Global recovery will be slow

A quick economic recovery? Perish the thought. Recovery is going to be slow. The IMF thinks so. So does the RBI.

As the IMF's latest World Economic Outlook makes clear, there are recessions and recessions. The worst are the ones created by a financial crisis, especially a crisis rooted in the banking sector. When recession is globally synchronised, that makes things even more difficult because no country can export its way out of trouble (as the East Asian economies could in 1998). Today, we have a combination of a financial crisis and a globally synchronised recession. So, expect recovery to be a slow affair. Not until 2010, says the IMF, and even then it will be long drawn out.

When you have a crisis rooted in the banking sector, the way out is to fix the banking sector. Sadly, the US administration has been dragging its feet over this for more than a year now. Fixing the banking sector in the US, given the scale of losses, means nationalisation. There is just no other alternative. But nationalisation would wipe out shareholders and too many rich people, including those in the US administration, don't want that. They would like to look for alternatives that preserve shareholder wealth. But every one of these alternatives entails a slow and painful economic recovery.

It won't be a Great Depression for reasons I spell out in my ET column, Don't bank on an early recovery. But it won't be a mild and short recession either.

I wrote my ET piece and sent it off last week as I was due to travel. On my return, I was gratified to note that my assessment accords with that of both Martin Wolf of the FT and the Economist. Wolf writes:

For better or worse, the authorities have decided to bail out their financial systems with taxpayer money. Almost all the affected countries should be able to afford to do this, at least on the IMF’s numbers. So now, having made the fundamental decision to prevent bankruptcy, they must return their financial systems to health as swiftly as they possibly can.

Even so, that will prove to be a necessary, not a sufficient, condition for a return to robust economic health. The overhang of debt makes deleveraging inevitable. But it has hardly begun. Those who hope for a swift return to what they thought normal two years ago are deluded.

Says the Economist:

The worst is over only in the narrowest sense that the pace of global decline has peaked. Thanks to massive—and unsustainable—fiscal and monetary transfusions, output will eventually stabilise. But in many ways, darker days lie ahead. Despite the scale of the slump, no conventional recovery is in sight. Growth, when it comes, will be too feeble to stop unemployment rising and idle capacity swelling. And for years most of the world’s economies will depend on their governments.

Axis Bank theatrics

The curtain has finally been rung down on the succession issue at Axis Bank. P J Nayak staged an undignified walk-out after a stormy board meeting, paving the way for Shikha Sharma from the ICICI group to take over as CEO with board member Prithviraj taking over as interim chairman.

Nayak, going by reports, was completely isolated on the succession issue, with even those close to him for long deserting him in the final moments. Nayak wanted Kaul, an executive director, to succeed him. He has argued in an interview with BS that an organisation should bring in an outsider only if it is weak. Not true. It may need to bring in an outsider also if the insiders are weak (which can happen in an organisation that is strong but has been a one-man show).

Nayak had earlier successfully resisted the RBI's efforts to bifurcate the positions of chairman and MD, saying he needed time to groom a successor. It turns out that he failed to do so even when given adequate time. This is not uncommon- BS had an edit yesterday mentioning the cases of L&T and ITC where the present chairmen seem to think themselves immortal.

The right thing has happened at Axis Bank and this is, in large measure, due to the role played by the nominees of SUUTI who presented a united front on the issue and made the process of finding a successor rigorous. It appears that even in a private bank, it is the government that has to be around to ensure the right outcome. This will not come as a surprise in the present times where the same phenomenon is being seen on a bigger scale in the US banking system and elsewhere.

One last point. Nayak's quitting as chairman in a huff was inappropriate. One could have understood if some legal or ethical issue had been involved. There wasn't any. Nayak left in a fit of pique only because he couldn't have his way.

This isn't done. Banks run on confidence and for an executive chairman to walk away without ensuring a smooth hand over can be potentially harmful. It's a different matter that the Indian banking system is in good shape and that we need not fear such an outcome in the present instance.

Incidentally, I was told that AT Paneerselvam, board member at Axis and former chairman of IBA, collapsed in his car and passed away while on his way to the airport from the seven hour board meeting. Strange that no paper has reported this.

Return of good times for US banks?

Several top US banks including Citigroup and Goldman Sachs have reported impressive results in the first quarter. Some have interpreted this as a sign that the banks are finding their way back to good health and they also see this as good news for the world economy.

Sorry, it ain't all that great. Even if banks start making profits, it only reduces accumulated losses - or helps banks write off bad assets. it does not help increase the quantity of loans- and more credit is what is required to get the wheels of the economy going. The balance sheets of US banks will shrink this way until banks are restored to health. This slow process of recovery helps shareholders who would otherwise be wiped out at one stroke if the US government were to nationalise them- which is why the government, run by ex-bankers and investment bankers, doesn't want to take that step.

Moreover, US bank profits have been helped by regulatory forbearance in several ways as an article in the FT points out:

First was the decision by the Federal Accounting Standards Board on April 2 to modify what many bankers considered the FASB’s onerous mark-to-market rules forc­ing securities firms to write down the value of their assets as they lost value in the in­creasingly illiquid market. (Seems like a reasonable idea to value assets at what they are really worth, no?) The FASB had been reviewing this change and received much commentary from the financial community “that asserted that fair value is not as relevant when financial markets are inactive or ­distressed”.

.....The Federal Reserve has also been listening carefully to the banks’ pleas. It has lowered the cost of money it charges banks – and since all the big Wall Street securities firms are either gone or have become banks, this means virtually everyone – to close to zero.

Then there is the sleight of hand, at least in the case of Goldman Sachs, which, when it converted from a securities firm to a bank holding company last autumn, changed its fiscal year-end to December 31 from November 30. Its first-quarter numbers, for the three months ended March 31 2009, did not include its horrific December results – into which Goldman threw everything but the kitchen sink – of a loss of more than $1bn. During the past seven months – including December (there was Christmas, right?) – Goldman in fact lost $1.5bn.

So much for the good news from the US.

Will banking become boring?

What world of banking can we expect to see once the dust settles down in the present crisis? Regulations will be more stringent and three elements will be central to the new world of banking- higher capital, constraints on financial innovation, restrictions on bankers' incentives. Higher capital requirement in itself spell lower returns and hence lesser rewards in banking. In other words, banks and "shadow banks" will have a presence in the economy that is more consistent with the requirements of the real economy instead of becoming a world unto itself.

This is greatly welcome when you consider the atrocious waste implied by the disproportionate flight of high quality talent towards finance in recent years. Finance and IT are two sectors that have completely distorted the labour market in India- and we should welcome the fact that both are being put in their places.

More on this in my ET article.

Academics in government

There has been much criticism about how the "dream team" of Manmohan Singh, Montek Ahluwallia and P Chidambaram did little or nothing on economic reforms. It's interesting that two of the three members have strong academic credentials. An article in FT echoes the criticism:

The whole reform programme relies on the prime minister himself. Mr Rao and A.B. Vajpayee proved their mettle, despite heavy political constraints. Mr Singh has failed; he should bear much of the blame. The Congress party does not deserve to be re-elected and the dream team does not deserve to continue in office.

It also has some strong things to say about academics in positions of authority:

........Mr Singh has proved a hopeless decision-maker as prime minister. Sadly, he proves the rule that academics should generally be “on tap” but not “on top”.

Lincoln and leadership

Leadership, as I have noted earlier, is, perhaps, the most written about topic in the Harvard Business Review - it's covered even more than that other perennial favourite of management gurus, strategy. I am inclined to believe that if all the literature on leadership has simply led on to more literature, then leadership must be pretty difficult to teach or learn- either you have it or you don't and the only real teacher can be life itself.

This feeling was reinforced by an interview in the latest HBR on Abraham Lincoln and leadership. The interview is with historian Doris Goodwin, whose book, Team of Rivals, is the one book that President Obama said he would take to the White House, apart from the Bible. Goodwin says of Lincoln's secret of leadership:

Lincoln surrounded himself with people, including his rivals, who had strong egos and high ambitions; who felt free to question his authority; and who were unafraid to argue with him.
.....Obama is obviously trying to do the same thing by choosing his chief rival, Hillary Clinton, to be secretary of state; by picking rival Joe Biden as his vice president; and by including powerful Republicans in his cabinet like Robert Gates and Ray LaHood.

But you have to remember, the idea is not just to put your rivals in power—the point is that you must choose the best and most able people in the country, for the good of the country. Lincoln came to power when the nation was in peril, and he had the intelligence, and the self-confidence, to know that he needed the best people by his side, people who were leaders in their own right and who were very aware of their own strengths. That’s an important insight whether you’re the leader of a country or the CEO of a company.

Hmm.... Let me see.... I have worked for several organisations, corporate and academic, served as consultant to and board member on quite a few. How many places can I think of where the person at the top did what Lincoln did- put strong people, including rivals, in key positions and let them fight it out with him? Only one !- and this was my immediate boss, not the CEO.

This was one boss who did not feel insecure about having people superior to him working for him, indeed he openly declared that he was inferior. Did he make it to the top? No way- he didn't last long in the corporate world and ended up as a small farmer in his village.

It may be well be that you need Lincoln's ability to surround yourself with strong people in order to be a super-achiever. But this ability, I am afraid, is rare and I can't see that it is something that people can be taught. That is why Lincoln is Lincoln, one of the towering figures of all time while many corporate and other leaders have ended in the dust-bin of history.

Satyam sale

The sale of Satyam to Tech Mahindra is a morale booster, never mind the ifs and buts as to whether the buyer can make a success of the acquisition. For once, the print and visual media were willing to acknowledge the role played by the government in preventing a debacle and arranging a rescue.

It's an amazing end when you think of how things would have ended in, say, the US. The moment the fraud came to light, the company would have gone into bankruptcy proceedings and it would have been embroiled in litigation. In a software company, value comes from intangible assets- the people and the brand- so there's little that investors can claim from liquidation and litigation.

The only hope is to turn the company around under new management and wait for the stock prices to revive. Those who filed class action suits in the US may well find that they may be better off waiting for the stock price to rise instead of trying to claim a settlement from the new management.

In making the decision that Satyam was too important to go under and that it could and should be revived, the Indian government was spot on. It also acted swiftly in putting in place a new board and the regulatory authorities helped by creating a fresh set of rules for takeovers in such exceptional cases. (This was wrongly derided by some as being anti-investor, overlooking the fact that we are talking of a company that was on the brink of a collapse that would have washed out investors altogether).

What can we learn from this episode? One is that government may need to intervene in the case of any systemically important institution, not just those in the financial sector. The second lesson- driven home already by the financial crisis- is that 'leave it to the market' can be sheer nonsense in such situations.

US gunmanship in Somalia

The US showed what it means to be a superpower when it effected a terrfic rescue of the captain of a ship, a US citizen, held hostage by pirates in the high seas off the coast of Somalia. The only detailed report of the rescue operation I came across was filed by Chidananda Rajghatta in TOI ( in the print edition, I can't trace it on the web, so I'm going to describe it in my own words).

The captain had been seized and held by four pirates after a failed piracy attempt in which the pirates were repelled by the ship's crew. They managed to escape on a motorised lifeboat with the ship's captain and were adrift for five full days. The US navy sent its warships into the area to hem them in and then ensured that other pirate vessels attempting to enter the area were shooed off.

The US navy then engaged the pirates in negotiations even as the pirates' rations and fuel ran out. One ship offered to tow the lifeboat away from choppy waters into calmer ones- this brought the lifeboat within firing range of the snipers on board the US ship. One pirate was taken aboard the US ship to help with the negotiations. President Obama, who was kept in the loop througout, gave the US navy the command to go ahead and shoot if the captain' s life was judged to be in imminent danger.

When the negotiations did not progress and the pirates came within the snipers' cross-hairs, all three pirates on the lifeboat were taken out with one bullet each. The pirate on board is in US custody and the captain is flying home.

The successful end saved President Obama an early security embarassment- Americans don't take kindly to botched military missions or the deaths of US citizens- but the head of the pirates has accused the Americans of treachery saying his colleagues had been ready to given up the captain without ranson when they were shot. Unfortunately, some 200 seamen from other nations and from various ships are being held hostage by various groups of pirates. The pirate chief has also warned of revenge against Americans seen in the waters again.

Reducing risk in the financial system

Naseem Taleb, former trader and something of a maverick in his views on the financial system, comes up with 10 rules for making the world "black swan free'- a black swan is that rare event which can end up destroying an institution or a system. His tenth rule I found particuarly drastic:

Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

His first two rules are also highly sensible but not easily enforceable:

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.

2. No socialisation of losses and privatisation of gains. Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.

Inflated claims at G-20

The headline grabbing item from G-20 was talk of $1.1 trillion in fresh funds to fight the recession. Most analysts were quick to point out that this included funds already committed. What was not noticed was that it includes amounts intended to be committed but which are unlikely to be committed. FT dissects the G-20 claim and finds that the correct figure is closer to $100 bn:

Almost half – $500bn – comes in the form of new money for the IMF so that it can guarantee it has enough money to lend to countries caught up in the financial crisis.

Japan unilaterally gave $100bn last November, while the EU pledged €75bn ($101bn) in March. There were no new commitments from the US, China or Saudi Arabia on Thursday, and instead a generalised pledge for a new financing scheme of $500bn into which all these existing commitments and new money would be placed.

.....If the new commitments to the IMF were conspicuous by their absence, the $250bn of new money in Special Drawing Rights – the Fund’s own currency – was new but not all it seems.

....The policy is significant because it represents new money that poor countries can turn into dollars, euros, yen and sterling but rich countries will get most of this new foreign exchange reserve. The group of seven largest and most advanced world economies will get 44 per cent alone. March.

On trade finance, ........ the $250bn figure fails to stand up to minimal testing. An annex to the communiqué says that the new money committed is only $3bn-$4bn and the $250bn figure is an aspiration for the amount of trade that will be financed over the next two years rather than the amount of new trade finance.

In contrast, the new $100bn of lending by multilateral development banks is much closer to reality.

When all the sums are added together, rather than $1,100bn, the new commitments appear to be below $100bn and most of those were in train without the G20 summit.

Turner Review

A number of committees in several countries are working on proposals for financial sector reform. In the UK, a committee headed by the chairman of the FSA, Adair Turner, has submitted a report, the Turner Review, backed by a Discussion Paper. It has 28 recommendations for regulatory reform along and another four issues thrown open for discussion.

What is striking about the Review is the pronounced swing of the pendulum in favour of tighter regulation and away from reliance on market discipline. The Review does not mince words:

“The financial crisis has challenged the intellectual assumptions on which previous regulatory approaches were largely built, and in particular the theory of rational and self-correcting markets. Much financial innovation has proved of little value, and market discipline of individual bank strategies has often proved ineffective.”

I have a critique of the Review in my ET column, One hell of a page turner. I seriously doubt that any future government can proceed with the substance of the recommendations of the Percy Mistry and Raghuram Rajan reports.

Let me highlight one important point made in the Review. It does not believe that separating commercial banking from investment banking will make the banking system any safer and it also believes that not having complex banks catering to multiple needs across the globe would entail forgoing significant benefits. Some of the arguments it makes in favour of not distinguishing between 'utility banking' and 'investment banking' are:<>

• while it is clear that the securitised credit model evolved in a fashion whichundermined the initial proposition that it would prove lower cost and lower risk, it is important to recognise that, if more effectively regulated and supervised, it could have thosenarrow banking, whose severity might have been reduced if an appropriate form of securitised credit trading and credit insurance had been in place.
• Furthermore, any idea that risky trading activities in institutions outside the utility banks, can be allowed to grow in an unregulated fashion, subject only to the market discipline that they will not receive LOLR or fiscal support in crisis, is not credible in a world of interconnected markets. Bear Stearns was not involved in any significant way in utility banking activities; but when it was on the verge of failure, the US authorities rightly identified it as systemically important.
• Finally, it is important to recognize that ‘narrow banks’ focusing almost entirely on classic commercial and retail banking activities can be extremely risky. NorthernRock,WashingtonMutual and IndyMac were all ‘narrow banks’.

G-20 protests focus on bankers

The G-20 meeting in London is attracting protests in the City of London. The target of the protesters' ire this time is not globalisation or climate change but banks. Entirely understandable given that banks are perceived to be at the root of the present chaos in the world economy and that several bankers have had no qualms about pocketing bonuses even when their banks were being bailed out by tax payer money. Sir Fred Goodwin, the erstwhile CEO of RBS, has had his home in Scotland vandalised.

FT carries a story on the protests:

Four marches, led by representations of horsemen of the apocalypse, converged on the Bank in the Financial Fools’ Day protest as demonstrators chanted “storm the banks”.

...Some of the banners read: “Balls to the Bankers”, “Eat the Bankers”, “Capitalism Isn’t Working” and “What a Load of Bankers”. One group of protesters urged people watching from the top of Santander bank to “jump”.....Olivier Dale, a 28 year old attending the demonstration said: ”I am sick of these bankers and this greed. It has got to stop. We have to make a stand. But we want it to be peaceful.”

...Most big employers – including the global investment banks and law firms – told employees they were expected to come into work as usual. But those near locations where demonstrations were held told staff to dress inconspicuously and avoid drawing attention to themselves.

Financial sector assessment programme

The RBI has finally unveiled its document arising from the financial sector assessment programme. Here is the link to the PPT and the report. It is, on the whole, an upbeat assessment of the state of Indian banking. Commercial banks are in good shape. Cooperative banks, regional rural banks and NBFCs constitute the problem areas.

There are clear signals in the document that the RBI will tread warily when it comes to financial sector reform- and especially in areas such as capital account convertibility, foreign banks and securitisation. No serious student of Indian banking afford to miss this report of the RBI.

A less profitable banking sector

Banking in the industrial world will be less profitable in the years to come than in the past. This is even after those economies recover- whenever that happens. One reason is that capital requirements will go up as regulators push banks towards lower leverage. Another is that high-risk products will come under the scanner and banks won't find it easy to hawk these.

Of course, there will be a shakeout and capacity will shrink. But that doesn't mean survivors will have easy pickings. Demand too will shrink - a whole range of securitised products and derivatives will find very little demand. An article in FT notes:

According to analysts at Citigroup, European banks earned a return on equity of 18-23 per cent between 2003 and 2007 compared with 12-15 per cent in the mid-1990s.This shift mainly reflected more borrowing: European banks’ leverage – the value of their assets as a proportion of their equity – rose from 24 times on average in 1995 to 39 times in 2007.

What about the banking sector in India? Here too, expect banks to be operating at a capital adequacy of around at least 15%. But volume growth will be strong- 20% or so- and margins are still higher than those elsewhere. Besides, the massive churn in thinking occasioned by the present crisis will mean continued caution in opening up to foreign banks, which are potentially the most potent threat to the profitability of domestic banks.

In short, over the next five years, expect the banking sector in India to be almost as profitable as in the recent past- and an outperformer in the Indian economy.