Streetwise Professor

Who woulda thunk that commodities-especially ones like aluminum-would become such a huge story.  Maybe it’s the summer news doldrums, but in the last week there have been two major, related stories using up loads of ink and pixels.  The stories are: (1) the Federal Reserve’s announcement that it is evaluating whether to continue permitting banks it regulates trade physical commodities, and own physical assets like storage facilities and power plants used to transform commodities in space, time, or form, and (2) the role of banks like Goldman and Morgan in the industrial metals storage business.  The latter story was the subject of an extensive piece in the NYT on Sunday.  The stories are related because the metals warehouse controversy is Exhibit A in the case against allowing banks to be involved in physical commodities.

First the warehouse story.  I wrote about this issue back in January.  There is smoke here.  The premiums in physical aluminum above the LME in-store price is an indication of a bottleneck in getting material out of warehouses.  The question is whether this bottleneck is being artificially exacerbated by game playing-manipulation, perhaps-by the warehouse operators.  The NYT article does cast some light on some mysterious practices, but it does not seal the deal in my mind.  Not to say that manipulation is not occurring, just that the NYT piece doesn’t convince me.

One puzzle is that the operators of warehouses, who cannot own physical metal in them, pay third parties a bonus over the LME price approximately equal to the cash market premium in order to put their material in store, and thereby put themselves at the mercy of the loadout queue.  Presumably, those taking these deals only do so because they are compensated for the higher storage expenses they incur once their metal gets stuck in the roach motels.  If Goldman (or any other warehouseman) paid everyone these premiums, Goldman couldn’t make any money by running the roach motel: it would pay in premium what it collects in storage fees.  It would compensate the roaches for the costs of getting stuck in the motel.  Which suggests that they only pay some customers the premium to attract metal.  What would be interesting to know is how this would permit the warehousemen to collect storage for a longer period from others whose metal is in the warehouses, but who don’t get paid the bonus.  Are there side deals with the storers who receive the premiums?   Does the mere fact that there is more metal in the warehouses increase the ability of the operators to slow down load-out, and thereby collect storage for a longer period?    This seems to be the most curious practice, but the articles I’ve read don’t shed enough light on how they could be part of a manipulative scheme.

Tom Maguire of Just One Minute does a good job at debunking the math in the Times piece: the profits accruing to Goldman and the costs imposed on soda and beer quaffing consumers alleged by the Times don’t withstand scrutiny.  To which I would add another point.  Namely, these calculations assume that the cash premiums reflect an inflation in price.  Any uneconomic act that exacerbates the bottleneck in the transformation of metal in store to metal outside LME warehouses has effects on prices on both sides of the bottleneck: it reduces the price of metal in store, and increases the price at the Coca Cola or Budweiser facility.  So even if the premium is inflated, this does not mean that the price paid by consumers (directly or indirectly) is inflated by the same amount because part of the inflation is due to a depression of the in-store price.  Those with metal in store, or producers who put their metal into store, bear some of the cost.

Now on to the bigger issue, which the hue and cry over bankers owning metals warehouses is intended to illustrate: namely, whether banks should be involved in physical commodity markets.  This is the subject of a Senate hearing today, where one of the main anti-bankers, Ohio Senator Sherrod Brown, is leading the charge to get the banker-squids’ tentacles off our commodities.

I find most of the reasons advanced for keeping banks out of physical commodities, and the ownership of commodity transformation assets, to be unpersuasive.  What’s so special about commodities?  Are they uniquely risky?

I think not, and believe that there are good economic reasons for banks to enter into the commodities business.

In addressing this issue, it’s important to be specific about the kinds of risk involved.  Price risk, spread risk, and operational and reputational risks are perhaps the most important to consider.

The conventional view is that commodity prices are extraordinarily volatile, and hence pose extraordinary risks on those who hold them.  One thing to note is that for a leveraged investor like a bank it is possible to transform a relatively low volatility flat price exposure into a much riskier exposure.  So one thing that matters is whether, taking leverage into account, bank positions in commodities are riskier than their positions in more traditional lines of business.  Moreover, it is risk at the portfolio level that matters, and the correlation between the price exposures and other elements of the banks’ portfolios.  A highly volatile position may not increase portfolio risk substantially if it is uncorrelated with other exposures, or negatively correlated.

But there’s a more important point.  Most commodity trading by commodity trading firms and banks does not consist of punts on the flat price, on whether the price of oil or copper is going to rise or fall.  Instead, most commodity trading is a margin business or a fee business.  Money is made on margins or fees in transportation, storage, and processing.  These margins-spreads-tend to be much more stable than flat prices.  Asset ownership, or contractual control of physical assets (of the type that JP Morgan has over California power plants that have attracted FERC’s ire), is a position on the value and cost of transformation, and spreads and margins measure these values and costs.  The riskiness in these spreads/margins, and the ability to manage spread/margin risk through paper trades, is what drives the risk of bank commodity plays.  My reading of the coverage has turned up virtually no understanding of this issue.

Moreover, the profitability of physical assets can provide a natural hedge for other bank businesses.  Most banking his highly pro-cyclical: it profits when the economy booms, and does badly when the economy tanks.  Some commodity assets are countercyclical.  Storage is a classic example.  The amount of oil or metal in storage-and revenues from storing these things-goes up when the economy weakens.  This is basic economics.  So metal or oil storage-a fee business-is a natural hedge against the strongly procyclical traditional banking and dealing businesses.

Taking these factors into consideration, it is wrong to believe that commodity businesses are unduly risky, compared to other banking activities.

Operational risks are perhaps more problematic.  A major oil spill, for instance, leads to substantial costs on the operator of the ship or pipeline or terminal that spills it.  A bank that owns or charters a tanker that ends up on a reef is potentially exposed to a substantial risk of loss.  But much of this risk can be passed on to insurance companies via the insurance market.  What’s more, the risk doesn’t go away if banks can’t touch physical oil: someone has to bear it.  The question is whether banks are less efficient bearers of this risk than others (where others include insurance companies).

Many of the stories that have come out in recent days focus on the reputational and legal risks associated with commodity trading.  For instance, JP Morgan’s impending settlement with FERC of allegations that it manipulated the California electricity markets has received considerable play.  Well, this is not a problem unique to commodities.  Traditional banking businesses, and other less traditional activities now widely considered to be legitimate activities for banks, have huge reputational and legal risks.  Consider Libor.  Or the Toure trial.  Or mis-selling.  Or mortgage servicing/foreclosures.

I could go on. And on. And on.  If you think that keeping banks out of commodities you’ll reduce their rep or legal risks, I have a bridge to sell you.

Furthermore, even if it is shown that banks have engaged in dodgy activity in commodities, that doesn’t mean that getting banks out of commodities will eliminate the dodgy activities.  Consider the warehouse issue.  If LME rules and cash market frictions make it profitable for warehouse operators to manipulate markets, forcing banks to sell off these assets won’t reduce the manipulation: the new owners will take ownership of the strategies along with the storage sheds.  Note that Glencore-not a bank!-has been accused of playing similar games.   Keeping banks out of commodities may affect who plays dodgy games, and profits therefrom, but won’t have much of an impact on the amount of dodginess in the markets.  That dodginess ultimately derives from economic opportunity (which is driven by frictions in the market) and regulation (flawed rules and rule enforcement mean that market participants calculate there’s a substantial probability of escaping punishment for misdeeds).  Barring banks from the market won’t change either of these things.  If crime pays, someone will commit it.  If you care about reducing the deadweight losses from manipulative activities, you shouldn’t really care about who profits from them.  You need to fix the problem at the level of incentives and enforcement of rules: keeping banks out of the market doesn’t do that.  Period.

The foregoing is basically a rebuttal-or at least a skeptical questioning-of the case against bank ownership of commodity assets, or participation in physical commodity markets.  What about the affirmative case for such participation?

For several years, in response to shrieks about the evil effects of the “financialization” of commodity markets, I’ve made the following basic point: a good deal of commodity trading is about allocating commodities over time, and allocating risk.  Both of these are fundamental financial functions: finance is about trading off the future and the present, and allocating risks.  Banks are linchpins of the financial system, and engage in intermediation of risk and of resources over time.  Why should we exclude them from a sector where the allocation of resources over time and the allocation of risk are vitally important?  That is the comparative advantage of banks: why keep them out?

Indeed, banks have gained market share in commodities in large part because they can perform the time- and risk-allocation functions more efficiently than others.  If banks have the lowest funding costs, it makes sense that they fund some inventories.  Banks have expertise in risk management and hedging, making it sensible that they utilize this expertise in the management of commodity price risks.  In other words, the success of banks in commodities is a feature, not a bug, because it reflects their comparative advantages in allocating risks and resources over time.

Moreover, there is often a synergy between financing and risk management activities, and banks can exploit these synergies.  For instance, one physical market activity that banks engage in is offtake agreements, whereby they provide say crude oil to a refinery, and receive the refinery’s output which they market.  This bundle of transactions involves a funding element-the bank is basically providing working capital to the refinery.  It also involves a risk management element: the bank is managing the price risks on the crude and refined product side (as well as the logistical/operational risks).

Crucially, by taking on the risk, the bank is reducing the moral hazard that would be involved if it was providing working capital financing to the refinery.  Yes, if it just extended loans or credit lines to the refinery, the bank would presumably impose requirements on the refinery to hedge its risks, but there are inherent agency problems associated with such an arrangement that can be avoided by putting the price risks on the bank.   Moreover, the operational and logistical risks cannot be hedged, and pose a potential moral hazard.

The most telling objection that might be raised against these arguments is that banks have gained market share in commodities because they are subsidized as a result of too big to fail.  I would note that the investment banks that made the first and biggest forays into commodities-Morgan Stanley, Goldman, Bear-did so when they did not have access to insured deposits for funding or to the Fed window, though one could argue that they still were subsidized by the belief that they were too big for the Fed to allow to fail.

But even if you buy into the subsidy argument, that’s no reason to single out commodities.  The subsidy leads to an excessive expansion of big banks generally, across all lines of business.   Meaning that keeping them out of commodities will not materially reduce the perverse effect of the subsidies.  Implicitly or explicitly subsidized banks will exploit that subsidy to the hilt, and if they can’t do it in commodities, they’ll do it somewhere else.  TBTF has to be tackled at the roots, not the branches or the leaves-and particular lines of business like commodities are the latter.

One last point.  It is beyond ironic that the banks are under attack for their commodity dealings.  GFMA wanted to hamstring banks’ competitors in commodity trading-namely, the commodity trading firms.  Perhaps they should have paid more attention to making the affirmative case for their participation in these markets, than they did attempting to raise their non-bank rivals’ costs.

The word karma comes to mind.

Marco Dialosa of the Pension Insurance Corporation echoes some SWP clearing themes in an interview on Derivsource.com (sorry we didn’t connect in London last month, Julia):

Q. Given the liquidity squeeze that will result from CCP clearing, where do you see the liquidity coming from?

A. We believe that the amount of high quality liquid assets on balance sheets will increase. We see the repo market as a mean to provide liquidity for cash variation margins. What is less clear at this stage is whether the repo market is the right place for collateral transformation and how this market will behave in times of stress. One of the unintended consequences of the clearing initiative is that it may be transferring systemic risk away from the OTC world into the repo market.

Q. Does the movement of systemic risk away from OTC world and into the repo market an unintended consequence concern you or do you view it as just inevitability?

A. It is an unintended consequence in our view. The OTC market is akin to an ecosystem, it is in a stable equilibrium. A small change in a particular parameter (i.e. central clearing) will be corrected by some negative feedback that will bring the parameter back to its original point of balance. It is extremely difficult to eliminate systemic risk in practice without disrupting the balance of the whole system.

Just so.  Most of the effects of clearing mandate are to redistribute risk, not to reduce it.  Moreover, the equilibrium in the system will adjust in response to an exogenous policy shift: the “negative feedback” will attempt to find a way to replicate the old equilibrium as closely as possible, given the constraints imposed by the new rule or regulation.

In other words: you need to take a systemic approach to analyzing systemic risk.  You have to understand how a change imposed on one part of the system is going to be transmitted to other parts of the system, and how those other parts are going to respond to this impulse.   Systems achieve a particular configuration for particular reasons, and it is very difficult to change these configurations fundamentally.  The particular reasons that led to its particular configuration lead to the negative feedbacks that Dialosa mentions.  And a good thing too.  Negative feedback is a stabilizing force.

Today Elizabeth Warren and John McCain unveiled the “21st Century Glass-Steagall Act” that would restore the separation of investment banking and commercial banking, along with a few new restrictions on the things commercial banks with access to deposit insurance can invest in.

I really don’t get the nostalgia for Glass-Steagall.  I really don’t.  What’s next?  High Button Shoes for the 21st Century?  Radio tubes for the 21st Century?

Smarter people than McCain and Warren (a bar that a snail could jump, I admit) have pumped for the restoration of Glass-Steagall.  Luigi Zingales is a prominent example. I expressed my criticisms of Zingales’s advocacy of Glass-Steagall a little more than a year ago, and nothing I’ve seen since changes my mind.  Certainly the bloviations of Warren and McCain don’t.

The essence of the argument for a restoration of Glass-Steagall, as well as “ring fencing” regulations in Europe, appears to be that deposit insurance creates a moral hazard: banks with access to insured deposits take on too much risk.  Preventing such banks from engaging in risky investment banking activities supposedly improves the safety of the banking system, and limits taxpayer exposure, by reducing that moral hazard.

There are only two problems with that.

First, access to deposit insurance is obviously not a necessary condition to induce risk taking.  None of the stand-alone IBs that took on leverage out the wazoo in the 2000s, and took exposures to highly risky real-estate related securities-Bear, Lehman, Merrill, Morgan Stanley and even, yes, Goldman-had access to deposit insurance.  And that was in  fact the problem.  Nor did they have statutory access to Fed support in the same way banks do.  They all relied on very fragile wholesale funding that ran like Usain Bolt when things started to look dodgy.

Second, Glass-Steagall-like restrictions on permitted activities/investments are not sufficient, by a long shot, to prevent commercial banks from taking on risks that threaten their solvency, and the stability of the financial system.  Look at all the banking problems in the 70s, 80s, and 90s that occurred despite Glass-Steagall.  Sovereign lending to Latin America.  The S&L crisis.  Lending to Asia before its 1997-1998 crisis.  Commercial lending to the energy industry.  Need I remind everyone that the phrase “too big to fail” was coined to describe Continental Bank, which became insolvent the old fashioned way: engaging in high risk commercial lending in the era of Glass-Steagall?

The “quiet period” of US banking the 50s and 60s was the result of a dense nexus of costly restrictions on banking activity.  Glass-Steagall was a part of that, but not the entire story by a long shot.  It just gets the most press, and the best press.  The complex web of restrictions on banks and financial intermediation during that period-restrictions that imposed substantial costs-is too hard to explain.  So Glass-Steagall has become the poster child for that era. People like Warren and McCain think that Golden Age can be restored by reviving Glass-Steagall.  As if.

I am deeply skeptical of restrictions on the activities of financial intermediaries; I am also skeptical of mandated impositions of market structure (e.g., clearing mandates).  The underlying incentives remain the same, and these Byzantine restrictions induce attempts to circumvent them.  It is better to operate at the level of incentives, through capital requirements, for instance.  Yes, there will be attempts to circumvent these too, but at least they provide some incentive for those with the information to internalize the risk-return trade-offs.  Structural restrictions, not so much.  At all.

Yes, moral hazard induced by deposit insurance matters.  But it matters a lot less than other things.   Breaking up universal banks will still leave large investment banks reliant on wholesale funding with incentives to lever up, and large commercial banks who can blow themselves up just fine, thank you, by making loans.  So the revivification of Glass-Steagall won’t materially reduce systemic risk, but it will induce costly efforts to circumvent the separation, and will sacrifice the synergies between investment and commercial banking activities.

When your diagnosis is wrong, the prescription is likely to be wrong too.  And with financial doctors like Warren and McCain, we should have no illusions that they’ve screwed up both.

Gary Gensler has been an evangelist for transparency in derivatives markets.  He has tirelessly argued that increasing transparency, especially in the OTC markets, will go a long way to making them more competitive and more efficient.

But Gensler apparently believes transparency works no such miracles for the operations of the CFTC.  Energy traders (including the industry and the banks) are completely at a loss to explain the CFTC’s ominous special call for information about exchange of futures for swaps (and other related positions (Risk subscription required-unless you know the trick.)  (I expressed my amazement at this ex post facto scrutiny when the story first broke.)   Why is the CFTC giving EFS the stink eye after years of not merely acquiescing to them, but actively encouraging them as a way of putting energy trading back on its feet after the merchant energy meltdown of 2002-2003?  Who knows?  The CFTC isn’t saying.  Hell, the CFTC isn’t even admitting that it is conducting an inquiry:

The notices contain no information about the CFTC’s motives – and a spokesman for the agency declines even to confirm the existence of the special calls – leaving dealers and their lawyers to guess why the regulator has sud-denly decided to probe a market that it helped set up over a decade ago. Part of the answer is that, however it may appear, this is not a sudden change of heart.

How’s that for transparency?!?

The Risk article does provide some interesting background on previous Commission attempts to crack down on certain kinds of EFS transactions.  Failed attempts, I should emphasize, because the proposal could not get a majority of the commissioners to vote for it.

To me, EFS seem like a tremendous example of financial innovation that solved a serious problem in the energy markets and facilitated an objective that Gensler otherwise embraces enthusiastically: moving OTC transactions into clearing.  The market success of this innovation speaks volumes about its value.  It’s rather hard for me to see what’s objectionable about it.

But maybe I’m wrong.  I’d be more than willing to entertain these objections.  But in order to do that, I’d have to, you know, know what they are.  Which would require some transparency from the Apostle of Transparency.

Say what you will about Mullet Man Igor Sechin, but don’t say he lacks chutzpah.  He’s proposing a substantial tax cut for oil companies.  You know, like Rosneft:

The head of Russia’s state-owned energy giant Rosneft has called for a large reduction in the tax burden on the oil industry, Vedomosti newspaper reported Monday, in a move that could increase friction with the government.

According to Vedomosti, Kremlin heavyweight and Rosneft CEO Igor Sechin said in a presentation that oil companies’ tax base should be cut from 55 percent to 35 percent to stimulate new investment and generate a windfall of up to 6 trillion rubles ($180 billion) for the state budget by 2030.

I’d be very interested to see Igor’s math.  Who knew he was a supply sider?

Russia is facing increasing budget stringency, caught between a slowing economy and Putin’s lavish pre-election promises to increase social spending.  (As one indication of increasing nervousness about Russia’s fiscal situation, Moody’s cut the ratings on the major Russian banks including Sberbank and VTB because of increasing doubts about whether the state could support them in a crunch.)Even if his math is impeccable, 2030 is a long way away.   Putin needs the money here and now. Which means that Sechin’s proposal is likely a non-starter.

But you have to give him points for brass.

Dealer banks and the CME squared off in the pages of the FT today, arguing over the systemic risks of CCPs.  Each made some good points; each whiffed on a few; both overlooked the real sources of systemic risk arising from clearing mandates.

First, the banks:

“We are losing track of the nominal risk,” warned Jean-Pierre Mustier, head of investment banking at UniCredit and a former board member at London-based LCH.Clearnet. “We’re moving from a set-up where banks were interconnected, because they had transactions between them, to a system where very lowly capitalised entities, the clearing houses, are supposed to protect the banks from a problem.”

. . . .

Banks have voiced concerns to regulators in Europe and the US that central clearing houses are providing insufficient data on their own risks and demanding lower-quality collateral for swaps transactions. They argue the risks are too opaque, and getting riskier.

“It’s going in the wrong direction,” said the head of credit trading at a large US bank. “The race to the bottom is on.” He and other executives were critical of the CME’s decision to accept corporate bonds as collateral, a step down from the safer instruments usually required for margin.

There are reasons to be concerned about the expansion of the collateral pool to include more risky assets.  This is especially true inasmuch as these assets are likely to become less liquid precisely when a CCP needs to liquidate them: during a systemic even that causes the failure of a large, or several large, clearing members.  This problem could be mitigated by giving CCPs access to central bank liquidity, collateralized by the corporate bonds, etc., they take in as initial margin.  But the fundamental driver here is that clearing mandates have dramatically increased the need for initial margin, and it was inevitable that this would result in expansion of eligible collateral.  It’s not a competitive race to the bottom, it’s facing reality: indeed, CCPs in individual product spaces face relatively little competition.

Concern about initial margin methodology is also reasonable.  Under-margining leads to the mutualization of risk in excess of what CMs had anticipated: over-margining leads to inflated trading costs.  But the crucial problem with any CCP methodology is that it takes into account position risk only, and doesn’t vary margin with the balance sheet risk of the member firms.  This tends to lead to excessive trading by weaker clearing members, as they don’t have to post higher collateral, as their poorer credit would suggest they should.  This is pretty much an inherent feature of clearing, for informational and governance reasons, as I’ve discussed frequently here on SWP in the past.

Now to CME,  as represented by Chairman Terry Duffy:

Terry Duffy, executive chairman of CME Group, said the shift in moving more OTC derivatives transactions was more profound than just transferring the risk and exposure to a counterparty default from banks to clearing houses. “The difference is with a clearing house we do market-to-market [risk management], either twice daily or have the ability to do it much more often,” he said on a visit to London.

“What’s important is making certain the pays and collects are done on a risk basis and not a mark-to-myth or anything else. Because of that, we have a much easier time doing the pays and collects than the banks do if it was a bilateral transaction. In turn, I think some of the banks are just not used to the model of clearing.”

This relates to variation margin, which was/is often collected in OTC transactions (once exposure exceeds negotiated credit limits between the parties.)  Several points to make here.  First, variation margin is basically a way of keeping initial margin levels current.  This doesn’t really address the issue raised by the banks of whether initial margin levels are adequate, banks can determine that, and the quality of the collateral posted as initial margin (and whether the haircuts applied against this collateral are commensurate with the risks).  Second, you can go through the process of marking to market, but the protection provided by that process depends crucially on the quality of the prices.  That depends on market liquidity, trading activity, etc.  You need a market to mark to, and for many products that will be brought into clearing there are serious doubts about the reliability of the prices used for markets.  If there’s a liquid market, the prices it generates more accurate MTM in both bilateral and cleared trades: if there isn’t, both cleared and bilateral MTMs are dodgy.  Third, as I’ll discuss more in detail, the mechanical process of marking to market can actually create systemic risks.

The FT reporter, Phillip Stafford, also mentions that banks complain about the inadequacy of CCP capital, but notes that CCPs also have default/guarantee funds that they can call on to prevent a CCP default. But that’s exactly what the big banks are worried about.  Their exposure to CCPs comes first and foremost through their participation in these funds.   There’s only a thin layer of CCP capital separating a defaulter’s margin (and default fund contribution) from the non-defaulters’ contributions.  If the CCP under margins, that capital can be blown through very quickly, and expose banks to substantial losses.  These losses are most likely to occur, moreover, during stressed market conditions when banks are least able to afford the hit.  This wrong way risk is precisely what banks are complaining about.

Truth be told, although both the banks and the CCPs (to the extent Duffy is representing the clearing industry perspective) have some valid points, they miss the big systemic risks associated with clearing and clearing mandates.  I’m sort of in the middle of my Streetwise Professor Worldwide Personified Clearing Tour, in which I’ve given talks on the systemic risks of clearing in Chicago, Frankfurt, Osaka, Istanbul, DC, and the UK (London and Oxford), and will give another in Paris in September.  (Rough duty, I know, but somebody has to do it.)  Here are some of the greatest hits I play at each stop.

• Clearing, and in particular multilateral netting, basically redistributes credit risk from derivatives counterparties to other creditors of defaulting CCP members.  These other creditors may be as systemically important and vulnerable, or even more systemically important and vulnerable, than CCP members.  For instance, moving to clearing is likely to make runs on money market funds more likely even if it makes runs on dealer banks less likely.  It is not evident that this is a desirable trade-off.
• The variation margining mechanism in clearing is particularly rigid, and can create substantial demand for liquidity precisely when funding liquidity dries up.  This is what almost brought down the CME clearinghouse on the Day After Black Monday in 1987.  This is why rigid marking-to-market and variation margining can be a systemically destabilizing bug, not a stabilizing feature.
• Clearing does not eliminate interconnections between big financial firms: it reconfigures the network of connections.  Moreover, it does so in a way that is rife with wrong way risk.  As noted before, CCP members-mainly big banks-are connected via CCP default funds, and are most likely to incur losses during periods of market stress, when they are least able to afford it.

Regulators are becoming increasingly aware of these problems, and are responding by attempting to make CCPs virtually immune to failure.  But this brings me to another of my greatest hits: beware the fallacy of composition.  Yes, failure of a CCP would be catastrophic, but making one part of the financial system stronger-a CCP, for instance-does not necessarily make the system stronger.  One of the main effects of increasing the financial resources of a CCP is to redistribute credit losses from derivatives counterparties to other creditors of defaulting firms, and to redistribute scarce liquidity.   It is not necessarily the case that this redistribution makes the system stronger.

The analogy that I’ve made here, and that I make on tour, is that of the levee.  Building up the levee around a CCP reduces the likelihood that it will be inundated, but forces the financial flood elsewhere.  Again, it is not evident that it’s better for systemic stability to redistribute the water from CCP members to other parts of the financial system.

My closing number is that CCPs have been vastly oversold as a means of reducing systemic risk.  It’s virtually impossible to know what the net effects are, but it’s likely that CCP mandates reduce systemic risk under some scenarios, but increase it under others.  What’s more, the main systemic risk is not necessarily the failure of a CCP, as bad as that would be, but the spillover effects from clearing to other parts of the financial system.

That is, it’s necessary to analyze the systemic risks of clearing by analyzing the financial system as a whole.  Regulators haven’t done that, for the most part, and the debate between the banks and Terry Duffy doesn’t really do that either.  Their’s is a CCP-centric debate, and although that’s not irrelevant, it doesn’t get at the nub of the matter.  Meaning that the show must go on.

In St. Petersburg a couple of weeks ago, Putin surprised some by coming out in favor of a law to give amnesty to biznessmen convicted of economic crimes:

While not the headline measure in Mr. Putin’s plan, the amnesty proposal was by far the most surprising item. It was the brainchild of Mr. Putin’s business ombudsman, Boris Titov, who has championed it as a means to improve the business climate.

“The period that just passed was not the best for defenders of property rights,” Mr. Titov said last week in an interview.

. . . .

The intention of the amnesty plan is to free thousands of run-of-the-mill businessmen caught up in this turmoil, while avoiding the high-profile and politically tinged cases, like those of Mr. Khodorkovsky, who is not expected to be freed.

Mr. Titov said that 110,000 people were serving prison time for economic crimes, and that 2,500 others were in pretrial detention. The draft of the amnesty bill, Mr. Titov said, covers 13,000 of them.

“This initiative will on the whole strengthen the trust of citizens” in the business community, Mr. Putin said in his speech. “I am certain the development of the state is possible only under conditions of respect for private property, to the values of economic freedom and the work and success of entrepreneurs.”

More broadly, though, the intention of Mr. Putin’s amnesty, Mr. Titov said, is to signal to the business community an easing police pressure. It is, he said, “a very positive, a very good signal for Russia, and that is important as in Russia. We don’t often have good signals.”

Well, don’t get too excited there, Boris, because while Putin was publicizing the idea, the Duma was working quite assiduously to neuter it:

The Duma subsequently reduced the number of criminal code provisions subject to the amnesty from 53 to 27 — in part to ensure that Putin’s most prominent critics, including Mikhail Khodorkovsky and Alexei Navalny, would not fall under any official pardon.  Fraud, the most misused criminal statute, was only partially included in the list of crimes subject to the amnesty. The draft legislation also included the demand that before one could be released, the accused had to make the victim whole and pay any outstanding expenses or damages.

As a result, Titov’s blanket amnesty has been watered down to a conditional release — and it remains unclear who is, or is not, covered. What happens to those convicted on multiple counts, one commentator asked, when only some are covered by the amnesty?

In addition, the requirement to compensate victims for any alleged losses essentially means that all entrepreneurs must concede their guilt before they can be released.  Such an admission runs counter to the primary justification for the amnesty — that charges were fabricated in an overwhelming number of cases.

With the Duma’s revisions, the estimated numbers of entrepreneurs covered by the proposed amnesty dropped from 100,000 to 10,000 — to potentially as low as 5,000.  Instead of boosting Russia’s small- and medium-sized businesses, the sector will most likely continue to contract. A sharp increase in the social tax last year has already driven hundreds of thousands of small companies out of business or into the shadow economy.

. . . .

As a result, the legal harassment of Russian entrepreneurs looks likely to continue long after any amnesty has come and gone. The amnesty also does not ease concerns of foreign investors, whose negative perception of the Russian legal system is unlikely to change because a few entrepreneurs are released from jail early.

The debate over the amnesty raises a more basic question: Does Putin want to solve this problem?  Though he talks about the need to diversify the economy — with small business playing a critical role — he overwhelmingly continues to bet on state capitalism as the path forward. Moreover, as he learned during his re-election campaign, it is the emerging middle class that is most likely to come out and demonstrate against his policies.

The amnesty partially disarms the opposition, since on paper Putin has now provided some relief to Russia’s struggling entrepreneurs. Yet this reprieve comes with considerable strings attached and does not address any of the fundamental legal and institutional deficiencies that created the problem in the first place.

Amnesty provides the appearance of a solution without getting to the root causes. This may be exactly what Putin wants right now.

That last paragraph nails it.  Putin wants to create a Potemkin simulacrum of a reform, while leaving the system fundamentally unchanged.

Which means that the Putin Hamster Wheel From Hell will just keep spinning away.

In other news related to the state-business nexus in Russia, Medvedev amazingly has taken on an ally of Igor Sechin:

Russian Prime Minister Dmitry Medvedev on Friday sacked a senior resources official, believed to be a close ally of Igor Sechin, the boss of state oil firm Rosneft, in a move analysts said was a sign of growing confrontation between the two men.

In an order published on Friday Medvedev dismissed Alexander Popov, the head of Rosnedra, an agency responsible for granting licences to develop natural resources.

Popov was an aide to Sechin when Sechin oversaw Russia’s energy sector as deputy prime minister.

. . . .

Sechin’s confrontation with Medvedev’s team has grown since then as Sechin has embarked on an aggressive consolidation of assets under Rosneft’s control. Medvedev’s deputy for energy, Arkady Dvorkovich, has pushed for more privatisation and lower state interference in the strategic industry.

A more recent spat came over a decision by Rosnedra to awarded Rosneft and state gas major Gazprom licenses to tap oil and gas fields in the Arctic, which Dvorkovich has criticised.

I’m actually shocked that Medvedev screwed up his courage enough to do this, as indirect a shot at Sechin as it is.  I wonder if he listened to “American Boy” to get himself psyched up for it.

Methinks this is at most a rear guard action against Sechin’s-and Rosneft’s-growing influence.  Privatization keeps receding over the horizon, like a mirage.  Rosneft is accumulating access to an increasing portfolio of resources, and is now essentially the gatekeeper to foreign access to Russian oil.   This action is probably the most that Medvedev can do to stop that development, which he rightly perceives as malign (whether that’s because he believes that a more competitive Russian oil sector is desirable for economic reasons, or just because Sechin is a political foe, I don’t know).  And that tells you all you need to know.

These stories are illustrations of superficial attempts to address Russia’s serious institutional deficit.  But at most, they demonstrate an acknowledgement of the problem, but no real determination to fix it.  Small changes that keep things pretty much the same.  The wheel keeps spinning.  The Putin Purgatory drags on.

The road to hell is paved with good intentions.  A couple of examples from environmentalist attempts to mitigate climate change.

The first relates to ethanol.  In its infinite wisdom, in 2010 Congress mandated the use of renewable fuels with lower CO2 content than corn ethanol to meet the renewable fuel standard it created in 2005.  Sugar ethanol from Brazil fits the bill.  But given the blend wall and other limits on ethanol usage, this created an excess of corn ethanol in the US, and created an incentive to export excess corn ethanol from the US to Brazil, and import sugar ethanol from Brazil.

The problem being, of course that all the fuel burned to ship ethanol from the US to Brazil, and from Brazil to the US, pours CO2 into the atmosphere.  And the net result: more CO2 emissions than would have occurred absent the mandate to meet the renewable fuel standards with low CO2 producing fuels:

As a result, since the start of 2011, the United States and Brazil have shipped over 1 billion gallons of ethanol back and forth – more than 500 million gallons each way. The emissions generated by the shipping have worsened the carbon footprint of both fuels.

Thomson Reuters Foundation found that this overseas trade has produced more than 312,000 tonnes of carbon dioxide (CO2) since the start of 2011, based on an industry method used to calculate greenhouse gas emissions from shipping. This equals a ratio of one tonne of CO2 emitted for every 10 tonnes of ethanol transported between the two countries.

Not to mention its just wasteful and stupid to expend real resources-fuel, labor, capital-to swap ethanol between hemispheres.

Not to mention that corn-based ethanol is a monstrosity.

The second example: electric cars.  Yes: No noxious fumes or CO2 come out of the (nonexistent tailpipe) of an electric vehicle.  But if you take into account emissions over the lifetime of the vehicle-including the CO2 emitted to generate the electricity that charges the batteries of electric cars-and the other environmental impacts of their construction-including battery disposal and the environmental costs of mining rare earth metals, etc.-it’s likely that electric cars have as bad or worse environmental effects as fossil-fuel powered ones.

Government policies have substantially encouraged the use of renewable fuels, and the development of electric cars, for the purpose of improving the environment.  But the actual effects of these policies often fall far short of the intended effects, and quite frequently  have the exact opposite effect, or unintended consequences that are more costly than the intended environmental benefits.

This illustrates several points.  First, policies frequently create perverse incentives that induce market participants to undertake actions contrary to the intent of the policy: this is what is going on in the ethanol trade.  Second, we live in a second best world.  The theory of the second best implies that when there are multiple “market failures” (i.e., multiple unpriced harms), mitigating one of them (e.g., reducing CO2 emissions) is not necessarily a good thing, because it can exacerbate the other market failures.  That’s the lesson in the case of electric vehicles.

It’s my sense that these problems are most likely to occur when legislators and regulators attempt to dictate technologies, rather than affect incentives through taxes on harms (e.g., CO2 taxes).   That seems to be particularly true of the first problem.  It’s less clear that’s true of the second problem.  For instance, a monomaniacal focus on CO2, whether implemented through taxes or cap and trade or dictating technology, tends to have substantial perverse effects because there are other unpriced harms and benefits.  The encouragement of wind power, for example, results in environmental damage in the form of massive bird kills and abandoned wind turbines.

Economics is sometimes called the dismal science, originally because of the Malthusian connection.  But the name has stuck long after economists have left Malthus far behind.  And for good reason.  We’re killjoys, with a habit of pointing out that things people do with the best of intentions often fail to realize those goals, or worse, are actually counterproductive.

The Obama administration has announced the delay of the implementation of the Obamacare employer mandate.  There are at least three aspects of this that deserve comment.

First, the practical impact.  Some have argued that this will undermine the other part of Obamacare-namely, the individual mandate and insurance “exchanges”.  Namely, it will induce firms to dump their corporate coverage, and force people onto the exchanges.  This will happen only because of other provisions of Obamacare that increase the cost of employer coverage. Firms that currently provide insurance without the mandate cannot be constrained by it, so relaxing this constraint will not induce them to change their behavior except to the extent that other aspects of Obamacare increase the cost of providing employer coverage.  That is, it would be the selective enforcement of various provisions of Obamacare that will lead to these perverse effects.  Obamacare is barely coherent, but mandates are an important part of maintaining that coherence that it possesses.  The law is rife with cross-subsidies and taxes, and mandates to purchase coverage are necessary to force the net payers to remain in the system and thereby subsidize the net recipients.

Second, the political impact.  This is obviously intended to push the implementation of a big part of Obamacare past the midterm elections.  Some firms would likely have responded to the mandate, with its various restrictions, by dropping coverage.  Especially given the unpreparedness of the exchanges, and the high costs that the young and healthy will incur buying coverage on exchanges, this would have been a major source of anger.

Third, there is the Constitutional issue.  Article II, Section 3 of the Constitution directs the President to “take care that the laws be faithfully executed.”  For worse or worst, Obamacare is law-at Obama’s insistence.  It is his Constitutional duty to execute the law.   He should not be able to walk away from this duty, just because it is politically expedient to do so.  That would be true if he hadn’t pushed the measure into law, but it is all the more necessary because he did, to hold him accountable for the consequences of his political choices.

Obama is the Chief Executive.  He needs to perform his Constitutional duty.  His black letter Constitutional duty.  His duty to execute the laws faithfully.  To fail to do so is to undermine the Constitutional order, in particular by respecting the separation of powers between the legislative and executive branches.  The blending of such responsibilities is a recipe for tyranny.

The WSJ has a very long and interesting article about the PBOC’s ham-fisted handling of the liquidity crunch of the past weeks.  The central bank was trying to send a signal that it wanted to restrain credit growth, especially in the shadow banking sector, but things got out of hand:

Since early June, the PBOC has sought to force Chinese banks to redirect their lending away from shadow bankers—a mélange of trust companies, pawnbrokers, leasing companies and others—whose lending is putting further stress on an economy already slowing, economists say.

To achieve this, the central bank withheld cash from the interbank market, essentially twisting the arms of traditional bankers to force them to change their lending practices.

On June 20, China’s leaders feared the credit squeeze was getting out of hand. Overnight interest rates at which banks borrow from each other spiked to as high as 30% that day. A rumor circulating in Shanghai that Bank of China had defaulted on an interbank payment was given more credence when a Chinese newspaper, the 21st Century Business Herald, reported the alleged default on its website around 6 p.m. According to the newspaper, Bank of China defaulted during that afternoon, “deferring transactions for half an hour due to a fund shortage.”

But shadow banks are holding a large amount of assets.  How are those assets going to be funded?  Does the PBOC want banks to bring them on their balance sheets?  Really?  If not, where will they go?  Another reason that the PBOC’s crackdown was not credible last month, and hence will be unlikely to have disciplinary effects going forward.

Deleveraging is hard, because leverage funds assets.  To reduce leverage, you have to reduce the assets, or find equity to finance them.  How?  Dump them, leading to fire sales and substantial declines in asset prices that spill over and harm the balance sheets of banks and other institutions?  If not, where is the equity going to come from to hold these assets?

The PBOC is probably right in its diagnosis that China is over-leveraged and that the leverage is particularly fragile.  But making the diagnosis is one thing.  Finding the cure is something different altogether.  The PBOC has found that cutting off funding to shadow banking isn’t feasible, because the assets it holds have to go somewhere.  And if a lot of those assets are bad-which is likely the case here-it’s truly a challenge.  Extend and pretend is the path of least resistance, meaning that the problem is deferred, and likely to matastasize. Meaning that even the most clever central banker is likely to find it very difficult to wean the financial system off cheap credit.  There is a path dependence here that makes that task very, very difficult.  So it’s likely that we haven’t read the last story about a liquidity crisis in China.