Ethics in finance

The Ethics in Finance Robin Cosgrov Prize was delivered a week ago in Geneva. Organized Prof. Dembinski and the Observatoire de la Finance, the prize is given to young people strenghening the case for a more ethical finance. Any formal regulation will never be truly effective without a change of "culture" across financial sectors.

Among others, the prize this year went to Prabhay Joshi, who analyzed how the different actors of the LIBOR manipulation interacted. Normally competing banks and individuals, bound by a culture of reciprocity, were cooperating to submit lower or higher rate. This is the dark side of social capital and one of the factors hindering the modernization of market economies in transitions countries, most notably in Russia. Complex financial sectors underpinned by dubious practices (clearly at the expense of the rest of the economy) does not always mean progress.

The death of traditional stock markets

Economists usualy tend to divide financial systems in two: market-based and bank-based financial system. Critics argue that this view is getting outdated as banking has evolved away from its traditional activities of lending and facilitating payments. But it is often overlooked that today's stock market have nothing to do with the one of our fathers. It is fragmented in sub-markets, dark pools and other Alternative Trading Sytems (ATS) and Multilateral Trading Facilities (MTF) in Europe.

Trading of shares in these dark pool of liquidity has risen 45% in the past six months. It accounts for 8% of stock trading in Europe (it is twice as much in the U.S.) and 98% of institutional investors choose to execute their trades in these venues.

The graph above illustrates the volume of equity traded in dark pool in Europe main financial centers. So the European Commission decided to regulate these alternative trading venues, proposing a trading cap for any one stock of 4% per venues or 8% on a European market wide basis. The EU commission is also concerned with the effects of dark liquidity (these plateforms do not publicly display orders) on the price discovery of publicly lit markets.  Hence the insistance on pre-trade and post-trade transparency. 

Reading "Broken Markets" by Arnuk and Saluzzi, one learns that the problems lies also in the presence of High Frequency Trading algorythms, preying on institutional investors order flows. Some dark pool also sell information to HFT firms, some brokerage firms sell off-the-shelf- algorythms to their institutional clients, so that they can predict their clients trading patterns. Arnuk and Saluzzi's account of the "industry" rapid change suggests there are deeper forces at play (p.74):

Demutualization changed the ownership of the exchanges from a member-owned, nonprofut organization to a shareholder-owned, for-profit corporation. What was once thought of as a quasi-government utility-type organization would now be a bottom-line driven publicy traded, shareholder-focused company. The old method of having members vote on proposals and rule changes would be abolished. Exchanges would now make decisions by executives who reported to the board of directors who served the shareholders. Unfortunately, as we have seen all too often, shareholder interests and investor interests are not always the same.

Global inequality spurring global excess demand for securities

Excess demand for high yields is the main culprit of the financial crisis. This very interesting perspective is proposed by Ph. Lysandrou here. While lots of attention was devoted to the supply side of the problem, less attention was directed at the factors pushing Western financial industries to come up with new financial products and high yield securities. Lysandrou's starting point is that governments and corporations are not viewed anymore as organisations who require external funding to carry on a certain function. Instead these organisations are now viewed by investors as containers of wealth. This new nature of corporation and governments depends on their capacity to issue securities. 

These past decades, the demand has been coming from four groups of investors: 1. large institutional investors 2. commercial banks 3. sovereign wealth fund 4. High net worth individuals. The pressure these groups created was exacerbated by some constraining factors such as standardisation (necessary to the commodisation of securities) and slow regional market development (EME's supplied only 15% of the global stock of securities). 

Banks and intermediaries thus responded to this pressure by getting creative and finding ways of supplying more standardized securities by making tranches out of packages of subprime mortgages. Lysandrou's paper is particularily interesting in that it isolate a particular group: high net worth individuals, 

who in 2006 numbered 9.5 million (a figure that represents just over 0.01% of the world's population of 6.8 billion) and who had combined wealth of $37 trillion, more than half of which, $19 trillion was in securities ( a figure that represents just under 10% if the total financial claims on the world's governments and large corporations. 

HNWI were the most important supplier of finance of hedge funds, who were the main buyers of CDO. Financialisation might have increased income inequality, but income inequality might also have caused financial innovation, triggering the last crisis. 

Financialisation, Economy, Society and Sustainable Development

FESSUD is a EU financed research project to understand how finance can better work for the economy and society at large. I went to its annual conference (a month ago...) but I am not ashamed to to say (a month later) that it was very interesting. Some posts to follow on the papers presented there,  hopefully during the course of this week (or this month). Some papers on European financial systems here. 

The Wall Street - Washington corridor

Robert Zoellik, former president of the World Bank is to be appointed as chairman of International Advisors at Goldman Sachs. 

The amounting evidences against financialisation

Bruce Barlett gathered a good list of findings on the broken financial sytems of western countries and their effect on economic growth. It might be slowed down, because financial sectors compete with other ones for scarce ressources (human ones, most importantly), because they diverts investments in the real sectors of the economy and because of rising fees paid by nonfinancial companies. 

These empirical evidences is proving that the effects of big financial sectors on economic growth (to say nothing about rising income inequality, increasing political weight and the changes it induces on corporate governance). In other words, they show the costs of size. Which Western societies could maybe accept if financial sectors were at least efficient in what they are supposed to do (i.e. allocating capital). Far from it, there are plenty of evidences that they became casinos. Not only the piggy eats some money - which could be normal - but is loosing some too. Because its broken. 

Missing the good old scandals

Patrick Chappatte for the International Herald Tribune, July 18, 2012

If you think the LIBOR fraud were difficult to understand, wait until the alegation of this one are proven to be true. FINMA - Switzerland financial regulator - is investigating some swiss banks for possible manipulation of FX rates, among which the WM/Reuters FX rates, used as benchmark for "90 percent of currency derivatives contracts, such as swaps and options". It is getting harder and harder to even joke about it :)

The main function of financial systems?

Is now clearly to allocate risk, instead of capital. What purpose serve catastrophe bonds if not diversifying risks? this one exemple might not be enough to argue the functional shift of an entire industry, but one has to note nevertheless that catastrophe bonds might have done well because they are not correlated to stock markets....where prices are supposed reflect all known information and rational market participants act accordingly. Rational actors of financial systems have to resort to gamble on natural disasters to diversify their portofolio, showing once more (as if we needed more proof by now) that financial markets are not efficient at reflecting fundamentals. 

Natural disasters as safe heaven from stock markets

Leonardo Da Vinci - Natural disaster

Betting on the likelihood of natural disasters has been one of the best investment since the financial crisis, after silver, gold, high-yield bonds from the US and EU countries. Catastrophe bonds are a fixed-income investements, but contrary to others, issuers do nothave to pay the full amount of the bond or the interest in the event of a natural disaster. 

Now get this: 

So why have cat bonds done so well in the last few years? Because they have practically no relationship to financial markets. This doesn't mean they're particularly safe: we've written before about the possibility of a bubble forming in the insurance industry. Then again, when the entire market can shift after a few comments from Federal Reserve chairman Ben Bernanke, as it did this week - or rests on the health of dubious bets from the financial industry - gambling on the likelihood of a natural disaster doesn't sound like such a bad idea. 

The stock market has become so unpredictable and so detached from economic fundamentals that natural disasters have become an alternative to it.  

About that Robin Hood tax

The Financial Transition Tax (FTT) proposed by 11 EU countries (including France, Germany, Spain and Italy - but not Britain nor Sweden), coined the Robin Hood Tax is, conceptually, an old idea. The stamp duty, the oldest tax still in existence in the U.K., is a form of financial transaction tax. Keynes argued for the implementation of such a tax on Wall Street, and after the end of the Bretton Woods regime, Tobin proposed a tax on currency exchange.

The FTT supported by the EU 11 group is supposed to be implemented in 2014, but as mentioned earlier, it is not going to be so simple. If one steps away from the technicality of this new piece of legislation, it appears more clearly than it is also an attempt to "slow down the engine", to "throw some sand in the wheel of finance", as Tobin said. In this regards, this reform reflects the momentum taken by the idea that finance has to work for the economy.  It is finally getting acceptable to say that that the liquidity and volume of financial markets are not an end in itself. 

This reform and the reactions it triggered represents the tensions between risk management and investment. Keynes already voiced his concerns about this dilemma. On the one hand: “Liquidity of investment markets often facilitates, though is sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is “liquid” (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment” (Keynes, 1935:133). On the other hand he warned that “when the capital development of a country becomes a by-product of the activities of a casino”, which is the outcome of “our having successfully organized “liquid” investment markets, the job is likely to be ill-done” (Keynes, 1935:133).

Behavioral finance is at the individual level

Courtesy of Kal, The Economist

Here are 7 psychology concepts showing that investors are not rational as orthodox financial economics holds. Investors have emotions and mental frameworks to process information that makes their decisions irrational, though perfectly "normal". 

But behavioral finance is at the individual level, not the group or the societal level. The title of the post linked above is clear: the biases examined by behavioral finance are psychological. At the group level, the dynamics might different, but to discover that, we need more work from the sociology of finance and crowd psychology. 

The politics of financial reform

The Financial Transaction Tax (FTT), otherwise known as the Robin Hood Tax, is likely going to be reviewed and postponed. It is a levy of 0.1 % on the trades of stocks and bonds and 0.01% on derivatives transactions involving at least one financial institutions based in the EU. The political tensions around this reform are mounting due to the design, feasability and the economic implications of the reform.

States dependency of finance means the tax base will be a crucial question. An FTT can tax stocks, bonds, forex, options and futures. It can tax the primary market and/or the secondary one, regulated market and/or OTC. If only one kind of instrument is targeted, the reform risks creating a bias in favor of others financial assets. If government bonds are not included in the tax base, it is likely to draw liquidity out of the corporate bond market, and raising the costs of capital. But taxing public sector debt is not uncontroversial either, as it will impose higher transaction costs, thereby raising government borrowing too. 

So support for the reform is starting to wane. Germany and France are worried about the backfire effect this tax could have. Austria and Belgium want an expection for pension funds. 

One argument concerns the impact it will have on European banks borrowing overnight using repurchase agreements (or repo). The borrowing bank sells liquid instruments that it agrees to repurchase later at a higher price. As the costs of borrowing overnight thourgh repo is very low, the tax would kill this segment. The ICMA, a lobby group, already made clear that the incidence of the reform over the repo market will be catastrophic. (That being said, the importance of the proper functioning of the repo market, not the most glamorous market of all, is often overlooked). The reform thus might need a carve-out for repo.

Making bankers behave...

has a cost, as Augar notes in the FT, reacting to the letter from Barclays' new boss that signals a push to reform the business culture and ethic of banking at Barclays. It is costly for Barclays, but it is also costly for the society as a whole, for the behaviors of a few discredit an entire profession whose activity requires social trust. 

Culture shift is a long and painful process though and it is still not very clear how to make value statement stick. More importantly though, if these kind of sporadic moves at the firm level are not accompanied by clear and simple signals at the state level, it risks being simply windows dressing. Yet,  it seems that the contrary is happening.  Financial regulation is getting more and more complex, but basic rule of law is being eroded, as noted in previously here. The latest case in point is HSBC deal with US government over charges of money laundering for mexican drug barons and terrorist groups and advices to Iran on how to avoid US sanctions. 

After too big to fail and too big to regulate: too big to jail. 

What does crowdfunding funds?

courtesy of saleschase.com where you can find the entire infographic

Crowdfunding is a form of financing start-up and SMEs that is becoming trendier and receiving a lot of attention lately. Experts do not see it replacing private equity and loans from banks however. The knowledge and management advices that SMEs get from private equity and bankers cannot be replaced by the power of crowd. There is, arguably, something unique in the lending relationship which has a lot to do with the transfer of knowledge and information. Crowdfunding, for all its benefits, does not reduce the distance between the investor and its investment location. Moreover, it seem more appropriate to fund certain sectors than other. The Economist provides the figures: 

A total of $320m was pledged by 2.2m people, making possible creative projects including a documentary on fracking, a home aquaponics kit and a community centre for circus arts. Games, a category which includes video, board and card games, received the most support, with $83m pledged to more than 900 projects. Given their high development costs and passionate fans, video games are a good match for crowdfunding, particularly as established publishers churn out ever more sequels, leaving a long tail of unmet demand

The paradoxes of financial regulation...

...when it has to regulate complex financial sector, is that it might have the opposite effects that financial regulation is supposed to have. The European Union intention to regulate of hedge funds and private equity funds might risks to be counterproductive. Sinead Cruise from Reuters explains the heart of the problem: 

A central plank of the new rules, which will be brought in from July, involves money managers who market funds in the EU being required to work with independent depositaries. These are banks that, for a fee, track what the manager does with clients' money and agree to cover investor losses in the event of unauthorised trading. Appointing a depositary is supposed to prevent a repeat of last year's MF Global debacle, in which $1.6 billion of client assets were allegedly used to top up bad bets that the now-bankrupt broker had struck with its own money. But it remains unclear how many funds or managers these financial custodians will be willing to backstop, or how much they might charge for the service.

This will be certainly be very costly for the industry, which risks driving many funds "underground", that is unregulated location, thereby concentrating the risk that the regulation want to reduce into fewer hands.  

Georgia's unobserved economy

has an importance for the dynamic of entrepreneurship. Half of the work force is considered as self-employed, officially unobserved. This represents a pool of entrepreneurial resource that Georgian policy makers shouldn't underestimate. So far little has been done. Agricultural centers with shiny big John Deer tractors  have mushroomed in the regions, but haven't been visited by anyone (expect official delegation), as it costs too much for farmers to rent this type of machinery, which is anyway not adapted to the small fields they have to plow. Details and figures in the article I wrote for the Caucasus Analytical Digest.