Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Monthly Archives: February 2017

Uberization or not of finance

Two years ago, Mike Carney (Chairman of the Financial Stability Board apart from being Governor of the Bank of England) warned financial regulators that they should:

not be in this position where we’re filling in with prudential regulation after the fact. In other words, facing an Uber-type situation in financial services, which many jurisdictions are struggling with.

(This discussion can be found around 59 minutes into the video from the World Economic Forum Annual Summit at Davos in 2015).

The Uberization of finance does appear to be a probable outcome, and many fintech startups are predicated on this possibility. But then I read the paper by Pollman and Barry on Regulatory Entrepreneurship which they define as:

pursuing a line of business in which changing the law is a significant part of the business plan

Uber and Airbnb are among the prominent examples of regulatory entrepreneurship that they discuss in their paper. Pollman and Barry enumerate several business-related factors, law-related factors and startup-related factors that facilitate regulatory entrepreneurship. Among these are two that appear to pour cold water on the Uberization of finance:

One important factor is the penalty that the law imposes on violators. For example, if the only penalty is a civil fine imposed on the corporation, pushing the boundaries of the law may be an attractive prospect. … On the other hand, if a law provides for the incarceration of the executives of a company that violates it, that may deter the guerrilla growth strategies that some modern regulatory entrepreneurs employ.

Relatedly, another key element is whether the law in question is determined at the local, state, or national level. Change at the state and local level is often possible more quickly than at the national level.

The authors refer to the shutting down of Napster to highlight the difficulties of regulatory entrepreneurship in the face of national level laws that carry significant criminal penalties. This lesson is clearly quite relevant to much of finance.

Another aspect that Pollman and Barry do not mention is that much of regulatory entrepreneurship has succeeded against incumbents who are not very technology savvy. The finance industry on the other hand is technologically quite sophisticated, and is quite capable of adopting and co-opting any successful innovations that the regulatory entrepreneurs may come up with. Examples of such behaviour include:

  • Large investments that the big banks have made in blockchain technology in response to Bitcoin which was a highly anarchist innovation to begin with.

  • Integration of peer lending institutions into mainstream finance – extensive use of securitization, reintermediation by hedge funds and other financiers, collaboration with large banks and so on.

A counterpoint to this is that historically some of the truly radical innovations in finance have come from criminal enterprises. Three centuries ago, central banking was created largely by criminals. Johan Palmstruch, the founder of the world’s oldest central bank, the Sveriges Riksbank of Sweden, was sentenced to death before a royal pardon reduced the death sentence to imprisonment. Another great pioneer of central banking was John Law, who escaped from the English prison where he was held on charges of murder, and went on to preside over the French experiment with central banking in the early eighteenth century. John Law was probably the greatest central banker of his generation, but he spent most of his life roaming across Europe as a fugitive from the law. The founder of the Bank of England, William Paterson was an exception in this regard (he was certainly of high integrity), but he was a reckless adventurer who would probably not be acceptable to any modern central bank. A lot of modern finance is actually re-purposed criminality – negotiable instruments (bills of exchange) were originally created to evade usury laws, fractional reserve banking is alleged to have evolved out of goldsmiths fraudulently lending out customer gold which was not theirs to lend (though this has been disputed), and so on. If there is money to be made in fintech, even the threat of a death penalty will not deter would-be entrepreneurs, and it is at this edge of criminality, that we must look for future radical innovations in finance.

Making India less dependent on banks

In the quarter century since economic reforms, India has created a reasonably well functioning equity market, but has failed to create a well functioning banking system. We began the reforms process with a broken banking system, and have come full circle to a broken banking system once again. And no, the mess is not confined to just the public sector banks.

I am reminded of Albert Einstein’s apocryphal remark that insanity consists in doing the same thing over and over again and expecting different results. That leads to the question: what can we do differently. I can think of several things:

  1. We can reduce dependence on debt and rely more on equity. An easy way to do that would be to abolish the tax deduction of interest and reduce the tax rate. A lower tax rate calculated on PBIT (Profit before Interest and Taxes) would raise the same revenue as a much higher tax rate applied to PBT (Profit before Taxes). This would incentivize firms to issue more equity than debt allowing the economy to benefit from the relatively better developed equity market. This would have the added benefit of reducing systemic risk in the economy. The banking system can be downsized by winding up the most inefficient banks. Incidentally, the tax reforms being formulated in the United States today do contemplate abolishing tax deduction for interest expense.

  2. We can try to forcibly create a bond market by either (a) starving the banking system of capital, or (b) imposing a differential tax on bank borrowing. If bank borrowing is rationed or taxed, companies will be forced to borrow from the bond markets. It is not often realized that one reason for the lack of a bond market is that the banking system is subsidized by repeated bailouts and Too Big to Fail (TBTF) subsidies. An unsubsidized bond market cannot compete against a subsidized banking system. The way to level the playing field and enable a vibrant bond market is to neutralize the banking subsidy through an offsetting tax or to limit the subsidy by rationing.

  3. We can leverage the equity market to improve the functioning of the bond market. More than a decade ago, I wrote:

    “Let me end with a provocative question. Having invented banks first, humanity found it necessary to invent CDOs because they are far more efficient and transparent ways of bundling and trading credit risk. Had we invented CDOs first, would we have ever found it necessary to invent banks?”

    For a short time in 2007, when the CDOs had started failing, but the bank failures had not yet begun, I did experience some degree of doubt about this statement. But now I am convinced that banks are simply badly designed CDOs. The global banking regulators seem to agree – much of the post crisis banking reforms (for example, contingent capital, total loss absorbing capital and funeral plans) are simply adapting the best design features of CDOs to banks. The question is why should we make banks more like CDOs when we can simply have real CDOs. In India, the lower tranches of the CDO could trade in our well functioning equity markets, because they offer equity like returns for equity like risks. The senior most tranche would be very much like bank deposits except that they would be backed by much more capital (supporting tranches).

  4. We could encourage the growth of non bank finance companies. Prior to the Global Financial Crisis, GE Capital was perhaps the sixth largest US financial institution by total assets. Even during the crisis, GE Capital perhaps fared better than the banks – it had only a liquidity problem and not a solvency problem. India too could try and create large non deposit taking non bank finance companies (NBFC) with large equity capital. Again NBFCs find it hard to compete against banks with their TBTF bailout subsidies. Neutralizing or rationing these subsidies is one way to let NBFCs grow larger.

I think the time has come to seriously think out of the box to make India less dependent on its non performing banks.

Predicting human behaviour is legal, predicting machines is not?

I read this Wired story about some hackers being sent to jail for “hacking” slot machines in US casinos. “Hacking” is probably the wrong word to use for this: they made money by predicting what the slot machine would do by observing it carefully, and using their knowledge of the insecure random number generator used in the software of the slot machines. It appears therefore that it is illegal to predict what a machine would do by figuring out its vulnerabilities and observing its behaviour.

The irony of the matter is that the entire business model of the casinos is built on figuring out the vulnerabilities of the human customers, predicting how they would bet under different situations and designing every minute detail of the casino to exploit these vulnerabilities. The New Yorker had a story five years ago about how a casino was redesigned completely when the customer profile changed from predominantly older male customers to more women:

So Thomas redesigned the room. He created a wall of windows to flood the slot machines with natural light. He threw out the old furniture, replacing it with a palette that he called “garden conservatory” … There are Italian marbles … Bowls of floating orchids are set on tables; stone mosaics frame the walkway; the ceiling is a quilt of gold mirrors. Thomas even bought a collection of antique lotus-flower sculptures

Casinos “monitor the earnings of the gaming machines and tables. If a space isn’t bringing in the expected revenue, then Thomas is often put to work.” The design is optimized using a massive amount of research which can justifiably be called “hacking” the human brain. If you look at the Google Scholar search results for the papers of just one top academic (Karen Finlay) in the field of casino design, you will see that she has studied every conceivable design element to determine what can cause people to bet more:

  • A comparison of ambient casino sound and music: Effects on dissociation and on perceptions of elapsed time while playing slot machines
  • Casino decor effects on gambling emotions and intentions
  • Assessing the contribution of gambling venue design elements to problem gambling behaviour
  • The Influence of Casino Architecture and Structure on Problem Gambling Behaviour
  • Measuring the Effects of Pictorial and Text Messages on Memory and Gambling Intentions Within a Casino Environment
  • The Effect of Visual Stimuli in Casinos on Emotional Responses and Problem Gambling Behavior
  • The Effect of Match and Mismatch Between Trait and State Emotion on At-Risk Gambling
  • Effects of slot machine characteristics on problem gambling behaviour

The more recent studies on human behaviour are done using a panoscope which:

features networked immersive displays where individuals are absorbed in an environment (12 feet in diameter) that surrounds them on a 360-degree basis. … Use of these panels creates a totally immersive life-like experience and facilitates the delivery of these manipulations. (Finlay-Gough, Karen, et al. “The Influence of Casino Architecture and Structure on Problem Gambling Behaviour: An Examination Using Virtual Reality Technology.” ECRM2015-Proceedings of the 14th European Conference on Research Methods 2015: ECRM 2015. Academic Conferences Limited, 2015.)

I do not see how this kind of attempt to fathom the workings of the human mind is much different from the hackers buying scrapped slot machines and figuring out how they work.

The better way to think about what is going on is to view it as a bad case of regulatory capture. The Wired story says that “Government regulators, such as the Missouri Gaming Commission, vet the integrity of each algorithm before casinos can deploy it.” The sensible thing to do is for the regulators to decertify these algorithms because the random number generators are not secure and force the casinos to use cryptographically secure random number generators. The casinos do not want to spend the money to change these slot machines and the captured regulators let them run these machines, while taxpayer money is expended chasing the hackers.

Perhaps, we should be less worried about what the hackers have done than about what the casinos are doing. Unlike the vulnerabilities in the slot machines, the vulnerabilities in the human brain cannot be fixed by a software update. Yet hacking the human brain is apparently completely legal, and it is not only the casinos which are doing this. Probably half of the finance industry is based on the same principles.