Category Archives: shadow finance

The Future of Oligopolies: Bright

Direktorium. image from wikipedia

[F]inance was a crucial prop for profits in the two decades to 2007, with the banking industry expanding rapidly and industrial firms such as GE and General Motors building huge shadow banks. The regulatory clampdown since the financial crisis means this adventure is now over.
Third, after 2007-08 firms relied heavily on pushing down the share of their profits that they paid out in wages. But now there are hints that wages are rising. On October 14th Walmart said that higher pay and training costs would lower its profits by $1.5 billion, or just under 10%, in 2017. A week later Chipotle, a fast-food chain specialising in burritos big enough to ballast a ship, blamed falling margins on labour costs. If the share of domestic gross earnings paid in wages were to rise back to the average level of the 1990s, the profits of American firms would drop by a fifth.  

Faced with stagnation, the quick fix is share buy-backs, which are running at $600 billion a year in America. They are a legitimate way to return cash to investors but also artificially boost earnings per share. IBM spent $121 billion on buy-backs over the past decade, twice what it forked out on research and development. In the third quarter its sales fell by 14%, or by 1% excluding currency movements and asset disposals. Big Blue should have invested more in its own business. Walmart spent $60 billion on buy-backs even as it fell far behind Amazon in e-commerce…. The Brazilian investment firm 3G has become a specialist in buying mature firms and cutting what it claims is fat. Sales at its most recent target, Kraft, are falling at a rate of 5% a year. 3G is the force behind the proposed $120 billion takeover of the brewer SABMiller by AB Inbev. Inbev’s volumes are shrinking at a rate of 2%. In America the telecoms, cable and health-insurance industries are consolidating. The aim is to create stodgy oligopolies.

Peak Profits: The Age of the Torporation, Economist, Oct. 24. 2015, at 59

A Ready-Made Vehicle for Dirty Money: Trade

Money-laundering. image from wikipedia

A few years ago American customs investigators uncovered a scheme in which a Colombian cartel used proceeds from drug sales to buy stuffed animals in Los Angeles. By exporting them to Colombia, it was able to bring its ill-gotten gains home, convert them to pesos and get them into the banking system.This is an example of “trade-based money laundering”, the misuse of commerce to get money across borders. Sometimes the aim is to evade taxes, duties or capital controls; often it is to get dirty money into the banking system. International efforts to stamp out money laundering have targeted banks and money-transmitters, and the smuggling of bulk cash.

But as the front door closes, the back door has been left open. Trade is “the next frontier in international money-laundering enforcement,” says John Cassara, who used to work for America’s Treasury department. Adepts include traffickers, terrorists and the tax-evading rich. Some “transfer pricing”—multinationals’ shuffling of revenues to cut their tax bills—probably counts, too. Firms insist that tax arbitrage is legal, and that the fault, if any, lies with disjointed international tax rules. Campaigners counter that many ruses would be banned if governments were less afraid of scaring off mobile capital. Trade is “a ready-made vehicle” for dirty money, says Balesh Kumar of the Enforcement Directorate, an Indian agency that fights economic crime. A 2012 report he helped write for the Asia/Pacific Group on Money Laundering, a regional crime-fighting body, is packed with examples of criminals combining the mispricing of goods with the misuse of trade-finance techniques. Using trade data, Global Financial Integrity (GFI), an NGO, estimates that $950 billion flowed illicitly out of poor countries in 2011, excluding trade in services and fraudulent transfer pricing. Four-fifths was trade-based laundering linked to arms smuggling, drug trafficking, terrorism or public corruption.

The basic technique is misinvoicing. To slip money into a country, undervalue imports or overvalue exports; do the reverse to get it out. A front company for a Mexican cartel might sell $1m-worth of oranges to an American importer while creating paperwork for $3m-worth, giving it cover to send a dirty $2m back home. One group of launderers was reportedly caught exporting plastic buckets that cost $970 each from the Czech Republic to America. To lessen the risk of discovery the deal may be sent via a shell company in a tax haven with strict secrecy rules. This may mean using a specialist “re-invoicing” firm to “buy” the oranges at an inflated price with an invoice to match and charge the importer the true price. The point is to get paperwork to justify an inflated transfer to the seller. Re-invoicers are used by multinationals to shift profits around, which gives them a veneer of respectability, says Brian LeBlanc of GFI—but they also “feed a giant black market in the offshore manipulation of paperwork”…

American authorities have ratcheted up penalties for banks that assist money-launderers, knowingly or not. In 2012 they reached a $1.9 billion settlement with HSBC after concluding that Latin American drug gangs had taken advantage of lax controls at its Mexican subsidiary. And last year they imposed a $102m forfeiture order on a Lebanese bank implicated in a complex scheme involving the export of used cars to West Africa with the proceeds funnelled to Hizbullah, an Islamist group. Alternative remittance systems and currency exchanges, such as the trust-based hawala networks in Asia and the Middle East, and Latin America’s Black Market Peso Exchange (BMPE), offer another route to launder money through trade. ..A recently leaked Turkish prosecutor’s report describes an alleged conspiracy involving Turkish front companies and banks, an Iranian bank and money-exchangers in Dubai. By marking up invoices for food and medicine allowed into Iran—to as much as $240 for a pound of sugar—the scheme gave Iranian banks access to hard currency from Iran’s oil sales that was locked in escrow accounts overseas, to be transferred only for approved transactions…

In the meantime, launderers who curb their greed and invoice goods worth $10 for $9, or $11, will probably continue to get away with it. A dodgy deal is almost impossible to spot if the pricing is only slightly out and you see just one end, says one American investigator. “You can study the slips all day long, and all you see is stuff being imported and exported.”

Excerpts from Trade and money laundering: Uncontained, Economist, May 3, 2014, at 54

The Bitcoin Haven: Hong Kong

bitcoin

Entrepreneurs in Hong Kong are scrambling to offer new services for bitcoin investors and enthusiasts in the region, despite a dip in confidence after the collapse of Mt Gox, a Japanese online exchange. The former British territory’s status has been enhanced by mainland China making it hard for the Bitcoin business—banning financial institutions from dealing in bitcoins and closing the bank accounts of online trading platforms.

Hong Kong, on the other hand, continues to be run under the “one country, two systems” set-up, agreed before it was handed back from British to Chinese sovereignty. So it has its own monetary authority and its own British-style legal system. A slew of startups are racing to lay out a network of Bitcoin ATM machines (where you pay money in to obtain bitcoins) and to open exchanges for online buying and selling, while a handful of bricks-and-mortar businesses are starting to accept payments in bitcoins.

As in so many areas, straightforward regulations and high-quality local talent have been the key to Hong Kong’s early success. Promising ventures have found no shortage of capital in the city. Li Ka-shing, a Hong Kong tycoon and Asia’s richest man, was an early investor in BitPay, a Bitcoin payment technology.

Still, the industry is experiencing growing pains, too. Two of the city’s first Bitcoin ATMs stopped working soon after being set up in March. Aurélian Menant, a former investment banker who left his job last year to start Gatecoin, a digital-currencies exchange website, waited nine months for his company to be granted a licence as a money-service operator.

Yet in spite of the teething problems, many observers believe Hong Kong’s transparent legal framework and its position on China’s doorstep can make it a leading global centre for Bitcoin, just as it has been for many other commodities. Authorities in the city have made their position clear. John Tsang, Hong Kong’s financial secretary, told a room of teenagers recently: “Bitcoin is not a currency. Just like your armour in World of Warcraft, since we don’t regulate those, we won’t be regulating Bitcoin.” In addition, any assets gained from the buying and selling of bitcoins are subject to the city’s attractive low flat-tax rate.

Some think the key for Bitcoin startups is to attract capital from flush mainland Chinese investors. The problem for David Shin, a Hong Kong banker who launched Cryptomex, a Bitcoin crowdfunding investment platform, is that investors in China “like to hoard their bitcoins”. Mr Shin hopes his venture could coax them to invest in startups, and that those businesses would in turn improve the security of transactions and earn digital currencies wider legitimacy.

Bitcoin in Hong Kong: Still different, Economist,  June 7, 2014, at 50

Automatic Global Information Sharing in Tax Matters

oecd  may 6, 2014

Forty-seven countries, including the Group of 20 and some prominent tax havens, [adopted a declaration–Declaration on Automatic Exchange
of Information in Tax Matters] on May 6, 2014 that will shake up the sharing of tax information. Under the present system, countries have to file requests with each other for data on suspected cheats…In the future the states will automatically exchange information once a year. This will include bank balances, interest income, dividends and the proceeds of sales, which can be used to assess capital-gains tax…The deal also increases pressure on banks to identify the ultimate owners of shell companies and trusts, behind which tax evaders often hide.

The catalyst for the agreement was America’s Foreign Account Tax Compliance Act (FATCA). The law, passed in 2010, will soon impose stiff penalties on foreign financial firms that fail to declare their American clients. Once America began pushing for automatic declarations, other big countries did the same.

The most eye-catching signatory to the accord is Switzerland, whose banks were at the centre of the scandals that gave rise to FATCA. The world’s most famous offshore wealth-management centre was built on supposedly ironclad bank secrecy, but it has been forced to buckle under international pressure. (The American authorities, for instance, are currently leaning on Credit Suisse to plead guilty to charges of aiding American tax dodgers.) This is momentous: for the Swiss, agreeing to swap client data systematically is the cultural equivalent of Americans giving up guns. Singapore, which has earned a reputation as the Switzerland of the East, is also a party to the deal.  Britain’s offshore satellites, such as Jersey and the Cayman Islands, are grudgingly on board. But it will be harder to corral Panama, Dubai and the havens dotted around the Indian and Pacific Oceans (although blacklisting can be a powerful tool). Until they sign up, the likes of Switzerland and Luxembourg may have an excuse to drag their feet in implementing the new rules.

Still, the pace of change has been remarkable. Global information exchange, unthinkable a decade ago, is within reach. Tax evaders can be ingenious, but their options are narrowing fast.

Tax evasion: The data revolution, Economist, May 10, 2014, at 74

Barclays Toxic Landfill

barclays

The lawsuit filed by New York’s top securities regulator against Barclays, alleges that it favoured high-speed traders using its “dark pool” trading venue, while misleading other investors.The 30-page complaint gives examples of what Eric Schneiderman, the state attorney-general, claims were the bank’s practices.

The lawsuit claims that Barclays took advantage of its institutional investor clients, known as “the buy side.”  The complaint quotes a former director as saying: “[T]he way the deal would work is [Barclays] would invite the high frequency firms in. They would trade with the buy side. The buy side would pay the commissions. The high frequency firms would pay basically nothing. They would make their money off of manipulating the price.“Barclays would make their money off the buy side. And the buy side would totally be taken advantage of because they got stuck with the bad trade . . . this happened over and over again.”

It also quotes a former Barclays director as saying: “There was a lot going on in the dark pool that was not in the best interests of clients. The practice of almost ensuring that every counterparty would be a high frequency firm, it seems to me that that wouldn’t be in the best interest of their clients . . . It’s almost like they are building a car and saying it has an airbag and there is no airbag or brakes.”…

The same day Barclays’ then-head of equities sales noted in reference to the analysis that some in the industry viewed Barclays’ dark pool as a “toxic landfill” and so “[i]f we can help ourselves we should[;] it’s in our control”.

The attorney-general alleges the bank’s “Liquidity Profiling” surveillance system failed to protect clients from predatory high-speed trading tactics…“Barclays has never prohibited a single firm from participating in its dark pool, no matter how toxic or predatory its activity was determined to be.”

Excerpts from John Aglionby, Lawsuit alleges Barclays misled dark pool clients, Financial Times, June 26, 2014

Bankers Vices: BNP Paribas and Iran

bnp paribas

BNP Paribas, France’s biggest bank, is reported to be facing a fine of more than $10bn  to settle allegations that it violated US sanctions against Iran and other countries.

The US justice department is pushing the bank to plead guilty to the charges and pay one of the biggest penalties ever imposed on a bank, according to the Wall Street Journal. A deal between the bank and the authorities is still weeks away and the final penalty could yet come in lower than $10bn. The Journal said BNP was seeking to pay less than $8bn, though a person familiar with the bank said its negotiators had not proposed that figure to the justice department…A $10bn fine would be more than five times the biggest amount paid by a bank to settle allegations of violating US sanctions. The US authorities have come down hard on foreign banks, many of them from the UK, for allowing transactions through the US financial system involving parties in Iran, Sudan and other blacklisted countries.

HSBC handed over $1.97bn in 2012, though that fine also settled allegations of money laundering for Mexican drug cartels. Standard Chartered was the next biggest offender, agreeing to pay a total of $667m to the justice department and New York’s banking regulator, mainly for allowing transactions linked to Iran.

On top of the potentially huge fine, BNP Paribas could suffer a temporary ban on processing dollar transactions, a business that is essential to the operations of an international bank. Benjamin Lawsky, New York’s aggressive financial regulator, is said to be seeking a suspension.

In addition to the US justice department, the US treasury department, the attorney’s office in Manhattan, the Manhattan district attorney’s office and Lawsky’s department are all investigating BNP Paribas’s conduct.

Excerpts, Sean Farrell, BNP Paribas faces fine of more than $10bn in US sanctions investigation,Guardian, May 30, 2014

Regulating Capital: the information challenge

stock market

During the financial crisis regulators discovered the hard way how little they knew about the risky derivatives portfolios built up by large financial institutions. Lehman Brothers, for example, was thought to have been a counterparty to about $5 trillion of credit default swaps. When they turned sour in 2008, it brought the financial system to its knees. In response leaders of the world’s main economies demanded in 2009 that derivatives deals should all be reported to “trade repositories”—vast central databases—to make it easier to identify and then reduce systemic risks.

On February 12th, 2014 European rules came into force requiring the reporting of all derivatives to one of six approved repositories. Similar rules have already been in place in America for about a year. But the effort, although concerted, is not consistent: the American and European reforms differ, making awkward transactions spanning the two jurisdictions. Moreover, even if these data can be reconciled, it is not clear what regulators will do with it.

The American regulations allow the reporting to be taken care of by one party to the trade. Yet Europe requires both parties to report. That means every fund manager or corporate treasurer trading derivatives has had to follow cumbersome rules, not just the banks that peddle most deals.  Getting both sides to report was originally seen as a means to ensure that every entity’s exposure could be rigorously monitored. But the complexities of obliging both parties to report trades, which then have to be reconciled with one another, have led many to question whether the additional burden is really worthwhile. “Dual reporting was required to avoid omissions in the data,” says Stewart Macbeth of the Depository Trust & Clearing Corporation, one of the approved repositories. But it “captures a lot of companies in the real economy that probably do not pose a systemic risk”.

The European rules differ from the American ones in other ways too. America staggered implementation of its rules over the course of several months as different sorts of contracts and counterparties were gradually brought within their scope. European regulators chose instead to have everyone start reporting everything on a single day. That created a bottleneck as participants rushed to put the necessary procedures and agreements in place.

Now that the deadline has passed, responsibility shifts to regulators, whose duty it will be to make sense of the torrents of data that are now flooding in. In America the Commodity Futures Trading Commission has openly acknowledged the problems it has already encountered coping with the deluge, with one commissioner blaming “inconsistencies and errors” in the rules. In Europe the problems are likely to be even worse as so many more counterparties are reporting data to multiple repositories. That will create an unfortunate opportunity for both omissions and duplications of data. In time the new reporting rules should reduce risks, but much work still needs to be done.

A paper published on February 4th by the Financial Stability Board (FSB) offers a solution. It proposes aggregating data from multiple repositories into one central one. That may iron out inconsistencies in the data—but it will not necessarily make it any more digestible.

Derivatives:  Data dump, Economist, Feb. 22, 2013, at 65

Watering Down Banking Regulations

bis

“IT was always the French and the Germans,” grumbles a senior financial regulator, blaming counterparts from those two countries for undermining international efforts to increase capital ratios for banks. Every time the Basel committee, a grouping of the world’s bank supervisors, neared agreement on a higher standard, he says, a phone call from the Chancellery in Berlin or the Trésor in Paris would send everyone back to the table.

Similar phone calls almost certainly inspired the committee’s decision on January 12th to water down a proposed new “leverage ratio” for banks. It had originally suggested obliging banks to hold equity (the loss-absorbing capital put up by investors) of at least 3% of assets. In theory, that standard will still apply. But the committee came up with various revisions to how the ratio is to be calculated, in effect making it less exacting.

The new rule will allow banks to offset some derivatives against one another and to exclude some assets from the calculation altogether, thus making their exposure seem smaller. Analysts at Barclays characterised it as a “substantial loosening”. Citibank called it “significant regulatory forbearance”. Shares in big European banks such as Barclays and Deutsche Bank surged to their highest level in nearly three years on the news.

Leverage ratios have their critics—even outside overleveraged banks. They contend that leverage is a crude and antiquated measure of risk compared with the practice of weighting assets by the likelihood of making losses on them, and calculating the required cushion of equity accordingly. The chances of losing money on a German government bond, the argument runs, are much smaller than they are on a car loan; but a simple leverage ratio makes no distinction between the two. As a result, leverage ratios might actually encourage banks to buy riskier assets, in the hope of increasing returns to shareholders. Officials at Germany’s central bank, for instance, have argued that a binding leverage ratio “punishes low-risk business models, and it favours high-risk businesses.

”Bankers also claim that tough leverage requirements risk stemming the flow of credit to the economy, as banks shrink their balance-sheets to comply. BNP Paribas, a French bank, says this would particularly disadvantage European banks because they do not tend to sell on as many of their home loans as American ones. The full extent of the new change is difficult to gauge, partly because there is still some uncertainty surrounding the rules. Yet a rough calculation suggests that they have been loosened just enough to allow most big European banks to pass the 3% test. Without the committee’s help as many as three-quarters of Europe’s big banks might have failed the test (see chart).

A detailed analysis by Kian Abouhossein of J.P. Morgan Cazenove, an investment bank, suggests that under the old rules big European banks may have had to raise as much as €70 billion ($95 billion) to get their leverage ratios to 3.5%, which is far enough above the minimum for comfort. Yet the new rules alone may improve big European banks’ leverage ratios by 0.2-0.5 percentage points compared with the previous ones, he reckons—enough for most to avoid raising new capital.

That does not mean banks will be able to shrug off the new leverage ratio entirely. Simon Samuels, an analyst at Barclays, expects it will prompt some European investment banks to reconsider their strategies. Some may have to cut lines of business and reduce their assets. That hints at the potency the measure could have had, if the regulators had allowed it.

Leverage ratios: Leavened, Economist,  Jan 18, 2014, t 72

How to Evade Capital Controls: the case of China

People's Bank of China. image from wikipedia

Is capital fleeing China? The recent crackdown on official corruption might suggest that fat cats are busy whisking their money out of the country to avoid scrutiny. That impression is strengthened by the apparently endless flow of Chinese money into luxury goods, penthouses and other trophies in London, New York and Paris.  Lots of money is undoubtedly leaving China, despite the country’s strict currency controls. However, a close look at the official figures suggests that, on balance, more hot money… has been flowing in.

A new study by Global Financial Integrity (GFI), a research firm, highlights one popular way illicit flows enter the mainland.   It claims that well over $400 billion has poured into China since 2006 outside the official channels, with inflows in the first quarter of 2013 alone topping $50 billion. GFI believes exporters on the mainland exaggerate the prices of goods sent to Hong Kong in order to evade China’s strict currency controls and bring back pots of cash.  Why would they bring money into China? One reason is to take advantage of a steadily appreciating yuan. Once punters sneak money into China, eye-catching if risky investments beckon in the overheated property market and poorly regulated shadow-banking sector.

Another explanation relates to the prolonged period of low interest rates in America. GFI notes that flows of hot money into China surged when the Federal Reserve began trying to suppress rates by buying up government bonds and other securities. Now that the Fed is “tapering” its asset purchases, it is reasonable to ask if the flow of hot money will slow or even reverse.  Chinese regulators have noisily complained about the illicit inflows. In December they promised a crackdown on over-invoicing and other such scams.

Chinese capital flows: Hot and hidden, Economist, Jan 18, 2014, at  73

Finance: the BlackRock Dominance

BlackRock headquarters

BlackRock, an investment manager, owns a stake in almost every listed company not just in America but globally. (Indeed, it is the biggest shareholder in Pearson, in turn the biggest shareholder in The Economist magazine.) Its reach extends further: to corporate bonds, sovereign debt, commodities, hedge funds and beyond. It is easily the biggest investor in the world, with $4.1 trillion of directly controlled assets (almost as much as all private-equity and hedge funds put together) and another $11 trillion it oversees through its trading platform, Aladdin.

Established in 1988 by a group of Wall Streeters led by Larry Fink, BlackRock succeeded in part by offering “passive” investment products, such as exchange-traded funds, which aim to track indices such as the S&P 500. These are cheap alternatives to traditional mutual funds, which often do more to enrich money managers than clients (though BlackRock offers plenty of those, too). The sector continues to grow fast, and BlackRock, partly through its iShares brand, is the largest competitor in an industry where scale brings benefits. Its clients, ranging from Arab sovereign-wealth funds to mom-and-pop investors, save billions in fees as a result.

The other reason for its success is its management of risk in its actively managed portfolio. Early on, for instance, it was a leader in mortgage-backed securities. But because it analysed their riskiness zipcode by zipcode, it not only avoided a bail-out in the chaos that followed the collapse of Lehman, but also advised the American government and others on how to keep the financial system ticking in the darkest days of 2008, and picked up profitable money-management units from struggling financial institutions in the aftermath of the crisis.

Compared with the many banks which are flourishing only thanks to state largesse, BlackRock’s success—based on providing value to customers and paying attention to detail—is well-deserved. Yet when taxpayers have spent billions rescuing financial institutions deemed too big to fail, a 25-year-old company that has grown so vast so quickly sets nerves jangling. American regulators are therefore thinking about designating BlackRock and some of its rivals as “systemically important”. The tag might land them with hefty regulatory requirements.

If the regulators’ concern is to avoid a repeat of the last crisis, they are barking up the wrong tree. Unlike banks, whose loans and deposits go on their balance-sheets as assets and liabilities, BlackRock is a mere manager of other people’s money. It has control over investments it holds on behalf of others—which gives it great influence—but it neither keeps the profits nor suffers the losses on them. Whereas banks tumble if their assets lose even a fraction of their value, BlackRock can pass on any shortfalls to its clients, and withstand far greater shocks. In fact, by being on hand to pick up assets cheaply from distressed sellers, an unleveraged asset manager arguably stabilises markets rather than disrupting them.

But for regulators that want not merely to prevent a repeat of the last blow-up but also to identify the sources of future systemic perils, BlackRock raises another, subtler issue, concerning not the ownership of assets but the way buying and selling decisions are made. The $15 trillion of assets managed on its Aladdin platform amount to around 7% of all the shares, bonds and loans in the world. As a result, those who oversee many of the world’s biggest pools of money are looking at the financial world, at least in part, through a lens crafted by BlackRock. Some 17,000 traders in banks, insurance companies, sovereign-wealth funds and others rely in part on BlackRock’s analytical models to guide their investing.

That is a tribute to BlackRock’s elaborate risk-management models, but it is also discomfiting. A principle of healthy markets is that a cacophony of diverse actors come to different conclusions on the price of things, based on their own idiosyncratic analyses. The value of any asset is discovered by melding all these different opinions into a single price. An ecosystem which is dominated by a single line of thinking is not healthy,

The rise of BlackRock, Ecomomist, Dec. 7, 2013, at 13