BIS reviews crisis and the policies

BIS reviews the crisis and the policy responses in its Annual Report 2008-09. As always, it is a lucid read with graphs and charts.

The failures that caused the crisis were broad-based. They included macroeconomic factors, such as large and persistent global current account imbalances and low real interest rates over a protracted period. And they also included microeconomic factors, such as flawed systems for measuring and managing risk, misaligned incentives and inadequate corporate governance at financial institutions. The result was a build-up of excessive leverage in the financial sector and in the household sector in a number of countries. Neither market discipline nor regulation and supervision were able to prevent these developments.

 

Advertisement

Handbook of inflation targeting frameworks

Gill Hammond of Bank of England has prepared a superb handbook. It tells you how inflation targeting (IT) is carried out in several countries.  I have always known that though it is one framework, there are numerous differences in the ways central banks achieve the target.

This handbook just confirms it. This paper is particularly good as it has compared all IT central banks across a few common points. It has prepapred a common chart for all the IT central banks and so it helps you compare immediately.

Superb Stuff.

A primer on quantitative easing

Bank of England Economists have written a nice primer on quantitative easing. It explains how it impacts markets and effects various players. It also points to a short review of  empirical work on QE:

Quantitative easing has been used on few occasions in the past, so there is little empirical evidence on which to draw. One obvious international example is the experience of Japan earlier this decade. Bernanke et al (2004) found some evidence of an impact on long-term  interest rates from quantitative easing. However, Baba et al (2005) concluded that the Bank of Japan’s commitment to keep policy rates low was more important for reducing long-term interest rates than its use of quantitative easing. Asset purchases have also been used to influence government bond yields in the United States in the past. Bernanke (2002) highlighted that the Federal Reserve was successful in maintaining a ceiling onlong-term Treasury bond yields in the 1940s.

Recent announcements of asset purchases by central banks provide further evidence that such purchases can influence asset prices. Kohn (2009) highlighted that the Federal Reserve’s announcements of purchases of mortgage-backed securities and Treasury bonds reduced mortgage and other long-term rates in the United States appreciably — by some estimates by as much as a percentage point. And the Bank of England’s announcement on 5 March that the Bank would be purchasing £75 billion of assets financed by central bank money also appeared to have an impact on UK government bond yields. Gilt yields in the 5 to 25 year maturity range eligible for purchase fell around 40–90 basis points by the end of the day following the announcement.

Evidence on the impact of money injections on output and inflation is sparser. For the Japanese episode, Kimura  et al (2003) found the effect to be small but highly uncertain. It is difficult to know how important quantitative easing was in the case of Japan without knowing how much worse the recession would have been without it.

The impact on yields was short-lived as we have seen them rising again. Moreover, yield moement depends on a list of other factors and it will be difficult to pinpoint the fall on QE alone.

A good quick read.

Literature Survey on Financial Stress, Recessions and How Finance affects Real Economy

IMF in its June 09 research bulletin has brief literature survey on all these 3 issues.

 Selim Elekdag reviews financial stressThe financial turmoil that started in the summer of 2007 mutated into a full-blown global crisis. The world economy has experienced a major downturn associated with one of the most severe episodes of financial stress witnessed in decades. While an episode of financial stress encompasses turbulent periods—such as the recent crisis—it also includes related events that only result in asset price corrections, which on occasion may be linked to banking distress. This article briefly surveys recent IMF research related to financial stress across both advanced and emerging economies.

 

Hui Tong reviews financial market linkages with real economyThe 2007–08 financial crisis began with problems in the subprime mortgage market in the United States but quickly turned into a global financial crisis. The crisis resulted in a wide range of adverse effects on the real economy, as nonfi nancial firms around the world appeared to spiral downward. A key potential contributor to the plight of the nonfinancial firms was the fi nancial crisis itself in the form of a negative shock to the supply of their external financing needs. This article briefly surveys recent IMF research on the real effects of the crisis.

 

Finally there is an interview of Marocs Terrones who reviews historical analysis of recessions in a Q&A format.

 Good insights. 

Understanding FDR’s Bank Holiday Move in 1933

Franklin D Roosvelt was the US President during Great Depression.  Some econ research praises FDR for his role in Great Depression, the others point to some grave errors in his policies. The first says Obama should be as courageous as FDR and latter suggests Obama to avoid the same mistakes.

Anyways, on 5 March 1933 FDR  proclaimed Bank Holiday. William Silber of NY Fed provides an excellent account of the event in this research note.

After a month-long run on American banks, Franklin Delano Roosevelt proclaimed a Bank Holiday, beginning March 6, 1933, that shut down the banking system. When the banks reopened on March 13, depositors stood in line to return their hoarded cash. This article attributes the success of the Bank Holiday and the remarkable turnaround in the public’s confidence to the Emergency Banking Act, passed by Congress on March 9, 1933.

Roosevelt used the emergency currency provisions of the Act to encourage the Federal Reserve to create de facto 100 percent deposit insurance in the reopened banks. The contemporary press confirms that the public recognized the implicit guarantee and, as a result, believed that the reopened banks would be safe, as the President explained in his first Fireside Chat on March 12, 1933.

Americans responded by returning more than half of their hoarded cash to the banks within two weeks and by bidding up stock prices by the largest ever one-day percentage price increase on March 15—the first trading day after the Bank Holiday ended.

The study concludes that the Bank Holiday and the Emergency Banking Act of 1933 reestablished the integrity of the U.S. payments system and demonstrated the power of credible regime-shifting policies.

Read the whole thing for details. A nice lesson in economic history. It provides you a good snapshot of the policies made at the crisis time.

PS.

Though am sure economists would differ whether bank holiday worked or not. There must be a lot of literature on the same. But then that is economics for you and you need to take research findings with a pinch of salt.

ABCDE Conference 2009

World Bank hosts this popular conference every year. It is called ABCDE (Annual (World) Bank Confernce on Development Economics). The 2009 conference was held in Korea and the papers are here. 

The papers on Indsutrial Policy look  quite good (haven’t seen others). The paper by Ha-Joon Chang, University of Cambridge is titled as – Industrial Policy: Can We Go Beyond an Unproductive Confrontation?

🙂  This is needed for almost everything in economics.

OECD Free E-book on International Trade

I received an email from a visitor about this free e-bookfrom OECD which serves as a primer on International Trade. It is written by Patrick Love (OECD economist; can’t find his profile page) and Ralph Lattimore.

The visitor is promoting the book and thought it might be useful for Mostly Economics Readers. The other visitors can see the book in case they find it interesting.

I will try and write a review later on the book in the blog.

PS.

This blog is not used for any advertisement purposes. However, if visitors have useful eco/fin related e-books which could be useful for ME readers, I don’t mind adding it on the blog.

Was Adam Smith a behavioral economist as well!

Yes Indeed! Nava Ashraf, Colin F. Camerer and. George Loewenstein say so in this paper.

Adam Smith’s The Wealth of Nations, first published in 1776, helped create the discipline of economics with its conjuring of the invisible hand, self-interest, and other explanations of market forces that have influenced academics, governments, and business leaders ever since. But it’s the insights from one of Smith’s earlier works, The Theory of Moral Sentiments, that caught the attention of Harvard Business School professor Nava Ashraf and coauthors Colin Camerer and George Loewenstein.

In “Adam Smith, Behavioral Economist,” published in the summer 2005 edition of The Journal of Economic Perspectives, the authors find that Smith’s insights from 1759 can contribute to modern thinking on everything from our fascination with celebrity to the theory of loss aversion. In fact, says Ashraf, Moral Sentiments presages the emerging field of behavioral economics.

Nava Ashraf explains in this HBSWK interview:

Ann Cullen: How did you and your coauthors come to be interested in this lesser known publication of Adam Smith?

Nava Ashraf:Several years ago while taking a graduate course at Harvard on the Scottish Enlightenment, I wrote a paper called “The Morals of a Market Society” focusing on the virtues Smith wrote about in The Theory of Moral Sentiments (TMS). Once I started more research in behavioral economics, I realized how closely Smith’s work from TMS related to this emerging field. Indeed, it looked very much like the field of behavioral economics, which economists usually think of as a “new” field, was in fact rigorously studying the very factors that Smith, arguably the “father” of modern-day economics, had always thought were critical in human behavior and interaction.

Simultaneously, both my esteemed coauthors, Colin Camerer and George Loewenstein, had been exploring TMS and had mentioned in their own work how important it was for economists to read this lesser known work. So it was great fun for the three of us to write this paper, to bring together Smith’s insights with advances in behavioral economics research. Our hope is that it encourages people to go back to TMS and read it for themselves—it’s a truly wonderful book.

What are the main Smith thoughts that make him a beh economist??

Q: According to your article, Smith’s Theory of Moral Sentiments argues that behavior is determined by a struggle between “passions” and the “impartial spectator.” What did he mean by this?

A:Smith believed that much of human behavior was under the influence of the “passions”—emotions such as fear and anger, and drives such as hunger and sex—but these passions were moderated by an internal “voice of reason,” which he called an “impartial spectator.” The impartial spectator allows one to see one’s own feelings and the pulls of immediate gratification from the perspective of an external observer. In the area of self-control and self-governance, the impartial spectator takes the form of a long-term interest (i.e., I won’t have that cookie today because I can see that I will regret it down the road). In the area of social interaction, the impartial spectator allows us to see things from another’s perspective rather than to be blinded by our own needs.

The conflict between the passions and the impartial spectator is the most fascinating part of Smith’s TMS for me. The conflict is particularly important when studying savings decisions, since savings is exactly a decision to delay immediate gratification for a long-term interest, to stay the voice of a short-term pull for the voice of the impartial spectator.

With my coauthors I applied this framework to designing a savings product for a bank in the Philippines that helps clients act in line with their long-term interests. In this “commitment savings product,” clients sign a contract with the bank that doesn’t let them withdraw their own money until a certain amount or date has been reached. It gives their control over to the bank to help them overcome short-term impulses to spend. The product had a large and significant effect on clients’ total savings, helping clients to buy land, improve their businesses, pay for large educational expenses, etc.

The paper on Phillipines’ saving product is here and Ashraf’s other research is here.

To show Adam Smith as a behavioral economist and his work as a presage for beh eco is simply crazy. Again, if you don’t know history you are bound to be surprised. But this is just too much of a surprise. It is  a complete shock….

I was completely unaware about this paper for a long time. This paper was publised in 2005 and I just found it now. Needless to say it is pretty exciting.

Knowing Business History is as important

This blog has written in many a posts the importance of knowing and remembering economic history.

HBSWK has an interview of Geoffrey Jones, Harvard University Prof who is a Business Historian. He has written a handbook on the subjectand the interview deals with findings and business history.

Over the last few decades, business historians have generated rich empirical data that in some cases confirms and in other cases contradicts many of today’s fashionable theories and assumptions by other disciplines, says Harvard Business School professor Geoffrey Jones, who edited the volume with University of Wisconsin-Madison professor Jonathan Zeitlin.

But unless you were a business historian, this data went largely unnoticed, and the consequences were not just academic.

“This loss of history has resulted in the spread of influential theories based on ill-informed understandings of the past,” says Jones. For example, current accepted advice is that wealth and growth will come to countries that open their borders to foreign direct investment. “The historical evidence shows clearly that this is an article of faith rather than proven by the historical evidence of the past,” says Jones.

🙂

A quick look at Financial regulation in India

Shyamala Gopinath, RBI Deputy Governor,  gives a glimpseof financial regulation in India and the way Indian regulators managed the crisis.

Her speech looks at a very important aspect of regulation – the perimeter of regulation i.e. what all should be covered and what all should be excluded. She says:

In the Indian context, what has provided a huge systemic advantage is the fact that the regulation of key financial markets – money market, Government securities market, forexmarket and credit market – vests withthe banking regulator i.e. the RBI. Thus the channels of interconnectedness between banks and other financial sector entities are not beyond the regulatory purview. From a financial stability perspective, the above framework has proved to be a sound model.

How times change? This was exactly the problem stressed by many expert committees asked to look at Indian financial sector. They said RBI is doing too many things and should instead just focus on price stability. The criticism was pretty severe and there was continuous coverage in media. S0me used pretty harsh words which was clearly not needed atleast in the public space.

And come this crisis, we have Fed, BoE etc each asking for more powers to regulate their financial system and firms. All of a sudden RBI’s model became from unwanted to wanted. As the crisis was setting, the Indian model criticisers were confident that the systems in US, UK etc would prevail and crisis would be averted. However, we now know nothing was far from truth. Things were more messy in the model states than anybody could imagine. Moreover, the same set of people are now criticising the earlier model states wrt their regulations, policies etc.

Convenience at its best. I have no problems with economists changing their views. You need to change them as times pass by. But atleast admit and acknowledge it.

What is also needed is a review of all those grand finance fix plans for India. The public clearly needs more answers on what lessons should India take from this crisis. Unfortunately as crisis has eased a little, we have started talking about same set of issues. I am not saying Indian model is not perfect and does not need to change. But let it  atleast be in line with the current reality.

Is Fiscal Pollcy useful in addressing Recessions?

The evergreen topic is visited once again by FRBSF economist Sylvain Leduc in this excellent short paper. The author says:

Should fiscal policy be used to fight recessions? Most economists would answer that, for normal economic ups and downs, business cycle stabilization should be left to monetary policy and that fiscal policy should focus on long-term goals. The main argument is that monetary policy can act quickly when output falls below an economy’s potential or when inflation varies from its optimal rate, and that these actions can be reversed quickly as conditions change. By contrast, modifications to the fiscal code take a long time to enact and implement and can be very difficult to undo.

However, the current recession is clearly not a typical downturn. In particular, unlike other post-World War II U.S. recessions, monetary policy has run out of its usual ammunition to boost economic activity.

Because of the severity of the recession and the uncertain effects of unconventional monetary policy tools, Congress and the Obama Administration have also enacted a fiscal stimulus package. The $787 billion program approved by Congress in February includes a mix of tax and spending measures aimed at creating jobs and boosting output. Yet, economists and political leaders heatedly debate whether tax cuts or increased spending are more effective, a dispute that’s hard to resolve because of the difficulty of determining the precise magnitude of fiscal policy’s impact on real GDP.

So what does fiscal multiplier imply theoretically?

Basic Keynesian theory suggests that the effect of a change in fiscal policy on real GDP is more than one-for-one. For instance, since government spending is one component of GDP, an increase in government purchases, by putting idle resources to work, boosts income one-for-one when the money is initially spent. In addition to that, though, since consumption is a function of current after-tax income in this framework, households also increase their consumption in line with their higher incomes, multiplying the effect of the initial government spending on GDP. The “multiplier effect” of government spending on GDP is thus greater than one.

This simple framework also predicts that the multiplier effect of a tax cut on GDP will be less than that for government spending. This is because a change in government spending affects GDP one-for-one, while part of a tax cut will be saved and will, at least initially, translate into a less than one-for-one increase in GDP.

However, the lit review suggests the opposite:

An interesting aspect of this new literature is that, notwithstanding their vastly different methodologies, they reach surprisingly similar conclusions. Regarding the impact of tax cuts on the level of real GDP one year after the change in taxes, the three studies predict a multiplier of roughly 1.2, as shown in Table 1.

 Moreover, Table 2 shows that, in contrast to theoretical predictions from the simple Keynesian framework, the analyses found that government spending had less bang for the buck than tax cuts. For instance, one year after the increase in spending, the impact on the level of real GDP is less than one-for-one, partly reflecting a decline in investment.

There is more disagreement, however, about the effects of tax cuts on output two years after they are implemented, as Table 1 indicates. The analyses of Romer and Romer and Mountford and Uhlig find very large tax multipliers, while Blanchard and Perotti continue to find effects similar to those occurring after one year.

🙂 Tyler Cowen had asked in his blog:

It’s about the influence of empirical economics:

I’d like one example, please. One example, from either micro or macro where people had to give up their prior beliefs about how the world works because of some regression analysis, ideally usually instrumental variables as that is the technique most used to clarify causation.

I will cite a few possible examples, although I won’t stick with instrumental variables:

I really do not know whether it is accepted within academia that tax cuts work better than govt expenditure after seeing empirical literature. I think it is still a controversial issue. But the evidence Leduc points in the above paper leans towards the list Cowen points to.

Superb insights. The question however still remains why is it so?

Lessons from Great Depressions of 20th Century and Keynes dictum turned on its head

We usually associate Great Depression with the huge recession in 1930s. The initial research focused on GD in US which was then expanded to other economies as well (See Bernanke’s paper for a review).

I just found that there were GDs in other economies and Tim Kehoe and Ed Prescott have done a project on the same. All the experiences have been complied in this book which should be a superb read.

Kehoe and Gonzalo Fernández de Córdoba have put up a small paper on lessons learnt. Findings:

Hearing on OTC Derivatives

Senate and House of Representative Hearings are again becoming hot once again. Quite a few are being held to look at numerous interesting issues – Financial Product Agency, How Merill Lynch buy which was considered a good buy became a candidate for taxpayer bailout (Bernanke’s version of the deal is to be heard on 25 June 2009), improving financial literacy etc.

Senate Banking  Committee heard from various people on OTC derivatives on 22 June 2009. The testimonies are here. On a quick glance it looks pretty interesting. You have comments from ISDA, CFTC, SEC, Academicians and Fin Market Players.

Happy reading :-).

Crisis Timeline for US and G-7 economies

I had pointed out to this BOJ official speech where he compares the policy responses with US now and Japan then.

The researchers are obviously interested in looking at these timelines for understanding many things – to compare policy responses across economies, reaction of a policy/decision on financial markets, time takes to ease conditions, policy failures  etc .

NY Fed has made this task a lot easier for this crisis (HT- Greg Mankiw’s Blog). It has developed 2 timelines – one for US and other for G-7 economies. The pdf files have links from where information is sourced about a particular policy etc. And it is updated every month.

Happy researching.

A superb source of literature reviews on varied economic topics

I don’t know how many of you know this. NBER has multiple programs under which research is categorised and done (this is pretty well-known). It issues a program report once in a while (I just discovered this so thought would share it with you) . These serve as excellent literature surveys on number of economic topics and provide a quick summary of the various papers presented under the program.

I was going through this recent released review on International Finance & Macroeconomics Program by Jeff Frankel. Needless to say, it is an excellent read. Gives you a good insight on the basic issues and what research says on the same. It points to number of papers on the crisis.

Hearing on Consumer Financial Protection Agency

House Committee on Financial Services has scheduled a hearing on the Consumer Financial Protection Agency on 24 June 2009. The testimonies are placed here.

One should especially read the fiery testimony by Elizabeth Warren (it is her brain child after all) and a counter by Alex Pollock (he says it is not really needed).

What about accounting principles in Central Banks and Ministries of Finance?

Charles Goodhart of LSE in his speech at Norges Bank’s Celebrating 20 years of Inflation Targeting Conference puts some interesting thoughts on independence of central banking. He says that central banks intervening along with Ministries to ease financial crisis does not undermine independence of central bank. Infact, there is no alternative.

He adds what is instead needed is to have 2 seperate committees within the central banks- one for price stability and other for financial stability.

However, the issue which has become more interesting is viability of central banks:

But something of a spanner has recently been thrown into the workings of this separability theorem in the guise of the recent adoption of quantitative easing. This latter involves enormous fluctuations in the size of the Central Bank’s own balance sheet, and puts the Central Bank in a position where it can make either huge profits or massive losses. In short the Central Bank’s balance sheet has become risky, and Central Banks do not themselves have sufficient capital to absorb such risks. At a time when the private sector is being asked to mark-to-market all such assets that are not being held to maturity, there are some interesting questions to be asked about the accounting principles being employed in Central Banks and in Ministries of Finance. After all, if one of the virtues of quantitative easing is its relatively flexible reversability, we can hardly assume that all the assets being bought by Central Banks are to be held to maturity, can we?

One can hardly deny that quantitative easing, QE, drives a horse and cart through the thesis of the separation of fiscal and monetary policies. In a sense this has already been recognised in a pragmatic way in the UK; we British tend to pride ourselves on being pragmatic in contrast to theoretical or ideological. Anyhow the Governor has agreed with the Chancellor the main modalities of QE, that is the overall amount and the strategy of how and on what classes of assets the total funds may be spent, though the initiative has, I believe, come from the Governor and the MPC, and the Chancellor has effectively indemnified the Bank against the risk of loss, and he, and the Treasury, then leave the MPC to get on with the application. The government has to be involved in setting the strategy; leaving operational tactics for an independent Central Bank. How far does that diminish the effective operational independence of the Bank of England? In my own view, hardly at all.

But can such a division of duties work so smoothly elsewhere, for example in the USA where the separation of powers leaves Congress with control over fiscal policy, or in Europe where M. Trichet has no euro-fiscal counterpart? Does QE by the Fed represent, in part, a form of fiscal operation which has, for the time being at any rate, bypassed Congress. There are some in the USA who consider that QE raises some ticklish questions about the constitutional relationships between the Fed, the Treasury and Congress. For the moment this may be swept under the crisis carpet, but can it be so for long? The same is true in the Euro-zone. Could the Governing Council just decide off their own bat to, shall we say, treble the size of the ECB’s balance sheet? What would happen if the member state governments were unhappy with this decision, as Angela Merkel would undoubtedly be?

Hmm. We all think quantitative easing and credit easing to be a function of central banks under abnormal times like these. But has it been understood that if the risks turn out to be negative all would have to be borne by the government?

Goodhart asks whether Fed has bypassed Congress in taking these risks. One of the many proposed reforms in the recently announced Finance Fix plan is:

Amend the Federal Reserve’s Emergency Lending Authority:

Section 13(3) of the Federal Reserve Act provides that in “unusual and exigent circumstances” the Federal Reserve Board, upon a vote of five or more members, may authorize a Federal Reserve Bank to lend to any individual, partnership, or corporation. The only constraints on such lending are that any such loans must be guaranteed or secured to the satisfaction of the Reserve Bank and that the Reserve Bank must obtain evidence that the borrower is unable to obtain “adequate credit accommodations” from banks.

During the recent financial crisis, the Federal Reserve Board has used this authority on several occasions to protect the financial system and the economy. It has lent to individual financial institutions to avoid their disorderly failure (e.g. AIG). It has created liquidity facilities to bolster confidence and liquidity in numerous sectors (e.g., investment banks, MMFs, commercial paper issuers). Further, it has created liquidity facilities designed to revive the securitization markets and thereby restore lending to consumers and businesses whose access to credit was dependent on those markets. The Federal Reserve Board currently has authority to make such loans without the approval of the Secretary of the Treasury. In practice, in each instance during the crisis in which it has used its Section 13(3) authority it has sought and received the approval of the Secretary. Indeed, the liquidity facilities designed to revive the securitization markets have involved use of TARP funds to secure the 13(3) loans and the facilities were jointly designed by the Federal Reserve and Treasury.

The Federal Reserve’s Section 13(3) authority should be subject to prior written approval of the Secretary of Treasury for lending under Section 13(3) to provide appropriate accountability going forward.

In other words, US Govt already is acknowledging that Fed had bypassed it because of a legal loophole. Who said only private sector looks at loopholes in law? Now I actually understand why section 13 (3) was used and is so powerful. It allows Fed to take big decisions without Govt approval. But there is a silver lining as well- The crisis could be much deeper if  this law had been amended earlier.

The important lesson I get from reading these developments is monetary policy is not just about usual economic stuff. It has some very important legal and polictial implications as well. The text-books and research literature make it all look so simple. Reality is different.

Comparing Russia in 1998 crisis and 2008 crisis

There was a story I read which said R from BRIC (Brazil, Russia, India, China) needs to be removed. The Russian economy has slipped big time as the 2008 crisis became deeper. Russia seemed to have undergone a major crisis in 1998 and comparisons are bound to be drawn.

There is an interesting analysis in IMF’s F&D comparing the two recessions in Russia.

Unlike the situation 10 years ago, the government now has sufficient funds to administer sizable demand-side fiscal stimulus and provide targeted social transfers to those hit particularly hard by the crisis. However, allocating public spending in a way that is productive and stimulates aggregate demand without creating new bottlenecks remains a challenge in Russia. In particular, the government’s capacity to manage large infrastructure programs is still limited. With the financial sector now playing a much more prominent role in the Russian economy compared with the 1990s, the potential costs of a banking system collapse for the real economy could be very high, as could be the cost of misguided fiscal policies. Russia’s government will have to tread carefully in the months ahead.

Read the whole thing for details.

I am actually wondering the experience of Russia like commodity driven economies. I know situation is bad as commodity/oil prices have declined and export bases must have shrunk. But how bad is the situation? What have been the policy responses? Chile had a stabilization fund from Copper exports which helped them sail through somewhat (same is the case with Russia as indicated in above analysis). It should be a good comparison study to do.

Forex derivatives losses in other emerging economies

This issue was a rage last year in business media but has been forgotten as of now- the losses from forex derivatives. The latest F&D Magazine has an article  saying similar losses were made in Latin American economies. The losses in these economies were quite large.

In another articleon the same issue, Randall Dodd asks:

If the KIKOs and TARNs were not suitable for hedging and not the best alternative for speculating, why were they traded in such large quantities? One hypothesis is that the investors were either unsophisticated or that they were not informed or knowledgeable of the risks. Indeed, the international financial markets had been benign for so long that investors in many markets began to underestimate certain risks. And the nonfinancial firms were presumably less sophisticated than the major banks offering these trades.

Another hypothesis is that investors were sometimes pressured into the contracts by banks as a condition for rolling over their loans. Some emerging market financial authorities, in interviews with the author, said that investors complained to them of bank pressure when the investors were refinancing loans. Yet one other explanation for the popularity of the derivatives is that the KIKOs and TARNs were priced in a way that attracted investors to the higher risks because the exotic derivatives offered exchange rates that were better than those prevailing in the market for standard forwards and options. This last point implies that investors were somewhat aware of the products and their risks. However, it does not follow that such exotic investments were their best choice. If investors knowingly accepted that risk-return trade-off, it would amount to a dangerously inefficient trade in which nonfinancial firms were selling insurance against large amounts of extreme risks to more sophisticated financial firms.

He suggests few points for regulators:

 At a national level, investor protection laws and antifraud provisions should be clarified and strengthened to discourage the use of inappropriate derivative transactions.

• Reporting requirements for derivative transactions should be established. Reporting price and other transaction data for derivatives would make the market more transparent and would endow national and multinational surveillance authorities with greater capability to detect potential problems before they escalate.

• The introduction of new and complex derivatives, or at least their use by firms other than qualified speculators, should be regulated through the use of either “positive” lists of acceptable financial instruments or “negative” lists of prohibited ones.

• Multilateral surveillance is needed to monitor markets globally and, among other functions, identify patterns of market misconduct and trading abuses such as occurred with KIKOs and TARNs. The authority, through its established relationships with national supervisory authorities, should be capable of promptly notifying them of alarming or suspicious developments. As a multinational body, the IMF could perform this task and already possesses some of the necessary resources and formal channels of cooperation among member countries

A check on India MF Industry

There was a lot of media coverage over a speech given by MS Sahoo, SEBI whole-time member. The speech has been included in SEBI’s May Bulletin and is a must read. You seldom across speeches by regulators who don’t agree to the practices of a certain market segment.

He looks at 5 issues:

• Most MFs are top cities and urban centric.
• MFs should cater to Retail investors but growth in assets comes from corporates (he says it nicely- the conclusion is  that the RIIs are also investors in the industry.)
• Portfolios are churned highly leading to higher costs for investors
• Too many types of MFs leading to confusion
• MFs say they are doing educational awareness  campaigns but are actually marketing campaigns

Read the speech for details. It is an excellent check on Indian MF industry. This blog has made these points across various posts. So let’s hope SEBI does something for this.

What interested me most is the 4th point on too many choices:

The 1990s witnessed the emergence of a variety of funds. There are funds which invest in growth stocks, funds which specialise in stocks of a particular sector, funds which invest in debt instruments and funds which invest aggressively and funds which do not do all these. Thus, we have income funds, balanced funds, liquid funds, Gilt funds, index funds, sectoral funds and there are open-ended funds, close-ended funds and fund of funds – there is a fund for everybody and for every need. The number of schemes at the end of February 2009 was close to 1,000, equal to the number of securities listed on the NSEIL.

The small investor has no means to know which fund or scheme to choose. He likes choice, but in this case he is lost with too many choices. To complicate his life further, a scheme has sub-schemes, which has different plans (wholesale, deposit, institutional), different options (dividend, growth, bonus), option variants (quarterly, annual), different AMC fees, etc., 1,000 schemes may have in all about 5,000 products. A small investor earlier had problem in choosing out of 2,000 securities, now he has to choose out of 5,000 MF products and 2,000 securities.

He wanted relief from the deep sea, but ended up between the deep sea and the devil.

Somewhere down the line people in the financial industry do not appreciate the problems faced by an investor. I have talked to a couple of people on this (this is by now way the majority, but just an anecdote) and they believe an investor should be able to slect the fund. The more choices are a plus and not a minus. They even add we are not forcing the investor to invest!! If he has decided to invest in this fund he would have done his homework etc.

His solution for the problem:

Probably, the industry needs to provide a few simple standard products which suit the needs of the majority of the small investors. In addition, they may provide niche products of different complexities for those who can understand. The MF, which provides the simplest products, needs to be recognized.

This is the vanilla products which even US is contemplating to introduce. I had mentioned in this post that if developed countries need such products, developing need it all the more. It is great to know one of SEBI’s members is thinking about the problem.

The question that next comes is. Should SEBI let industry develop such products or intervene to ask MF industry to develop them? I don’t see former happening and can only see more and more MF products being added. It will be good if SEBI forms a committee with industry people as members and design such products.