Tuesday, November 30, 2010

Bonuses: disclosure is not the only weapon

What happened: Chancellor George Osborne decided not to implement UK bonus disclosure rules proposed by Sir David Walker. The rules would have forced banks to disclose in anonymous bands how many employees earned more than £1 in a year.

What it means: 2010 bonuses for UK banks will be paid without the new disclosure rules. Shareholders will not be able to challenge boards on staff pay. Public outrage, already heightened by austerity measures, will be less than it might have been, but meaningful reductions in bank pay and reform of risk-inducing compensation practices will be delayed.

What happens next: Osborne will write to European finance ministers to seek European agreement on bonus disclosure. He will find a willing audience on the Continent, especially France, but less likely in the US. The result may be European disclosure rules next year or later, watered down by the UK to compete with Wall Street. In the meantime, banks are raising basic salaries to compensate for lower bonuses.

Comment: Few people now doubt that high financial sector pay was central to the financial crisis; it feeds asymmetric risks, encourages economic rent-gouging and has contributed to the under-capitalisation of lending banks. Sir David Walker's disclosure rules were supposed to help shareholders control financial pay but now Osborne has back-tracked it is worth asking - would they have been enough, and what other options are there?

Monday, November 15, 2010

Basel 3 may hold the key to monetary reform

If radical monetary reform is too much too soon, perhaps a little-discussed part of Basel 3 holds the answer.

Monetary reform is rapidly gaining the public’s interest, something the Basel rules on bank capital adequacy have never quite managed. But perhaps Basel has a special role to play in helping monetary reform come of age.

Calls for monetary reform are being led by a small band of unorthodox economists whose ideas are catching on in these austerity days.

At its heart is the realisation that today's money is in fact credit, or debt, and it is mostly created by private banks when they add digits to people’s bank accounts.

As a plethora of online presentations explain (type “how banks create money” into google), it’s illegal to print bank notes but not to create digital credits – the online equivalent - as long as you’re a bank and you follow the rules.

This is how fractional reserve banking works in a digital age but the realisation has potentially big implications for politicians fighting deficits and stagflation.

Wednesday, October 6, 2010

How to get banks lending to SMEs

David Cameron enjoyed his swipe at the banks today, using his speech at the party conference to lambast them for not lending to small and medium sized enterprises. He wants the economy to get moving despite huge public spending cuts and said he’s fed up with banks not doing their bit. Sadly for us, lending targets and prime ministerial taunts won’t help, even if they are fun.

How about some other options; couldn't we harness some of the billions the Bank of England is creating through quantitative easing to lend to SMEs? And what about the new Basel 3 rules, they must have something to offer?

Sunday, August 22, 2010

A suggestion for commodity hedging

Problem:  influx of assets into soft commodity derivatives is increasing volatility and imposing costs for producers and food companies.

Solution:  treat commodity hedging as a utility public service. Financial players would state their purpose as hedgers or speculators, with different regulatory regimes applying to each. Regulators could vary the mix and capture rents for the public benefit.

Friday, August 20, 2010

Stock exchanges: stop the robots

Regulators must stop the robots from ruining our stock exchanges, according to democrat Senator Ted Kaufman.

In a 5 August letter to SEC chairman Mary Shapiro, Kaufman warns that some algorithmic trading harms long term investors and dominates the equity markets in a way that brings no social utility. He describes some murky algo practices such as trading on advance information about other people’s orders, collecting unearned liquidity rebates and unnecessary intermediation, to support his case.

The Senator has picked up a useful ally in Gillian Tett, who used her FT column today to back his call for a review of high frequency trading. Tett explains his argument that the benefits of the narrow spreads which high frequency trading supposedly brings may be outweighed by hidden costs, leaving only a “thin crust” of liquidity that evaporates in bad times, as with the flash crash of 6 May.

In an separate but related story, the paper reports that two day-traders in Norway were indicted on charges of market manipulation after they stumbled across – and exploited - a trading pattern that tricked programme trading computers into raising their prices. Despite the breach of market rules, plenty of people cheered the duo for beating the machines: “Robots are designed to push the market but when someone pushes the robots it is suddenly a criminal offence,” was one comment on a Norwegian chat forum, according to the report.

Behind both these stories lies an unease about the growing dominance of robot trading. While not quite an android invasion, the increasing use of computers to arbitrage short-term price anomalies is a sinister development whose effects are not well understood. But it accounts for nearly 70% of US equity trading, making it an important source of revenue for stock exchanges.

Wednesday, August 18, 2010

Appropriating or creating, economists must tell us which is which

John Kay returns to one of his favourite topics in today’s FT: the Robber Barons of the Rhine, who in the 13th century charged illegal tolls on cargo passing their stretch of the river. Old-school baddies like Werner von Bolander and Philip von Hohenfels, who lived in fabulous castles and plundered their neighbours, are a colourful metaphor for modern finance, which Kay uses to make this point:
"The distinction between the creation and the appropriation of wealth – between those who add value to the cargo and those who help themselves to a fraction of it as it sails by – is vital, if not always clear. But our ability to recognise it will determine, not just the fate of individuals, but the future of modern capitalism."
When Adair Turner suggested there might be good finance and pointless finance, he was probably thinking of this. Despite the City's appalled reaction, many people felt they knew exactly what he was on about.

Kay’s distinction between “brigandry and productive business” exists and has been tackled before without resorting to communism, despite the theoretical difficulties.

Tuesday, June 15, 2010

Update on Global Bank Levies

Problem: several different bank taxes have been proposed but none have been implemented, partly as there is confusion about what each should be for

Suggested approach: widen the debate to publicise all the benefits of each tax, then push for internationally coordinated asset levies together with national taxes on bank profits and selected financial transactions.

Since the last post here on this hot topic, two major developments have moved the debate a long way forward. The IMF has proposed two new bank taxes: a Financial Stability Contribution and a Financial Activities Tax, and a popular movement aimed at funding development (the Robin Hood campaign) has pushed financial transaction taxes onto the international agenda.

At the end of this month in Toronto, G20 leaders are likely to discuss global levies and transaction taxes, despite opposition from host country Canada and others. Germany, France , the UK and USA are keen for a bank levy on assets. No consensus exists on profit and transaction taxes.

So what’s on the table?
(22 June update - UK has introduced an asset levy and said it will consider a profits tax).

Thursday, June 10, 2010

Conflicted credit ratings

Problem: ratings agencies conflicted by their issuer-pays business model

Solution: fund agencies through a levy on security purchases, distributed according to demand

The conflict that ratings agencies have between offering objective advice and being paid by issuers has inspired a number of proposals.

Most recently, the head of European credit research at Schroders, D. Patrick McCullagh, suggested that investors pay their investment managers to assess credit quality as part of buy-side research, consistent with the caveat emptor principle, with the cost picked up as a management fee borne by investors, in whose interests the rating is conducted. But is it the best solution?

Wednesday, June 9, 2010

Capitalism and the stable state

Problem: economic growth + population growth + finite resources = crisis, somewhere along the line

Solution: reduce the aggregate requirement for economic growth by enabling businesses to profit from resource reduction instead of top line growth

As any school-kid knows, capitalism rewards individuals for making and selling things. To form capital and reward entrepreneurs there must be constant economic expansion. Business schools teach that growth is an elixir for turning ambition into production and ultimately wealth. This is so widely accepted it is part of our identity. Meanwhile, the human population continues to grow in all but the richest countries, while demand for natural resources is growing so fast that some are bound to run out. What gives?

Tuesday, June 8, 2010

Accounting independence

Problem: The big four accountancy firms are facing reform calls over perceived conflicts of interest, since they are paid by the companies they audit and sell consultancy services to the same clients.

Solutions: Complete separation of the audit and consultancy wings of the big firms or financial separation of audit and consultancy profits, together with some specific changes to the UK Corporate Governance Code on how auditors are appointed.

Tuesday, April 13, 2010

Private equity and debt interest taxation

Problem: Tax rules that allow debt interest to be offset against profits create a preference for debt over equity funding, which contributes to over-gearing and systemic risk and encourages financial engineering and short-termism, especially in private equity

Solution: Equalise the tax treatment of debt and equity, instead of the current system where dividends are taxed but interest can be deducted from taxable profits. Policy Exchange (p60-66) estimates that if debt and equity were taxed equally at 10%, headline corporate tax could be reduced from 28% to 17% for the same tax revenue. The idea has many supporters including John Plender at the FT, Bank of England, IMF, Institute of Fiscal Studies and Conservative Party.

Private equity benefits include:

• Modernizing investee companies
• Helping industry to shed non-core assets
• Challenging PLC management
• Sheltering companies in transition from quarterly public reporting
• Restoring bankrupt companies with fresh capital
• Providing an alternative source of returns for diversity-seeking investors
• Adapting PE business model with the economy and needs of their investors (or limited partners, LPs)

Problems from PE reliance on financial engineering:

• Makes unviable LBOs viable purely for tax reasons
• Transfers wealth from taxpayers through interest deductibility
• Diverts R&D spend and capital investment to service debt
• Miss-allocates resources as buyout firms target cashflow companies instead of turnarounds
• Increases bankruptcy risk through unsuitable capital structures, eg high gearing against cyclical earnings, adding to welfare costs from unemployment and inequality
• Reduced customer service has economic costs, especially in infrastructure and health
• Distribution of PE-related leveraged loans increases financial systemic risk, especially as PE refinancing peak in 2012 approaches
• Transfers equity yields from future pension savers to current PE investors
• Distorts the tax system by blurring income and capital, allowing inefficiencies such as the taxation of carried interest as capital

General policies against short-termism:

• For executives, make share-based incentives vest over longer periods to reduce gearing incentives, link executive pay also to non-financial measures related to delivery of the corporation’s purpose such as customer ratings, market position and market share
• For equity owners, equalize the time horizons of asset managers and their underlying investors to remove the pressure for short-term gains, such as geared dividends or takeovers
• For lenders, restore discipline to securitisation through higher disclosure, retention of risk by originators, independently funded credit ratings and more buy-side diligence.

Reforms to the PE industry:

• For the General Partners, or managers, of PE firms, improve transparency on the true origin and extent of returns, including effects of fees and tax subsidies, and extent of true risk taken by GP after fees.
• Reward operational turnarounds through long-term tax incentives, while discouraging financial engineering through higher taxes on debt.
• Exclude PE firms from tax grouping rules (as with OEICs) and keep liability for acquisition debt and the risks from over-gearing at bidder level
• Extend the “Source of Strength” doctrine from bank holding companies, requiring PE firms to provide assistance for subsidiaries at risk of bankruptcy. Rank GPs with LPs so that financial assistance is funded with clawbacks on PE management fees and carried interest as well as investor funds

Problems with tax reform of debt interest:

• Abolishing debt interest deductibility could push firms into bankruptcy, needs transitional implementation
• May not stop excessive gearing through sale-and-leasebacks, needs coordinated provisions
• Does not address credit bubbles caused by low interest rates and excess savings in China and Germany
• Could reduce investor returns if profits are retained

The EC’s proposed Directive on Alternative Investment Fund Managers is pushing for measures...

Monday, April 5, 2010

Global bank levy I

Problem: taxpayer funded bail-outs (or private gains and social losses; or bank “pollution”)

Proposed Solution: Countries would impose a bank levy to recover past and future bail-out monies. It may be charged on banks, insurance companies, PE and hedge funds, depending on local preference. Could be applied to ‘risky activities’ as in the US by wholesale funding, or on turnover, profit or remuneration. Currently under discussion in the US, Germany, France and the UK, with implementation possible in other G20 countries.

Benefits: Repays bail-out money to the taxpayer. Helps restore public finances. Pays for future bail-outs in advance. Changes banks’ social and economic contract with society. Promotes social and financial stability by reducing excess bank profits. Could reduce systemic risk if levied on wholesale funding. Could address bonus culture if levied on remuneration. Incentive for banks to self-regulate if levy is set according to peer group risk levels, or banks’ individual systemic importance. Could lead to voluntary structural reform (eg narrow banking) by penalising bank holding companies. Could lead to international cooperation in other areas of financial reform.

Disadvantages: Only recovers a portion of public losses as it excludes GDP costs of recession. Slows down the rebuilding of bank balance sheets and their ability to lend. Worsens moral hazard by making the public guarantee explicit. Easy to pass through to bank customers and shareholders. Implementation could favour bigger banks and discourage new entrants to the industry. Needs agreement on what constitutes systemic importance or risky activity. Needs agreement on whether the purpose is to raise revenue or change behaviour. Encourages regulatory arbitrage between countries. Does not address rentier behaviour or agent/principal problems. Dissipates the momentum for structural reform of finance.

Suggestion: Implement primarily as a revenue-raising measure with a sunset clause after ten years. Separate the levy entirely from structural reforms, to avoid wasting political momentum, but leave it as a bargaining chip against the bank lobby for structural reform if needed. Implement with resolution and recovery regimes (living wills) to contain moral hazard, and with a competition review to minimise pass-through to customers and shareholders. Implement unilaterally with scope for subsequent coordination with other countries.

Tuesday, March 30, 2010

Canaries at the Treasury over negative swap spreads

The FT's Gillian Tett today highlighted a curious reversal in Treasury bond spreads, asking in her article Will negative swap spreads be our coal mine canaries? whether we might be seeing the start of something scary.

Tett explains that the yield on ten year Treasuries is supposed to be lower than the cost of borrowing in the interbank market, or swaps. The idea that this "swaps spread" is always positive assumes, logically enough, that private banks will go bust before governments do.

But recently there has been an inversion of some swap spreads, so it is now cheaper for banks to lend to each other than to the US and UK governments through 30- and 10-year government bonds. Is this the canary that indicates a deadly gas leak at the Treasury?

Monday, March 29, 2010

Chancellors debate promises policies for wealth inequality

Wealth inequality looks set to become an election issue, according to comments from the shadow chancellor, George Osborne, and Liberal Democrat treasury spokesman, Vince Cable, on Monday night.

Their comments will be taken as a validation by One Society and The Equality Trust, which argue that many social problems can be tackled by addressing the unequal distribution of income within society.

In a live televised debate on Channel 4, Osborne and Cable agreed with the chancellor, Alistair Darling, that they want a fairer society. Osborne and Cable then went on to cite wealth inequality specifically as a factor behind their policy ideas.

Cable outlined several policies aimed at tax fairness and the financial services industry. “You have to reduce wealth inequality,” he said.

Osborne pointed to falling social mobility and increasing child poverty, saying: “The gap between rich and poor makes a society weaker. A fairer society is an objective of government.”

Darling did not mention wealth inequality during the debate but noted that his one-off bankers’ bonus tax had raised a lot of revenue. “Fairness must be central to government,” he said.

Wednesday, March 24, 2010

Budget 2010 - what does it mean for equality?

"Great inequality is the scourge of modern societies," reads the introduction to The Equality Trust's website. Until recently I had thought spam and alcopops were top contenders for that title, but a presentation of new research hosted by the Policy Exchange last week has changed all that.

The Equality Trust was promoting the evidence of a new book, The Spirit Level, about the effects of income inequality on society. According to the speakers, its main insight is that income inequality is closely linked to social well-being as measured by health, crime and various other statistics, with the surprise being that the correlation is just as strong among the rich as the poor.

For today's budget, Capital Ravings has put aside its alcopops and spam cartons to work with the Equality Trust's political wing, campaign group OneSociety, in assessing what the budget means for inequality. Here's the summary:

Thursday, February 25, 2010

Joseph Stiglitz on financial innovation

Here's an extract from an online debate organised by The Economist magazine entitled "This house believes that financial innovation boosts economic growth". It's the case opposing the motion, written by Joseph Stiglitz, a former chief economist at the World Bank and Nobel laureate. Stiglitz calls for financial services to fulfil their economic function but believes most recent innovations in finance had the exact opposite effect, while plenty of good financial innovations were suppressed by the industry. Here is his summary of where it all went wrong:

Saturday, February 20, 2010

Robin Hood ambushed by Undercover Economist

Tim Hartford, the FT’s Undercover Economist, leapt out of the shrubbery to launch a stinging attack on the Robin Hood campaign today.

In my view he was too harsh and should have treated the campaign more as an opening salvo in a debate about financial transaction taxes than the last word. The campaign, run by charities not finance experts, made a tactical blunder in describing the tax in too much detail, too early.

Tuesday, February 16, 2010

The Robin Hood tax

There’s a lively debate on the Robin Hood campaign’s website about whether the introduction of a transaction tax is worth all the controversy.

Unlike the original Tobin tax idea of 1% on currency markets, the Robin Hood tax would be 0.05% on all non-retail financial transactions. Its aim would be to raise revenue rather than curb speculation.

It’s worth pointing out that, quite apart from the 0.5% stamp duty on UK equities, there is already a far bigger private version of the Tobin tax in place - the transaction costs of financial intermediaries.

Tuesday, January 19, 2010

Cadbury's deal puts M&A on notice for return of long-termism

Cadbury’s resistance to Kraft finally melted away today when the price rose to 850p including dividend. Like so many “bear hugs” before it, this was an entirely predictable ending, with price being the only barrier to a deal.

But something stands out. In the small print of its announcement, Kraft said it will drop its acceptance condition from 90 to 50%. For a large public deal with so much bank debt, this is not normal behaviour. It means refinancing in the bond market could be messy and expensive. It will weigh on Kraft’s credit rating and place huge pressure to cut costs, an area where Kraft is already feeling some heat. So why do it?