More on the TBTF problem

Simon Johnson, one of the most vocal advocates of breaking up the big banks, lays out his case in this excellent analysis

"Today’s most dangerous government sponsored enterprises are the largest six bank holding companies: JP Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley. They are undoubtedly too big to fail – if they were on the brink of failure, they would be rescued by the government, in the sense that their creditors would be protected 100 percent. The market knows this and, as a result, these large institutions can borrow more cheaply than their smaller competitors. This lets them stay big and – amazingly – get bigger.

In the latest available data (Q3 of 2010), the big 6 had assets worth 64 percent of GDP. This is up from before the crisis – assets in the big six at the end of 2006 were only about 55 percent of GDP. And this is up massively from 1995, when these same banks (some of which had different names back then) were only 17 percent of GDP. No one can show significant social benefits from the increase in bank size, leverage, and overall riskiness over the past 15 years. The social costs of these banks – and their complete capture of the regulatory apparatus – are apparent in the worst recession and slowest recovery since the 1930s."

Arguably, the two biggest policy problems with modern financial markets relate to the nature of financial institutions - their size and their financing pattern. (Paul Krugman sees the shadow banking sector as another problem) Bankers point to the economies of scale benefits of large bank holding companies to refute the TBTF arguement. They also warn that increased equity requirements would restrict lending and impede growth.

As Simon Johnson pointed out, there is very little or no research evidence to support either arguments. The most pro-market of financial market economists, Eugene Fama has argued that too-big-to-fail (TBTF) is "perverting activities and incentives" in financial markets and is giving big financial firms "a license to increase risk; where the taxpayers will bear the downside and firms will bear the upside".

A number of the most distinguished American finance acedemics recently questioned the claim that greater equity requirements would adversely affect financial market efficiency,

"Using more equity changes how risk and reward are divided between equity holders and debt holders, but does not by itself affect funding costs. Tax codes that provide advantages to debt financing over equity encourage banks to borrow too much. It is paradoxical to subsidize debt that generates systemic risk and then regulate to try to limit debt...

Ensuring that banks are funded with significantly more equity should be a key element of effective bank regulatory reform. Much more equity funding would permit banks to perform all their useful functions and support growth without endangering the financial system by systemic fragility. It would give banks incentives to take better account of risks they take and reduce their incentives to game the system. And it would sharply reduce the likelihood of crises."

Mark Thoma attributes the persistence of TBTF institutions, despite the overwhelming evidence of their riskiness to regulatory capture. He writes,

"The potential costs of too big to fail banks are large and well known, and unless there are demonstrable benefits to offset the known costs, there is sufficient basis for breaking the banks up. But yet, with scant evidence of the benefits, but plenty of evidence about the costs, too big to fail banks not only persist, the banks are getting bigger. To me, that speaks directly too regulatory capture, and not in a kind way."

Update 1 (15/1/2011)

Simon Johnson has another excellent post on Goldman Sachs' denial of the TBTF problem. See this presentation and paper by Prof Anat Admati that clearly refutes the ("equity is expensive") notion that higher capital requirements will adversely affect banks competitiveness and innovation. She writes,

"We conclude that bank equity is not socially expensive, and that high leverage is not necessary for banks to perform all their socially valuable functions, including lending, taking deposits and issuing money-like securities. To the contrary, better capitalized banks suffer fewer distortions in lending decisions and would perform better. The fact that banks choose high leverage does not imply that this is socially optimal, and, except for government subsidies and viewed from an ex ante perspective, high leverage may not even be privately optimal for banks.

Setting equity requirements significantly higher than the levels currently proposed would entail large social benefits and minimal, if any, social costs. Approaches based on equity dominate alternatives, including contingent capital. To achieve better capitalization quickly and efficiently and prevent disruption to lending, regulators must actively control equity payouts and issuance. If remaining challenges are addressed, capital regulation can be a powerful tool for enhancing the role of banks in the economy."

Budgeting and savings bank accounts

All private firms and government organizations, small and big, today manage their finances using modern budgeting principles. Accordingly, cash inflows and outflows from and to different sources are escrowed into seprate heads of accounts. This separation of revenues and expenditures into multiple and clearly-defined sub-heads is at the heart of budgeting and is central to modern day firms and organizations. It contributes to financial discipline and helps in effective management of their incomes and expenditures. All firms have separate accounting wings to manage their finances based on these principles.

People and families too face the same broad spending and savings choices and dilemmas as firms and organizations. Their problems are amplified by powerful cognitive biases like self-control problems and hyperbolic discounting (much higher preference for the immediate as opposed to the latter). Further, for poor families, effective management of their incomes determines whether they go to bed hungry or not.

A myriad government-run poverty alleviation and welfare programs seek to increase the incomes of poor people. However, very little or no attention is paid to help people manage their finances more effectively. In recent times, there have been initiatives on financial inclusion and providing a savings bank account for every individual. However, this does not help people with budgeting nor address the aforementioned behavioural problems. How do we therefore empower people to manage their finances more efficiently?

It is obviously both impractical and expensive for individuals to employ accountants. Effective management of finances depends on the manner in which people handle money. Ordinarily this is done through their savings bank account. However, a single tier, savings bank account cannot address the aforementioned problems. In the circumstances, as I have blogged earlier, a multi-tier bank account with use-directed tiers, can be an effective instrument in optimizing financial management for individuals.

The psychology behind multi-tier accounts is mental accounting - the division of income into separate, end-use based mental accounts. It helps people manage their finances more effectively in two ways. One, people are inclined to save if they are aware of what they are saving for. For example, a "car account" is a strong nudge to get people to save for purchasing a car. Two, separation of expenditure heads with pre-defined allocations help in effective management of expenditures. It is easier to fritter away Rs 1000 on an evening out from the total monthly salary of Rs 10000, than from a leisure account allocation of only Rs 2000.

The science behind such accounts is that it has an inherent budgeting dimension. The tiers are classified into broad spending pockets, with pre-defined income allocation ratios. The savings account could come with a default allocation ratio, which could be changed by the account holders, depending on their specific requirements. An appropriately designed multi-tier account can therefore address both the behavioural and budgeting challenges.

For example, people could classify their incomes into say, five broad heads - pension and insurance, child education, house loan repayment, recurring household expenditure, and leisure goods. An individual could customize such a five-tier savings account offered by banks into five specific heads - pension, child education, car-purchase, household expenditures, and lesiure. Modern information, communication and data management technologies makes administration of such accounts very simple.

Resurgent Africa?

The Economist finds that over the ten years to 2010, six of the world’s ten fastest-growing economies were in sub-Saharan Africa. Further, on IMF forecasts Africa will grab seven of the top ten places over the next five years.



As The Economist writes, the China factor looms large on Africa's fortunes,

"Africa’s changing fortunes have largely been driven by China’s surging demand for raw materials and higher commodity prices, but other factors have also counted. Africa has benefited from big inflows of foreign direct investment, especially from China, as well as foreign aid and debt relief."

Update 1 (24/4/2011)

Excellent article in Economist that highlights the various dimensions of Chinese investments and interventions in Africa and the resistance it is provoking.

The myth of Japan's "lost decade"?

Daniel Gros provides an interesting twist to the conventional wisdom that Japan suffered a "lost decade" in the first decade of the millennium, posting annualized real GDP growth of just 0.6% (to US's 1.7%) - demography!

He argues that instead of blindly comparing the overall GDP growth rates, a more meaningful standard for comparison will be the growth of income per head of the working-age population (WAP)(which represents an economy’s productive potential). And a comparison reveals,

"When one looks at GDP/WAP (defined as population aged 20-60), one gets a surprising result: Japan has actually done better than the US or most European countries over the last decade. The reason is simple: Japan’s overall growth rates have been quite low, but growth was achieved despite a rapidly shrinking working-age population.

The difference between Japan and the US is instructive here: in terms of overall GDP growth, it was about one percentage point, but larger in terms of the annual WAP growth rates – more than 1.5 percentage points, given that the US working-age population grew by 0.8%, whereas Japan’s has been shrinking at about the same rate.

Another indication that Japan has fully used its potential is that the unemployment rate has been constant over the last decade. By contrast, the US unemployment rate has almost doubled, now approaching 10%. One might thus conclude that the US should take Japan as an example not of stagnation, but of how to squeeze maximum growth from limited potential."

Assuming the working population as the measure of the country's productive capacity, it can be safely concluded that Japan has been successful in squeezing out the most from its shrinking working population. Since its working age population will continue to shrink by about 1% per year, Japan's continued relative decline is to be expected. Germany and Italy too are likely to follow in Japan's footsteps. Prof Gros attributes the current strength of the German economy partly due to the temporary demographic stabilization in the 2005-15 period.



In many respects, Japan's current problems can be a reliable precursor for many of the other developed economies, including the US. The stand-out performance of the US economy over the past two decades, in comparison to the weakness in Japan and Europe, conceals the demographic advantage enjoyed by the US. In this context, Prof Gros raises concerns about the long-term growth prospects of developed economies, given their unfavorable demographic trends

"Slow growth in Japan over the last decade was due not to insufficiently aggressive macroeconomic policies, but to an unfavorable demographic trend. Second, a further slowdown in rich countries’ growth rates appears inevitable, given that even in the more dynamic countries the growth rates of the working-age population is declining. In the less dynamic ones, like Japan, Germany, and Italy, near-stagnation seems inevitable."

Origins of food inflation - the role of big retailers?

The search for the causes of the stubbornly persistent food price inflation in India has taken us through several possible causes - lower growth in cultivation coupled with increased demand, bad weather and resultant reduction in crop yields and crop damages, trade controls, diversion to use as bio-fuels, hoarding by middlemen, and even the base effect of index changes. The real reason will surely be a combination of all or some of the aforementioned factors, depending on the crop.

Further, there is one possible reason that has, surprisingly enough, not received the level of attention it deserves. What is the contribution of the big-box retailers in the inflation story? Conventional wisdom argues that these big chains lower inflation rate by easing bottlenecks in the supply-chain and reducing waste.

However, it is also possible that these big retailers may be putting upward pressure on prices by their hoarding effect. Here are a few possible lines of reasoning in favor of this argument.

1. In recent years, there has been a proliferation of food retail chains, though their access remains restricted to a small section of the urban population. They exercise considerable market power, especially in the local markets where they procure. This in turn generates a ripple-effect. Local prices immediately shoot up, and the price signals invariably get transmitted across all surrounding markets and so on.

2. Fundamentally, big retailers exercise market power through the bulk nature of their procurements (in relation to local production), ownership of large go-downs and cold storages, and product purchase agreements with large numbers of farmers.

It is now well-established that even small marginal reductions or spikes in vegetable and fruit supplies arriving in the markets can influence prices in a dramatic manner. Even a handful of big retailers, with their bulk procurements and so on, therefore have the potential to exert a disproportionate effect on prices.

3. The retail chains service a small section of the urban population, albeit whose per-capita food consumption is amongst the highest. As indicated earlier, these retailers make bulk procurements, mostly contracted in advance directly from producers and middlemen. They generally have multiple supply sources that covers up for likely deficits from a few sources.

When the supply-side experiences market constraints due to some reason, the retailers amplify the impact on the market. They crowd-in a large supplies through multiple channels, thereby draining out an equivalent quantity from an already supply-constrained general market (which is experiencing scarcity). In other words, retailers make the general market bear the full burden of any supply squeeze, thereby putting upward pressure on prices in all markets.

4. Production of food - grains, vegetables, and fruits - has not increased dramatically since the big retailers made their entry in the last few years. Therefore, the big retailers and the general market are competing to source more or less the same supply. The big retailers have an obvious advantage in this race. This is borne out by the fact that big retail prices are upto 40% less than the general market prices. The general market ends up experiencing occasional bouts of shortages.

Econ 101 teaches us that such problems cannot exist in a free retail market. But that assumes an infinite number of retailers, catering to all potential buyers. As the aforementioned analysis shows, both these conditions are absent with the food market and big retailers in India.

Let me illustrate all this with the example of vegetables market exposed to some supply shock. Assume that the vegetable consuming population can be divided into two groups - the big retailers and the general market. A highly simplified graphic (for ease of representation) of the market, when exposed to a supply-shock, will be as follows.



Qe - total quantity supplied at equilibrium
Q1 - total quantity supplied after the shock
Qm - quantity supplied to the general market at equilibrium
Qm1 - quantity available in the general market after the shock
Qr - quantity supplied by the retailers

Qe = Qm + Qr, and
Q1 = Qm1 + Qr,

Subtracting we get
Qe-Q1 = Qm-Qm1

Reduction in total quantity available due to the supply shock = reduction in general market supplies.

The intriguing case of Facebook valuation

For some time now, private market valuations of non-listed business enterprises and their assets have been one of the most controversial areas within financial markets. They form part of the larger issue of lack of transparency and evident conflicts of interests that plague these markets. There is now ample evidence that conclusively points to their critical role in the sub-prime meltdown and the resultant financial crisis.

The recent news that Facebook has been privately valued at a whopping $50 bn and the euphoria surrounding it clearly indicates that Wall Street and investors appear to have learnt little from the tumult of the past three years.

For the record, Facebook which was valued at $27 billion in August 2010, has a reported $2 billion in revenue and negligible profits. Its current valuation makes it more valuable than the likes of Time Warner, DuPont and Morgan Stanley, leave alone Yahoo and Co. More unrealistically, its valuation has jumped 20% virtually overnight from last week's private market valuation of $42.4 billion. Talk about Goldman's midas touch!

Early this week, news came out that Goldman Sachs has invested $500 mn in Facebook in a transaction that values the company at $50 bn. As part of its deal with Facebook, Goldman is expected to raise as much as $1.5 billion from investors for Facebook through private placement route. Goldman has signalled to prospective investors that they would need to invest a minimum of $2 million and would be prohibited from selling their shares until 2013.

Goldman's eye-popping $50 bn valuation of Facebook is in line with similar staggering valuations of privately held technology firms in the last decade. However, what is of great concern is the virtual absence of transparency associated with this valuation exercise. Little or no information is available in the public domain about the details of this valuation.

In fact, there have been allegations that Goldman have been not too forthcoming with information and time for potential investors to make informed investment decision on Facebook. Goldman has given its clients limited information and time to conclude the deal or lose out on a potentially lucrative investment opportunity.

In this context, a recent Times article points to two examples of the capricity associated with such valuations. The $ 7 bn investment made in Freescale Semiconductor in 2006 by a pack of three private equity firms - the Blackstone Group, the Carlyle Group, Permira Advisers and TPG Capital - is valued at $3.15 billion, $2.45 billion, and $1.75 billion respectively by the three firms. Similarly, Kohlberg Kravis & Roberts (KKR) and TPG Capital attach widely different values to their investments in the largest private equity deal ever, the $48 bn buyout in 2007 of Energy Future Holdings of Texas (formerly TXU). KKR now values its investment at 20 cents on the dollar, while TPG values its stake at twice that, 40 cents.

These wide differences in valuations are an accurate representation of the lack of transparency in private equity investments. The differences are all the more baffling since the same securities, the same company, the same data and the same information from board meetings are used to arrive at these widely varying valuations.

Some of the differences can be attributed to the timings of the respective valuation exercises. The major part of the differences come from the variations in the accounting principles and their interpretation. Accounting principles suffer from numerous discrepancies that even experts disagree on the interpretation of certain provisions. For example, one of the commonest source of difference is the variations in the weights placed on various measures like discounted cash flow.

In the prevailing environment, there is no reliable means for investors to assess the value of their investments. They have to ipso facto accept the valuations attached by their fund managers in the private equity firm. This opacity in valuations will continue so long as private equity investment valuations are done in confidentiality without any disclosure requirements. The lack of transparency has generated considerable concern, so much so that the US SEC recently initiated an enquiry against the unprecedented surge in the trade of shares of privately held Internet companies.

There is a clear conflict of interest at work here. On the one hand, private equity firms manage the finances of their clients on a partnership of trust. They promise competitive returns on investment and are duty-bound to present all available details about their investments without with-holding anything. But on the other hand, private equity firms have a clear interest in boosting the valuations of their investments. Higher valuations attract investors, lured in by the prospects of the high promised returns. Besides, it also ensures higher management fees for the PE firm.

Of even greater concern is the fact that Goldman is not only acting on behalf of its clients, but is also a directly interested party. It has leveraged its balance sheet to make the $500 mn investment in Facebook. It is therefore in its immediate interest that the value of this stake get amplified through a surge in investor interest. The structuring of the investment and the route for raising the $1.5 bn, apparently through an SPV, is seen as an attempt to avoid SEC disclosure requirements and maintain the opacity in these transactions. In simple terms, as William Cohan wrote, Goldman is assuming several roles at once — investor, salesman, money manager, IPO underwriter - thereby creating serious conflicts of interests.

Faced with these two conflicting choices, many PE firms have been found to have acted dis-honestly with their investors. Goldman, in particular, has been accused many times, even recently, of being less than honest, even untruthful, with its clients.

Though not yet listed, like other technology majors before, Facebook shares/stakes are traded in the secondary market. Sellers are either employees or investors trying to off-load their stakes, while buyers (like Goldman's clients) are high net-worth investors looking for high returns. Goldman would benefit in atleast two ways from the deal - immediately bag investment banking fees by raising and managing money and being ahead in the race to manage Facebook's inevitable lucrative IPO.

The systemic risks posed by these subjective valuations arise from the fact that public pension funds, local governments, endowments, and institutional investors have considerable exposure to private equity firms. At the slightest eruption of market uncertainty, these valuations are likely to unravel wiping out billions of dollars and generating a cascading downward spiral.

The Times quotes Harvard Professor, Josh Lerner, who points that though private equity firms are usually riskier than underlying public markets (since they use borrowed money for their investments), they ought to have "declined atleast as much as the public markets did, if not more — probably considerably more" in the late 2008 crash. That they did not is an indicator of "smoothing" and "stagecraft".

Update 1 (7/1/2011)

Simon Johnson makes the important point that Goldman's bank-holding company status provides it unfettered access to the Fed's discount window (it can borrow against all kinds of assets in its portfolio). This coupled with the moral hazard arising from the "too-big-to-fail" syndrome incentivizes Goldman to assume excessive risks without any fear of downside. In case of any crisis, Goldman and its creditors are sure to be protected. All this keep Goldman's financing cost much cheaper than before and than its competitors.

James Kwak puts this TBTF interest rate subsidy to be around 50 basis points for banks with more than $100 billion in total assets. As Prof Johnson writes,

"It has effectively become a new form of government-sponsored enterprise. Goldman is not a venture capital fund or primarily an equity-financed investment fund. It is a highly leveraged bank, meaning that it borrows through the capital markets most of the money that it puts to work...

Most of its operations could be funded with equity – after all, it is not in the retail deposit business. But issuing debt is attractive to shareholders because of the subsidies associated with debt financing for banks and to bank executives because their compensation is based on return on equity — as measured, that increases with leverage. If banks have more debt relative to equity, this increases the potential upside for investors. It also increases the probability that the firm could fail — unless you believe, as the market does, that Goldman is too big to fail."

Addressing civic issues - limits of regulation and enforcement

How do we control urination in public places? How do we get people to disciplined parking in commercial streets? How do we prevent people from littering? How do we get people to wear helmets or seat-belts? At once simple and commonplace, they are also among the most difficult of challenges facing municipal authorities in India. How do we address such civic problems? This post will examine the challenges in all its dimensions and subsequent posts will look at solutions that stand the best chance of success.

As we all know by now, regulations and punishments though necessary are not sufficient. They need to be accompanied with enforcement. But enforcement immediately raises several troubling issues. Let us take the case of urinals. How can we enforce a ban on public urination without adequate and widely available public urinals? Even if adequate urinals are constructed, people will not use them if the maintenance is poor (as is often the case). And maintaining urinals with the cleanliness and in the scale required for large Indian cities costs money and demands the collection of reasonable user charges. Are people, especially those who need such urinals, willing to pay these user charges?

Even assuming people will pay, there is the very practical issue of locating large numbers of urinals. Given the size of our cities, labyrinthine roads and streets in commercial areas, and population densities, it becomes important to have urinals located close to each other, atleast at the major public places. This becomes all the more important given the considerable search costs (even with signages) and time value of the likely users. Further, since these areas are all built up, all these toilets will have to be constructed along road margins and adjacent to existing commercial establishments. This naturally generates the "not-in-my-backyard" resistance from the nearby shopkeepers.

And, I have not even talked about the formidable socio-political obstacles that have to be surmounted at each of the aforementioned stages! The same analysis can be extended to littering - even with large numbers of dust bins (with the risk of being stolen) - and parking - even with adequate parking lots, large numbers of policemen and private security guards and outsourced parking contractors.

Popular impression of law and its enforcement is viewed in terms of mainly penalties and less so, rewards. Governments promulgate laws and establish enforcement agencies. Law breakers are penalized and the deterrent effect of these penalties keep people honest. If people continue to violate, then it is a problem of enforcement. All this appears very simple and therefore baffling to citizens about why governments can't get it right.

However, I am inclined to believe that the aforementioned narrative does not convey the full story. It gives the impression that fear of punishment is the major reason why people abide by the law. This overlooks the powerful influence of people's inherent civic sensibilities in bringing about collective conformity to law. In societies marked by widespread conformity to law of the land, the latter (civic sensibility) is a far greater contributory factor than the former (punishment). The deterrent effect of enforcement acts mainly at the margins, on those most likely to violate. Its power lies in forcing the small numbers of deviant people into conforming to the standard practice (among similar people).

In simple terms, strong enforcement will be successful in deterring the exceptions, not the norm. When everyone, or atleast the majority, are violators, then violation becomes the norm, the unwritten (and stigma-less) convention. Such practices persist because of their convenience - minimal or no costs, ease, socialization, inaccessibility to alternatives etc. Overcoming them requires addressing the problem at all these levels. Without this, it immediately provokes public resistance and political opposition.

Therefore, at a practical level, the challenge of enforcement when the major share of the population (the "public urinating" part of the population) is not internalized into using the public urinals (by searching out the urinals and paying the user charge) is enormous.

Further, since problems vary across localities (in terms of the respective magnitudes of the different contributors), there is need for location-specific implementation designs. This in turn depends on local initiative, driven by the respective local officials and the local community. As we are aware, the former is scarce and the latter suffers from the collective action problem. A confluence of both these forces is therefore a matter of chance or luck. See this excellent account of one such experience by Shoba Narayan.

Let us also not be carried away by exceptional achievements of a small localities in a few cities which have achieved success with such civic issues. They stand out precisely because they are the glorious exceptions and not the norm. However, these bright spots may provide important lessons that are necessary for any effort at successful emulation. Even with all logistics and other requirements in place, it would require massive personal commitments and efforts at every level, coupled with fortuitous confluence of circumstances and dollops of luck for such initiatives to succeed.