This is not how an efficient financial system works. As Percy Mistry’s report says, in the future, government needs to to reorganise itself to fit the regulatory requirements of a sophisticated financial system, instead of trying to force financial firms to reorganise themselves to fit the almost accidental regulatory architecture that prevails in India today.

In recent years, many changes in finance have hinged on breaking the strictures of this silo system. Two success stories that come to mind include ETFs on gold and currency futures.

In this setting, we have a big new development in across-silo thinking: an order by SEBI against insurance companies selling mutual-fund-like products without being regulated as mutual funds are. [pdf]

We need the Financial Stability and Development Council (FSDC) yesterday.

I was surprised to see how small the market reaction was (this image is from Yahoo Finance):

What am I not understanding?

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Q1: Should central banks target asset prices?

Davies points out that the consensus view is that central banks should remain focused on inflation targeting and not target asset prices.

However, pretty much everyone would agree that information from the world around us, about asset prices, is useful for forecasting inflation and output, and should be used in figuring out what values for output and inflation we put into our Taylor rules (whatever they might be).

So it seems that on this question, there is consensus: Asset prices are (and have always been) useful inputs in monetary policy formulation, but monetary policy should continue to do inflation targeting and not asset price targeting.

Q2: Should the measure of inflation targeted include an element of asset price, and particularly house price inflation?

Any reasonable CPI must have house rent in it, and through this, a boom in house prices and thus rents will get reflected in the CPI. This would give one more channel through which asset prices would directly influence a traditional inflation-targeting central bank.

Q3: Is it possible to identify serious asset price misalignments, and are they of legitimate concern to monetary policy-makers?

This is controversial territory. Some economists believe it is possible to ask central banks to make a call on when asset prices are misaligned.

I am personally skeptical about the extent to which this is possible. It is always easy to look back, ex-post, and say that it was obvious that US house prices were way off in 2006. But how many of the people who say this today were shorting US housing then?

Making a call about asset price fluctuations is hard even for a well motivated hedge fund manager. It is doubly hard in the public sector given the peculiar combination of skills and incentives that are found within central banks. The people with real skill in these things are unlikely to choose to work in a central bank; years spent in a central bank do not hone skills at market timing; the public will be very irritated if a central bank calls wrong.

So overall, I’m skeptical about the extent to which central banks (past or future) can usefully make calls about when asset prices are out of whack.

Q4: Even if we can identify misalignments, and believe that some price adjustment is bound to occur, is it right to use interest rates to try to moderate the expansion?

Even if you knew that asset prices were grossly wrong, interest rates seem to be a very blunt tool, which inflict collateral damage all around the economy. Davies quotes Mervyn King who said two months ago: Diverting monetary policy from its goal of price stability risks making the economy less stable and the financial system no more so.

Q5: Should we try to find and use mechanisms other than interest rates to moderate extravagant credit expansion and associated asset price bubbles?

I think there is a good case for building some kinds of counter-cyclicality into financial regulation. But operationalising this is hard.

It should be feasible for financial regulators to have three manuals which govern boom times, normal times, and recessions. Full public disclosure of these three manuals is, of course essential, to avoid the usual issues of transparency and consistency. The question is: When would you flip from one manual to another?

Doing this based on asset prices runs into the difficulties articulated above. How is a civil servant to know when asset prices are in a boom or a bust?

Doing it based on business cycle conditions is more objective and feasible. It should be possible to setup indicators like Eurocoin which give low latency information about a coincident indicator. This could be used to drive rules about when we go into each of the three manuals. I personally think this would be useful.

Such efforts can be rationalised on the narrow ground that we seek to reduce the extent to which finance is a source of pro-cyclicality in the economy. If this is done right, it would reduce the amount of heavy lifting that monetary and fiscal policy have to do by way of stabilisation.

You don’t have to have a `financial markets are irrational’ view to support this. All you have to believe is that the existing structures of financial regulation are a source of pro-cyclicality. If that much is agreed, then there is a case for changing the framework of financial regulation so as to reduce the extent to which this is the case.

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North American Securities Administrators Association (NASAA) – the oldest international organisation devoted to investor protection.

In consideration of the settlement, American states will agree to terminate their investigation of Credit Suisse’s marketing and sale of such securities to individual investors.

The ARS market involved investors buying and selling instruments that resembled corporate debt whose interest rates were reset at regular auctions, some as frequently as every seven days.

Market meltdown

They were sold as being as safe as cash but the market fell apart amid the downturn in credit markets.

Investigators have been trying to work out who was responsible and whether banks knowingly misrepresented the safety of the securities when selling them to investors.

In a statement from New York, the Zurich-based bank noted: “Credit Suisse neither admits nor denies allegations of wrongdoing.”

Eligible individual investors must have bought their ARS through Credit Suisse before February 14, it added.

The bank joins a growing list of major financial institutions – including Switzerland’s largest bank UBS – to reach settlements, with more than $51 billion targeted for repurchase, and state and federal penalties totalling an estimated $537 million.

“The industry is taking responsibility for correcting a problem they helped create, and that’s a good thing,” Cuomo commented in a statement.

“Return money”

“The fundamental goal has been to return money into the hands of investors, and that’s what these deals do.”

NASAA President Karen Tyler was also satisfied with the Credit Suisse settlement.

She described it as “another step on the road to recovery for thousands of Main Street investors who have been trapped in the auction rate securities meltdown”.

UBS last month announced a comprehensive settlement, in principle, for all clients holding auction rate securities at an estimated cost to the bank of $900 million.

It pledged to buy a total of $8.3 billion of ARS at face value from most private clients during two years from January 1, 2009. However, private clients and charities holding less than $1 million in household assets would be able to obtain this relief from October 31.

It said it would also provide solutions to institutional investors and agreed to buy all or any of the remaining $10.3 billion at face value from its institutional clients from June 30, 2010.

In July, UBS announced its intention to buy back up to $3.5 billion in auction-rate securities in the face of a lawsuit by Massachusetts’ authorities.

swissinfo with agencies

UBS, Switzerland’s largest bank, has similarly agreed  to reimburse shareholders

Andrew Cuomo, New York state’s Attorney General, “The industry is taking responibility for correcting a problem they helped create

NASAA President Karen Tyler  the Credit Suisse settlement.

She described it as “another step on the road to recovery for thousands of Main Street investors who have been trapped in the auction rate securities meltdown”.

UBS last month announced a comprehensive settlement, in principle, for all clients holding auction rate securities at an estimated cost to the bank of $900 million.

It pledged to buy a total of $8.3 billion of ARS at face value from most private clients during two years from January 1, 2009. However, private clients and charities holding less than $1 million in household assets would be able to obtain this relief from October 31.

It said it would also provide solutions to institutional investors and agreed to buy all or any of the remaining $10.3 billion at face value from its institutional clients from June 30, 2010.

In July, UBS announced its intention to buy back up to $3.5 billion in auction-rate securities in the face of a lawsuit by Massachusetts’ authorities.