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Monthly Archives: April 2012

Karl Smith is wondering who may be getting the upside of clearing but recessionary markets in the UK, or why they are otherwise not clearing. He is also keen on bashing Apple for reinvesting its abundant profits in a shiny cash pile. Might there be a salient comparison somewhere?

UK finance minister George Osborne with a red box

UK plc Chief Financial Officer George Osborne introduces a new laptop to customers.

So, which prices are moving in the UK? The government sector seems a prime candidate. The UK government has been following a strict austerian line — incidentally, so much for all the arguments that the eurozone’s structure forces austerity on its members: the UK behaves as if it was inside the eurozone, despite being out and having no such constraints; they could as well be in.

Let’s assume that taxes represent the price of government services. Basically a household pays some money and gets a basket of goods and services. Even if the goods are not priced proportionally to consumption, it’s still some sort of customer-supplier relationship, and in aggregate the distributive question — how each individual consumer is charged their share of total revenue — is not that material.

So what has UK Miscellany Services plc been doing? They’ve been increasing taxes and cutting services. Tim Hartford says they’ve actually done more of the former than the latter, which surprised me a bit, but either way the amount of tax raised for each unit of delivered services has gone up, that is the price for their wares has gone markedly up.

How would that have an effect in everyday life? A typical taxpayer might have been using a basket of government services, and find that suddenly one of them is not available anymore. If it was not essential (say the library they used to attend has closed) they may content themselves without it, or substitute for it with a cheap or free activity (e.g. read blogs instead of library books). The price increase here shouldn’t have a sizeable impact: it becomes a lower standard of living, and possibly even minimally so if there are free or low cost alternatives.

But if the service was essential, and more so than the marginally essential goods or services the taxpayer gets from the private sector, they will probably pay out of pocket. In this case the price of government services has clearly increased: they pay the same/more tax for a reduced basket of goods. And how do they pay for the substitute? They could save less, which would probably be desirable in the current predicament, but they may also, if as cash constrained as most people are, just substitute: buy the formerly government provided service from the private sector (possibly from a former government employee having converted their activity into a private business). This result in further price pressure on the private sector. This scales from one taxpayer to the aggregate of all taxpayers.

So basically the government, as a supplier of services, has increased its profit margin. As it happens to be a loss-making venture, it has really merely reduced its losses, but the effect is the same. What matters here is the change, not the absolute value. Then, what are the government doing with this extra margin: they are reducing their debt, that is increasing their cash pile — making their negative cash pile less negative than it otherwise would be. Like Apple.

And by hoarding profits both Apple and HM Government are contributing to a depressed world economy.

While the reaction to the financial crisis has lead to many proposals to restrict, regulate, or otherwise reorganise, the way banks operate, hoping to prevent future financial crisis, the idea of getting rid of the banking sector altogether remains fringe. There seems to be a broad consensus, across the political spectrum, that banks have some useful functions that we can’t do without, and that the problem is to get them to accomplish these useful functions without causing unwanted damage.

But, are banks actually net useful? Do they produce more good than damage across a full banking/business cycle? I remain to be convinced. I think it’s relevant to ask the question: can a modern economy operate without a banking sector? I suspect the answer is yes, and to try to understand why, let’s see what banks do, and for each function of a modern bank, which currently existing, or imaginable, institution could take over that function.

  • Payment system:¬† this consists of operating cash deposit accounts, electronic fund transfers, payment cards (debit card, or the payment function of credit card less the borrowing), and handling cash (operating ATMs and cash deposits). This could be operated by pure payment processors, of which there are already examples, online (e.g. PayPal) or offline (prepaid debit card operators). Narrowly defined payment processors would be required to hold 100% of customer balances with the regulating sovereign, so that the government’s guarantee on deposits is explicit and enforced in the structure, and that no loss is possible outside of pure fraud cases. Customers are not allowed debit (negative) balances, and positive balance pay no, or less than the short term rate, or even cost some fee to maintain, because the processors get the short term rates, and deduce their operating costs as fees. People are not expected to keep their savings in these institutions, and if they do, they pay for it through the low returns.
  • Brokerage: this allow people to buy and sell credit instruments (shares, bonds, etc) emitted by third parties in one convenient place. At its core, it’s a financial plumbing service business that requires little capital. Banks have broker department but brokers can operate perfectly well independently, and some of the largest brokers are not part of a bank (e.g. Interactive Brokers). There is no essential problem in requiring that brokers are not part of banks. Brokers still have a shadow banking function via (a) holding cash balances at banks (b) offering margin trading where they take credit risk. The former can be delegated to a payment process as above, or internally via sweep to money market or government bonds based instrument which nowadays can be realised with minimal trading costs. The margin trading function can also be made illegal, and replaced by equivalent products with third parties (see below).
  • Savings accounts: deposit accounts at traditional banks with a government guarantee are in effect very similar to a government bond, they are a sort of derivative product: a synthetic treasury bill (to use US terminology). Like many derivatives, the systemic social utility of the product is probably negative. This could be dealt with by abolishing the government guarantee. Savers wanting deposit account-like products could buy government paper, or approximations thereof, without explicit guarantees but usually higher rates, directly through brokers.
  • Credit intermediation: this is perhaps the function that people have the hardest time imagining how to do without. One of the core function banks operate is risk pooling and control: you lend to the bank and they asses the credit worthiness of borrowers and pool the risk among many borrowers for you. But there is already plenty of alternatives structures that also fulfil that role: large companies most often raise money directly from investors via share and corporate bond issuance. The technology is now there to expand those markets to smaller businesses. Peer-to-peer lending platform already do this for credit to individual or single person businesses. Funds of corporate credit or private equity fill a similar role for mid-size companies. There are also so called non-bank lenders who raise money from the market (shares, bonds) and then lend to individuals or small or medium size businesses, without being involved in guaranteed deposits. So the role of credit intermediation that banks currently do could be entirely taken over by a combination of direct markets, aggregation platforms, and specialist intermediary businesses. All these businesses are funded via equity and corporate credit, whose failure is usually non-systemic and where the creditors know they are taking risk.
  • Issuance placement: this is old school investment banking, where banks play the role of an intermediary to have large borrowers meet with investors and solve the somewhat tricky issue of pricing bulk issues of credit instruments. I’m not sure whether non-bank companies are involved in this business, but I don’t see either that it needs to be part of banks at all. This is not capital intensive (the intermediary is paid via a fee) and there’s little systemic advantage to have that role entangled with banking. Indeed, conflicts of interests are rife.
  • Market making and derivative issuance: banks trading department often have inventory of financial instruments (aka trading positions) via which they provide liquidity to non-bank parties who may otherwise not find someone to match their trade. Several firms operate as independent market makers successfully. The barriers to entry are low on electronic markets with central clearing. There’s no reason to think the market would not fill that niche should banks be banned from proprietary trading of all forms, including market making (the current attempts at trying to limit proprietary trading while allowing market making are inadequate, because systematic rules to distinguish the two activities are virtually impossible to devise).
  • Monetary policy transmission: in the payment processor model above, the processors are not allowed to borrow from the central bank, and thus only pre-existing money circulates in the system. There may be a shortage, that is today implemented by central banks via the operation of bank reserves and open market monetary operations, where the central bank controls the quantity of core money to match the financial activity without triggering too much inflation or deflation. This is the one function that is today almost exclusively done by banks, but could they be circumvented? The Brazilian central bank, cleverly, operates some of its policy implementation via open trading of interest rates derivatives. The Swiss central bank is today implementing policy via the cap on the EUR/CHF exchange rate, which they put into effect by trading directly on the foreign exchange market. I don’t see any reason why the entire monetary policy couldn’t be thus implemented. There’s a wide variety of instruments that are broad enough to prevent becoming an active investor, which is indeed not a desirable function of central bankers. Intervention on the forex market; interest, equity indices, maybe property index¬† derivatives would achieve the same function as reserve management, and probably with greater precision to boot.

So, if we ban banks for operating the functions above where narrow institutions can replace them, are we left with anything? I’d like to be corrected but I can’t think of a useful function that banks do better than specialists institutions.

In conclusion, how should we ensure that banks do not cause the next financial crisis? by making banking an illegal business to be in, after allowing a long period for winding down existing banks in an orderly manner.

The invisible hand will swiftly replace bankers with less toxic operators. It will not prevent all types of future systemic crisis — you can still get unwieldy financial entanglements without banks — but it should make it easier to understand and regulate the system and avoid the worst of the unwanted socialisation of losses that banks can inflict of society via their privileged role as de-facto issuers of synthetic sovereign debt.

I do very little fundamental company-level trading but I couldn’t help taking a negative view — arguably like almost everyone else — on Research in Motion (NASDAQ: RIMM).

The Canadian company’s claim to fame is the BlackBerry, a family of smartphones everyone in the finance industry, and business more widely, including the more shadowy types, was using before the iPhone, and then other touch phones, came to the market.

The BlackBerry innovations were (1) phones with a miniature keyboard, (2) a closed-garden messaging system well integrated with “enterprise” email systems (aka MS Exchange). Touch phones have killed the interest in keyboards, and for those users who still prefer them, all smartphone manufacturers bar Apple now have some decent offering in that space. The closed-garden messaging system is also actively of very little interest to anybody, except legacy users, like end users networking within the system, and slow-moving IT departments.

They haven’t reacted much so their platform is now well out of date. The competition is so ahead that even catching up will probably not help, even if they pull it, which will be hard, it might not help. Among the headwinds, all the techies working for them will know they’re doomed so either have already left, will leave, or will be unenthusiastic about being left in a sinking boat. Mediocre techies will stay the longest, of course.

They also have a very good track record at producing ugly phones, and it’s difficult to see how they could catch up when most of the competition is doing not too badly chasing Apple on that front.

So what could they do?

  • Orderly shutdown: turn the legacy proprietary services into apps for the iPhone, Android, and perhaps Windows Mobile. Support legacy users with the app and the existing server side infrastructure, close down or sell everything else, and stop manufacturing devices. The question then is can the cost of the shutdown leave a profitable if much smaller business?
  • Do a Nokia: adopt either Android or Windows Phone, turn the legacy services into an app for the chosen platform and sell devices with the third party OS and make that app exclusively available on their own hardware, so that people who want the legacy services (or ugly retro phones) still have to buy their phones, but without being stuck with a dead platform. So they save platform development and maintenance costs, escape being in a dead end ghetto, but then they become an also-ran among makers of phones for someone else’s operating system. It’s not obvious that this can be done profitably. The jury is still out on Nokia, who actually have some strength left in some areas and is probably in a better position than RIM. The simplest way to do that would possibly be to merge with Nokia, though it may be hard to find conditions where it would be advantageous for Nokia to take the burden.
  • Try to catch up on their own: it seems to be what they’re currently doing and the most likely outcome. Good luck with that. This is very likely to end up in bankruptcy proceedings.

What are the macro lessons? The market system lacks an efficient system that would allow such failing or outdated companies to go through corporate euthanasia as smoothly as possible. As it is they keep trying and burning resources in the process. People working there are wasting their time and everybody would be better off if they were redeployed to more productive endeavours.

In passing, I was amused reading recently, in the comment thread of a blog post about Apple’s dividend announcements, contributors who stated proudly that they have invested all of their liquid wealth in Apple stock and are rejoicing about how they will retire on the proceeds, some decades ahead from now. Apple’s business has a visibility of about 2-3 years, and at its peak RIM appeared, at least to non-technical people, similarly unassailable. I wonder if anybody had invested their life savings in RIM then… Apple could still do better, but it’s one hell of a single horse bet.

From a trading angle, the stock has been going down significantly already, and could have temporary rebounds, but this type of failing company seems in general to slowly trend towards zero, possibly partly because it takes time for longs to admit defeat, hence my assumption that not all the failure potential is priced in. I’m using put options to avoid exposure to either a temporary backlash or a permanent resurrection.

Disclosure: long December 2012 RIMM put options at $15.