Financial innovation is a virus!

"Financial innovation is like a virus, finding weaknesses in existing inventive schemes and regulations. When something is growing very fast, that suggests they have found a weakness." - Jeremy Stein Harvard University. 

This is one way to think about financial innovation, but it is not very appealing. It argues that innovation is just an attempt to evade regulation. There is no doubt that some goals of innovation are evasion, but there are also other reasons, such as market efficiency. Nonetheless, one can argue that regulation reduces efficiency, and innovation attempts to address the problem. If the problem is corrected, there will be more growth in innovation. Securitization, derivatives, and ETFs are all significant innovations that make the markets more efficient, while also addressing regulatory concerns.

Some basic rules for financial regulation

  

From an old article in the Institutional investors by John Liew of AQR, there is a good list of what government regulation should and should not do with respect to finance. I agree with this list and would be happy to add to it, if there is something missing. 

• The government should recognize that bubbles can happen. It is rare, but the cost of a bubble is high and should be addressed prior to the peak. 

• The government should not subsidize or penalize some activities over others. Picking winners and losers should not be the role of the government even if other country may have a different view.
• The government should not promise to eliminate the downside. Capitalism is about winning and losing.
• The government should encourage disciplining mechanisms like short-selling (and conversely, it shouldn’t ban or penalize them). Markets need short-seller to keep the markets honest.
• The government should encourage, not tax, liquidity provision. Liquidity is critical for the pricing of markets and regulation to reduce it will have strong negative effects. 
• The government should punish true fraud harshly. Fraud creates a lack of trust. Trust is critical for market success.
• The government should have consistent laws consistently applied (for example, when it comes to bankruptcy). Consistency is critical if long-term investment decisions are to be made.

• The government and self-regulatory bodies should encourage consistent and reasonable accounting. Accounting is the lifeblood of market information.
• The government should encourage that financial institutions mark more things to market.  Book value accounting masks mistakes.

 

Connectedness and contagion tied to institutional structures

 

There is a lot of talk about connectedness and contagion in markets, yet the institutional structures are often overlooked as major contributors to the cause or control of major market shock events that are associated with panics. Hal Scott in his book Connectedness and Contagion: Protecting the financial system from panics. As a lawyer Scott has a different perspective than most economists, but this is a useful book for any economist who is studying panics. The focus is on the policies and their impact on markets from the Great Financial Crisis. Some policies have been critical at mitigating any panic and contagion, but Scott also suggests that policy changes and structures can add to potential risks. 

We often find that markets are more connected than expected during a crisis. Whether third party creditors, derivative counterparties, prime brokerage, structured securities, or money market funds, there are a myriad of connections that lead to connectedness and higher correlations. The contagion during the GFC was significant across the banking system, money markets, and brokerage firms. There have been changes in the system, but we again found that significant connections existed during the Great Pandemic. Solve one problem and a new one will arise. 

All the panic problems are attempted to be solved through the lender of last resort, yet the idea of lending freely in a crisis is not as easy as waiving some magic monetary or fiscal wand. The rules and programs that need to be in place or are in place can be very complex. Unfortunately, Scott makes the case that some of the rules post-GFC have reduced the ability of the Fed and the government to serve as the lender of last resort, and rules can add significant complexity to the marketplace. There is not uniformity of rules across all central banks, so if there is a global contagion, it is not clear how different central banks will respond. 

Banking rules such as the Basel III framework are complex, yet other supposedly simple approaches will not solve the problem. The designation of globally systematically important banks, risk-weighted assets, leverage ratios, stress tests, liquidity requirements, living wills, contingent capital, or other attempts to solve contagion may lead to other problems which are not obvious. Money market funds like banking institutions have similar problem with trying to regulate away crises. However, rules are needed because bailouts are expensive and in a crisis mistakes will be made.

The watch words form this book - know your institutions and regulation before a crisis because once a panic comes it will be too late to try and understand the system.     

15 years post Lehman - What has changed?

As we "celebrate" the fifteenth anniversary of the Lehman failure, it may be good to look at what may have changed since that time. This is not exhaustive, nor does it try and tell a complete narrative, but I make some observations that jumps out at me. 

• The too-big-to-fail issue has not been addressed. Banks are more concentrated than before the Great Recession. Are they less risky, hard to say. There is clearly more regulation, but the linkages and points of potential risk still exist with the largest institutions.

• The systemically important label is being broadened to include more non-bank institutions, yet it is not clear that this will help the financial system. As regulation increases, no structures are developed to avoid regulation. More debt and leverage are managed through private markets as opposed to regulated banks. Banks risks may be less, yet debt risks are not lower.

• Monitoring has gotten better through the Financial Stability Oversight Council but it is unclear the goals of this monitoring other than getting more information. Regulators are watching but that is different than acting. The bank failures in 2023 is a perfect point. The information was available, but action was lacking.

• The debt problems still exist.  Debt excess has switched from households to governments although Treasuries are viewed as safe assets. 

• The Treasury market is less safe given the size of dealers relative to the Treasury debt outstanding. The Fed is the biggest player in the Treasury market, so it tries behavior. 

• The Fed has less flexibility and has generally overreached after crises. The lender of last resort is now a long-term lender for all situations.

• The Fed has created the foundation for a new financial crisis. By holding rates low for too long, and now taking rates to 5.5% they have created a problem for debt holders.  Markets are processing and adjusting to the new rate market, but that means that losses will have to be taken. Firms and households will have to pay more for debt. This is still working through the financial markets.

• Excesses in policy lead to market distorts which then need new policies to stop the resulting pain. It is a treadmill that cannot be easily left.  

• In the heat of the moment action was taken to not support Lehman. It may have been the right action. It could be argued as the wrong action. However, we do know that the subsequent actions are still being felt throughout the economy.

Does bank regulation need to be streamlined? Should the Fed be the key bank regulator?

 

Who is the top regulator of banks? The Fed. Yet, the Fed is not a government agency. It was formed by an act of Congress but is a public/private combination where there are 12 regional banks with board of directors from member banks in a region. The banks must hold stock in the regional Fed bank, but all excess profits from the Fed are sent to the Treasury. The Fed and its regional banks have their own budgets, but the Chairman is required to report to Congress and the Board of Governors of the Federal Reserve System are selected by the president subject to approval by the Senate. Within this structure, the regional banks will regulate member institutions. 

To put it simply, the regional Fed banks will regulate banks that can have executives on their board of directors. That was the case for SVB. The supervisors have a conflict with their member boards. It may not occur, but the appearances or chance for conflicts seems high. 

All the problems with SVB were evident by reading their SEC filings, so what were the bank supervisors doing? What effective oversight were they providing? What should be their role to limit bad behavior before we have a tun on a bank? 

The Fed has supervision of national banks so that it can ensure the safety and soundness of the financial system and the execution of monetary policy. A streamlined regulatory system makes sense, but is that what we currently have? 

Just in case you need a refresher, here is a simple map of current regulatory oversight from Chris Skinner.  So, who is responsible for overseeing bad management? If everyone is in charge, then no one is in charge.

Here are two more graphs which should make the point clearer from everycrsreport.com. So, can you tell me who is the chief regulator and who should be held accountable? There should be clarity and no conflicts. I don't know if we have that.

Financial crises - Not what was unforeseen but what was unaddressed

"Nothing about this crisis was unforeseen, it was just unaddressed." 

- Karen Shaw Petrou referring to a past financial crisis

Perhaps the unaddressed is always what is the problem not what was unforeseen. As we explore the details about the current bank failures, we see that there was no surprise event that drove the crisis. We are again learning that, after the fact, all the information concerning a problem was readily available. 

A crisis occurs not from a surprise but from a cascade of change after the information is internalized or realized by a critical mass of investors. An event may serve as the wake-up call, but the underlying risks already existed. The problem is when everyone realizes there is a problem at the same time. 

Silicon Valley Bank - The huge asset-liability mismatch was well known and reported in their financial statements. The strong deposit growth which had to be invested was well-known. The large funding from the FHLB was well-known. Regulators at the San Francisco Fed were fully aware of the problem.  

Signature bank - The excess of uninsured deposits was well-known. The risks with it being a bank for crypto firms was well know. It was the focus of regulators.

Republic Bank - The excess of large deposits and significant inflows from Silicon Valley firms was well-known.

Credit Suisse - The poor management, losses, and regulatory problems were all well-known earlier. It was a bank filled with problems which could have been addressed earlier by regulators. Investor clearly had issues as evidenced by the stock price. It was just a matter of time.

All were hit with the problem of higher rates which again was not a surprise. Poor early action has led to crisis times. We cannot just say that "mistakes were made", nor can we say that these firms were hit by a shock. They were already working with poor odds. In all these cases, a critical mass of depositors acted on this awareness in a cascade which caused a run.

Group Dynamics and the Fed - If everyone is thinking alike, someone is not thinking

 "If everyone is thinking alike, someone is not thinking." - General George Patton 

What would Patton think about the consensus building at the Fed. Votes are often unanimous. There is seldom any dissension. 

Fed regional presidents seem to now come from other Fed banks or from the Fed staff. There is a culture that is based on getting along with the crowd. Fed officials seem to love to give speeches between FOMC meetings, yet few say anything controversial and in the case of regional Fed presidents even fewer focus on local conditions of their constituents. 

Many of the president are from the Fed system and did not get moved to Fed presidencies through questioning policy decisions. Most have never underwritten a loan or run a profit and loss for a business. They cannot appreciate community banking because they never were community bankers. They cannot appreciate job loss or hiring issues because they never had to hire from a diverse pool of workers. They never had to deal with regulation because they are the creators of regulation. Of course, regulation does not have costs when you don't have to bear the costs.

The Cleveland Fed president, Loretta Mester spoke at a MIT Golub Center for Finance and Policy conference in Cambridge. Did the conference need her unique Midwest perspective? I don't think so. She spent her entire career at the Philadelphia Fed as an economist before moving to Cleveland. She is a competent economist and a good administrator, but does she offer an alternative perspective and a Cleveland regional view? 

Another Fed president states in her bio, "has charted a vision as a premier public service organization, dedicated to helping create unreserved opportunity for all Americans". Worthy goals, but is a local Fed bank a public service organization? Could this just be done better at the Board of Governors and eliminate any regional banking duties? 

Is it wrong to hire economists from within the Fed? No, but like any excess too many leads to wrong thinking. A few internal hires are good. All hires from within is bad for gaining diversity. 

There is noise when there is less agreement, but is it more important to have consensus with a wrong policy or conflict which may lead to the right policy?

Should we have more dissension about current Fed policy? what is the role of the regional banks when there is a major policy shift? 

Policy uncertainty between world, EU, and US growing

Economic policy uncertainty provides a good measure on what the economic risk environment looks like for investors beyond classic volatility measures. A high uncertainty reading should negatively impact global investment. Capital will not be deployed in new projects if the policy future is unclear. 

There is a growing uncertainty gap between developed countries outside the US and the US. Given geopolitical risks (the war in Ukraine), the ongoing energy crisis, and economic sanctions, policy choices and decisions are in a state of flux. New global investments will be curtailed and the slowdown in the global economy will deepen. The US uncertainty picture is stable but subject to high volatility. Nee investment is not likely to support a growth story.

Powell reappointment - It is not the money, it is the regulation

The chances of J. Powell being reappointed as Fed Chairman is a key focus for current monetary policy discussions. It is adding to market uncertainty. President Biden can choose the devil he knows or get someone different who better aligns with his economic vision. Unfortunately, the vision beyond minimizing the cost of debt financing is not clear.

The reappointment discussion is not as clearly focused about rates, inflation, or quantitative tightening, as one would expect but seems to be centered on the role of the Fed as a regulator. The Fed Chairman is supposed to be a better bank and financial markets cop and not just a monetary controller of the macroeconomic environment. The current bank regulation scheme is too complex and beyond the understanding of any average banker, investor, or policy-maker. Some "simple" diagrams show the current regulatory complexity.

It is unclear whether the Fed should be the top bank regulator; however, under the current environment, it has that role. In fact, banks may not be the location of greatest financial risk, so the fed also has responsibility for all significant financial institutions. Does the Fed need to know the workings of the banking system? Absolutely. Does that mean that all bank regulation should be conducted by central bankers? No. Can there be conflict between bank regulation and monetary policy? Yes.

Macro-prudential policies have been a critical area of focus for the Fed as it should be given the impact of crises on the macroeconomy; however, the operational goals and oversight for these macro-prudential policies is unclear. More important than being a bank regulator is having clarity with the scope of its macro-prudential responsibilities.

The reappointment by Fed Chairman Powell should be based on his ability to meet the mandate of full employment and controlled inflation and the protection of financial markets if that is the desire of Congress. There is enough here for discussing whether he has done an effective job without adding the issue of bank regulation. 

Environmental themes and infrastructure bills - Concentrated risk

Within ESG asset management is the sub-strategy of environmental theme investing. Instead of focusing on the overall ESG rating based on criteria set by any number of firms, investors buy into themes that are associated with key ESG sectors like alternative (clean) energy and technology which includes wind and solar or electric cars and batteries as well as other infrastructure investing. This technology may not be cost efficient until there are better economies of scale. Scale is reached through mass production. The average and marginal cost will fall if there is greater demand often created from subsidies by the government. The subsidies can come in many forms, but all require legislation or regulatory changes. 

Looking at leading clean energy ETFs (KLN, PBW, and FAN) shows the concentration of investment risk around subsidies and government support. After the presidential election, the component stocks of these clean ETFs rose under the expectations of a huge green new deal. As the possibility of an infrastructure deal declined, returns declined to current levels. Investors in the clean energy ETFs are not just buying technology but making a play on the green energy bill that will create scale opportunities. If the stock prices rise, it is signaling a higher probability of legislative success.

Hedge funds drive Treasury market - Their behavior may create market dislocations

Solve one supposed problem and you may create another, the law of unintended consequences. Banks used to be the key driver of trading in Treasury, but that has changed with Dodd-Frank and other bank regulation. In its place, hedge funds have become the dominate player in active trading. A change in players with different capital commitments and trading objectives will spill-over to issues of pricing and liquidity. This switch to hedge funds has not been an overnight change, but hedge fund gross Treasury exposures have risen to $2.4 trillion in 2020 with a large focus on relative value arbitrage between cash and futures supported through repo funding. Treasury trades by hedge funds were crowded before the March pandemic. 

New analysis has found that hedge fund Treasury exposures declined significantly in March 2020 as returns from basis trading and RV trading declined. See "Hedge fund Treasury trading and funding fragility: Evidence from the COVID-19 Crisis". The threat to market liquidity from changes in hedge fund exposures is significant. Highly levered hedge fund trading will be sensitive to performance and will impact the trading of other Treasury market players when there are large position adjustments. The Treasury market may be more sensitive to macro surprises that impact the yield curve and financing. This places greater pressure Treasury dealers and increase risk premia especially for off-the-run Treasury issues. 

Market structure is a critical component for understanding the changing sensitivities of prices to market information.

GameStop (GME) - A game changer? Focus on the rules of the game

 

I can live with risk as measured by the volatility of markets. What is harder to live with is the risk or uncertainty on the rules of the game or the structure of markets. While there has a focus on the wild moves in some equities attributed to retail herds, crowds, or swarms, there has been less attention to what is happening with the rules of the game. 

Investor should expect increases in margin for volatile stocks, futures and options. This is a rule of the game. You may not like it, it may come at the wrong time, and it may actually further increase market volatility, but it is part of the game. Cash has to be reserved for this contingency. However, what happens if some brokers restrict trading in specific names given their capital requirements. It is within their rights and it may be a prudent call to protect the business, yet if an investor does not have a contingency for this change, there will be a whole new level of business risk.

The rules of the game also mean there can be short squeezes. If short interest gets so large, normal dynamics will be adjusted to account one-sided behavior. Borrowing costs will increase. Long will account for their advantage by just not selling. 

Extreme behavior leads to extreme responses and like a car that begins to skid a quick response may be the real problem and feedback gets reinforced and accentuated. And, we have not even begun to see the response by regulators. 

Is a structural response necessary to these market moves? An immediate answer is yes. Markets cannot be driven to either meltdowns or melt-ups by a feedback loop of trading driven by non-fundamental excess whether it be from the long or short side. Uncertainty can be minimized by reducing ignorance and know how the market structure works and what rules may change. 

Public pension funds -There are no quick fixes

The National Conference on Public Employee Retirement Systems (NCPERS) produced a paper, "Ten Ways to Close Public Pension Funding Gaps" which tries to provide some solutions to the problem with public pension shortfalls. All have some merit, but all fall short of the real problem. More money, lots of it, has to be raised or benefits, lots of them, will have to be sacrificed. Without clear specifics for each proposal, it is hard to see how much of the funding gaps will be closed. For those public pensions that are close to full funding any of these choices may be enough to solve any small gap. For those that have significant gaps, the policy proposals will not solve the problem.

The choices:

Leverage and liquify - Borrow money to support pensions or liquify existing assets  

• Pension obligation bonds 
• Action of the Fed - For example, buying municipal bonds to allow leverage and liquidity 
• Bridge loans 
• Securitizing public assets - liquify public assets to pay for benefits

Structural changes - target payments to pensions, obtain scale, target contribution adjustments, increase taxes 

• Dedicated revenue streams 
• Stabilization funds 
• Monthly employer contributions 
• Plan consolidations
• Auto triggers to adjust contributions 
• Reforming revenue and increased taxes 

Why is this a global macro problem? The dynamics of pension will lead to long-term macro drags that cannot be easily solved by monetary policy or federal fiscal policy. If inflation increases or valuations decline, the impact on pay-outs will be real. Any inflation adjustment will not close the funding gap. Lower expected returns will only increase the gap. This is a problem that will have to be addressed by the new US president.

Monetary policy creates fragility - Now policymakers have to solve the problem

There are a few concepts that everyone should takeaway from their economics 101 class. One, economic agents response to incentives. Two, there will always be unintended consequences when incentives are changed. Change the incentives and behavior will change. Unfortunately, we don’t always know what will be the behavioral change. Perhaps the greatest problem in economic forecasting is trying to figure out how behavior adapts when faced with new circumstances. 

Given the law of unintended consequences, any policy should be crafted with care for the simple reason that the market response will not always be clear. This is especially the case for financial markets where capital is fluid. Policymaker then have to adjust to the response by markets to their initial action. These thoughts are forefront in my mind after reading the IMF World Economic Outlook Report and Global Financial Stability Report.

Global economic growth is slowing and central banks are again responding through an aggressive monetary policy of lowering rates. There is now worry that rate cuts will be less effective than fiscal policy, but there is little questioning in the minds of central bankers for this need. 

However, reading the IMF Global Financial Stability Report describes an environment filled with financial excesses. In this world, low interest rates have been the fuel for excessive leverage and an ongoing reach for yield by investors that must be addressed with macro prudential policies to curb behavior.

Financial stability is affected by three factors: size, valuation, and vulnerability. While not at excessive levels in some sectors, non-financial firms, non-bank financing and sovereigns are all at elevated exposure levels at or above levels from the Financial Crisis. Valuation in both credit and equity markets are high, which increase risks to investors. The markets may not be vulnerable given relatively loose financial conditions, but any downward change in financial conditions will place the borrowers and lenders in a difficult state. 

Central banks lowered yields to offset the risks from the Financial Crisis, a balance sheet recession. Nevertheless, leverage has not declined but has actually grown over the last decade. Many firms have gone on a binge of borrowing sustained by savers willing to take on risks to offset low yields. Bank leverage may have been curtailed but alternative sources of funding have arisen to offset any bank void.

Now governments are suggesting more aggressive macro prudential policies to offset the effects of aggressive monetary policy. The incentives put into place caused a change in borrowing and lending behaviors which now have to be curtailed through new constraints.

Monetary policy is a blunt instrument  that can create fragility that now has to be solved with new policies imposed on the market. This is just the next phase of further financial repression. For investors, there is a need to assess sector risks and start to adjust risk positioning before financial fragility is discounted in prices. 

FCM concentration - Is this good for futures? We don't know.

Market structure matters regardless of the industry. The interaction of economic agents will impact market behavior and drive pricing. Competition reduces markets frictions and transaction costs. If there is less competition, the cost of execution will be higher, and there will be less liquidity. This applies even to highly regulated markets like futures trading. A simple graph shows the decline in the number of FCM's operating in the futures markets. The number has been cut in half since 2011. 

To just say that more firms are always better than less is perhaps too simplistic. There can be significant competition, but it is between the top ten firms with the rest just being able to compete with less attractive prices. All we know for certain is the FCM industry is going through radical change and the number of players is falling fast. Stories tell us that smaller firms are having a more difficult time finding FCM's, larger FCM's are cutting less profitable clients, and if you don't bring trading volume, you will pay a higher price even in an electronic world.

Since the Financial Crisis, regulators have increased rules in an attempt to reduce systemic risks. There have been FCM failures in the system that had to be addressed, yet regulation may have increased the cost of business and forced market consolidation. Low interest rates have also hurt the FCM community because a portion of profits comes from returns on segregated funds, albeit this is much more regulated. Technology has also added significant costs which have forced smaller players from the market. Clearing activities have become even more of a scale business. The question is how great is the impact on trading for different customer types. (Hat tip to Gary Flagler a long time futures veteran I have  know from First Chicago for the graphs.)

The top five FCM's have over 50% of the clearing business as measured by seg funds. The top 10 FCM firms have just under 75% of the seg funds. Using a traditional measure of industry competition and concentration, this may be high but not a great concern. A deeper analysis is necessary to understand the closing of smaller FCM's. Technology has made this even more of a scale business and regulation has increased the break-even business necessary to be successful. What is most interesting is that none of the top 5 and only 1 out of the top 10 FCM's is a non-bank. Banks dominate the processing of trades and margin. This issue how scale economics affect users and their ability to access the market at attractive prices. 

At the same time as the FCM's have become more concentrated, exchanges have done the same. With a single exchange dominating futures trading in the US, the unique role of FCM's standing between clients and different exchange margins is not necessary. 

From a microeconomic view, we can discuss the costs of the firms and talk about economies of scale. This discussion is relatively straight-forward; however, what is not straightforward is the impact on smaller users. The macro or systematic risk issues are more complex and have not been truly addressed. Does higher concentration in financial markets increase systemic risk? The probability of failure for any firm may be less, but is the potential for a system failure higher? I am waiting see some careful work in this area. This work has to be done before the impact of consolidation becomes irreversible. 

The global scope of post-crisis regulation - it affects all of the finance industry

Not until you look at complete set of regulation to do realize how much the financial industry has and will change over the last 5-7 years. The World Economic Forum paper  - The Future of Alternative Investments provides some good graphics on the amount of regulation. These will have a huge impact on all parts of finance. Alternative investments will not be immune to the new regulations in the US, EU, and Great Britain.

Costs from regulation are going up while fees are going down. This causes the alternative industry to move to a scaling model. Firms have to grow to pay for this oversight.

Norges Bank Investment Management view of exchanges - a call for change

The Norges Bank Investment Management (NBIM) company which runs the Norway SWF has written a provocative piece on the role of exchanges in current capital  markets which asks for a significant change in focus. Provocative may seem like a strong word, but on most finance issues SWF's try to keep a low profile. There are two key points that I believe NBIM want to make in the their piece "The Role of Exchanges in Well Functioning Markets: An Asset Manager Perspective".

One, the equity markets are more fragmented than what many may think. There are fewer exchanges, but more mechanisms for accessing liquidity which makes for a less well-functioing markets. Asset managers have to search for liquidity and develop and access multiple systems to find this liquidity. This search for liquidity comes at a cost.

Second, the limits to speed have been reached and this technological drive may not meet the needs of large institutional investors. High frequency and support for this smaller size trading is not consistent with the structural changes in the asset management area over the decade. Pension funds have gotten larger. SWF are larger and generally the size of asset managers around the global have increased significantly over the last two decades. Money management has become a game of scale. Asset managers need liquidity to trade size not speed. The exchanges have to come to grips with the size needs of institutional money managers who actually represent many small investors.

Continual markets that focus on speed do not help the manager who wants to trade blocks at fair prices. This is a fair comment from one of the big guys. The questions is how to find the right mix between size, speed, and price discovery. It is not clear that exchanges or regulators will be able to handle these issues.

"Markets too important to be left to investors"

I was speaking at a RCM Alternatives event in Boston with Ben Hunt of Salient Partners. He made a very good point when discussing the actions of China to slow its stock market slide. It seems regulators and central banks believe, "Markets are too important to be left to the actions of investors."

This phrase may sum up the view of all governments right now and what causes the low volatility. If investors want to get out of equity markets, we have to stop them. If investors do not want to make risky investments in fixed income, we have to force rates down and keep them down to ensure investors are willing to move money out the curve. Governments have to steepen yield curves to make banks profitable. Rates cannot be set higher because that will cause investors to rethink their fixed income holdings. We have to have regulations to control leverage, trading, and capital usage all to get the market results that governments want. We have to finance sovereigns when private investors do not want to hold.

Do not get me wrong, there is a need for regulation in the financial sector and central banks have an important job to help stabilize business and financial cycles, but the goal should not be to replace the markets.

Exit fees on bonds funds? So much for liquidity

The FT reported that the Fed is considering exits fees on bonds funds to avert a run on the funds. The Fed is considering corporate bonds funds a part of the "shadow banking" system since they compete in the loan market. In this case, those bond funds have the same liquidity risk as a bank that could have a run when depositors ask for their money and the bank is holding illiquid assets. The Fed stated that a fund run is more likely because banks and Wall Street dealers do not have the same commitment to market-making given the added regulations on these institutions. In a crisis, there is less liquidity available when funds have to sell bonds to raise cash for investor redemptions.

So let's make sure we get this straight. The Fed regulated bank dealers out of committing capital to market-making which makes the trading of bonds more risky Given this risk, you now have to charge investors a fee to get out of investments when the market turns against them. You tax liquidity so it is harder for investors to pull their money out of unsafe investments. Ok, this makes a lot of sense. Why stop with an exit fee? Why not just give the Fed the authority to declare a fund holiday and stop people from getting their money? See what that will do to the markets.

There will be liquidity events when there will be more sellers and buyers which will result in price declines, but is it the place of government to now impose an exit fee on when investors want their money? Would it be imposed all of the time or just some of the time? 

The law of unintended consequences will be imposed. Would investors avoid corporate bond funds because of this rule? Is it possible the cost of capital for firms trying to raise debt financing will increase when bond fund investors will be required to pay a fee to get their money back?

The intention of this proposal may be good, but the result of imposing the fee could be worse.

Corruption index shows business is difficult to do

The corruption index for 2013 does not tell a very pretty picture especially when you look at emerging market countries. This has important implications for international finance and the movement of money. There is an ongoing issue of why there are capital flows moving from South to North. Capital should be flowing from developed countries; however, if there is ongoing corruption such that many view that funds are not safe, there will still be movement to developed markets even if returns are lower.

If corruption is lowered around the world, capital will flow more freely to countries that actually need it.