5/2/15: Where the Models Are Wanting: Banks Networks, Risks & Modern Investment Theory

My post for Learn Signal blog: "Where the Models Are Wanting Part 2: Banks Networks, Risks and Modern Investment Theory" covering networks effects on risk propagation in the financial services sector and the impact of these networks on equity pricing models is now available here: http://blog.learnsignal.com/?p=153.

23/1/2012: Extreme Events

Going through 2 charts and mapping the big themes of the ongoing crises, one has to be in awe of the volatility. Here are the maps of extreme (3-Sigma-plus) events with 'directionality' reflected:

Lovely, aren't they? But the trick in the above is: we are not at the decay stage of volatility on the sovereigns re-pricing stage. This, to me, suggests that once the sovereign crisis re-pricing draws to conclusion (whenever that might happen - isa different story), there will be the need for finding that 'new normal' (reversion-to-the-trend target) for the markets valuations overall. And that is the whole new game, dependent less on the previous equilibrium that should have followed the Great Bursting period, but more on the future risks and trends in post-debt economies. Which, itself, really depends on whether any given market can sustain growth without endless supports (implicit and explicit) from the Government borrowings.

Just thought I'd throw few thoughts out there...

13/09/2011: Latest research on Tax Havens & Safe Havens

A recent CEPR research paper (CEPR Discussion Paper No. 8570, "TAX HAVENS OR SAFE HAVENS" by Patrice Pieretti, Jacques-François Thisse and Skerdilajda Zanaj, from September 2011) attempts to explain -at least in theory - the policy choices of a small open economy (SOE) that wants to be a viable international banking center (IBC).

The basic dilemma faced by such an economy is that to attract IBC activity, the economy needs to choose between either becoming a tax haven, a safety haven or both for investors from large economy. In other words, the SOE is required to establish a competitive advantage relative to a large economy in terms of two possible instruments: taxation and institutional infrastructure.

The problem is that in reality, the same SOE will not be able to provide both - quality institutions and tax haven protection, since the latter contradicts the former. One can argue that in the past some tax havens were institutionally extremely robust, but in the current globalization-altered world, good institutions require compliance across the borders, not just within the country.

What the paper shows is that in such a setting, the tax haven can act as a catalyst to induce institutional reforms despite the fact that it cannot create institutional competitive advantage. The reason is that competition amongst tax havens drives institutional improvements in these IBCs.

As surveyed in the paper, a recent study by Dharmapala and Hines (2009) "investigated 209 countries and territories to determine which jurisdictions become tax havens and why. They found that successful jurisdictions are overwhelmingly small, but that they are especially well governed, with sound legal institutions and low levels of corruption. Poorly run jurisdictions fail to attract or retain foreign capital, and many do not even try. Thus, the quality of governance seems to matter for the existence of tax havens. According to Gonzalez and Schipke (2011), there is some empirical evidence that countries that apply stronger regulation rules have benefited from higher portfolio investments."

The CEPR study largely confirms this. The core conclusions are:

• "...whether the small country becomes a tax haven depends on the integration of financial markets and the intensity of the small country's comparative advantage."
• "The nature of government matters too to the extent that benevolent governments never build a tax haven. They prefer to erect an IBC through the provision of better institutional infrastructure."
• "By contrast, tax havens may emerge under Leviathan governments. This may explain why tax havens are developed in microstates where there is almost no conflict between social welfare and tax revenues because the local population benefits from the taxes which are mainly levied on foreign investors."
• "Our analysis also reveals that the presence of heterogeneous investors matters for the viability of the IBC and the nature of the policy mix."
• "IBCs need not be as bad as claimed in the media because they foster institutional competition which is beneficial to all investors."
• "Our results provide evidence that safe havens have a place in the global financial environment and provide benefits to governments, firms and households."
  

Economics 28/06/2010: Watch out for VIX

Short-term VIX options and VIX itself are starting this week on the upside... is risk contagion spreading from sovereign bonds to corporate?
An interesting view here.

Let's put this on record - I think we are now in 50:50 chance of a new recession - Euro area, UK and US, plus Japan. Time horizon - 6 months.

Economics 04/02/2010: McKinsey gets banal with risk

Latest McKinsey Quarterly (here) contains an article on global risks. Sub-titled "Top risk forecasters highlight their picks for this year's economic and political hot spots", the article is short and... really, really, really banal.

Here it is in its full glory (emphasis is mine):

Where will the greatest risks — known and unknown — flare up on the global business landscape this year? In this roundup, three prominent forecasters scan the horizon. [Notice the use of the future tense, forward-looking language]

...Economist Intelligence Unit's latest global business risk assessment highlights ...growing political instability from rising global unemployment, macroeconomic risks as stimulus measures fade, and financial-system risk spreading to sovereign debt in Greece and other countries.

European fiscal divergence makes the list as well at the Eurasia Group, which also sees diminished appeal of economic partnership between China and the United States raising concern, while Iran faces growing pressure at home, regionally, and globally.

And the World Economic Forum's 2010 Global Risks report focused on, among other risks, the barriers to growth posed by structurally deficient or obsolete infrastructure, the spread of chronic disease, and illicit trade."

Let me re-list them:

• 'growing political instability from rising global unemployment' - hmmm, wasn't that already apparent in Greece back in December? or in Ireland during local and European elections? or in the US in the last Presidential elections? I can go on and on;
• 'macroeconomic risks as stimulus measures fade' - you don't need EIU's forecasting powers to spot that one - everyone trading in financial markets has been factoring it into valuation for months;
• 'financial-system risk spreading to sovereign debt in Greece and other countries' - now what's new here (given the last 15 months of erratic markets behavior and record bond issuance) is the 'financial-system risk spreading' bit. Which financial-system risk? It is a purely nonsensical statement, unless one means by it that the bond finance system itself is under threat (US Treasuries? German bunds?);
• The risk of 'European fiscal divergence' has been with us for some 5 years now and has been growing steadily;
• 'diminished appeal of economic partnership between China and the United States' - but, folks, 'economic partnership between the two is a traffic of investment from US into China in return of exports from China into the US. This 'partnership' was coming under pressure for decade now. It really started to unravel with undervaluation of yuan bearing on the dollar balance of trade in 2006-2007. Since then, the prospect of the 'diminished appeal' was pronounced in US politics, culminating in the last Presidential Campaign. President Obama has been promising a protectionist corporate tax system overhaul to 'diminish appeal' of investing in China for US MNCs since before his election. I wonder if this is really a risk for 2010;
• 'Iran faces growing pressure at home, regionally, and globally' - oh no, who could have guessed. Certainly 2009 elections - with violent clashes, murder of internal opposition leaders etc, all caught on TV news and broadcast around the world were not a sign of 'growing pressures at home'. And Russia moving alongside the US and Europe to attempt to curb Iranian nuclear ambitions (a process that started back in 2006) is also not a sign of 'growing pressures... regionally and globally'. In short - this 'prediction' is too - old news.

Only WEF actually returns some interesting (aka not-banal) risks - infrastructure constraint on growth is a good one (although there is an element of 'old news' here as well, as crumbling bridges in the US and collapsing new builds in Korea have been with us for almost 10 years now). WEF could have added to it the lack of Governments' capacity to find funding to repair this crumbling infrastructure as a new-ish constraint - post-crisis. They did not...

Illicit trade being on the rise? Predictable risk - in any recession, black markets grow.

But the pearl is the prediction of chronic diseases spreading in 2010. Of course 'chronic' refers to the rate of onset of disease and development being spread over longer time horizon (at least 3 months). So how would we know if chronic disease is spreading in the remaining 10 months of 2010? especially ones with gestation periods measured in years?

Precious stuff, really. Makes me want to create my own list of forward-looking risks for 2010 and beyond. It will start with something impactfull, like "Parts of the world will experience droughts while other parts will get flooded. Grey skies will cover Ireland on many occasions throughout 2010."

Any suggestions what else to include?