Streetwise Professor

The issue of the systemic risks posed by a clearing mandate that expands the scale and scope of central counterparties has come to the fore of late.  Too late, perhaps, but even at this late date it is an advance.

The focus of this concern is now on whether CCPs will be too big to fail, and whether they should have access to the Fed’s liquidity provision facilities.

Now that the financial defo . . . I mean “reform” bill is on the verge of passage, with (a) a clearing mandate, and (b) a provision granting CCPs access to the Fed, as one of the people who raised the profile of this issue I should restate my views.

First, yes, the clearing mandate will make CCPs a much more integral part of the broader financial system; CCPs can fail; a failure would be catastrophic; and hence CCPs are likely too big to fail.

TBTF is pernicious.  So how to deal with it?  In this instance, by not mandating clearing and thereby creating new TBTF institutions.

But it looks like a clearing mandate is inevitable, so the question becomes: given that CCPs are crucial financial institutions whose failure threatens the stability of the financial system, should they have access to the Fed?

Here, my answer is a qualified yes.  The Fed has legitimate lender of last resort functions that involve the supply of liquidity to solvent institutions during times of liquidity crises.  CCPs can be prodigious consumers of liquidity, especially during times of market stress that induce big price movements that trigger big flows of margin money.  A solvent CCP could face a severe liquidity crunch in such circumstances, and access to Fed liquidity, either directly, or indirectly (a la 1987) can prevent this liquidity crunch from causing the failure of a CCP–which would have serious systemic consequences.  These consequences include the closure of markets, large moves in asset prices, and asset fire sales.  Thus, if one could trust the Fed to be a classical Bagehotian LOLR, lending to solvent institutions against good collateral, permitting CCP access to the Fed’s liquidity programs could improve the stability of the financial system.  This would make a disastrous meltdown of CCPs due to liquidity problems less likely.

But that “if one could trust the Fed” clause is why my answer is a qualified one.  The truth is that the Bernanke Fed has stretched and bent the Fed’s legitimate LOLR functions beyond recognition in a way that must have Bagehot spinning in his grave.  Many of its actions (e.g., AIG) can legitimately be seen as bailouts that exacerbate moral hazard problems going forward.  As a result, there is reason for legitimate concern that giving the Fed a new set of institutions to bail out is a very bad thing indeed.

But the problem is that although cutting off CCPs from the Fed altogether would preclude it from bailing them out, it would also preclude legitimate liquidity support.  It is difficult to say, here and now and in the abstract, whether this package deal is superior to the alternative–a risk of bailouts, but the ability to prevent future liquidity crises from blowing up CCPs.   As it stands, that is the choice.  It is a stark one, and not an easy one to make.

This illustrates a fundamental problem with a lot of the financial regulation debate.  The issues that are being debated are the consequence of underlying problems that remain unaddressed.  In the present instance, the underlying issues are (a) the role, power, and discretion of the Fed, and (b) clearing mandates that expand clearing, and expand it into more problematic and difficult areas.  Clearing mandates have been a given from almost the beginning.  The Fed’s role has been debated, but it has emerged from the process as powerful, or more powerful than before.  The failure to address these underlying issues is why we are confronted with the Hobson’s choice between risking CCP bailouts and being unable to respond to CCP liquidity crises.

The increasing angst over the Hobson’s choice should have led to a serious rethink of clearing mandates.  To spark such a rethink was one reason why I have hammered on this issue for some time.  But that hasn’t happened; since the whole rationale for clearing was to reduce systemic risk, to proceed apace with mandates even as it became evident that CCPs created their own systemic risks and then argue over how to deal with that consequence was irresponsible in the extreme.  It should have also led to a more searching evaluation of how to constrain the Fed to its legitimate Bagehotian LOLR role.  That hasn’t happened either.

Well, Congress has made its choices, and we’ll all have to live with them.  It’s summertime, but the living ain’t easy.

Can you say that any more?  Well, even if use of the word “retarded” is increasingly frowned upon, there are some special cases in which its use is so evocative, and hence so appropriate, that it should be blessed.

The compromise on the Lincoln amendment is one such case:

The bill also includes a provision, authored by Sen. Blanche Lincoln (D., Ark), which would limit the ability of federally insured banks to trade derivatives. This provision almost derailed the bill following vehement objections from New York Democrats. Ms. Lincoln worked out a deal in the early hours of Friday morning that would allow banks to trade interest-rate swaps, certain credit derivatives and others—in other words the kind of standard safeguards a bank would take to hedge its own risk.

Banks, however, would have to set up separately capitalized affiliates to trade derivatives in areas lawmakers perceived as riskier, including metals, energy swaps, and agriculture commodities, among other things.

Under any modern understanding of what “risk” means, this makes no sense.  Ever heard of diversification, or the fact that “risk” of a particular position is attributable to its contribution to the payoff distribution of the entire portfolio of risks, not anything inherent to the position itself?  (Meaning that even if energy prices are volatile, doing energy swaps may not be that risky in a portfolio context.)  Under any modern understanding of the economics of financial intermediation (in which information about counterparties is vital) this makes no sense either.  (Meaning that the costs of intermediation are lower if information obtained in trading one instrument with a counterparty can be used when dealing in other instruments.)  Under any modern understanding of counterparty risk, where maximizing netting opportunities can be quite valuable, this makes no sense; splitting up businesses in an arbitrary fashion like this reduces scope economies from netting and other things.  It also makes no sense even on its own terms, because yes, banks use interest rate and credit derivatives to manage their own risks, but from my understanding of the provision, banks will still be able to be dealers in these products, and the whole basis of Lincoln’s proposal (to the extent that it had one) is that dealing is a particularly risky activity.  Not that I am buying into that argument; I’m only pointing out that is that’s what you believe, this provision is contrary to that belief.

This is transparently a compromise to save the face of a senator in over her head, who made a wild legislative proposal to stave off a primary challenge.  The banks were willing to throw a couple of bones in order to save their biggest books; metals, energy, and ags are small potatoes compared to interest rates and credit.  Lincoln gets to do what senators do best–pose.  The banks largely escape major damage.

Even by sausage making standards, this is revolting.  It is good that the most egregious parts of the Lincoln proposal have been jettisoned.  It is bad news, however, for liquidity and hedging in the disfavored products, especially commodities.  This, along with the position limit measure in the bill, and the clearing mandate, will increase the costs of managing commodity price risks in particular.

All pain, no gain: the only thing that can be said is the pain could have been a lot worse.

He being Gary Gensler, and his story being that mandated clearing will improve the stability of the financial system by eliminating interconnectedness:

“Over-the-counter derivatives are meant to lower risk on our economy, and to some extent they do,” Mr. Gensler says. “But they have concentrated risk in a few big banks…through their interconnectedness.” He says forcing them onto clearinghouses would shift the risk from any single institution to the clearinghouse. It can more easily offset, for instance, bets that interest rates will rise with bets that they will fall. That would make it possible to allow a big financial firm that is floundering to fail, restoring market discipline.

Repeating the same BS over and over doesn’t turn it into gold.  Clearinghouses are interconnected.   And they will almost certainly be too big to fail–and they can fail, a point that Gensler has never acknowledge.  Even the New York Times sort of gets it (although I disagree with a lot of what they say in this editorial).  “Interconnection” is just about the worst argument to make in support of clearing mandates.

Gensler has company in Europe. Gertrude Tempell-Gugerel of the European Central Bank supports central clearing mandates, for equally inane reasons.  She starts out with a non sequitur (since Lehman and AIG failed, clearing must be better–wrong), and goes downhill from there:

Therefore central clearing has become part of the G20’s agenda and mandatory clearing is seen as a tool to address the risks in OTC derivatives trading. Should a counterparty involved in OTC trading go bankrupt under central clearing, it would not create the chain reaction that the default of Lehman Brothers triggered. A central counterparty (CCP) would allow an institution with offsetting positions to net their exposures and substantially reduce counterparty risk.

In addition, a CCP would need to comply with high risk management standards and require counterparties to post appropriate collateral. Moreover, mandatory reporting of contracts to trade repositories would significantly enhance information on OTC derivatives exposures, to the benefit of authorities and market participants alike.

No chain reaction is possible when there is a clearinghouse?  Really?  What is the color of the sky on the planet where that is true?  Netting already takes place to a considerable extent.  Indeed, clearing done badly can actually REDUCE the amount of netting, if clearing is fragmented by product and even within products (e.g., multiple competing interest rate swap or CDS CCPs). And for the billionth time (perhaps I exaggerate), netting like this is a private benefit: if the benefit is as great as Gert (and many other regulators) say, why haven’t private parties fallen all over themselves to exploit it?  Mightn’t there be some costs that more than offset this putative benefit?   “High risk management standards”–why not impose them on banks?  And what about the information disadvantage that CCPs are likely to suffer vis a vis dealer banks?  That goes unmentioned.  Collateral can be the trigger for a systemic crisis.  Moreover, Tempel-Gugerel overlooks the likely equilibrium responses to a clearing mandate.  Rather than extending credit implicitly in derivatives transactions (as is often the case now) big banks are likely to extend credit to their customers to permit them to post margins, leaving the overall amount of leverage in the system pretty much unchanged.  Since it’s leverage that is ultimately the source of systemic risk, this obsession with collateral is likely to provide a false sense of security.  The information benefits can be achieved by mandatory trade reporting to a repository (which I’ve advocated for well over 7 years) without requiring mutualized counterparty risk sharing, or centralized risk pricing (in the face of severe information disadvantages).

The advocates of clearing mandates have had almost two years to come up with credible arguments, and to attempt to rebut counter arguments.  They’ve done neither.  They keep recycling the same old BS, and don’t even acknowledge, let alone address, the myriad arguments that have been raised against clearing mandates.

Policies built on willful ignorance do not end well.

Igor Sechin is on a charm campaign.

Let me repeat that.   Igor Sechin is on a charm campaign.

There is a long piece about him in a recent FT:

As Russia seeks to shake off an economic crisis that wiped out layer after layer of the oil-fuelled gains of the Putin era, Mr Sechin – viewed with fear and awe for overseeing the state takeover of the strategic heights of the economy – is striking a new, surprisingly accommodating tone. The Kremlin, taken aback by how vulnerable Russia’s oil and gas-driven economy proved to be to the global financial crisis and recession, has started to change its tune.

I said Sechin is trying to be charming.  I didn’t say that he had gone so far as to actually tell the truth, or anything.  In fact, he makes a couple of complete howlers.  One relates to how Rosneft, and other Russian state  energy companies, came by some of their prize assets:

In his first public comments on how the reinvigorated Putin state managed to recover important energy assets from oligarchs who picked them up cheaply during chaotic post-Soviet privatisations, Mr Sechin says these properties were not “repossessed”. It was, he insists, a legal process where state companies paid market prices for assets that are now managed no differently from private ones.

Riiiiigggghhhhtttt.  Legal process.  Market prices.  Uh huh.  Tell me another one, Igor.

So he obliges:

Russia’s state-controlled companies cannot use their resources as political weapons, or “instruments to put pressure on consumers” as he puts it. The likes of Rosneft and Gazprom are, he adds, “normal public companies, working under international laws, and this makes it impossible for them to break their obligations to consumers”.

Stop it, you’re killing me!

But he can’t stop:

Russian companies are not subject to state fiat in the same way as national oil companies set up by the world’s other big producers.

“When we speak with our colleagues from Opec, they say that Russia should operate quotas just like they do. I tell them that unfortunately we have no such instruments, because Russian oil companies are private companies. Even those that are partly state-owned are private companies. They are working in the conditions of the market and have obligations to their partners which do not allow them to take unilateral decisions.”

Sechin has been peddling this line going back to late-2008, when he was playing Lucy and the football with OPEC.  As I wrote then, and in early-2009, it is complete tripe.  Not that I WANT Russia to cooperate with OPEC, but even given that it has some “private” companies rather than completely nationalized oil sectors, Russia can control exports at a whim, and has the policy tool to do so: its export duty.  By raising the export duty, Russia would reduce export volumes, just as by reducing output national oil companies can reduce export volumes; both actions raise the world oil price.  Russia tweaks its oil export duty all the time.  It adjusts other export duties as well, in order to achieve policy objectives.

In brief: if Russian (and Sechin) wanted to coordinate output with OPEC, it would have no difficulty in doing so via the export duty.  The truth is, it doesn’t want to coordinate output with OPEC; it doesn’t want to cut Russian output.  Quite rationally, Russia wants OPEC to bear all the costs of supporting world oil prices by cutting OPEC output, and to reap the benefit by producing as much as it can.  That’s what Russia has done.  Like I say, as a net short, I (and the US) benefits from Russia’s action; the world is a better place for it.  But it doesn’t do Sechin’s credibility any good for him to tell such laughable falsehoods.

Perhaps Sechin’s choir boy act indicates that finally, Russia has learned that you catch more flies with sugar than gall.  Perhaps.

But I wouldn’t consider this to be a sincere conversion.  It is, at best, a pragmatic trimming in response to changed economic and political conditions.  And if and when those conditions change again, don’t be surprised if the Old Igor, the Bad Igor, returns, fangs bared.

Whether it is with Sechin or Lavrov or Putin or Medvedev: anyone who puts their faith in their more moderate statements does so at their peril.  For as Sechin demonstrates, even when he tries to act nice, he does so with a stream of falsehoods.

I have been in Germany (in Strasbourg today, returning to Germany tomorrow).  It has been amusing to watch the German reaction to the hectoring/lecturing from the US about the need for Germany to increase government spending.  The German reaction ranges from bemusement to disdain.  Here’s the Bloomberg take:

Merkel, addressing a business audience in Berlin today, said she told Obama in a phone call that cutting government debt is “absolutely important for us,” exposing a second point of contention ahead of the June 26-27 G-20 summit in Canada.

Reducing the budget deficit by 10 billion euros ($12 billion) per year “won’t put a brake on the world’s economic growth,” Merkel said, relating what she told Obama yesterday. Germans are more likely to spend money if they feel the government “is taking precautions” to ensure solid finances, she said.

Four days before world leaders meet in Toronto, Germany is heading for conflict with the rest of the G-20 over tighter financial regulation, a banking levy and U.S. calls to boost growth rather than cut debt.

The G-20 must “safeguard and strengthen” the economic recovery and promote “global demand growth that avoids the imbalances of the past,” Obama said in a June 16 letter to fellow G-20 leaders. He expressed concern about “heavy reliance on exports by some countries,” which he didn’t name. Treasury Secretary Timothy F. Geithner called on June 5 for “stronger domestic demand growth” in European countries like Germany that have trade surpluses.

I have been ambivalent on Merkel.  She has been good on some issues, but has been terrible on Russia, and hasn’t shown a lot of leadership in the Greek/PIIGs crisis.  But at least it is clear that she hasn’t drunk the Keynesian KoolAid that Timmy! (and Obama, and Summers, etc.) are pushing.  Indeed, it is encouraging to see the leader of a major government acknowledge, at least implicitly, the Ricardian point that current consumer spending depends in no small way on expectations about future government expenditures: “Germans are more likely to spend money if they feel the government ‘is taking precautions’ to ensure solid finances, she said.”  It would be refreshing if our policy makers would consider the possibility that American consumers and investors are reluctant to spend freely because of the looming fiscal imbalances in the US.  Unlikely, but refreshing.

Matt Leising and Shannon Harrington report that smaller firms are accusing the big dealers of blocking access to clearinghouses:

Rules intended to lessen the risk of a systemwide failure are “working to restrict access to only the incumbent dealers,” the Swaps and Derivatives Market Association said in a statement sent today to Theo Lubke, senior vice president at the Federal Reserve Bank of New York. The group of more than 20 brokers including Jefferies & Co., Imperial Capital LLC and Newedge USA LLC formed in February to lobby Congress and regulators for access to derivatives clearing.

Intercontinental Exchange Inc., CME Group Inc. and other companies that operate clearinghouses for the $615 trillion privately negotiated derivatives markets enforce capital requirements and trading rules intended to bolster the ability of the clearinghouses to withstand losses. Those requirements, though, prevent all but the world’s largest banks, including Goldman Sachs Group Inc., JPMorgan Chase & Co. and Barclays Plc, from sending trades to the clearinghouses, according to the statement by the brokers group.

“The effort to protect clearing, however, is actually a proxy war to limit competition to the incumbent dealers’ $100 billion in profits for derivatives execution,” the brokers group said. Mike Hisler, a spokesman for the association, and Ray Zorovich, the group’s policy assistant, are listed as contacts on the statement. Hisler also is a partner at New York- based Hexagon Securities LLC, a member of the association.

This was only a matter of time.  I’ve written academic articles dating back well into the 1990s that in the presence of large scale economies in a particular service (e.g., trading), including scale economies arising from network effects, a suboptimally small coalition of suppliers can form a cooperative firm that offers this service (see, for instance, my 1999 J. of Financial Markets and 2002 J. of Law, Econ., and Org. articles).  The cooperative is smaller than optimal, but just big enough that no competing coalition can form because it cannot achieve the same scale economies.  Because it is suboptimally small, and faces no competition, the members of the dominant coalition/cooperative firm earn rents.

I applied this argument to clearing in the early-2000s, and again in a couple of papers done in 2007 and 2008.  So, what Matt and Shannon report is no surprise to me.  None whatsoever.  It was a direct implication of the work I’ve done for going on 15 years.

Indeed, when many asked me whether dealer opposition to clearing was motivated by their desire to limit competition, I would often reply that forming a clearinghouse that limited entry was perhaps the best way to cartelize the industry, and make even more profits.

But that’s not the end of the story.  I’ve also written that there are good economic reasons to limit entry into a clearinghouse.  In particular, rigorous financial requirements are necessary to ensure the safety and soundness of the CCP.  Moreover, I’ve also written that the transaction costs/organizational costs of operating a clearinghouse will be greater, the more heterogeneous the membership: this provides further justification for limiting membership to a relatively homogeneous group of firms.  Setting margin, capital levels, etc. is more difficult, and the process more rancorous, the more heterogeneous the membership.  (The effects of heterogeneity on governance was the focus of my 2000 JLE piece on exchange organization.)

In brief: just as is the case in virtually all trading services, market structure issues in clearing are extremely, extremely knotty because of the pervasive scale and scope economies.  The pronounced scope and scale economies create opportunities for the exercise of market power, most notably by the formation of cooperative firms that restrict entry and face no competition.  This is the way that exchanges earned rents for their members for years, and years, and years.  At the same, time, open entry is particularly problematic for CCPs given the effects of heterogeneity on governance costs, and the extreme importance of financial stability.

Battles over market structure in securities have been raging for decades, due in large part to similar considerations.  Ditto recently in futures markets.  (Note the battles that raged over the CME-CBT and CME-NYMEX mergers.)

Note that this battle over entry is going to create serious legislative and regulatory conflicts because, as I have pointed out ad nauseum (including in a forthcoming Policy Paper for Cato) there is a fundamental tension between enhancing competition and reducing systemic risk in CCPs.  Conventional political economy considerations are going to play out here.  The pressure of the SDMA and other firms will inevitably lead to regulatory interventions that will open up entry and access, and thereby threaten to compromise the financial soundness of CCPs.

The irony is almost too much to take.

There are no free lunches.  None.  Only very difficult trade-offs.

Is their any evidence that any legislator or regulator has given serious consideration to this problem?  Not that I’ve seen.  But now, with clearing mandates on the horizon, there will be years of knock down-drag out fights over CCP rules, membership requirements, etc.  At every turn, there will be a tension between the systemic risk issues and the competition issues.  The results will not be pretty: they will be driven by the political economy considerations that dominate all such issues.  Economic efficiency and the soundness of the financial system will take a back seat, a distant back seat, to rent seeking.  We know how that usually works out.

No regulator or legislator can say that s/he wasn’t warned.  They just weren’t paying attention, or thinking seriously about the subject.  Oh yes, they said: just mandate clearing and we can go live on the big rock candy mountain.  As if.

For some reason Mark 6:4 just popped into my head.

I think I’ve made the analogy before on SWP, but it bears repeating.  There’s an old story about the Indian village that is beset by mice, and brings in cats to get rid of them.  The village is soon overrun by the cats, so they bring in dogs to scare off the cats, but then the dogs become a plague, so they bring in the elephants . . . and then realize that mice weren’t such a bad problem after all, so they bring back the mice to scare off the elephants.  The moral: short sighted “solutions” to a problem adopted without consideration of all of the consequences can lead to worse problems than you started with.

The criticism of CCP membership problems is just a harbinger of things to come: after too long, the mice might look pretty good by comparison.

Kudos to Jeremy Grant at FT’s Trading room, who published not one, not two, but three articles expressing serious reservations about clearing mandates.  One is by Sanjit Das, another by Shearman and Sterling attorney Barney Reynolds, and the third byReuben Lee.   Each echoes points I’ve been making over the last 20 months.

The Reynolds piece was interesting, though I don’t quite track his claim that end user clearing will result in said end users posting collateral to a clearing house, and to the dealer it trades through, to cover the dealer’s collateral costs.  But Reynolds does make a key point: namely, that the impacts of clearing on the normal day to day operations of the market should be taken into account, not just the systemic risk implications.   He says that clearing rules should be set “with a view to preserving commercial hedging activity, not merely with a view to protecting financial institutions from another black swan event.”

Since it is quite possible that CCPs are vulnerable to black swan events, systemic risk considerations are close to a push.  This means that the efficiency effects of clearing under normal market conditions should be given considerable weight, and as Reynolds argues, and as I argue, OTC bilateral dealings have clear advantages on this score.

But it doesn’t really matter, does it?  The clearing train has probably left the station, both in the US and Europe.  A clearing mandate is in both bills currently being merged in conference between House and Senate, so it’s a done deal here, and the European Commission has made it plain that it will require the bulk of deals to be cleared.

It would have been nice if people had spoken up rather earlier, when it was possible to influence the debate.  As it is, I don’t think it’s an exaggeration to say that I was nearly alone, at least among academics, in my criticism of clearing mandates when they were first mooted.  And who am I, anyways?  People have finally figured out that this is a big deal, and that Sorcerer’s Apprentices may wreak havoc with ill considered rules on clearing.  So they are saying this now, but now is too late.

This is, to my mind, a black mark against the academic community.  It has, for the most part, paid virtually no attention to matters of market infrastructure, despite their crucial importance; the subject has been relegated to, at best, specialty journals, and often not even there.  My stock remark in this regard is that in the military it is said that amateurs talk tactics, professionals talk logistics, and in finance professionals talk counterparty risk and how to manage it, but academics are amateurs who ignore it by and large.  At the margin, the value of an imperfect paper on clearing or counterparty risk is far greater than the value of yet another paper on testing asset pricing models or on some aspect of corporate finance.  But that value isn’t recognized, and such things are devilishly hard to get published, so that Nth paper on asset pricing or capital structure gets written and perhaps published.  As a result, academics have far too little to say, and hence far too little influence, on what is perhaps the most important of the seismic changes that will take place in financial markets by legislative fiat.

(As an aside, some academics have weighed in on clearing issues late in the game, including some very prominent ones.  Much of what they have to say is an embarrassment, unfortunately.)

At best, serious thinking and research might affect the implementation of the clearing regulations.  Legislation will leave a lot of the specifics to regulators like the CFTC (God help us all), and perhaps some serious academics could lead to Pareto improvements by weighing in now, even at this late date.

* This is one of my grandfather’s expressions. (He had many, which I have appropriated, often to the mystification of those to whom I am speaking.) It always mystified me, so I asked him to explain it.  Apparently there was a product to treat baldness, back in the 30s or 40s, called Herpicide.  (Yeah, like I’d put something with THAT name on my head.)  Apparently you had to use it just when you were starting to lose your hair; it wouldn’t work–they said–if you waited too long.  To make the point, they ran an ad campaign with pictures of cue-ball headed men, with the caption “It’s A Little Late for Herpicide.”  So now you know.

Isn’t it interesting that the current mortal threat to the stability of the world financial system isn’t the dreaded “D” word–derivatives–but plain jane government debt?  Isn’t it interesting that the major force behind the last crisis–mortgage debt–and the major force behind this one–sovereign debt–received very favorable capital treatment for banks?; both were considered eminently safe, and banks had to hold very little capital against them.  What’s more, given the favorable treatment, banks loaded up with them by the gross.  Therefore, mightn’t one conclude that perverse bank capital rules are a major systemic risk?  Shouldn’t this raise concerns that centralized price setting mechanisms–such as centrally determined capital requirements–are not going to save us from the next crisis, but create it?

It is inevitable that such a mechanism will underprice some risks; that this will induce financial institutions to overinvest in those instruments; and that as a result, they are likely to be the source of a financial “surprise” that wreaks havoc.

And isn’t it interesting that the capital rules gave very favorable treatment to politically favored instruments–mortgage debt/real estate, and government debt?

Russian central bank head Sergei Ignatiev claims that the European crisis poses no threat to Russia:

“I don’t think all these events will have a strongly negative effect on the Russian economy,” Ignatiev said at a conference in St. Petersburg today. “The Russian banking system is better prepared for external shocks than it was in 2008.”

The economy is protected by sufficient liquidity, a “much more flexible ruble,” and large international reserves, the world’s third biggest after China and Japan, according to Ignatiev. While the Russian currency reflects external volatility, it can better withstand external shocks than it did before the global financial crisis, he said.

Of course, that’s what Putin, Medvedev, and even my boy Kudrin said said in 2008, when the storm clouds were breaking in the United States and Europe.  And we know how that worked out: rather than being a safe harbor from the storms buffeting other economies, as Putin and Kudrin had claimed, Russia was hit harder than virtually any economy.  Indeed, only months after boasting about his country’s immunity from the world crisis, in a speech at Davos Putin raged at the West for creating a “perfect storm” that had swept over Russia.

Putin’s confidence in September was based on many of the same factors Ignatiev cites, notably its reserves.  But its reserves have been depleted, and its economy has not recovered from its battering in 2008-2009.  There is also considerable reason to doubt his happy talk about the banking system.

It’s interesting to compare what Ignatiev said to what Kudrin said in January, 2008, when the strains on the world financial system were becoming manifest:

Russian Minister for Finance, Aleksey Kudrin, released a sensational statement Wednesday. Speaking at the World Economic Forum in Davos, the Russian minister offered to mitigate the world credit crisis with the help of Russia’s reserves. Kudrin stated that Russia was an “island of stability in the sea of the world crisis.”

“Investors will continue to invest billions of dollars in the rising Russian economy. Stock market crises and their consequences will not be utterly negative for us,” Kudrin said. “Our country managed to achieve economic stability and to save considerable gold and currency reserves which play the role of an air bag for the national economy,” Kudrin said.

Mr. Ignatiev, it appears, has learned nothing, and forgotten nothing.  Russia’s reserves did not save it from the crisis, let alone the world.  Why would Ignatiev think things would be any different a second time around?  That would be a triumph of hope over bitter experience.

If Europe spins downwards, as is still possible, or if China runs into turbulence (trying to deflate asset bubbles, for instance), the same dynamic that ravaged Russia before will do it again.  A recurrence of the financial crisis, this time driven by a sovereign debt crisis instead of a real estate crisis, would again crater demand for Russian material exports, reducing national income sharply and putting added strain on government finances.  The “flexible currency” Ignatiev touts is unlikely to prove so, as the same terror at repeating the 1998 ruble collapse would induce Russia to spend its reserves to prop up the currency.

If you’ve been following the volatile markets lately, you’ll have noticed that oil prices have swooned as worries about the sovereign debt crisis have waxed, and have rallied as these worries have waned (like today).  You’ll have noticed too that the Russian equity market and the ruble have been riding the same roller coaster.

As I said often during the crisis, Russia is a high beta economy.  Due to its commodity price exposure, and the sensitivity of commodity prices to world economic conditions, Russia remains hostage to world economic conditions; when Europe and/or the US and/or China get the chills, Russia catches pneumonia.  The European debt crisis threatens those conditions, and Russia with it.

So Ignatiev is either a fool, or whistling past the graveyard when he responds with such insouciance to the European crisis.  If the European situation turns for the worse–as I think it is likely to do, today’s market euphoria notwithstanding–Russia will awake to the strains of “I’ve Got You Babe” and relive the terrors of 2008-2009.

After Putin elbows him aside in 2012, Russian president Dmitri Medvedev should move to Branson and open a theater.  His standup routine is priceless.  (At least I think he’s standing up–with the diminutive Medvedev it’s always hard to tell.)

Yesterday’s routine was delivered before a group of US venture capitalists.  It’s a howl:

Boosting Kremlin plans to transform Moscow into a global financial center, President Dmitry Medvedev told visiting U.S. fund managers that his country was a haven for equity firms suffering from stricter financial regulation at home.

Medvedev said tough policies enacted by a host of governments after the financial crisis should raise the appeal of the Kremlin’s plans.

“We invite all those who suffer at home to come to Russia,” Medvedev said, according to a transcript posted on his web site.

Suffering at home?  Come to Russia, where they really know about suffering!  They consider it a national virtue!

I agree Europe and the US are slouching towards far less free capital markets (although the egregious Dodd “angels” provision died a merciful death).  But things would have to get worse by orders of magnitude for the situation to be anywhere near as bad as they are in Russia.  Let’s just come up with a little list about the dangers of investing in Russia: (a) lack of a rule of law, (b) no secure property rights, (c) constant risk of expropriation, (d) no real protection of intellectual property, (d) corporate raiding a la Russe, (e) corruption, (f) crime, (g) mafia shakedowns, (h) government shakedowns, (i) decrepit infrastructure, (j) declining working age population, (k) decaying educational system (hopefully later I’ll comment on a story documenting the massive bribery in Russian education–starting in pre-school (!), (l) acute dependence on raw material exports, which hold the country’s economy hostage to world economic conditions (meaning that if things go bad in Europe and the US, they’ll go even worse in Russian), (m) relatedly, the resource curse in all its manifestations.  I could go on, but you get the point.

One of Medvedev’s best one liners: “I will not take time listing specific advantages of the Russian economy today.”  Why not?  That wouldn’t take much time at all.

Captain Obvious also made an appearance: “”As regards the mood of American and foreign investors in general, who are often guided by the negative experiences of their predecessors.”  Who knew?

I actually sympathize for Medvedev.  He knows, I am sure, of Russia’s debilitating handicaps–virtually all self-inflicted–as a market for investment.  Indeed, he acknowledged some of these handicaps in his remarks.  But he offered nothing concrete in the way of palliatives.  Indeed, he cautioned against expectations that the only specific measure discussed–an agency to protect foreign investments–would actually accomplish anything:

As regards the possible creation of an agency for protecting foreign investments, Medvedev noted that the powers of this body were at issue, as judicial protection or intervention by prosecutors is often needed due to business conflicts. He said that all such an agency could do is give “a political impulse, which is sometimes a good thing”.

“There should be a body which reports to the country’s leadership about what is happening, but the question is its scope, because there are arguments both for and against,” Medvedev said.

He rather pathetically argued that Russia’s laws “are quite reasonable” but “often this legislation may not be properly observed by business entities and may not be always interpreted accurately in judicial proceedings. Besides, there is a problem of court awards enforcement.”  Other than that, things are great!

But Medvedev is actually powerless to do anything to address these problems.  He can point them out–and bully for him for at least acknowledging them–but the fact that he can diagnose but cannot cure only points out his basic irrelevance.  In the end, Medvedev was reduced to the Tinker Bell Strategy (has he been talking to Krugman?): “It is the position of those investors who admit positive changes in the Russian investment climate that could be used to change the view of foreign businesses with regard to investment in this country, Medvedev said.”  Problem is, if the dogs don’t like the dogfood, all of the happy talk advertising in the world isn’t worth a damn.  Especially since everybody knows that Putin is making the dogfood, and that Medvedev is just the pitchman.

Medvedev’s words count for little when corporate raiders who work for him and the jailers–murderers–of Magnitsky- walk free.

The fact is, long after Medvedev retires to take up residence near Yakov Smirnov, the Osmond Brothers, and Silver Dollar City, investors would be well advised to pay little attention to his blandishments, or those of his successors, and instead pay heed to the warning of American venture capitalist David Kronfeld: “There is a widespread feeling that there are thousands of ways to steal your money in Russia.”  Yes, that’s the punchline, but it’s no laughing matter.