risk management tools to business and denies them to
  households and this situation cannot be allowed to continue.
• The time has come for the regulator to move away from micro
  managing the design of specific derivative products and establish
  broad principles instead. Any product which meets minimum standards in
  terms of economic need and safeguards against market manipulation
  should be permitted. Competition in the marketplace should decide
  which products succeed and which fail. Regulators should stop
  pretending that they are wiser than the Markets.

Deposit Insurance and Northern Rock

The flurry of comments and discussion that followed Mervyn King’s interview
to the BBC on November 6, 2007 have led me to the conclusion that the
true lessons from Northern Rock are largely about deposit insurance and not
about bank supervision.

Mervyn King’s interview about the handling of Northern Rock
prompted a series of comments last week in the Financial
Times by Philip Stevens, Willem Buiter and Martin Wolf. This
has prompted me to revisit Northern Rock which I blogged about last
month here
and here. I
am even more convinced than before that the Northern Rock episode does
not reveal fundamental flaws with the model of unified regulation and
separation of monetary policy from bank supervision. I also think that
King’s decision to provide liquidity only at penal rates and
against top class collateral was quite correct. Mervyn King said
in his interview:

If you look at what the European Central Bank lent to banks through
their auctions that they conducted, relative to the size of the
banking system they lent an average of 230 million pounds per bank
participating in their auctions. Northern Rock needed something closer
to 25 billion, 100 times larger than the average amount which the
European Central Bank was lending to banks through their auctions. The
scale of the funding that was needed was staggeringly large.

…

So could we have had an auction that was sufficiently large that
all the banks would have got 20 to 30 billion and Northern Rock
wouldn’t have been noticed in that process? Well, that would
have been an auction on a scale 50 odd times that which any other
Central Bank had engaged in. And I’m absolutely convinced that
the first question you would have asked on that day is: “What on
earth must have happened to the entire British banking system to have
merited an auction of that size?” We were doing this not to bail
out the British banking system, which didn’t need bailing out,
but actually to get money into one institution that needed it.

In my view, the lessons from Northern Rock are:

• In the age of television, even a small bank with retail deposits
  is systemically important. When television starts relaying images of
  depositor panic, there is a risk that investors worldwide are going to
  think that there is a problem with the entire banking system of the
  country in question. This means that the only politically feasible
  solution is to regard almost all retail deposits as de
  facto insured. The only question is whether the deposit
  insurance is ex ante or ex post. The
  realistic solution is a ceiling for deposit insurance approximately
  equal to the level of financial wealth at which financial regulators
  stop worrying about investor protection and treat the individual
  investor on par with institutional investors. In most developed
  countries, this would imply that the ceiling would have to be in the
  range of 1 to 5 million US dollars. To be non distortionary, such a
  large deposit insurance would not only have to be risk based but would
  also have to be funded by a tax on all bank deposits. The point is
  that the negative externality of banking is so large that it needs to
  be addressed with a large tax.
• There is a problem when a bank with some retail deposits has
  disproportionately large wholesale liabilities. Since wholesale
  lenders usually recognize a problem sooner than either retail lenders
  or regulators, uninsured wholesale liabilities are effectively senior
  to insured retail deposits. Thus wholesale lenders obtain the
  advantage of deposit insurance without paying for it. Therefore,
  regulators need to see liquidity management not as a problem for bank
  management, but as the primary mechanism by which uninsured wholesale
  lenders are prevented from free-riding on the deposit insurance
  provided to retail depositors. One way to make this happen is to make
  deposit insurance prohibitively expensive when wholesale liabilities
  become disproportionately large. This would have shut down Northern
  Rock long ago or forced it to become a pure wholesale
  operation. Either way, the problem would have been avoided.

OTC Equity Derivatives in India

I wrote an article
in the Business Standard today arguing for the creation
of an OTC equity derivative market in India.

I made the following points

• Competition between Over the Counter (OTC) markets and exchanges
  forces each market to lower costs and to adopt the best practices of
  the the other market.
• Standardized and highly liquid contracts are best traded in
  organized exchanges because of the enhanced transparency and lower
  systemic risk. However new contracts are often best incubated in OTC
  markets until they achieve a critical mass of liquidity and widespread
  participation at which point they can be moved to the exchange traded
  format. Long dated equity options are today best incubated in OTC
  markets.
• Exchanges should be allowed to introduce flexible options where
  market participants can choose parameters such as exercise prices,
  expiration date and type of expiration (American or European style)
  provided they trade the contracts in large blocks (say $10 million
  notional value). These flexible options are listed, margined and
  cleared like the standard options and therefore combine the
  flexibility of OTC options with the transparency and low systemic risk
  of exchange traded options.
• The Participatory Note (PN) or Offshore Derivative Instruments
  (ODI) market which the Foreign Institutional Investors (FIIs) have
  created outside India is essentially an OTC market in Indian equity
  derivatives. Indian regulations have driven this important market
  outside India and the result is a loss of liquidity for Indian
  markets, a loss of income for Indian financial services firms and a
  loss of access to OTC derivative markets for Indian securities and
  investment firms.
• To bring the PN/ODI market back to India, we need to do two
  things.
  1. The Securities Contract Regulation Act should be
     amended quickly to allow OTC equity derivatives in India. (Flexible
     options are a short term measure that avoids this statutory
     amendment).
  2. We must also establish a tax system for portfolio
     investment similar to that of the United States. The US does not tax
     “Portfolio Interest” income, capital gains on securities
     and income from derivative transactions (“Notional Principal
     Contract” income) earned by foreign investors. For too long,
     India has used the Mauritius double taxation agreement as an excuse
     for not doing something similar, but the Mauritius solution works only
     for investment in equities and not for investment through
     derivatives. The time has come to take Mauritius out of the loop
     altogether.

  I look forward to the day when a securities firm in India
  can sell an OTC derivative to a foreign hedge fund without any of the
  fee income leaking out of India to Mauritius or elsewhere.

Quiet Period in US Public Offerings

Earlier this year, I blogged
about the problems created by the quiet period during public offerings
of shares in the United States. The Lex column on “Quiet
Periods” in the Financial Times yesterday raises the
same issues and refers to the Blackstone example that I mentioned in
my blog posting. Lex concludes by saying that the US Securities and
Exchange Commission (SEC) should put the “onus on companies to
talk rather than hide”. This is a very elegant way of putting
it. Regulations must always impose a duty to disclose rather than a
duty to keep quiet.