Wednesday, June 21, 2017

Banking fragility remains an issue

A certain complacency seems to have set into the banking sector following the reforms put in place after the financial crisis of 2007. Bank managers especially think that banks are safe now, thanks to the combination of higher capital requirements and living wills. Jamie Dimon, chairman of J P Morgan Chase, typies this point of view.

I am among those who would beg to defer. Banks may be better placed than before but banking systems remains fragile. Regulators need to raise the capital requirements even further. The minimum leverage ratio (the ratio of equity to assets) for banks is general is 3%; for systemically important banks, it's 5-6%. The US Congress has a proposal which would give banks a choice of going with Basel 3 and the Dodd-Frank provisions or having a leverage ratio of 10%. The latter is indeed the way to go.

More in my EPW article, Are banks safer today than before the crisis.

Thursday, June 15, 2017

Watch it: the wrong joke could cost your your job

A joke deemed sexist has cost a board member of Uber his place on the board, FT reports. Board member David Bonderman, had to quit after he interrupted Ms Arian Huffington, fellow member on the board, with a remark that was considered inappropriate:
As Ms Huffington was telling staff that research showed boards with one female director were more likely to appoint a second, Mr Bonderman interjected: “Actually what it shows is that it’s much more likely to be more talking.”
Ms Huffington laughed awkwardly and said it would be his turn to talk soon. After the meeting, Mr Bonderman emailed Uber employees to apologise — and later announced he was resigning from the board. 

The problem, of course, is that the remark could not have been made at a worse time. The board of Uber is dealing with serious cultural issues, including issues of harassment, highlighted by a report commissioned by the board. The report has led to the exit of several senior executives and the founder and CEO, Travis Kalanick, has proceeded on indefinite leave, although it appears he will still be involved in strategic decisions and key leadership appointments.

The refreshing takeaway from the turmoil at Uber is that the world is no longer going to accept a firm just because it has a great valuation. Culture matters. Which means how you create value is also important. It's hard to beat a quote the FT carries on the subject:
“The spoiled brats of Silicon Valley don’t know the basics,” said Vivek Wadhwa, a fellow at the Rock Center of Corporate Governance and author. “It is a revelation for Silicon Valley: ‘duh, you have to have HR people, you can’t sleep with each other . . . you have to be respectful’.”

Sunday, June 11, 2017

Tech firms' cash pile

Infosys, TCS, Cognizant and other Indian IT firms have had to take tough questions from investors on the cash pile they have been sitting on for years. This pile produces low returns from investment in bank deposits and the rest. Investors think if the firms have no investment avenues for the pile, they should return much of it to investors. At long last, the tech firms have said yes.

Huge cash piles are not limited to Indian tech firms.Schumpeter points out that the top five tech firms of the world- Apple, Alphabet, Microsoft, Amazon and Facebook- are sitting on a net cash (cash minus debt) pile of $330 bn, twice their gross cash flow. This is set to touch $ 680 bn by 2020, three times their cash flow.

One reason for the cash pile is that much of it is stashed away abroad and not brought back to the US in order to avoid tax. But the tax bill by itself does not justify the cash hoard. Another reason is having to making large investments in R&D. The five tech firms spent $100 bn on investment last year. For them not to grow their cash pile, Schumpeter estimates that investment would have to rise to $300 bn. That is a staggering figure by any reckoning:
That is over twice what the global venture-capital industry spends each year. It is 51 times the annual cash burned up by Netflix, Uber and Tesla, three firms famous for being cash hungry. And it is 37 times the average annual amount of cash the five firms have in total spent on acquisitions to gain new technologies and products, such as Facebook’s $19bn purchase of WhatsApp, a messaging service in 2014, or Google’s $3.1bn acquisition of DoubleClick, an advertising firm, in 2007.

What could be the reason then for the cash pile? Schumpeter reckons that uncertainty about future profit could be a factor. The tech firms probably reckon that the cash pile may not grow as much as projected now, given that various threats could emerge. But if they do manage to add on to their cash they may diversity in a big way into cars, media or hardware firms. 

Friday, June 09, 2017

Harvard Business School sources of funds

Schumpeter, writing in the Economist, gives an interesting breakdown of the sources of funds for HBS: tuition fee (17%), executive education (23%), publishing (29%) and endowments (31%). The IIMs and other business schools should compare their own funding pattern with that of HBS and see how they stack up. The crucial thing to note is that tuition accounts for only a sixth of revenues.

The break-up for IIMA in 2013-14 (the last year for which the annual report is available) is: tuition fee (43%), consulting (22%), interest income (21%) and others (14%). It should be clear that tuition bears a much bigger chunk of the burden of generating funds at IIMA than at HBS.

Tuesday, June 06, 2017

Compelling case for the RBI to cut its policy rate

I argue in the Hindu today that the case for a rate cut is quite compelling. It's not just that CPI inflation is below the RBI target of 4%. The strengthening rupee and strong capital inflows address a concern RBI would have had even a few months ago: lowering the gap between Indian and dollar yields would cause an exodus of funds and destabilise the rupee. We don't have to worry that much about the Fed stance at the moment.

A rate cut will not just boost growth, it will help the bottom lines of banks and that of corporates- it would help address the "twin balance" sheet problem. The problem, as I see it, is that the RBI committed itself to a 4 per cent inflation target when the government gave it a flexible band of 4 plus or minus 2 per cent. Now, that's called being overzealous.

By the way, Surjit  Bhalla flays the MPC today for getting its inflation forecasts hopelessly wrong:

At its first demonetisation meeting on December 7, the MPC concluded that demonetisation was temporary and so, it should look through its effects on dampening inflation and growth. It expected inflation and GDP growth to hustle up in a “V-shaped” pattern. The reality — GDP growth has been flat at 7 per cent, inflation has followed just the first half of the V. The MPC’s post-demonetisation short-term three-month forward forecast for March 2017 was 5 per cent with an upside bias. Actual March 2017 CPI inflation — a low 3.5 per cent! Actual April CPI inflation — 3 per cent. I have searched far and wide but not found any central bank, or even an amateur economist, with such a large forecast error for a three-month projection. These forecast errors are liable to get worse.

He also points out that the RBI has moved deftly from targeting headline inflation to what he calls a "false" measure of inflation:
First, the MPC broadly hinted that it was going against its own mandate of targeting headline inflation and was now considering targeting core inflation. But most brazenly, it chose to emphasise false core inflation as its target, that is, core inflation including petrol. No central bank in the world targets false core; it seems the RBI felt it was appropriate to do so because oil prices were hovering round $55/barrel and domestic petrol prices were inflating at 18 per cent per annum. So false core was sticky at 5 per cent, as the MPC “rightly” concluded. However, no sooner had the MPC penned this excuse that oil prices (internationally and domestically) began to fall. And, along with it, false core inflation. The April CPI data, released just days after the MPC excuses on April 7, now showed even false core hovering around 4.4 per cent, having declined from 5 per cent a month earlier.
True core inflation — CPI minus food minus energy minus petrol — meanwhile continued its downward trend, 5.3 per cent in April 2016; April 2017, it registered 4.2 per cent.

That's a pretty strong indictment. It's necessary to require the MPC to publish its forecasting record- forecast inflation versus actual - every time it meets. There is a fundamental problem with the MPC mandate: the MPC has to explain if inflation exceeds six per cent but not if inflation falls below 4 per cent (unless it dips below 2 per cent which is a remote possibility). Put differently, the MPC is accountable for inflation but not for growth. There has to be a way to address this issue. A good starting point is to publish the MPC's forecasting record.

Monday, June 05, 2017

My latest book- on bank regulation- is out


Happy to share with you that my latest book is out. It's titled Towards a Safer World of Banking: Bank Regulation after the sub-prime crisis and is published by Business Expert Press in New York.

The book reviews the record of financial crises in the past and the changes to bank regulation since the sub-prime crisis. It argues that these changes are inadequate. It contends that we need to think of some of the out-of-the-box solutions proposed and it also suggests that regulators elsewhere may have something to learn from the experience of the Indian banking sector.

Here's the link to the book website.

Tuesday, May 16, 2017

Capital is crucial to resolving India's bad loan problem

The government's Ordinance empowering the RBI to take steps to resolve the bad loan problem, it is hoped, will make a difference. It can- provided the government is willing to back it with the necessary capital. Indeed, by not infusing capital into public sector banks for so long the government has caused the bad loan problem to worsen. This is because banks have not been able to write off bad loans and because they haven't been able to expand credit, which, in turn, results in the bad loan to advances ratio looking bad.

Over a two year period, I expect the government will need to put in around Rs 100,000 crore. Mention something like this and you will see another round of public sector bashing. There will be calls to privatise PSBs because putting capital into them is "money down the drain".

Rubbish. You only have to look at the capital that governments in US and Europe have poured into private banks in order to see that this contention doesn't hold water. And here's an astonishing fact: the recapitalisation cost of India's PSBs, even if the government puts in Rs 100,000 crore on top of the Rs 70,000 crore it has committed under Indradhanush would be among the lowest in the world!

More in my column in BS, Don't dither on bank recapitalisation.

Don’t dither on bank recapitalisation
Following the financial crisis of 2007, America’s banks have bounced back faster than those in Europe. There’s little dispute as to how this happened. The authorities in the US moved faster to recapitalise banks than their counterparts in Europe. In the US, the government pumped $245 billion into banks. The banks eventually repaid $275 billion, including interest and dividend. 
There had been colossal failures in both management and governance at American banks. Yet, nobody argued that recapitalisation should be held back until these were overhauled. The rule in a financial crisis is simple enough: Recapitalise as quickly as you can. At many banks in the US, CEOs were replaced. There were some changes in the composition of bank boards. But the infusion of capital did not await a sea change in management or governance. 
If governments in US and Europe had withheld capital from banks until they had made sure that it would be used wisely, they might have waited for ever. Recovery in those economies would not have happened.  
The contrast in the approach pursued in India could not be starker. In 2015 , the requirement of equity capital at public sector banks (PSBs)  was estimated at around ~2,50,000 crore out of which at least ~1,25,000 crore was to have come from the government. Under Indradhanush, the government committed a much smaller amount — ~70,000 crore ($11 billion) — over a four year period, 2016-19.
In 2016, following the Asset Quality Review, bad loans, and hence the requirement of capital, soared. The government has, however, stuck to the sum committed under Indradhanush. It also took the position that capital would be given strictly on the basis of performance — weaker banks would have to fend themselves. It was a case of too little, too late. We should not be surprised that banks have sunk deeper into the mire and economic recovery has been tepid. 
Those opposed to giving capital to PSBs contend that mismanagement and poor governance are mainly responsible for the bad loan problems at PSBs. Infusing more capital into them would be only “money down the drain”.They should have said this to governments in the US and Europe who poured capital into privately owned banks during the financial crisis. 
The crisis of 2007 was only the latest in nearly 150 episodes of banking crises in 115 economies in the past four decades. Private banking systems plunge into crisis time and again. Each crisis makes enormous demands on tax payer money. That does not seem to be “money down the drain”. 
It is not true that the bad loan problem in India is mainly on account of mismanagement. The Economic Survey (2016-17) says emphatically, “Without doubt, there are cases where debt repayment problems have been caused by diversion of funds. But the vast bulk of the problem has been caused by unexpected changes in the economic environment: Timetables, exchange rates, and growth rate assumptions going wrong.” Translation: The bad loan problem is the result mostly of factors beyond the control of bank management.
If the finance ministry takes its own Chief Economic Advisor seriously, the course for the government should have been clear enough long back: Provide enough capital to PSBs, ensure  the right people are appointed as CEOs and strengthen the boards. None of this happened. The bad loan problem has remained unresolved. Together, these have led to a worsening of the financials of PSBs.

The government seems to have finally come out of its stupor. An Ordinance that empowers the RBI to address the bad loan problem has been issued. CEOs have been appointed at 10 PSBs. But these moves will not suffice unless they are backed with adequate capital. This year’s provision of ~10,000 crore means nothing. If bad loan resolution happens, the amount required this year alone could be up to ~50,000 crore.

Most people will recoil in horror at the sums involved. They will wail that PSBs make unacceptable demands on the exchequer because of inefficiencies inherent in public ownership of banks. This is an absolute myth.

The way banking systems are designed today, they are prone to failure — and these are overwhelmingly private banking systems. Governments everywhere incur recapitalisation costs from time to time. The best we can hope for is that the costs stay below an acceptable threshold. The Vickers Commission in the UK defined the threshold as an annual cost of 3 per cent of GDP. If this seems excessive, a cost of 5 per cent of GDP over, say, two decades would be the absolute minimum.

The cost of recapitalising PSBs over the entire period 1994-2016 amounts to less than 0.5 per cent of India’s average GDP in the period. This is about the lowest recapitalisation cost that any banking system in the world has inflicted on the economy. Enough of dithering. The government should put in whatever it takes to recapitalise PSBs.