Open source research in finance

Eighteen months ago, Bill Ackman of the Pershing Square hedge fund
released his “Open Source Model” providing detailed data on
30,499 tranches of 534 CDOs to which the big US bond insurers (MBIA
and Ambac) had exposure. On the basis of this model, he claimed that
MBIA and Ambac were insolvent. At the time, many regarded it as a
publicity stunt; after all Ackman was heavily short these insurers and
was merely talking his book.

While many read Ackman’s
letter, few bothered to download the actual data. This was partly
because the data was really huge (110 megabytes) and the letter warned
that each recalculation of the model took about half an hour on a
typical workstation. Moreover, the yousendit
link where the data was uploaded expired within a few days. In any
case, after the near-collapse of the bond insurers, people lost interest in
the model.

However, last month Benmelech and Dlugosz published a paper on what they called
“The Credit Rating Crisis” which relies partly on this
data to document the failures of the rating agencies. Among other
things, Benmelech and Dlugosz show that CDOs rated by only one rating
agency were more likely to be downgraded than those rated by two or
more agencies. They also confirm what was well known anecdotally about
one particular rating agency being worse than the others.

This suggests that open source research can work in finance. One
way to get transparency about the balance sheet of financial
institutions might be for the regulators to create large detailed
databases which anybody can analyse. I think several gigabytes of data
would do the job, but even if the data grows to a terabyte or more, it
would be well worth the effort.

Updated: Changed “collapse of the bond insurers” to “near-collapse of the bond insurers”

More on Debt Management Office and the Reserve Bank of India

Sankt Ingen responds
to my previous piece
on this subject and asks what is it that the Debt Management Office
can do that the RBI cannot do. Sankt Ingen thinks that I am arguing
for fancy derivatives and similar stuff conjured up by bright young
MBAs. No, what I would like to see is very low brow stuff.

In an institution like the RBI that does something as high brow as
monetary policy and financial stability, the low brow job of peddling
government bonds will never be treated with respect and
seriousness. While the DMO whose sole job is to peddle those bonds
will I hope do that with the same professionalism that an FMCG company
brings to peddling toothpaste.

Yes, I mean that in all seriousness. The job of distributing
government bonds to every nook and corner of the country is as much a
matter of logistics, distribution and marketing as the selling of
detergents and toothpastes. In India (and in many other countries),
the system for distributing toothpastes is far superior to the system
of distributing government bonds (and many other financial
products).

Government bonds are a critical element of the asset allocation
strategies of individuals, companies and institutions. It is a scandal
that their effective distribution is restricted to a handful of elite
institutions.

This lack of diversity of participants is a key factor in the
underdevelopment of the government securities market in India. In
equities, when domestic retail investors are selling, maybe domestic
institutions are buying, and when both of them are selling, maybe
foreign institutions are buying. One wishes that foreign retail could
also participate and bring even greater variety to the market, but we
do have reasonable diversity of players. We did not have this
diversity in the late 1980s or early 1990s in Indian equities and the
markets then lacked the resilience that they have now. At the
slightest shock, the exchanges simply shut down the market to deal
with the imbalance.

When I look at government securities market today, it is just banks
(and LIC at the long end). All banks face the same liquidity shocks
and markets can therefore easily become highly one sided. At a deeper
level, banks are the wrong kind of buyers for long term government
bonds because of the asset liability mismatch. The real reason why
governments borrow from banks is the same as the reason why robbers
steal from banks – that is where the money is easily
available.

The government securities market today is not a market filled with
investors, hedgers and speculators with diverse liquidity needs and
different investment horizons. We have a crazy scheme of small savings
that completely fragments the market by segregating retail investors
in separate instruments altogether. Even the retail trading of
government securities themselves is segregated from the inter bank
market.

The biggest problem is that the RBI does not see investors in
government securities as its customers at all – the banks are
its wards and retail investors are just a nuisance to be segregated in
a tiny and separate corner of the market. I wrote a paper
on this five years ago.

I believe that with the right market design, India can and should
aspire for a government securities market that is deeper and more
liquid than that of the typical emerging market. I think in terms of
the size of the economy, the outstanding stock of rupee government
debt, the existence of a critical mass of financial intermediaries of
reasonable sophistication and the abundance of finance talent in the
country. Yet, the vibrancy that one sees in the equity market or the
commodity derivatives market is lacking in the government bond
market.

I hope that we will get a DMO with a low brow mandate of making
government securities as easy to buy as toothpastes and detergents. I
hope that such a low brow DMO will over a period of several years give
us a deep and vibrant government securities market. This may be a
misplaced hope, but hope is the last thing that I would like to
lose. Anybody who hoped in the 1980s to see a well functioning equity
market would have been dismissed as a day dreamer, but over two
decades, this has indeed come about. Maybe we can repeat that miracle
once again in the market for government securities.

Debt Management Office and the Reserve Bank of India

I wrote a column
in the Financial Express today about the reported views
of the Reserve Bank of India on the establishment of a Debt Management
Office in India.

I deliberately avoided mentioning monetary policy anywhere in the
whole column, but focused on the implications for the government
securities market and for borrowing costs.

The reported suggestion by RBI to postpone the establishment of a
debt management office (DMO) is not a good idea. An independent DMO
would help create a vibrant and dynamic government debt market, and
would reduce the government’s borrowing cost in the long run.

It is worth remembering that the development of a vibrant
government debt market is one of the few financial innovations that
have changed the course of world history. Beginning with sixteenth
century Holland, whose war for independence from the Spanish Empire
was immensely aided by its superior debt market, it has been true that
governments that have been able to borrow from willing lenders have
prevailed over those that have had to rely on forced loans.

India is today at a stage in its economic and financial development
where it needs to shift from relying on captive buyers of government
securities (the modern day equivalent of forced loans) to creating a
deep market of willing buyers for its debt. I see the DMO as an
essential and valuable step in this direction.

When a private sector company issues securities, it goes to great
lengths to assess investor appetite for different kinds of securities
and tries to tailor its securities accordingly. It works with its
investment bankers to improve the liquidity of its securities because
it knows that higher liquidity ultimately reduces the cost of its
borrowing.

Until the late twentieth century, governments around the world were
insufficiently sensitive to these factors and often behaved in a
distinctly investor unfriendly way. All that has changed with the
creation of professionally managed debt management offices in country
after country both in the developed world and in emerging markets.

These DMOs look at debt issuance exactly the way a corporate
treasurer looks at corporate debt issuance. They have a mandate to
borrow at the lowest possible cost, and they know that they can do
this only by making their securities attractive to investors. DMOs
around the world have worked on making the systems for issuing,
trading and settling government securities much more investor
friendly.

Partly as a result of this, government debt markets globally have
evolved in depth, liquidity and sophistication. For too long, India
has relied on the easy route of placing government securities with
captive banks and insurance companies. The unfortunate side effect of
doing this is that the development of government securities markets in
India has been stunted.

Thanks to our fiscal profligacy, India has a large outstanding
stock of government securities as a percentage of GDP. This large
stock of debt provides a foundation for a very liquid and deep
market. Unfortunately, this potential has not been realised.

Other than a few on “the run securities”, most
government securities are hardly traded. Even the market for liquid
“the run securities” securities lacks diversity of
players. Government securities is largely an inter bank market. As a
result, when there is a liquidity shock to the banking system, the
government securities market becomes a one sided market. It lacks
resilience – the ability of the market to quickly return to normalcy
after a large shock.

A professionally managed DMO should change all this. In the long
run, the establishment of a DMO with a clear mandate and
accountability would help reduce borrowing costs for the government in
many ways. Unlike the RBI or the Ministry of Finance, the DMO has only
one function and a very well defined objective. This makes it easy to
measure the performance of the DMO.

When one reads the audit reports evaluating the DMOs of some
leading countries in the world, one is impressed by the clarity of
discussion on factors like the maturity composition of debt that
impact the borrowing cost of the government. In India by contrast,
there is today no real accountability for the interest cost of the
government, which is currently the single biggest item of government
expenditure.

Apart from lower borrowing costs for the government, there are many
other benefits from a liquid and well developed market for government
bonds. The yield curve for “risk free” government
securities is the benchmark for all other interest rates in the
economy.

The lack of a reliable and robust yield curve in the Indian
government securities market impedes the valuation and trading of
other debt securities as well. In other words, a sophisticated
government securities market is the first step to the creation of a
vibrant corporate debt market.

I believe therefore that India should not waste any time in setting
up a professionally managed DMO. What about the argument that this is
the wrong time to do so because of the large borrowing programme this
year? The savings pool in India is deep enough for the government to
borrow enough to cover its fiscal deficit in the free market. No, we
do not need “forced loans” – at least not yet.

Simplified Finance: Part III

In my last two posts on this subject, I talked about how a
simplified financial sector would look like. Part I presented an ultra simplified financial sector with a payment system, a stock exchange, “narrow” insurance companies and practically nothing else. I argued that this system with no banks, no debt and no central banks would do a reasonably good job of supporting economic growth provided high levels of corporate governance could be
enforced. Since that was unlikely to happen, Part II introduced long term corporate debt but still avoided banks. The difficulty here was that debt would not be available to smaller enterprises.

What happens when we introduce banks or bank like entities? To
understand this we must recognize that corporate debt is already a
derivative contract – because of limited liability, debt is
economically the same as a put option on the assets of the company. If the value of the assets is less than the amount of debt, the company default and the assets belong to the creditors. This is economically equivalent to the shareholders selling the assets to the creditors at a price equal to the amount of debt. This is nothing but a put option. So the model of Part II had derivatives already though they were not described as such.

In part II, the toxicity of these derivatives was reduced by two
means – first by allowing only long term debt and second by
requiring this debt to be bought directly by individuals and not by
financial intermediaries. The effect of this restriction would be to
reduce the quantum of the debt and thereby reduce the amount of
derivatives floating around in the economy. The low leverage also
avoids the need for corporate hedging.

Once we introduce banks, we would also have to bring in short term debt since the assets and liabilities of the banks would be short
term. The presence of banks as well as short term debt would encourage companies to take on higher levels of leverage to benefit from the interest tax shield. This makes corporate risk management
essential.

More troubling is the risk management of the banks themselves. A
bank is nothing but a CDO as I argued
more than three years ago (see also this entry) – it is a portfolio of debt securities. The probability distribution of a credit portfolio is
extremely skewed and fat tailed even if the values of the real assets
are normally distributed. (Vasicek derived this so called normal
inverse distribution way back in 1997). If the real assets themselves
have fat tailed distributions and display non linear dependence
patterns, the distribution of the credit portfolio is even more
toxic. To manage the toxicity of this distribution, the bank has to
use various risk management tools.

An economy with free floating exchange rates and interest rates
must provide its banks (and leverage companies) with interest rate and currency derivatives. This presents us with a trilemma – (1) the economy can operate with fixed exchange rates and administered (repressed) interest rates or (2) it can run without banks and leveraged companies or (3) it can create derivative markets. In terms of financial innovation we cannot roll the clock back to the 1970s without also restoring the world economic order of the early 1970s

In all this, I have not talked about credit to individuals at all
because it is possible to visualize a fairly advanced economy in which
there is no consumer credit at all. It is possible to argue that the
economic benefits of retail credit is quite small. Most of retail
credit is for housing and as I argued in Part I, there is little economic reason for people to own the houses that they live. From the days when the suffrage was limited to those owning immovable property, home ownership has been a political question rather than an economic one. Most of the other consumer credit (credit cards and credit for consumer durables) is taken by those who are less than fully rational.

While economists talk about consumption smoothing, very little of
consumer credit actually performs this function. The only important
consumer credit in my opinion is the educational loan which allows
investment in human capital. This is potentially as important as
credit to businesses (which allows investment in physical capital),
but as I argued in Part I, there are other equity like solutions to
this problem as well.

A financial system without a mortgage market at all would not have encountered the crisis of 2007 and 2008 which have been rooted in the mortgage markets. But it would not have been immune to crises. Financial history teaches us that exposure to commercial real estate and to over-leveraged companies can create banking crises without any help from mortgages or from any other financial
innovation.

In short, creation of banks and other pools of credit is the most
toxic financial innovation ever but there might be good reasons for
living with the consequences of this toxicity.

Loose fiscal plus tight monetary policy

I have a column
in the Financial Express today on the dangers of
combining loose fiscal policy with tight monetary policy.

The movement of equity and bond markets after the announcement of
the budget is threatening to look like a re-run of early 2008 when
falling stock markets and rising interest rates delivered a double
whammy to the economy. Monetary policy needs to respond to this threat
and avoid a similar double whammy now.

To recall what happened in early 2008, the stock market dropped by
nearly 40% from mid-January to mid-July, while the 10-year government
bond yield rose by over 180 basis points. The corporate sector found
that both equity and debt were either unavailable or too
expensive. With a lag, this funding squeeze had a highly negative
impact on investment and on the broader economy.

The rise in interest rates at that time was due to the tight money
policy followed by the RBI in response to double digit inflation
caused by rising prices of food and oil. What nobody knew then, but is
evident now is that the inflation of early 2008 was a transient
phenomenon that was being killed by the global economic downturn. In
retrospect, the tightening of interest rates was unnecessary.

The situation now has some similarities. The failure of the monsoon
so far is causing fears of food price inflation. These fears would
weigh on RBI and could induce it to keep monetary policy too tight. At
the same time, the spending and borrowing programmes announced in the
budget has caused long-term interest rates to rise. Interest rates
would rise even further if RBI does not accommodate the borrowing
through monetary easing.

Loose fiscal policy combined with a monetary policy fixated on
inflation can cause interest rates to explode. In the US, in the early
1980s this was what happened when President Reagan embarked on a
spending spree while the Federal Reserve under Paul Volcker declared
war on inflation. The yield on long term US government bonds crossed
15% and shorter maturity yields rose even higher. This combined with
the rising dollar (itself a result of the high interest rates) brought
about a nasty recession in the US.

A recession induced by high interest rates is the last thing that
India needs today when the economy is being kept afloat by a large
fiscal stimulus. If we take away the support provided to the core
sectors from government spending on infrastructure and the support
provided to consumer durables by the sixth pay commission, the economy
is in pretty bad shape. In this context, the fiscal stimulus is
unavoidable and the only question is whether the central bank will
accommodate the fiscal deficit through its monetary policy.

A lot of the discussion on the fiscal deficit in recent days has
focused on the ‘crowding out’ of private borrowing by
government borrowing. In today’s environment I worry more about
private borrowing being crowded out by high interest rates, and
fortunately monetary policy is a tool that can prevent this.

Many countries are running large deficits. The fiscal deficits of
the US and the UK are much higher than ours as a percentage of
GDP. The big difference is that in those countries, extremely loose
monetary policy has worked in tandem with the fiscal policy. At
extremely low interest rates, higher levels of government debt are
sustainable simply because the cost of servicing the debt is low.

In India on the other hand, we have turned to fiscal policy long
before exhausting the limits of monetary policy. This means that the
government is undertaking huge borrowing at relatively high interest
rates. The resulting high interest bill will only make the fiscal
position worse in coming years.

In the event of a failed monsoon, tight monetary policy can control
food price inflation by ensuring people run out of money before they
run out of food. It is, however, much less painful for the broader
economy to take advantage of our comfortable foreign exchange reserves
and tackle food price inflation through aggressive imports.

Turning to the stock market, a modest decline in stock prices is
not worrying. There is little point in propping up asset price bubbles
when the economic fundamentals are as weak as they are today. What I
find more worrying is the possible closing of the primary equity
market that had begun to open up for Indian companies in May and June
in the form of private placements.

There are signs that this window is closing again due to rising
global risk aversion as well as changing risk perceptions about
India. If this were to happen, then the corporate sector would be
starved of risk capital as it tries to restructure and deleverage
while grappling with the challenging economic environment. It is
important to keep the primary market open for sound companies that are
willing to raise equity at realistic valuations.

Lehman Risk, Segregation, Net Margins and Cash Margins

Lehman’s bankruptcy was a nightmare for those who had
deposited margins with Lehman (particularly Lehman Brothers
International Europe in London) for their derivative trades. Many of
them ended up as unsecured creditors of Lehman and will have to wait
for years to get back a few cents in the dollar. Margins deposited
with Lehman US were protected by segregation rules which cannot be
overridden by contract, but apparently many hedge funds chose to use
LBIE in London to get higher leverage and signed away many of their
rights.

Lehman risk is a significant risk for derivative exchanges because
even when the risk containment processes of the exchanges work
perfectly, the ultimate customer ends up with little or no protection
at all. This is an important issue, but even after fruitful
discussions with some UK lawyers on this matter, my understanding of
the legal issues has been rather poor.

Now however we have access to a 158 page report
submitted by derivative dealers to the New York Fed that is based on
work by 13 lawyers from six countries on all the legal complexities
involved in providing protection to ultimate customers. The report
focuses on Central Counter Parties (CCPs) clearing CDS contracts but
the principles are of broader application.

The key takeaways from the report are:

• In the event of a CM [Clearing Member] default, the two essential
  elements of the customer protection analysis are (i) the manner in
  which margin is provided and held, and particularly, the extent to
  which margin is segregated from the CM’s assets and recoverable
  by the customers (the “Segregation Analysis”) and (ii) the
  effectiveness of the CCP’s procedures for the transfer or
  novation of customer positions and related margin (the
  “Portability Analysis”).
• Collection by CCPs of the Gross Amount (rather than just the Net
  Amount) may enhance both the Segregation Analysis and the Portability
  Analysis.
• It is better for customers to grant a security interest in the
  securities provided as margin than to transfer the securities outright
  to the CM. By doing this they ensure that the margin would remain
  property of the customers. Proprietary claimants may have the
  ability (subject to tracing or other requirements) to recover their
  property ahead of unsecured creditors, on the ground that the property
  they deposited with the insolvent entity did not form part of the
  insolvency estate, but was merely held in a safekeeping or custodial
  capacity.
• For certain entity types of CMs, the posting of securities is
  preferable to cash from a customer protection standpoint.
• Holding margin away from an insolvent CM may be helpful to
  customers for several reasons.
• Where margin is held at the CCP or a third-party custodian, it is
  generally the case that, the more direct the contractual relationship
  between customers and the CCP or third-party custodian, the stronger
  the corresponding Segregation Analysis becomes. For instance, the
  notion that ownership of customer margin does not pass to the CM would
  be buttressed to the extent the CM were acting as agent
  vis-á-vis the CCP on behalf of customers (rather than as
  principal).
• Portability of positions and related margin is highly desirable,
  as it reduces the need for position close-outs and resulting
  transaction costs. Any transfer or novation of positions and related
  margin requires a willing transferee CM, but it is important to be
  able to effect the transfer legally without the consent of the
  insolvent transferor CM.

Finally, the report states upfront that “This Report does not
address the risk of fraud, and assumes that the relevant CM has
complied with its segregation and other obligations in respect of
customer margin.”

Indian derivative exchanges use gross margins and enforce some
degree of segregation of client assets, but I think that a lot can and
needs to be done to improve customer protection against Lehman
risk. I particularly like the idea of replacing cash margins with
security interest in low risk securities.

Simplified Finance: Part II

In my earlier post (see Part
I) on this subject, I talked about an ultra-simplified financial
system that “has a payment system, a spot foreign exchange
market, “pure” life insurance companies, an equity market
and practically nothing else … no banks, no central banks, no debt
markets and no derivative markets.”

I did emphasize that my speculation was completely ahistorical. I
did not perhaps make it clear that I also assumed fairly well
developed legal systems and governance structures without which equity
markets are a complete non starter. In early stages of economic and
financial development, it is difficult to create equity markets that
work. I have no quarrels with the claim (for example at the Lin
roundtable) that stock exchanges are pre-mature at that stage of
development.

Coming back to the minimalist design, the next thing that one would
want to add would be a debt market. First a government bond market and
second a corporate bond market.

I mentioned in my first post that the government bond market is as
above all a concession to the practical reality of governmental
profligacy. Many people that I talk to think of government bond
markets as mechanisms that increase the asset allocation opportunities
for investors and allow them to choose less risky portfolios if they
like. I think that a lot of this is money illusion. Government bonds
are in fact very risky because of the ever present threat of inflation
and hyper inflation. The tail risk of bonds is greater than the tail
risk of equities.

The introduction of government bonds does not by itself require the
introduction of any other markets including interest rate
derivatives. These derivatives are needed when you have leveraged
financial institutions and in the minimalist design so far there are
no such institutions.

Adding a corporate bond market is more complicated because it
creates leveraged entities. It is difficult for leveraged entities to
exist without derivative markets particularly commodity and currency
derivatives. We could avoid this by having only long term corporate
bond markets. The absence of financial institutions and short term
debt markets would automatically limit the leverage of firms and then
it may be possible to get by without derivative markets.

More troublesome is that adding corporate bonds without adding
banks and other financial intermediaries would create a strong bias
against small firms. It is easier for small firms to access equity
markets than it is for them to access corporate bond markets. To level
the playing field, it may be necessary to add bank like intermediaries
that would lend to smaller enterprises. But once we add leveraged
financial intermediaries, it is impossible to have a simplified
financial system anymore as I shall discuss in the next part of this
series.

UK proposal for consumer guidance in financial services

The UK has put out its proposals
for financial regulation reforms, but many people expect the current
government to lose the elections next year and believe that the new
government will push regulations in a totally different direction.

The Governor of the Bank of England has been on a confrontational
path with the government and some believe that he is already more
concerned about his relationships with the next government than with
the current one. He has been arguing for more powers to go with the
Bank’s mandate for financial stability complaining
that

So it is not entirely clear how the Bank will be able to
discharge its new statutory responsibility if we can do no more than
issue sermons or organise burials.

I thought therefore that the following passage in the
government’s proposal was telling the governor to get on with
his sermons and stop complaining.:

One of the existing key responsibilities of the Bank of England,
which will continue to be a significant feature of its new role, is to
analyse and warn of emerging risks to financial stability in the UK,
principally by means of its Financial Stability Report, published
twice-yearly. It is important that the Bank retains this independent
voice, to warn publicly of risks facing banks and financial markets in
the UK.”

What I found more interesting than all this petty politics is the
set of suggestions on consumer education and protection:

• “While financial services and food are clearly very
  different classes of consumer products, there may be important lessons
  to be learned from food labelling for improving the transparency of
  financial products … However, there is a risk that a voluntary
  scheme would not work – for products which would be rated as
  complex or expensive, there would be a strong incentive on providers
  not to provide a rating at all. The Government is therefore inclined
  to work towards a compulsory scheme.”
• “ The Government therefore invites views on the case for
  legislating to … introduce some form of collective action through
  which consumers can enforce their rights to redress.” This
  looked exciting but the actual proposal is quite dull and very
  different from the US class action mechanism.
• The big ticket item in terms of cost is the money guidance service
  for “making impartial generic financial advice on a wide range
  of personal finance issues accessible to all.” The government
  estimates that over the next 52 years, the cost (present value) of
  providing this service will be £1.3 – 2.7 billion. It believes
  however that the benefits will be ten times as large. Personally, I
  think that the money
  made clear web site run by the FSA is a good service, but the
  proposals go far beyond a good web site: “ This service offers
  impartial help that consumers can trust, safe in the knowledge that
  Moneymadeclear advisors will never try to sell them anything. People
  can access the service in a way that suits them – through the
  website or by speaking to trained advisors on the phone or face to
  face, who can give information and support that is tailored to
  individuals’ needs and circumstances.” For this kind of
  service, the cost estimate appears ridiculously low.

One distressing element in the cost benefit analysis is the claim
that arming the FSA with greater powers to curb short selling would
bring benefits of up to £9 billion over the next ten years in
present value terms. I think the upper bound here should be zero and
the lower bound a large negative number.

Governance of banks

I read two interesting pieces today about bank governance. First
was John Kay’s column (“Our banks are beyond the control
of mere mortals”) in the Financial Times in which
he says that the top management of UK banks were people of exceptional
ability:

… most of the people who sat on the boards of failed banks were
individuals whose services other companies would have been delighted
to attract … Our banks were not run by idiots. They were run by able
men who were out of their depth. If their aspirations were beyond
their capacity it is because they were probably beyond anyone’s
capacity.

The statement of Kay that I agreed with most was:

If you employ an alchemist who fails to turn base metal into gold,
the alchemist is certainly a fool and a fraud but the greater fool is
the patron.

Needless to say my understanding is that the true patron in this
case was not the shareholder but the government.

Today, I also read a paper (“Subprime
Crisis and Board (In-)Competence: Private vs. Public Banks in Germany
”) by Hau and Thum (hat tip FinanceProfessor). This
paper tries to understand why during the current crisis, the losses at
the large public sector banks in Germany were far worse than those of
private sector banks. While the big three private banks (Deutsche,
Commerzbank and Dresdner) have suffered quite badly, the losses (as a
percentage of assets) of the large public sector banks (like Bayern
LB, West LB and KfW) are truly dismal.

Hau and Thum do a painstaking job of going through the biographical
data of each and every board member of each of the 29 banks in Germany
with assets above € 40 billion and rating each of these 593 board
members on 14 different indicators measuring three dimensions of
competence – educational qualification, management experience
and finance related experience. They first show that the board members
of public sector banks fared badly on all these three
dimensions. Next, their regression results show that performance of
banks is strongly related to the finance experience of the board
members. They conclude that the poor performance of the German public
sector banks is due to their poor governance.

My only problem with this conclusion is that their first regression
equation using just a dummy variable for state ownership has much
higher explanatory power (R-square) than their later regressions using
board competence measures. Unfortunately, they do not report any
regressions containing both board competence and the ownership dummy.
Therefore, we do not know whether board competence has any incremental
explanatory power over and above that as a proxy for state
ownership. The only light that they throw on this is a regression
where they show that state ownership has only a small impact on
executive compensation. They use this result to argue that state
ownership is not the causal variable. But state ownership can affect
performance in other ways – for example, by encouraging greater
risk taking because of the implicit government support.

How far can finance be simplified? Part I

In the wake of the global financial crisis, there has been a lot of
discussion about how finance became too complex and how it needs to be
simplified. This led me to speculate on how far finance can indeed be
simplified. This is a question that I would like to address in
several parts as I use this blog to clarify my own thoughts. Caveat:
my entire speculation is completely ahistorical – it is a clean
slate design which ignores the existing institutional structure
completely.

In this post, I describe an ultra-minimalist financial sector that
has a payment system, a spot foreign exchange market,
“pure” life insurance companies, an equity market and
practically nothing else. In this ultra-minimalist model, there are no
banks, no central banks, no debt markets and no derivative
markets. The payment system would essentially be a retail version of a
real time gross settlement system which in principle needs neither
banks nor a central bank. It is essentially a piece of technological
infrastructure and nothing more – a central depository for
cash. Money could be fiat money or commodity money or anything
else.

By pure life insurance, I mean first of all that the companies
offer term insurance which unlike endowment insurance is not bundled
with investment products. Secondly, level premiums would be replaced
by rising (actuarially fair) premiums so that there is very little
investment component in the insurance product. Finally, insurance
would ideally be redesigned so that the life insurers take micro
mortality risk (the cross sectional variation in mortality rates at a
point in time) but not macro mortality risk (changes in life
expectancy over time).

If we can make these changes, insurance companies become easy to
run and easy to regulate. They simply become applications of the law
of large numbers and involve vastly reduced risk taking over long
horizons. Incidentally, I believe that macro-mortality risk is
practically unhedgeable and uninsurable. Insurers can credibly claim
to provide protection against this risk only by having recourse to a
bail out by the state. Perhaps, it is ultimately beyond even the
resources of the state to credibly insure against macro-mortality
risk.

In the absence of debt, there are hardly any prudential regulations
except possibly for the insurance companies. Financial regulation
consists primarily of conduct of business regulators and consumer
protection regulators.

How can a financial system operate without debt? Well, the
Modigliani-Miller theorem says that lack of debt is not a serious
problem for the corporate sector except that the tax advantage of debt
is lost. One could assume that the government simply enacts a lower
rate of corporate tax so that the elimination of tax deductible
interest is revenue neutral to the state.

If there is no leverage of any kind, the need for derivative
markets is vastly reduced. Corporate use of derivatives is principally
to economize on equity capital. Since equity is the ultimate hedge of
every conceivable (and inconceivable) kind of risk, if you have enough
of equity, you can choose not to hedge anything at all and still you
will not go broke. One could use a version of the Modigliani-Miller
argument to show that corporate hedging is irrelevant unless it
introduces deadweight losses like bankruptcy costs.

This is not the whole story because apart from corporate hedging we
must also worry about optimal allocation of risk among individuals. I
believe however that in the spirit of Arrow’s 1964 paper
(“The role of securities in the optimal allocation of
risk-bearing”), the equity markets span sufficient states of the
world to permit a reasonable allocation of risk bearing among
individuals. The practical consequences of not having a derivative
market may not be much in a world without debt.

General insurance is essentially a substitute for derivatives and
it too can be eliminated in this minimalist design. If corporations do
not have debt and if individuals hold diversified portfolios of non
human assets, then they can self-insure all forms of property
risk. Insurance is required only for non diversifiable human capital
which is why pure life insurance cannot be eliminated.

The Capital Asset Pricing Model would not hold because there is no
risk free asset. I do not see this as a problem because we would still
have the zero beta model of Black (1972) which is not significantly
more difficult to use. (As an aside, if we focus on real returns
instead of nominal returns, there is no risk free asset
anyway. Inflation indexed bonds issued by the government are subject
to significant default risk since the printing press is not sufficient
to pay off these bonds.)

Passively managed mutual funds (exchange traded index funds for
example) are nice to have because they allow individuals to achieve
diversified portfolios very easily. But if the stock exchange allows
shares to be traded in small lots, even small investors may be able to
hold 25-40 stocks directly and obtain most of the gains of
diversification. Exchanges could also allow basket trades in indices
to achieve the same thing.

In the ultra-minimalist design there is no trade finance other than
whatever trade credit one corporation chooses to extend to another out
of its own resources. There are no letters of credit (which are
actually highly complex credit derivatives!).

The absence of a debt market means that there are no mortgages. One
possibility is that most houses are owned by corporations that rent it
out to individuals. We do not need to own the homes that we live in
any more than we need to own the offices that we work in. (See my post
on this a year go.)Individuals would be able to obtain exposure to
real estate by buying shares of these companies. (Another – less
preferred – option is that people would live in rented houses in
early stages of the life cycle and buy houses only later in life.)

One difficulty with the minimalist design is the lack of
educational loans. Education would have to be financed through equity
claims to an even bigger extent than it is today. Even today, the
successful university that attracts lots of endowments essentially has
an equity claim (an out of the money call option?) on the human
capital of each of its alumni and the returns on this equity claim are
used to subsidize (finance) a lot of the education.

I see two big problems with this ultra-minimalist design. First is
that Jensen-Meckling pointed out in 1976 that the disciplining power
of debt is useful in reducing the agency problems between the managers
and the shareholders. We would therefore need very robust corporate
governance frameworks (including a healthy market for corporate
control) in a world without any debt. This would be a problem more for
mature businesses that generate a lot of free cash flow.

Second is that under the assumption that governments are and will
always be profligate, we need a government bond market. Theoretically
also government debt can achieve some intergenerational transfers that
would otherwise be difficult to accomplish, but I think this is less
important than the practical reality of governmental profligacy.

In subsequent blog posts, I hope to extend the ultra-minimalist
financial sector to allow for a corporate and government debt market
increasing complexity one step at a time.

On the whole however, even the ultra-minimalist financial sector
would be able to support a vibrant and modern economy. Clearly, it is
the equity market that does the heavy lifting in this minimalist
design by taking charge of both resource allocation and risk
allocation.