Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Allowing a corporate body to be a director

A few months back, Joseph Franco published a fascinating paper about a commoditized governance model adopted by a small minority of US mutual funds where the entire governance is outsourced to an unaffiliated entity that specializes in providing governance services. (Commoditized Governance: The Curious Case of Investment Company Shared Series Trusts (February 14, 2019). 44 J. Corp. L. 233 (2018) ; Suffolk University Law School Research Paper No. 19-7. Available at SSRN: Franco concludes that this model is merely an interesting curiosity:

Where a board’s role primarily involves organizational, rather than strategic, oversight of an underlying business, as in the fund industry, commoditized governance may prove attractive for at least some industry participants. In contrast, where a board’s role encompasses both organizational and strategic oversight of an underlying business, as is more commonly the case, commoditized governance will not be a successful governance model. Accordingly, and consistent with practical experience, commoditized governance will exist largely as an exceptional, rather than common, form of entity governance.

This discussion got me thinking about a related idea – would it make sense to let specialized unaffiliated corporate bodies (like LLPs, LLCs or private companies) to become independent directors of large companies? (I do not want to contemplate the recursion involved in letting the independent director be another listed company.)

The current model of allowing only individuals to become independent directors is not working well. First of all, most independent directors have quite meagre wealth, and so when things go wrong, investors can recover virtually nothing by suing the independent directors (They gain much more by suing the auditors or other gatekeepers). At the same time, prosecutors and regulators are very keen to punish the directors, and this keenness often depends more on the quantum of the loss and less on the degree of negligence of the director. This means that highly risk averse people would be reluctant to become independent directors. If the only people willing to serve on the board are those with a high degree of risk tolerance, then the companies that they govern would naturally tend to pursue high risk strategies as was well illustrated by the Global Financial Crisis of 2008.

Second, most independent directors lack the administrative and analytical support that is often needed to challenge management strategy at a fundamental level. Almost all independent directors can only envy the massive support that non independent directors (venture capitalists, private equity firms, activist investors, nominees of the lenders and representatives of controlling shareholders) get from their respective organizations. Unfortunately, these well endowed non independent directors are often more interested in looking after the interests of their respective constituencies, than the interests of the company itself or its shareholders as a whole.

The governance deficit that we observe in some of the largest companies in the US, in India, and elsewhere in the world, is symptomatic of these fundamental problems of the current model of relying on individuals to serve as independent directors. I think there is much to be gained by shifting to a model of incorporated independent directors. This will also make it easier to impose capital adequacy and skin in the game requirements. Valuation metrics in the financial services industry (for example, asset managers and rating agencies) suggest that a large incorporated independent director service provider would command a valuation of 5 – 10 times revenue. If independent directors are paid 0.5 – 1% of profits, and each incorporated independent director serves on boards of 30 – 100 large companies, then the independent directors of a company would probably have a combined valuation of twice the annual profits of a large company. That would represent a juicy litigation target for shareholders who suffer losses due to a governance failure (probably a more juicy target than the auditors). The large franchise value of the business would motivate these incorporated independent directors to exercise a high degree of diligence in performing their work, and would also make them highly sensitive to reputation risk. Would this not be a major improvement over the current system?


Bonds and loans

Banks give loans, while mutual funds buy bonds. Recent difficulties of Indian debt mutual funds in dealing with corporate defaults suggest, however, that these lines are quite blurred. Illiquid bonds are like loans in all but name, and then mutual funds start looking a lot like banks with all the attendant risks. Problems of this kind are not unique to India. The suspension of dealing in the LF Woodward Equity Income Fund run by one of the UK’s “star” fund managers raises similar questions about the difference between an equity mutual fund and a venture capital fund.

Both in the Indian and the UK situations, the core of the problem is that while regulators insisted on mutual funds investing in listed assets, “listed” does not necessarily mean “liquid”. The core premise of an open end mutual fund is that assets are sufficiently liquid that (a) no external liquidity support is needed and (b) a fair Net Asset Value (NAV) can be reliably computed. The problem is that many listed assets do not meet this requirement (and, on the contrary, some unlisted assets might).

In India, we have created a large debt mutual fund industry without paying enough attention to creating a liquid corporate bond market. The result is that much of what passes as bonds are loans dressed up in the legalese of bonds and listed on exchanges which collect listing fees but do not provide worthwhile liquidity.

More importantly, we have not encouraged the creation of a vibrant Credit Default Swap (CDS) market. A liquid CDS market would facilitate the flow of negative information about bonds (through shorting the CDS) and would thus hopefully provide early warning signals about impending downgrades and defaults. Currently, distressed bonds are often valued close to par right up to the date of default, and then they just fall off a cliff.

Unfortunately, regulators in India have been hesitant to allow markets that can speak truth to power, while being very happy to create a simulacrum of a corporate bond market.

Korean derivatives reforms come full circle

Back in 2011, South Korea embarked on a significant clampdown on retail participation in its equity derivatives market which is one of the largest in the world. The result of these measures was to effectively hand over the Korean derivatives market to foreigners. As for protecting retail investors from speculative misadventures, probably the only effect was to divert the speculative energies into bitcoin, exotic structured products and the like. It took the Koreans eight years to realize that the 2011 measures had basically thrown the baby out with the bathwater. Now they are pedalling back furiously and trying to bring Korean investors back into the market. The announcement last week by the Korean Financial Services Commission (FSC) reads like a mea culpa (if you read between the lines).

This episode holds a lot of lessons for India as well as we too have a host of would-be reformers who would love to clampdown on retail speculation in equity derivatives. There is every reason to believe that if they succeed, the results will be similar to that in Korea – the purported cure will be worse than the purported disease.

Blockchain in Finance

I have a perspectives piece in the current issue of Vikalpa about Blockchain in Finance. I have been teaching an elective course on the Blockchain for over three years now, and my approach has been to treat both mainstream finance and crypto finance with equal dollops of scepticism, cynicism and openness. That is what I do in this piece as well:

Blockchain – the decentralized replicated ledger technology that underlies Bitcoin and other cryptocurrencies – provides a potentially attractive alternative way to organize modern finance. Currently, the financial system depends on a number of centralized trusted intermediaries: central counter parties (CCPs) guarantee trades in exchanges; central securities depositories (CSDs) provide securities settlement; the Society for Worldwide Interbank Financial Telecommunication (SWIFT) intermediates global transfer of money; CLS Bank handles the settlement of foreign exchange transactions, a handful of banks dominate correspondent banking, and an even smaller number provide custodial services to large investment institutions. Until a decade ago, it was commonly assumed that the financial strength and sound management of these central hubs ensured that they were extremely unlikely to fail. More importantly, it was assumed that they were too big to fail (TBTF), so that the government would step in and bail them out if they did fail. The Global Financial Crisis of 2007–2008 shattered these assumptions as many large banks in the most advanced economies of the world either failed or were very reluctantly bailed out. The Eurozone Crisis of 2010–2012 stoked the fear that even rich country sovereigns could potentially default on their obligations. Finally, repeated instances of hacking of the computers of large financial institutions is another factor that has destroyed trust. When trust in the central hubs of finance is being increasingly questioned, decentralized systems like the blockchain that reduce the need for such trust become attractive.

However, even a decade after the launch of Bitcoin, we have seen only a few pilot applications of blockchains to other parts of finance. This is because cryptocurrencies (while being extremely challenging technologically) encountered very few legal/commercial barriers, and could therefore make quick progress after Bitcoin solved the engineering problem. The blockchain has many other potential finance applications – mainstream payment and settlement, securities issuance, clearing and settlement, derivatives and other financial instruments, trade repositories, credit bureaus, corporate governance, and many others. Blockchain applications in many of these domains are already technologically feasible, and the challenges are primarily legal, regulatory, institutional, and commercial. It could take many years to overcome these legal/commercial barriers, and mainstream financial intermediaries could use this time window to rebuild their lost trust quickly enough to stave off the blockchain challenge. However, whether they are successful in rebuilding the trust, or whether they will be disrupted by the new technology remains to be seen.

Blockchain is still an evolving and therefore immature technology; it is hard to predict how successful it would be outside its only proven use domain of cryptocurrencies. History teaches us that radically new technologies take many decades to realize their full potential. Thus it is perfectly possible that blockchain would prove revolutionary in the years to come despite its patchy success so far. What is certain is that businesses should be looking at this technology and understanding it because its underlying ideas are powerful and likely to be influential.

Learning from Crises

Last week, Anwer S. Ahmed, Brant E. Christensen, Adam J. Olson and Christopher G. Yust posted a summary of their research on how banks with leaders experienced in past crises fared in global financial crisis (GFC). Their conclusion is:

We find that banks led by executives and directors with past crisis experience had significantly higher ROA before and during the GFC, fewer failures during the GFC, lower risk-weighted assets in the GFC, less exposure to real estate loans both before and during the GFC, timelier loan loss provisions in the GFC, and more persistent earnings before and during the GFC.

There are two ways of looking at this result. At the micro level, organizations should try to recruit managers with such experience. More important in my view is the macro level implication: it is good for society to have a large pool of managers with past crisis experience. That would ensure that the entire financial system copes better with new crises. But for that to happen, we need crises (at least mild crises) to happen with some degree of regularity.

Already, a decade after the GFC, I think a whole generation of traders and bankers have entered the financial system who have no first hand knowledge of dealing with a crisis. All that they have seen is a financial market numbed by ultra loose monetary policy and policy-puts. Their experience so far is that large economic and geo-political shocks (Brexit or the US-China trade war) have very mild and transient effects on market prices and volatility. The complacency of this generation is probably balanced by the battle scarred veterans who dominate the senior ranks of most banks. But over a period of time, many of these crisis-experienced leaders will retire or leave. It is quite likely that when the next big crisis comes along, there will be a shortage of crisis experience in the trenches.

Outside of finance, it is well understood that preventing small crises is a bad idea: frequent small earthquakes are better than an occasional big one; periodic restricted forest fires are preferred to one rare but big conflagration, and so on. In finance, there is a reluctance to permit even small failures. Regulators and policy makers are rewarded for moving swiftly to “solve” mini-crises. The tragedy is that this leaves institutions, individuals (and even regulators) ill equipped to cope with the big crises when they come.

Inverting the intermediary theory of asset pricing

In the last few years, the intermediary theory of asset pricing has emerged as a single factor model of asset pricing that does as well as the standard four factor model and thus subsumes the size, value and momentum factors (Adrian, T., Etula, E., & Muir, T. (2014). Financial intermediaries and the cross‐section of asset returns. The Journal of Finance, 69(6), 2557-2596). The theoretical justification for this model is that since financial intermediaries are the marginal buyers of many assets, their marginal value of wealth is a more relevant stochastic discount factor than that of a representative consumer. Though the idea that leverage is a good proxy for marginal value of wealth strains credulity, the empirical results seem quite strong, and there is some case to be made that the shadow price of a leverage constraint is related to the marginal value of wealth.

I see two problems with this. First of all, the major risk factors (like Momentum, Value, Carry and BAB) have been demonstrated in two centuries of data (1799-2016) from across all major world markets (Baltussen, Guido and Swinkels, Laurens and van Vliet, Pim, Global Factor Premiums (January 31, 2019). Available at SSRN: It is evident that the structure of financial intermediation has changed beyond recognition over the last two centuries; for example, 19th Century giants like the Rothschilds operated with far lower levels of leverage than modern security dealers, and were in fact more principals than intermediaries. If the risk factors are solely due to intermediary leverage constraints, I would not expect to see such strong Sharpe ratios for the risk factors in the 19th Century data.

Second, there is a vertical split within the intermediary theory itself. He, Kelly and Manela presented a competing theory (Intermediary asset pricing: New evidence from many asset classes. Journal of Financial Economics, 2017, 126(1), 1-35) with drastically different results. I sometimes joke that Adrian, Etula & Muir (AEM) and He, Kelly & Manela (HKM) refute each other and so there is nothing more to be said. The first direct contradiction is that AEM find a positive price of risk for leverage, while HKM find a positive price of risk for the capital ratio (which is the reciprocal of leverage). Second, HKM get their nice results when they measure capital of the primary dealers at the holding company level unlike AEM who measure security dealer leverage at the unit level. Finally, AEM find book leverage to be more important, but for HKM, it is the market value capital ratio that is relevant.

I am veering around to the view that risk factors are not priced because of intermediary leverage constraints, but it is the other way around. Factor risk premiums have very long and deep drawdowns (for India, the drawdown plots are available at As Cliff Asness put it,

I say “This strategy works.” I mean “in the cowardly statistician fashion.” It works two out of three years for a hundred years. We get small p-values, large t-statistics, if anyone likes those kind of numbers out there. We’re reasonably sure the average return is positive. It has horrible streaks within that of not working. If your car worked like this, you’d fire your mechanic, if it worked like I use that word.

So it is easier to harvest factor premiums if you are gambling with other people’s money especially with a taxpayer backstop for extreme tail events. Since Too Big to Fail (TBTF) banks are ideal candidates for doing this, you could well see significant correlations between the factors and the capital/leverage of these banks, but these correlations might be very sensitive to the measurement procedures that you use. In short, perhaps, we need to invert the intermediary theory of asset pricing.

When do you sell your best businesses?

The traditional recipe for reducing the leverage of an over indebted business conglomerate is to (a) sell non core peripheral unviable businesses, and (b) focus on improving the cash flows of the core profitable businesses. Most companies tend to do this, at least after they have gone past the stage of denial and business as usual.

But there is an alternative view expressed most forcefully two decades ago by a senior Korean government official in response to a restructuring proposal submitted by the Daewoo group: you do not reduce debt by selling unviable business, you do it by selling profitable businesses. (This statement most probably came from the Korean Financial Supervisory Commission (FSC) then led by the no-nonsense Lee Hun Jai, but I am not now able to trace this quote though the tussle between Daewoo and the government was well covered in the international press.)

I do recall one company that sold its best business without any prodding from creditors or government: RJR Nabisco under the private equity group KKR. Way back in 1995, with the tobacco business in the doldrums (as a result of Marlboro_Friday and tobacco litigation), RJR sold a part of the more attractive food business in a public issue, and used the proceeds to pay off some of its humongous debt. Apparently, the reason for not selling off the entire food business was legal advice that this could expose the board members to liability for fraudulent conveyance. (Baker & Smith discuss this episode in some detail in Chapter 4 of their book on KKR – The new financial capitalists: Kohlberg Kravis Roberts and the creation of corporate value. Cambridge University Press, 1998).

There are two arguments in favour of the radical approach of selling your best businesses to reduce debt. The first is that deleveraging is often carried out under acute time pressure and it is the good businesses that can be sold quickly and easily. Dilly dallying over deleveraging can quickly take things out of the control of management, and potentially lead to the complete dismantling and liquidation of the group as happened to Daewoo. The second argument is that financial stress at the conglomerate level acts as a drag on the good businesses that might need capital to grow or might need strong balance sheets to retain customer confidence and loyalty. In times of financial stringency, the functioning of the internal capital markets within the conglomerate becomes impaired and the good businesses tend to suffer the most. When internal capital markets start prioritizing survival over growth, good businesses should be rapidly migrated to stronger balance sheets that can both preserve value and support growth.

Many business groups in India are today trying to deleverage in response to changes in the legal regime that empower creditors, but they are still focused on selling their bad businesses. The risk is that this may prove too little, too late. At least some of them should consider the heretical idea of selling their crown jewels.

Globally, perhaps the largest conglomerate that needs to evaluate the strategy of selling its best business is GE. The aviation business is the crown jewel that is at risk from the troubles in the conglomerate. A year ago, John Hempton explained why this business needs a pristine balance sheet: whoever buys a plane powered by a GE engine needs to be confident that GE will be around and solvent in 40 years to actually maintain that engine. Moreover, the business needs massive investment in research and development, and the ability of a struggling GE to do this might be questionable. John Hempton proposed an equity raising as the solution, but the window for that might be slipping away as the share price continues to slide.

In times of stress, companies need level headed managers who can take rational decisions without being swayed by a maudlin attachment to their crown jewels.

Ignoring operational risk

Operational risk has always been less glamorous compared to market risk, interest rate risk and credit risk which are all now dominated by sophisticated mathematical models and apparent analytical rigour. Regulators too are uncomfortable dealing with operational risk because of its judgemental nature. Yesterday, for example, the US Federal Reserve Board announced that the largest US banks would no longer be subject to the “qualitative objection” which was the rubric under which it dealt with operational risk (see pages 13-14 of the summary instructions).

The reality however is that in big financial institutions with large well diversified portfolios, most risk management failures involve operational risk. This was true for example of JP Morgan’s London Whale, of the Nirav Modi scam at Punjab National Bank, of Nick Leeson, and many other cases. Even in the Global Financial Crisis, many of the largest losses were due as much to operational risk as to systemic events (which is why some banks had much larger losses than others).

Chernobai, Ozdagli and Wang have a paper showing that operational risk is aggravated for large and complex institutions (Business Complexity and Risk Management: Evidence from Operational Risk Events in U.S. Bank Holding Companies (December 18, 2018). Available at SSRN). They show that operational risk increased significantly when the business complexity of banks increased and provide evidence that this results from managerial failure rather than strategic risk taking. A year ago, I wrote on this blog that

banks are so opaque that even insiders cannot see through the opacity when bad things happen … 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.

Ignoring operational risks for the largest and most complex banks because it is too qualitative and judgemental does not appear to me to be a very good idea.

Can a strong Gresham’s law make good money worthless?

Gresham’s law states that if good money and bad money are circulating simultaneously, everybody would hoard the good money and spend the bad money thereby driving the good money out of circulation. Essentially, the good money becomes a store of value, and the bad money becomes the medium of exchange. I am beginning to think that an even more perverse outcome is possible – the good money having ceased to be money can suddenly become nearly worthless (because the store of value function of the previously good money depended on its being money). This strong form of Gresham’s law came to my mind after reading Wiegand’s recent paper presenting a “prisoners’ dilemma” model of Germany’s adoption of the gold standard in the 1870s.

The story as Wiegand describes it is as follows. In the mid 19th century, a large bloc of countries led by France was on a bimetallic standard with both gold and silver being used as money at a fixed exchange rate. New discoveries in California and Australia brought new supplies of gold in the 1850s, leading to relative shortage of silver whose output grew slowly. While in 1849, annual production (by value) of gold was less than that of silver, in the 1850s and 1860s, gold output was 2-3 times that of silver. Gresham’s law operated as expected to cause hoarding of silver in the bimetallic world: the share of gold in the French currency in circulation rose from below 30% in 1849 to over 80% in the 1860s. As the proportion of gold in France approached 100%, the possibility emerged of silver simply ceasing to be money. But if silver was no longer money, its price would decline to its value in cutlery or jewellery (the first photographic rolls using silver halide came only in the 1880s). We know from 40-year old first generation currency crisis models (Krugman, P. (1979). A model of balance-of-payments crises. Journal of money, credit and banking, 11(3), 311-325.), that the transition from France being 90% on gold to 100% on gold would not be smooth, but would happen in a sudden speculative attack that demonitizes silver. My reading of Wiegand is that Germany acted like a mega George Soros in executing this speculative attack by shifting to a gold standard and dumping all its silver on world markets; soon everybody abandoned silver and its price collapsed. (In the French bimetallic standard, it took only 15.5 ounces of silver to buy an ounce of gold; currently it takes more than five times that many ounces of silver to buy an ounce of gold.) Wiegand’s “prisoners’ dilemma” model is that Germany was forced to act pre-emptively to prevent France from launching a similar speculative attack on Germany’s silver standard.

This is what I am calling the strong Gresham’s Law: in a world of competing monies, the good money would be destroyed by a sudden speculative attack if it undergoes excessive deflation. All successful moneys have been mildly inflationary over sufficiently long periods (Triffin’s dilemma also leads to the same insight).

On the other hand, it is well known that the bad (inflationary) money could also become worthless if inflation accelerates beyond a point (Bernolz has labelled this reverse of Gresham’s law as Thiers’ law). The two laws together imply that all moneys are likely to die over multi-century time frames because of the low probability of staying on the razor’s edge between being demonitized by (a) deflation (the strong Gresham’s Law) and (b) inflation (Thiers’ law) for such long periods of time. This is consistent with the historical evidence: the ultimate fate of every fiat money in human history beginning with 11th Century China seems to be to become worthless. Near worthlessness has also been the ultimate fate of every commodity money except gold (and who knows how long gold’s luck will last?).

This has implications for crypto currency money supply rules as well. Seared by an abundance of hyper inflationary episodes in the 20th Century, crypto currencies have been designed with a deflationary bias. Many of them have inbuilt rules that freeze the money supply after an initial period of gradual monetary emission. In the wake of the collapse of crypto currency prices in recent months, some are making their systems more deflationary. Commentators are interpreting the reduced rate of monetary emission under tomorrow’s Constantinople Upgrade in Ethereum as a move to increase its market price. The weak and strong Gresham’s Laws suggests that all this might be misguided. It appears to me that after the rapid appreciation of crypto currencies in 2017, the weak Gresham’s Law kicked in and crypto currencies ceased to be medium of exchange; they became mere stores of value as exemplified by the hodl meme. It remains to be seen whether the 2018 price collapse in crypto currencies is the beginning of the effect of the strong Gresham’s Law that could destroy these currencies. Counter intuitively, an increased rate of monetary emission might actually be the way to salvage these currencies. Models with multiple equilibria are indeed quite messy.

Convergence of insurance and derivatives

During the global financial crisis, it became fashionable to say that a CDS (Credit Default Swap) is insurance in disguise and should be regulated as such. My response used to be that (a) a lot of insurance is derivatives in disguise, (b) an LC (Letter of Credit) issued by a bank is a CDS in disguise, and (c) it might be better for both them to be regulated as derivatives with mark to market discipline and some pre/post trade transparency. Reinsurance for example is best thought of as put options on a portfolio of non traded or illiquid assets as I wrote in a blog post nearly 11 years ago.

More recently, I am beginning to think that a convergence of derivatives and insurance could happen as “parametric insurance” moves from a fringe idea to a mainstream insurance product. The common description of parametric insurance reads almost like a definition of a weather derivative:

Parametric insurance, …, provides coverage monies automatically upon the existence of certain objective weather-related parameters based upon a set formula.
(Van Nostrand, J. M., & Nevius, J. G. (2011). Parametric insurance: using objective measures to address the impacts of natural disasters and climate change. Environmental Claims Journal, 23(3-4), 227-237.)

The parametric insurance literature talks a lot about “basis risk” which indicates convergence with derivatives not only in substance but also in terminology. More recently, proposals have emerged to move from digital call/put option payoffs (payout triggered by a variable such as rainfall amount, wind speed, or earthquake magnitude being observed to exceed a threshold) to more complex functional forms depending in non linear fashion on multiple indices (for example, Figueiredo, R., Martina, M. L., Stephenson, D. B., & Youngman, B. D. (2018). A Probabilistic Paradigm for the Parametric Insurance of Natural Hazards. Risk Analysis, 38(11), 2400-2414.) A traditional derivative structuring expert would be quite at home here.

Till now, parametric insurance has tended to be a niche product used for large transactions (often involving sovereigns or multilateral organizations). The derivatives analogy for this would be a transaction between two ISDA (International Swaps and Derivatives Association) counterparties. But that could change as well because FinTech (financial technology) players now see parametric insurance as an opportunity to break into the insurance space. They dream of using smart contracts and IOT (internet of things) to turn parametric insurance into a retail product. In some of these grandiose plans, a sensor in my home will inform the insurance company that it detected flood waters inside my home and the insurance company will automatically transfer the payout (or is it payoff?) to my bank account, and perhaps, all of this will happen on the blockchain. So we will have the equivalent of retail weather derivatives. I hope there will be a mark to market regulation somewhere.