Fail safe regulation!

Obama's financial sector regulation is under scrutiny. In one word will it prevent crisis - no. Will if prevent this crisis from occurring again - possibly. Why? Is it so ineffective? Well no, the terms are well intentioned. What we need is Fail-Safe regulation.

Fail Safe - engineering definition v/s common definition

There are two definitions of fail safe. Generally, fail safe means does not fail. Whereas in engineering fail safe means - when it fails it does not cause harm. It is impossible that regulation will never fail. So financial regulation needs to apply engineering definition.

Using Engineering fail safe regulation...
Now we need not regulate hedge funds, or investment banks or increase their capital adequacy beyond certain limit. We simply need to ensure that when banks fail they do not take the world with them. Hence I proposed the new banking system.

In the new structure, we should see polarization of financial institutions along the risk axis. The high risk FIs, like hedge funds and private equity, will never be bailed out. Investors into these asset classes should sign a government disclosure that they know they can potentially loose their money - just like hedge fund investors. We will see more groups joining hedge funds and private equity in this pole.

In any case regulation has to take responsibility for low-risk financial infrastructure part of the system, leaving other pole to dynamics of capitalism.

In Sum...
The current regulations are good intentions with potentially poor outcome. I hope Obama advisors are able to get around to the engineering fail-safe regulations.

Market turmoil and picking Survivors

Global markets showed weakness again today. Over the past few days global markets have weakened about 2% per day. There are theories that point to a three week correction before a pick up in prices.

Picking survivors
A popular anecdote highlights importance of holding stocks for long term. So people often tell me - so what if price is too high - just "sit on it" for XX years and you will be fine. Unfortunately that is a wrong strategy. Current situation is more about picking winners.

Winners change and lot of companies fall by the way-side during times such as these. In a smaller crisis, bigger companies are typically better off. But not so for structural crisis such as we are seeing now. A long term investment strategy is more about picking survivors. Survivors will loose less value when market falls and will rise higher when it gains.

Airline example - British Airways and Singapore Airlines
Airline operators were part of massive industry slowdown after 9/11. These two companies used this opportunity to replace their fleet with young more fuel efficient planes at reduced prices thus building tactical advantage for years to follow.

Stockpiling Commodities - What is China doing?

China stock-piling commodities or buying US assets seems useless to me. If US dollar were to loose value and commodities / dollar assets were to retain value – then technically Chinese Yuan should also retain same value. US dollar starts loosing value means commodity prices start shooting up. Meaning, in technical terms, US will then export its inflation to the rest of the world. There are few responses to this –

• the world keeps global exchange rates constant
• The world let dollar go down alone
• Some allow exchange rate changes some (like china) dont

If everyone keeps exchange rates same – we will have another recession and commodity prices will come down. And whatever you do this cycle will repeat itself till world is sick of the pain. The fundamentally sound parts of world can recover if they let currencies appreciate.

Holding commodity assets signals the Chinese intent to keep the Yuan (RMB) hard pegged to the dollar. This is clear signal of pushing towards "status quo". The stockpile will help China reduce the inflationary impact on its economy while US recovers. But ideally this should require inventories equal to the expected duration of such inflationary scenario.

The only other reason could be - China expects disruption is supply chain. Such disruptions occur in crisis - so China might be preparing for crisis possibly even a war.

China's domestic demand and other notes

Brad Setser starts a wonderful discussion on "How can we explain growth of China while all other export oriented economies continue to slide?" Thereafter follows a range of serve and volley explanations that are delicious treat for thought! Here are my views:

Walmart sales increased when other retailers went bankrupt because Walmart was lower cost than most. Same logic, I believe, explains partly why Chinese exports did not slowdown as much as others.

China’s monetary expansion will have two components – domestic stimulus and US treasury demand. It will be interesting to understand which will be bigger and will there be any crowding out effects.

If you push large liquidity through the system fast – high value, long-term assets (houses, stocks, etc) tend to inflate. This keeps overall inflation low (since these do not form part of consumption basket) giving an impression that everything is fine. This corners the excess liquidity to one end of the pool. Eventually the system breaks but till that time we have fantastic illusions.


Problems of Europe
Europe is about 13 billion giant (excluding Russia). Problems of Europe will impact world recovery to the same / slightly more than problems of US. We have somehow left Europe out of discussion.


Domestic demand / Market
Creating domestic markets is not easy and does not simply happen by throwing capital. Domestic tastes and preferences, as we see in India, are lot different than we anticipated. Same logic should hold for China.It is easier to customize goods (like restaurant services) are easy to manage – but inflexible goods (capital goods e.g.) take long time. The changes cascade from consumer side till they reach the top end. Examples:

1. A large part of textile industry may be geared to service cotton clothes – whereas Chinese might prefer silk. (OK I simplified it a bit too much)
2. You take milk, some producers added some hormones to aid milk production. Resulting milk was not safe for children. Now we need institutions, legal, regulatory etc that create a feedback system to discover and curb such practices. These complex frameworks anchors in democratic setup – leading us to political minefield.

If someone clarified the entrepreneurial scene – we may actually get better clues about domestic demand. Large entrepreneurial pool backed by venture funds experimenting with products and distribution is the best way to create (and an indicator for thriving or potentially thriving) domestic market.

The easiest part of domestic demand stimulus is to allow top brands to enter the domestic market and give them some price leeway through currency appreciation. Louis vitton bags, Chanel perfumes etc will kick start domestic consumption faster.


Psychology of excess
This is one of the problems facing China. In its quest to stimulate – it might create excesses that can haunt it later. Large ammunition is mega problem if it explodes in you own backyard.


China is our hope
Our global recovery hopes are pinning on China. The question is does China know and will it take the responsibility?

A New Banking System

The current crisis made us realize how financial sector in general and banks in particular can hold the economy hostage. The crisis was precipitated by a credit freeze triggered by fall of Lehman Brothers. As a response Fed kept pushing money into the bank but none of it reached the deserving households or small enterprises. So we know we need a new Financial system. Mike has a nice post about The financial sector we want.

Rethinking banking - Banking as water management system
We can think of banking as water management network. We have water reservoir, the piping and usage meters, then we have used water drainage, used-water treatment and back to other reservoir. The used-water is savings that feed into the reservoir - bank deposits. The worst part of banking crisis was the looming disappearance of the the piping and drainage network.

Now, the network needs to be as big as possible, bigger the better. A larger network means accessibility across the country / world, it means freedom for the consumer. It means the network will be operated like a utility company, with very small fee and highly regulated operation.

The reservoir however, needs to be small enough to be manageable. And more the merrier. Here replacing one by other will ease the strain on the economy. In radical times, Fed can directly be the money reservoir and plug itself into the system.

Tomorrow's Banks = Today's banks - Banking infrastructure "system"
So we are looking at splitting banking into three parts - financial infrastructure system, deposit taking institutions and loan making institutions. While, the last two can be same, they cannot ever be infrastructure. Glass-Steagall Act achieved this in smaller degree. I think, looking at recent experience, it makes sense for the financial infrastructure to be government owned. At least, it needs to be heavily regulated large utility like power transmission company or water supply company. Alternatively, it can be a well-designed Internet based system as well - then no need for any company.

What is financial infrastructure system?
The role of financial infrastructure company will be that of a conduit. Citizens will have an online account, with a free (zero fee+ zero charge) debit card. It will allow the citizen to login and allocate his/her savings to deposit-taking-institution of choice that can manage it with promise of interest income. The system will collect a fee from deposit-taking-institution as an insurance against insolvency of the institution. The amount of fee retained will depend on rating of the institution.

Further, lender (including credit card providers) can lend to citizen based on report generated by system. These reports will protect privacy as per legal guidelines and give information enough for processing creditworthiness test. It may also generate a FICO-like score for the borrower. Lender, once satisfied, can be plugged into citizen's account. The system will schedule and process payments or at least set alerts to prevent defaults.

Privacy and prudence
The suggestion also raises privacy and government intrusion concerns. I am not sure I understand all the problems that may arise in such scenario. However, it is definitely an idea worth exploring.