Finance and SMEs in Azerbaijan

The State Secretariat for Economic Affairs of Switzerland is financing projects to help Azerbaijan diversifying its oil and gaz dominated economy. 50% of Azerbaijan's GDP is indeed coming from its oil field. That leaves fewer economic opportunities for SMEs development. Needless to say the linkages between the financial sector and SMEs are weak as well. With markets slowly emerging, Azerbaijan is a good example of the chicken-and-egg problem of the "finance and growth" debate. Does finance spur economic growth or is it the other way around ? 

The Georgian parliamentary election

All night long, group of people were honking the street of Tbilisi.  It is still not official, but the by exit polls and main voting station, opposition won. Tbilisi voted against Micha. As the Economist wrote, this election was dangerously polarized. Myriad of buses loaded with (paid) supporters came from the various regions to Tbilisi on Friday and Saturday, armed with flags. For a look at the sometimes empty economic reforms and the neoliberal window dressing used by the power since the Rose Revolution, see my piece in, s'il vous plait, le Monde Diplomatique. 

The need for simple financial regulations

As argued previously (here and there), financial sectors need simple regulations, not more complicated ones. This is being voiced more frequently than ever. Nicholas Brady calls for a new simplicity agenda, in the FT:

Regulators need a clear “bright line” that they can apply to bank activities. The aim should be to permit innovation, and prudent risk taking, while also creating less varied and complex boundaries that banks cannot cross and that everyone can understand. The new simplicity should establish a clear ability to determine when to say yes, and when to say no; and the meaning of “no” should be unambiguous.The debate should shift to focus on the total leverage permitted in the bank’s books – that is the “bright line”. Banks should be permitted to devise their own strategies and use trading as they see fit, but they should be restricted from taking positions that use leverage of more than “X-to-1”. That may limit the upside of their operations, but at the same time it will limit the downside for taxpayers. It also puts responsibility for operational decisions where they belong, in the hands of the bankers themselves. What should be the boundary? Will it take additional time to design? Yes, but it will be worth it. For a change the public will both understand and agree with it.

The case of "less is better" is gaining more weight against the traditional paradigm of regulation. Some are indeed pushing for more and different way of data gathering about risks and quantities. But the last financial crisis reminded us of the difference between risks (quantifiable) and uncertainty (which is not). It took back from the shelf Knight, Keynes and Minsky and  in a speech at the Fed's Jackson Hole conference, Mr. Haldane from the Bank of England:

The degree of complexity also raises serious questions about the robustness of the regulatory framework given its degree of over-parameterisation. This million-dimension parameter set is based on the in-sample statistical fit of models drawn from short historical samples. If previous studies tell us it may take 250 years of data for a complex asset pricing model to beat a simple one, it is difficult to imagine how long a sample would be needed to justify a million-digit parameter set.

The visible hands of financial markets

A stream of study reveal that formal institutions and regulations were not and are not the only elements allowing for financial markets to emerge. Late 17th century England  financial revolution provides valuable lessons for todays regulators and all the parties interested in making financial markets more efficient and less risky: formal complex regulation is not the answer. Formal simple regulation might address the need to rebuild confidence in the solvency of financial firms, but Western economies needs to think of mechanisms to address the loss of trust. Financial history perspectives are insightful in that regard. Carlos, Key amd Dupree showed that learning took place before the official establishement of the financial market and how crucial it was for its emergence and proper functionning:

The key is learning. Individual investors learned how to make (and lose) money in ways that did not directly involve productive processes. They learned how to share risk in commercial and financial endeavors; how to buy and sell, and where to buy and sell. They learned about the financial rewards and losses they could incur. Concomitant with this was the learning by specialized brokers who managed the trade during these early years. The goldsmith bankers increased their expertise in the equity section of the market

Google, math and the physics of finance

The algorithm on which google is based, PageRank, could be replicated and applied to finance, so as to measure the extent to which financial institutions are interconnected. PageRank links pages to each others and the ones most connected to other important ones will be ranked accordingly. In others words, the algorythm captures the circularity of interconnection. Buchanan explains Bloomberg the parrallel with an algorithm European phycisits and economist developed:

Their algorithm, DebtRank, seeks to measure the total economic value that would be destroyed if a bank became distressed or went into default. It does so by moving outward from the bank through the web of links in the financial system to estimate all the various consequences likely to accrue from one failure. Banks connected to more banks with high DebtRank scores would, naturally, have higher DebtRank scores themselves.

The increasing interdependence between financial media and market participants

The picture above is of Jim Cramer, a financial news anchor, host of Mad Money. The one beaten up by  John Stewart  there and there. The whole clash is a must-see and is about the transmission of information. On one side, the financial news industry in the US and probably to a lesser extent in Europe is simplifying the complicated intricacies of modern financial sectors. Because educating wouldn't be good for ratings. This is about the diffusion of financial news to the wider public with the mask of entertainment. But the relationship between media and finance at the beginning of the transmission belt is problematic too. Oberlechner and Hocking studied empirically the linkages between financial journalists and analysts: 

More than two thirds of journalists agree strongly or agree that market participants can influence news providers (87%), that news media and market participants have become more dependent on each other (75%), and that the immediate reporting of events has significantly gained in importance vis-a-vis background analyses (67%). Sixty three percent of financial journalists agree that they depend on market participants to interpret news. More than half of the journalists agree that new technology has brought along an increased risk to report unverified news (59%), and that speed has become more decisive than contents in financial news reporting (55%). [...] Foreign exchange traders and financial wire journalists mutually rate each other as the most important information source. The most important informa- tion sources of wire journalists, their personal contacts at commercial banks, are also the main customers of the financial wire services. Consequently, information of the news services often consists of trading participants' perceptions and interpretations of the market, which are fed back to the traders in the market. As a result, a highly circular cycle of collective information processing in the market emerges. The finding that for non-wire financial journalists, the wire services are the most important sources of information further enhances this circularity of information gathering and disseminating in the foreign exchange market

 More photos of Jim after the jump.

Central banks and the media

A new study by the Swiss National Bank compares the two ways central banks have to reduce financial markets overreaction to their statements: "disclosing information to a fraction of market participants only (partial publicity) or by disclosing information to all participants but with ambiguity (partial transparency)". 

I would love to be able the comment on the mathematical formulas in it or, even better, refine it...but...

How to finance the missing middle

Debt or stocks ? Banks or equity markets ? As France fears for its petite et moyennes enterprises, whose access to bank loans is going to be more expensive, the chief executive of the London Stock Exchange Group insists that even small entreprises could be financed through equity. The biggest problem of financing SMEs is informational asymmetries, as the reason why they are financed by debt where the interest rate of the loan function as a risk management mechanisms. So Mr. Rollet seems to think simple disclosure would be enough:

The cost of satisfying disclosure requirements must be reduced, as well as the time required to bring an issue to market. A shelf registration system would allow companies greater flexibility, accessing the public funding markets while satisfying all applicable disclosure requirements. The recent US JOBS Act – Jump Start our Business Start-ups – is designed to reinvigorate access to equity funding for entrepreneurs. The UK needs its own JOBS Act.

He misses two points, to my opinion: 

1. He seems to equates information with knowledge. SMEs businesses are blurry and banks are reluctant to finance them if they do, the costs of capital - the interest rate - reflect the uncertainty inherent in any young business. But disclosing more accounting data or being more transparent will not reduce this uncertainty. The right equity investors for SMEs are the one capable of manufacturing knowledge with information. 

2. And that is why SMEs need finance accompanied with management and experience. So I don't think that the "hands off" approach to equity finance of SMEs through stock market that Mr. Rollet advocates is the right one. The "hands in" approach to private equity though, might be much more appropriate. New studies (NBER, University of Chicago) show that private equity contributes greatly to employment through SMEs growth. 

The costs of complexity II

The Economist underlines what I think is going to be a growing debate about financial regulation:  The push for simple rules:

But it did not do what a regulator charged with supervising exceedingly complicated institutions should: focus on the simplest rules possible where there is the least room for interpretation. Banks need to obey high capital standards, backed by robust leverage ratios that are not easily gamed.

"Boring banking vs fancy finance"

Krugman's aphorism describes more than a sense of nostalgia for the good old bankers of our parents. Boring banking had regulatory and "moral" implication advantages that fancy finance, for all the (alleged) efficiency it brings to financial markets, seems to lack. Matthew Yeglesias takes the latest LIBOR scandal to illustrate the point and concludes: 

The lesson of Libor is that regulators need to recognize that bankers have cast aside the clubby values of yore, and they need to respond in kind. Banks will try to abide by the letter of the law, but where loopholes exist, they’ll be ruthlessly exploited—through dishonest means if necessary—and the financial cops need to have a fundamentally suspicious attitude toward the regulated entities. Time and again, when tighter regulation of trading is proposed, the concern is raised that stringency will push activity to foreign centers. In the short run, that’s almost certainly true. Banks will want to move to wherever they’re most likely to be able to get away with more shady dealings. But an economic development strategy based on turning your country into an appealing location for dishonest banking is just going to get you a financial system that’s rotten with dishonesty. It’s time to stop being surprised and start realizing that these are the inevitable fruits of a regulatory system that’s weak by design.

High Frequency Trading and Market Quality

 A new report by Credit Suisse looks at the data and finds that HFT has not made markets worse off. Their chosen measures of market quality is volatility, spread, the messaging traffic and the risks of flash crash events. While one must applaud the effort of looking at a set of objective data, the report says nothing about allocational efficiency. Yes ! HFT certainly helps to bring down volatility, but it then means that HFT, like most financial innovation these past decades, helps allocating risk - and not capital.

Does finance has a natural size limit ?

The murky world of hedge fund suggests that there is some truth in it. From Bloomberg's interview with Richard Maraviglia, a small hedge fund manager who outperformed better-known rivals managing billion: 

“If you want strong outperformance, a smaller fund has a better chance of producing that,” said Maraviglia, who plans to close his hedge fund to new money after receiving commitments from investors for the $250 million. “How big an allocation can a big fund make to a great trading idea for it to make much of a difference in their total portfolio?”

 This points to a dilemma between the size and efficient captital allocation. Would the same reasoning be valid at the whole financial sector level ?

How to regulate the financial sector

 

She has a point, being surprised at the level of public attention JP Morgan received because it lost some of its own money (close to 7 billion in risky investments). But the JP Morgan was upheld as the very last bank that did not make these "risky investment". The surprise of the public is also legitimate, even though it is none if its business.

Her first point, however, on the regulation of CDS, has to be commented. The central argument she is making is that CDS bring valuable information to a lot of market player. That does not say anything about the quality of this information. The spread of Credit Default Obligation (CDO)  is commonly attributed to the development of a mathematical formula called the "gaussian copula", by David X. Li. His formula was quickly adopted by Wall Street, because it gave a convenient approximation of the complex reality behind CDOs. The central problem that lies beneath this issue is to know what kind of information financial market are giving participants. Too much and too complex information can be conducive to a loss of information. That is also the price of complexity. Prices are supposed to be the magic signal making coordination possible. Do prices of all traded financial assets traded reflect truly economic fundamental today ?

More on the Gaussian copula here, and here, and here. 

Financialisation watch

The Boston review adds the historical background to the now more and more accepted argument that the political weight Wall Street is getting from the phenomenon of financialization changes the political economy landscape of the U.S: 

American politics has always been dominated by wealth, but only rarely have wealthy people from a single industry dominated politics as much as those from the financial industry dominate both parties today. I can only think of two examples: the Southern planters before the Civil War and the railroad tycoons in the 1860s and 1870s, before the rise of wealthy manufacturers in the late 19th century. The recent financialization of politics was made possible by the bubble economy. Over time, even without reform, the inflated financial share of the economy is likely to shrink, with influence shifting partly to economic elites in other sectors, including perhaps the energy sector and a partly-revived manufacturing sector. As a rule, ordinary Americans have been better off when rival economic elites are forced to compete for their votes than when a single industry supplies the donors and much of the personnel of both parties.

"The costs of complexity: just because it's difficult to quantify, it does not mean its zero !"

Complex environments (the western financial systems, arguably) can be very costly. That's the reason why  big is not necessarily better in complexity economics: there is a “clear trade off between the benefit of scale and the coordination costs and constraints created by complexity” (Beinhocker: 151). These are costs inherent to any system and applying complexity economics theories to financial systems requires a level of abstract thinking I am not willing to do on a sunday afternoon. That would be a "too big to fail" metaphor, but at the level of entire financial system. Regulatory costs are easier costs to reflect upon.

It is necessary to point out right away here that deregulation does not mean less rules, but the contrary. The British financial revolution of the 1980s illustrate that very well. The Financial Services Act (FSA) passed after the Big Bang gave birth to a myriad of regulatory agencies. He also noted a change in “regulatory culture”: “The FSA may have revolutionized life in the City even more than the Big Bang, for in matters of regulation it replaced the informal with the formal, the flexible with the rigid, and the personal with the legalistic” (Vogel:93). This shows as well that financial regulation also is embedded in broader social and cultural structures that evolve over time.

But as regulation are getting more complex, it becomes - irony -  a source of risk in itself too. I believe the regulatory problems that Barclay's LIBOR fraud (for the latest development of the saga, go there) are actually symptomatic of a problem of discipline within the financial sector that the multiplication of rules did not help to ciment. Yes ! FT Philipp Augar is right "Banking supervisors would be well advised to leave as little as possible to management discretion and to go for bold, simple rules that are easy to understand and possible to enforce". The "too big to regulate" has to be considered too.

It is NOT about inequality II

The TED speech of Frans de Waal about the moral behavior of animals offers some great footage of the importance of fairness in a game. Watch the reaction to unequal pay at 14.05m. "So, this is basically the wall street protest that you see here..."

Financial sectors in post-communist economies

Domestic credit provided by banking sector (% of GDP)

Data from World Bank

The last EBRD report mentions the importance of sound financial systems as a shield to crisis. The graph above shows to what extent financial sectors in various economies in transition are efficient intermediaries. Germany is taken as a benchmark. 

Trust no one

Guiso explores the impact of the financial crisis on people's trust, using the Financial Trust Index Survey from the University of Chicago conducted several time after the crisis on a sample of American households. It doesn't look pretty. Traditionally Americans trusted banks and financial markets 50 percent more than they trusted a random person, which is normal since we don't rely on a random person to keep our savings. This measure experienced a u-turn: 

The fall in trust was so strong that after the crisis people show more trust towards a generic unknown individual than towards a bank or a banker, that is towards those institutions and people that should deserve to be trusted the most in light of the role they play as the custodians of our savings.

Guiso also aptly separates two kind of confidence and ties it to the risks an investment implies. Confidence about an institution's ability to repay its debt, which implies intrinsic riskiness is different from the confidence that one will not be cheated when entering economic relationships. That second notion of confidence entails a social risk and is much harder to rebuild than the first one. The trust measures below taken from Guiso's study "reflect the greater perceptions of an increased social risk that has deteriorated the relation between investors and financial intermediaries".  

 

Now add to this the notion of  trust in political systems (national and European institutions) which has been tracked by Roth, Nowak-Lehman and Otter, and you get the beginning of a picture where economic crises (that financial sectors may cause or not) have political repercussions.