Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Monthly Archives: February 2018

Is there a bank-sovereign feedback loop in India?

Between early October 2016 (shortly before demonetization) and today, the Reserve Bank of India (RBI) has cut its policy rate twice (October 4, 2016 and August 2, 2017) to bring the repo rate down by 50 basis points from 6.5% to 6.0%. But the ten year Government of India bond yield is roughly 100 basis points higher than it was in early October 2016. Apparent monetary easing has been accompanied by a substantial tightening of financial conditions. This looks like a reverse of Greenspan’s Conundrum of 2005 in which the concern was that 150 basis points of rise in the US policy rate was accompanied by a falling trend in the long term yield.

Is it possible that the Indian situation could be a mild form of the bank-sovereign feedback loop?

  1. A deterioration of the health of the public sector banks (non performing assets) causes fiscal stress because the sovereign has to recapitalize the banks.

  2. The enhanced borrowing requirement of government causes a rise in government bond yields.

  3. Rising bond yields cause more stress in the public sector banks because they hold a large amount of long term government bonds (unlike the private and foreign banks who tend to hold shorter term bonds). Rising bond yields may also act as a drag on the economy and worsen the non performing assets of the banks. In either case, the deterioration of the health of the public sector banks takes us back to Step 1 and the cycle can begin all over again.

If this analysis is correct, what can be done to break the bank-sovereign feedback loop? Several possibilities come to mind:

  • The government could take duration risk out of the banks with a giant interest rate swap that immunizes the banking system from rising government bond yields. This turns a significant fraction of government debt into floating rate debt.

  • The RBI could take a leaf out of the Yield Curve Control policy of the Bank of Japan, and set monetary policy to prevent a rise in Indian government bond yields. In essence, the policy rate would no longer be the repo rate but the 10 year government bond yield.

  • The government could accomplish a massive pre-emptive recapitalization of the banking system that breaks the loop decisively.

  • The government could turn many of the public sector banks into narrow banks (or even shut them down) to eliminate the feedback loop.

The bank-sovereign feedback loop should not be a big problem for a currency issuing sovereign. This does not require any appeal to MMT, but is simply a reflection of the fact that banking sector liabilities are all nominal liabilities, and a currency issuing sovereign should not have any problem in backstopping these liabilities. If we still see evidence of such a loop, it should reflect some degree of mismatch between monetary policy, fiscal policy, and the bank recapitalization framework. And it should not be hard to fix the problem.











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Can radical blockchain transparency decrease banking frauds?

During the last week, the Indian financial sector has been gripped by the $1.8 billion fraud at Punjab National Bank (PNB). Fingers have been pointed at bank management, at the auditors and at the regulators, but finger pointing and angry denunciations do not solve problems. We did not solve the problem of unfriendly bank tellers by shouting at them; we solved it using technology (Paul Volcker once remarked that the most important financial innovation that he had seen was the ATM). That is probably the route we must take again: we cannot change human nature, but we can change the technology.

The blockchain technology that underpins cryptocurrencies like Bitcoin has the potential to reduce large banking frauds drastically because it enables radical transparency. Every transaction on Bitcoin is public and you do not even need a Bitcoin wallet to see these transactions. Many websites like https://blockexplorer.com/, https://blockchain.info/, https://www.blocktrail.com/BTC, https://btc.com/, and https://live.blockcypher.com/btc/ allow anybody with a web browser anywhere in the world to see every single transaction as it happens. We can use the same technology to allow the whole world to see every large financing or guarantee transaction (above some threshold like a billion rupees).

The shibboleth of bank secrecy can be discarded for large financing transactions because many of them become public anyway:

  • Borrowers disclose a lot of information in their financial statements.
  • Many lenders (mutual funds for example) disclose large bond holdings as part of their portfolio disclosures.
  • All secured lending is entered in a public register of charges under company law.

We could extend this into a uniform requirement to make large loans public:

  • Any large lending (say above a billion rupees) by a financial intermediary.
  • Any lending (regardless of size) to a large borrower (say, with aggregate liabilities to the financial sector of over 10 billion rupees).

The natural medium for such a disclosure is the blockchain. The alternative idea of using a credit registry has been an unmitigated disaster (just think of Equifax), and these agencies create more opaqueness than transparency.

If the PNB fraud pushes us to use the blockchain to make finance more transparent and therefore safer, $1.8 billion may end up being a price well worth paying.

Are banks too opaque to manage?

Fabrizio Spargoli and Christian Upper have a BIS Working Paper with a different title: “Are Banks Opaque? Evidence from Insider Trading” with the following findings:

Our results do not support the conventional wisdom that banks are more opaque than other firms. Yes, purchases by bank insiders are followed by positive stock returns, indicating that banks are opaque. But banks are not special as we find the same effect for other firms. Where banks are special is when bad news arrive. We find that sales by bank insiders are not followed by negative stock returns. This suggests that bank insiders do not receive bad news earlier than outsiders. By contrast, insider sales at non-banks tend to be followed by a decline in stock prices.

My interpretation of the result is quite the opposite: banks are so opaque that even insiders cannot see through the opacity when bad things happen. Sometimes, as in the case of the London Whale, a market participant outside the bank has greater visibility to what is going on.

It appears to me that the findings of Spargoli and Upper are evidence that banks are too opaque to manage. Even a very competent chief executive can be clueless about some activities in a corner of the bank that have the potential to bring down the bank or at least cause severe losses. That would be an additional argument for moving from bank-dominated to market-dominated financial systems.

In the sister blog and on Twitter during December 2017 and January 2018

The following posts appeared on the sister blog (on Computing) during December 2017 and January 2018:

Tweets during December 2017 and January 2018 (other than blog post tweets):