JC Flowers, the Private Equity house based in New York, has agreed to pay GBP50m for a 49% stake in a Joint Venture with Kent Reliance Building Society (KRBS).

Does JC Flowers see KRBS as a major business opportunity? Hardly, because KRBS has only one branch and 45 employees. So it is definitely not in the multi-billion dollar league in which JC Flowers normally plays.

No, JC Flowers has done this deal for one reason only – to get cheap, fast access to a banking license. Whilst the “Grumpy Old Men” (Peston’s name for the group of banking industry veterans who have clubbed together to form a company to buy bank branches which the big4 are being forced to sell) are applying for a license from scratch (although with special dispensation from the UK Financial Services Authority which allows the group to bid for banking assets at the same time – so the outcome of the license application is pretty clear), JC Flowers has bypassed this.

A UK banking license is a valuable commodity. Under EU legislation, banks are now able to “passport” the licenses throughout the EU, obviating the need to apply for a license in each member state. So the moment the JC Flowers / KRBS deal is closed, JC Flowers is able to use this vehicle to provide banking services throughout the EU.

Should banking licenses be available in this manner? Or should there be a requirement that any significant change in shareholders or executive officers triggers a review of the license, and possibly a requirement to repeat (a subset of) the application process, forcing would-be bidders to think very carefully?

For sure the banking regulator can revoke a license, but this is a very serious and very public course of action, and exposes the regulator to unwanted public scrutiny of its approach. Refusing to grant a license initially, or postponing this until further requirements are fulfilled, is much easier.

Here at Vox Sapiens, we have concerns that there is a route to bypass the hoops that must be jumped through to obtain a banking license, thereby increasing the risk of problems in the banking industry. And we know what havoc these can cause.

The European Union parliament will vote next week on new legislation to curb bankers’ bonuses. The rules on bonuses are included within a larger proposal on capital requirements. According to the Financial Times, ‘lawmakers and EU officials welcomed the agreement and said it should help to reduce the “bonus culture” in the banking sector.’

Well here at Vox Sapiens, at risk of repeating ourselves (see Bankers’ bonuses – wrong target) we think the bonus culture should be increased, not reduced. This is because a properly designed bonus structure should align a banking employee’s goals with those of the employer. The problem is not one of a bonus culture, it is one of misalignment.

First, let’s consider where we find the most extreme bonus cultures. Is it in banking? Absolutely not. Instead, take a look at the “little man in the street” (or “little woman” – for reasons of brevity I will use only the masculine henceforth, but references to males should be read as equally applicable to females) that the authorities believe they are protecting by reducing his liability to bail out banks. Let us assume that this “little man” is self employed. So this “little man” generates business, performs some services, and receives payment. The business therefore generates a profit. How much of this profit is attributable to the “little man”? Well clearly, in the case of a sole trader, 100%. And for the vast majority of small limited liability businesses, also 100%.

Now let’s think about bankers. Typically around 50% of a bank’s profits are paid out to employees.

So where is the bonus culture strongest? Actually in the hundreds of thousands of “little men.”

So all this hot air about the banking bonus culture is completely wrong.

What is wrong, is the misalignment – paying bonuses from non-existent profits (not possible in the “little man” scenario), and/or developing bonus calculation mechanisms that reward employees for taking risks where the employee’s downside does not balance his upside (possible to a degree for the “little man” although the typical downside might be bankruptcy, which is far worse than being fired).

There will continue to be a clash while politicians and mandarins continue to pander to barely-informed populist agendas and rail against the bonus culture per se, rather than work on a serious framework to induce alignment between risk-based performance and reward.

The latest European passenger vehicle emissions standard (“Euro5″) was introduced in September 2009. Since that date, in Europe it has been illegal to sell new vehicles that do not meet this standard. Older models that only met the Euro4 standard can only be exported outside Europe to markets with more lenient standards. Within Europe the cars have little value – they can only be disassembled in order to reuse the components – and this value is therefore below cost.

This situation alone raises the possibility that dominant carmakers in the other markets will already be very suspicious of Euro4-compliant automakers. But it can get worse, much worse. Imagine that the government in another market introduced emissions standards that the locally dominant carmakers were not meeting, but with which the Euro4 vehicles were compliant. Imagine that, to compound that, the local market had only recently introduced a new emissions standard so many vehicles were in the early phases of their marketing cycles and the automaker had not had much time to prepare for the new emissions standard.

So the consequence is that the locally dominant carmakers find that (part of) their range is no longer legally saleable before they have achieved payback, plus they do not have new compliant models waiting for release to fill the gaps. And so the Euro4 compliant automakers find a hungry market for their formerly almost-worthless cars.

Well from July 2010, China will require compliance with Chinese5 emissions standards. And guess what? Chinese5 is basically the same as Euro4. So vehicles that become unsaleable in Europe last year remain compliant in China whilst some competing models in that market will be withdrawn from sale. And guess what else? Chinese3 emissions standards were only introduced in July 2008. So some of the vehicles to be withdrawn may have only been available for two years.

So perhaps there will be an opportunity for China to complain about dumping?

The US Senate has started to debate the Financial Reform bill. This bill proposes the most sweeping changes to US (and, therefore, global) financial markets regulatory practices since the Great Depression of the 1930s.

So one might think this an extremely important bill, right? So all the Senators have read it? Dream on!

The bill presented to the Senate is 1,300 pages long. How many people will read all of it? And even those few souls who do manage to read all the way through, will they really digest it, thoroughly, all of it? Of course they won’t.

So here we have what is possibly the most important piece of legislation relating to financial services for decades, and nobody fully understands it. Isn’t that frightening?

Perhaps in clauses hundreds of pages apart there are disparities that will keep lawyers employed for years.

In addition to its length, another problem is the breadth of the subject matter. Whilst all of the bill relates to financial markets in the broadest sense of the word, there are sections that are barely related to each other. A key risk here is that concessions and watering-down will be agreed in one section in order to gain support for a completely unrelated section. So, for example, the agreement to the derivatives section might affect regulation of deposits, or comments on naked insurance might impact international wire safeguards. These are just possible examples, the Vox Sapiens team hasn’t read the bill.

The US has an opportunity to show real leadership to the world here. It should cut the bill up into smaller sections that allow proper understanding of the consequences of each clause.

As Tolstoy said: “There is no greatness where there is not simplicity.” Is there greatness in this bill?

Let us hope that debating this bill doesn’t encourage many Senators to snore so that others can fleece us.

The Consumer Watchdog April 21 asked the US Department of Justice (DOJ) to launch an antitrust action against Google. In its request it suggested that Google might be broken up.

While there is the potential for Google to develop into something that needs to be broken up, right now there is a candidate that is way higher in priority. And that is Paypal.

In a previous post I pointed out that the attacks on bankers’ bonuses missed the point (see Bankers’ bonuses – wrong target). The Consumer Watchdog has performed a similar trick here.

So why should Paypal be at the front of the queue?

1. It has become a monopoly – it demonstrates Metcalfe’s Law beautifully – and, if the allegations repeated below are true, is now abusing its status. Without Paypal you are unable to send money to or receive money from a very large proportion of Internet users. For sure there are competitors such as Google Checkout and 2CO. But if you can use only these, whilst most people are using Paypal, you are extremely restricted in your ability to engage in web-based financial transactions.
2. Paypal provides a service for which there is no viable alternative. You can’t realistically barter online, you need to use some form of electronic payment system.
3. Alledgedly Paypal has repeatedly misunderstood how dangerous false positives are to a person’s financial position. The web is full of stories of people who claim that Paypal has frozen their account without warning, usually on the basis of “suspicious transactions,” only to discover that the transactions are valid. Now this also happens a lot offline – personally I find my erratic credit card usage results in a new card approximately once every three months. But I can own 2 or 3 credit cards, and if one is cancelled I can use another. It is not so easy to have multiple Paypal accounts, and even if you do have more than one account, switching is not as easy as taking a different credit card out of your pocket. You need to modify your email address associations, so that Paypal transactions linked to the email address associated with the frozen account do not fail. If you are using Paypal buttons to sell, you need to recreate buttons to associate to your new account and update your website. For some people who make their living selling online, a frozen Paypal account can put them out of business in days – and for those working as sole traders or with personal guarantees to a separate incorporated business, the result can be much worse when supplier contracts cannot be immediately termninated.
4. Alledgedly Paypal is also reticient to reinstate accounts, potentially leaving people permanently excluded from the growing online economy.
5. Your online Paypal activities can impact your offline financial status too. Many people almost see Paypal as “play money” – especially if they are sending friends, say, 99 cents. What they don’t realise is that Paypal is linked into many of the credit reference agencies, and your offline creditworthiness can be decreased by your online activities. So your application for a mortgage might get refused, or the interest rate increase by a couple percentage points, because Paypal has reported “suspicious transactions.” For sure this is not all Paypal’s fault, but Paypal could do a better job of teaching people that they need to be as responsible with their Paypal account as they do with their bank account.

So what should be done about the situation?

1. Fungibility is required between Paypal and other online payment providers. I can setup an automated payment from a bank account in one country to deliver funds into a bank accounts in another country (with a few exceptions) – I am not restricted to depositing into accounts in foreign branches of my own bank. I should be able to send money between online payment providers.
2. Paypal needs better regulatory oversight. In particular, the issue of alleged indiscriminate account freezing must be investigated and addressed. This will require international coordination between regulators.

And if Paypal does not agree?

It should be split into three or four separate companies, each with the same international coverage as Paypal provides now, thereby giving consumers a choice of online payments provider. And by starting from a common position, IT system interconnectivity will be simple, and therefore fungibility can be built in from the beginning.

A condition of the licence to trade should be that fungibility should be maintained, even in the event that one of the baby-Paypals is bought by, for example, a commercial bank.

My personal expectation is that, under this scenario, one of the first buyers would be Google, which would merge the baby-Paypal with Google Checkout to take advantage of the fungibility with the other baby-Paypals – this might then provide grounds to investigate Google if it were to use the inaccessiblity of Google Checkout-only functionality in an anti-competitive manner.

The Icelandic Special Investigation Committee (SIC) yesterday (April 12th, 2010) delivered its report on the collapse of the three main banks in Iceland. It makes shocking reading.

It can be downloaded here.

At Vox Sapiens, our initial vision was of a couple Escher’s masterpieces.

“Ascending and Descending” depicts a monastery where half the monks are forever walking upstairs and half are forever walking downstairs.

“Waterfall” depicts a perpetual motion machine in which water runs forever downhill.

The business empires of the owners of the three large Icelandic banks – Landsbanki, Glitnir and Kaupthing – allegedly demonstrate similar features.

The banks’ owners are alleged to have borrowed money from their own banks, and to have used some of this money to buy shares in the banks, resulting in an increase in the share price. The SIC refers to this as “weak equity” and it grew to represent more than 25% of the banks’ capital base.

These shares were also used as collateral against loans, further leveraging the banks’ positions.

And the growth of the banks was out of all proportion when compared to the Icelandic economy and the ability of its officers to supervise the banks.

In seven years the banks grew to twenty times their size until their debt issuance exceeded the GDP of Iceland and grossly distorted the requirement for foreign currency reserves. The writedown in the value of the banks’ loans in 2008 was the equivalent of five years GDP.

At the same time, a country of only 320 000 people was not able to provide a sufficiently large and experienced banking oversight regime to handle three large banks.

Finally, there appears to have been insufficiently long arms when lending contracts were established. Not only were loans provided to the banks’ owners, but also to the owners’ other businesses. These other businesses also pledged icelandic shares when borrowing from foreign banks. As the icelandic share prices fell, the icelandic businesses had to repay the foreign banks, and the icelandic banks stepped in to replace this debt, further leveraging the icelandic economy. The SIC summary presentation at the press conference states that “these investment companies had an abnormally easy access to loans in the banks in the capacity of their ownership and influence within them.”

A sorry state indeed.

Note: These images are available for commercial reuse.
Ascending and Descending search
Waterfall search

They can be obtained from:
Waterfall: http://picasaweb.google.com/lh/photo/36X8UHueP5H6pycVt_JBEA and
Ascending and Descending: http://picasaweb.google.com/lh/photo/gwkazaD_DWA9EyY3W0LyfA

The recent financial crisis was exacerbated by several failures, one of which was poor risk management by banks. Previous attempts to coerce management into being more responsible have failed. How about this approach?

In principle, fining companies for risk management failures is not very effective. A fine is a one-off that can be explained as such and the magnitude is of minor importance because financial accounts can be presented excluding the effects of the fine.

However, an alternative approach would be that the capital adequecy requirements of companies are affected by the results of risk management failures. The Basel requirements calculation could be modified to include factors to compensate for poor risk management (evidenced either through the identification of weaknesses during an audit or through the manifestation of a failure).

By forcing banks with poor risk management to hold more capital, this introduces a market adjustment and puts such banks at a competitive disadvantage, thereby encouraging better risk management.

Furthermore, this approach would embody the “prevention is better than cure” principle by improving risk management before banks got into serious difficulties rather than adopting some of the ring-fencing techniques (such as the currently fashionable contingent capital approaches) to prevent contagion and systemic failures.

There would be some pre-requisites for this approach, including:

• improvements in regulatory competence – the failure of the regulators being another reason for the magnitude of the financial crisis
• clear guidelines for assessing the severity of risks to make sure that the capital surcharge penalty was appropriate for the crime
• detailed modelling to ensure that banks cannot game the rules and continue to allow weaknesses because fixing them costs more than the cost of holding the additional capital

So how does this proposal differ from (UK Financial Services Authority Chairman) Lord Turner’s capital surcharge for risky banks proposal?

Well firstly, I should say that the approaches can work together. In fact, they should work together.

The emphasis of the UK regulator’s proposal is a bank’s strategy – additional capital is required in order to engage in risky activities. What Lord Turner’s approach does not cover is banks’ capabilities to manage the risks in these activities. In effect it assumes that all banks are equally competent at risk management.

However, this is clearly not the case.

So the Vox Sapiens proposal suggests that risk management competence is also measured and used to compute an appropriate capital requirement.

So Microsoft (presumably on the advice of lawyers) used the DCMA (Digital Millennium Copyright Act) to force Cryptome.org’s hosting provider, Network Solutions, to close down the website and keep a lock on the domain name to prevent the site being relocated. Then a day later the complaint was rescinded, allowing the site to be restored.

This was a bad thing to do? Why?

OK, where should I start?

Well firstly, it brought huge publicity to the situation, and the number of people aware of it is now many orders of magnitude greater than it would have been. Cryptome.org’s typical readership is a combination of technogeeks, political activists and privacy specialists. Most would have a good idea where to find a document that other parties might wish to keep out of cyberspace. So even if Microsoft had been successful in forcing the removal of the document from the Cryptome.org site, it would have appeared somewhere else, and the people really interested in it would still be able to get to see it.

Secondly, Microsoft has egg on its face. Such a sharp reversal of policy in 24 hours hints at a lack of crisis management expertise in Redmond. Theoretically this could impact the share price, particularly because Microsoft is not a stranger to legal battles, albeit ones that focus on monopolies rather than copyright.

Thirdly, it is another thing to think about when registering a domain name, and could impact the US-located domain registrars’ businesses. If Cryptome.org had been registered with a foreign domain registrar, it would have been out of the reach of the DCMA. I assume this is one reason behind the choice of registrar for Wikileaks. Even if you are a non-US business using a non-US server your site can still be brought down, permanantly, if the domain name is registered through a US registrar.

And fourthly, and most importantly, this will really scare a huge number of Microsoft customers and potential customers. By bringing this action, Microsoft has made the general public aware that it is keeping track of what they are doing, and archiving the information that it knows. Long term, this could be very costly indeed.

This is just the latest in a string of similar foolhardy activities. Why did people not learn from Bridgeport Hospital, from Julius Baer, from Royal Dutch Shell, and from many other large organisations?

When will lawyers learn that just become something is “the law” and their client is “in the right” there might be very good practical and strategic reasons to avoid attempting to enforce it. And when will the large organisations learn to manage their lawyers instead of being managed by them?

Greece uses the same currency as Germany. But Greek government bonds yield almost four per cent more than German government bonds, an all time record for the eurozone.

This is telling us something; really telling us something. The bond market is pricing in a high possibility of default by the Greek state.

Until recently, the market perceived barely any difference in credit risk between different European Union countries. The yields on bonds were pretty similar between countries – so low that some commentators suggested the differences should be greater. But the perceived wisdom was that the risk of default by an alleged profligate state (predominantly those with a mediterranean coastline) was very low, and that even if a default was imminent the other austere and prudent states would step in to help their prodigal sibling.

But Herr Brüderle, the German Economics Minister, put an end to those thoughts. First acknowledging, in a speech to German Members of Parliament (more similar to Representatives than to Senators), that “some euro states are showing dangerous weakness. This may have fatal effects on all states in the eurozone,” he then went on to add that “there should not be a collective bailout for lopsided developments at national level.”

There is likely to be plenty of coverage of the “will they, won’t they” predictions over the next few days. But say they won’t, and Greece defaults. What are the implications? Vox Sapiens will be following this closely and answering the question.

As a footnote, it is likely that the Ouzu crisis will appear as just a small ripple compared to the Shochu crisis. But that’s another post.

The Tata Nano is likely to change the lives of an immense number of families in the developing world, with the possibility that the Indian car market will increase by 65%, according to Standard and Poor’s Indian arm, CRISIL (source India Times). And much has been written about Ratan Tata’s dream of migrating Indian families from two wheels to four.

But how about the developed world? I believe that it will be disruptive here too – by fundamentally altering the tax applied to private vehicles.

Car ownership patterns

The Tata Nano promises to bring a fundamental change to car ownership in the developing world. It is cheap enough to appeal to a new group of car owners for whom no other car is affordable. However, I believe that the Nano is also cheap enough to be affordable as a second, or third, or even fourth car, for developed world families. And it comes with the benefits of new car warranties, rather than the potential cost of breakdowns that accompany used cars that can be found at the same price.

The basic model, the Nano BSII, sells in Delhi, India for about 115,000 Rupees (about 2,400 US dollars), and for between 5% and 10% more in most other Indian cities (source Tatamotors.com). Expectations are that the “Nano Europa” prices in the developed world (meaning mainly Europe, rather than North America) will be a little more than double this – so a westerner will be able to buy one for about 6,000 US dollars (about 4,500 Euros). And the Nano is very economical to run, with the extremely good fuel economy that one might expect from a car that only weighs the same as a Formula One Grand Prix car (including driver).

How many developed world households will replace public transport usage by an additional car at this price? How many parents will be able to provide their eighteen-year-old child (17 in UK, Ireland, Poland) with a Nano so that the child no longer needs to ride the bus to school/college/university, or catch a lift with the parent?

A surge in vehicle ownership

And what will be the effect of all of these additional cars?

Well there have been several comments on the web about the potential gridlock that the anticipated traffic volume surge will create. And also many comments about the environmental effect of the additional exhaust gases, for example:

• The New Scientist Environment Blog
• The Independent (a UK newspaper)

But there has been previous little commentary on how governments will react, particularly regarding fiscal matters.

Welcome the “Nano Tax”

I believe that the time is ripe for an “additional car tax” or “Nano Tax” as it could be called. I think that governments might seize the opportunity to portray green credentials and formulate a new approach to vehicle taxation. And the additional income will be most welcome as a contribution towards paying down the public debt mountains that the recession has given western economies.

For governments this is almost a “must win, can’t lose” story:

• too many additional cars on the road, outpacing road building programmes, will lead to congestion for everybody – so people will support measures that reduce the number of “other drivers”
• governments need to meet the requirements of the Kyoto Protocol – and the notable absentees from the list of signatories, USA and Australia, are not the most attractive markets for Nanos and other ultra-cheap but very small cars, due to their low population densities and requirements to travel long distances
• a tax on additional vehicles does not penalise the poorer families that can only afford one car – in fact left-wing governments could portray this as a redistributive tax if the tax for the primary car was reduced

Forms that the Nano Tax may take

A substantial amount of mathematical modelling would be required to predict the impact of the Nano and how vehicle tax changes might alter the impact. Would a 30% increase in tax be required to avoid a 10% increase in the number of vehicles on the average European highway? I don’t know. My gut tells me that Europe’s citizens will be quite inelastic to changes in the tax charge when offered such a radical reduction in the cost of vehicle ownership. Thus I expect that a major increase in vehicle tax will be required to halt the increase in vehicle ownership, and that governments will need to reduce the tax on the primary vehicle in order that the overall vehicle tax revenue doesn’t increase so much that the governments are accused of profiteering.

And so where will the increase in tax fall hardest? The upper working class and the lower middle class. These groups, already comprising a large number of two-car families, and dependent upon two cars, will not have the disposable income to handle a radical change in second-car tax policy. The lower working class will probably benefit, if the tax on the first car is reduced, due to the low rate of second vehicle ownership. And the upper middle class and upper class have enough disposable income to absorb the additional tax.

So if you are in these social classes, enjoy your second car while you can. In 2011 or 2012 you might find it becoming a luxury that you have to live without.