Incriminating email trail

Remember Henry Blodget? He was the Merrill Lynch analyst who acquired notoriety during the dotcom bubble when his email showed that he was having views on stocks that conflicted with what ML put out officially for its clients.

Well, credit rating agencies appear to be facing the same problem. Jaimini Bhagwati, writing in BS,quotes a manager at S&P as sending an email to a colleague saying that the rating agencies continue to create an “even bigger monster — the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters”. (Source: Summary Report of Issues Identified by the Securities and Exchange Commission Staff’s Examinations of Select Rating Agencies dated July 2008).

As investigations into failed institutions continue, we can expect to see more such email. Strange that financial sector employees don't learn from mistakes made in the past even in elementary matters. The operating rule should have been: never express opinions over email.

Pastry eating competition claims life

This item took my breath away: an engineer at Nokia Siemens Networking in Gurgaon died while taking part in a pasty-eating competition at the office at lunch time.

A lunch-hour pastry-eating competition’ among colleagues at an MNC office in Gurgaon turned into a grim tragedy when one of the contestants’ choked and died after eating too much, too fast. Saurav Sabbarwal, 22, working as solutions engineer with Nokia Siemens Networking , was declared ‘brought dead’ at the Max Hospital after colleagues reportedly found him unconscious in the office

Bail out for India Inc

TOI carried a story yesterday saying that Ratan Tata had written to the PM asking for a special fund to be created for Indian companies that have borrowed abroad in recent times but now face the prospect that loans will either not be rolled over or will be too expensive.

The report says that about $45 bn could become due for repayment by December- and much of this would now have to come from the Indian banking system. This amounts to a bail out by Indian banks for two reasons. First, it is not clear that Indian banks would take this sort of exposure of their own accord. Secondly, the cost cannot be very different from that of the earlier foreign currency loans, which would imply a subsidy.

The danger is that, in dealing with the present funds crisis faced by India Inc, we are left with an enfeebled banking system. A better solution would be to have a special fund supported by the fisc. Alternatively, if the banking system is to provide funds, the implicit subsidies should be borne by the exchequer. The banking system and the tax payer need to be protected from the costs of the excesses indulged in by Indian companies.

Nothing "altruistic" about it

Layoffs are taking place but, perhaps, not in a big way since the PM made it clear to businessmen that they ought to show restraint in the matter. The deal seems to be that government will do what it can by way of bail-outs or interest rate cuts in exchange for industry not resorting to layoffs in the run-up to elections.

Some companies have the taken the route of leaving it to employees to take a year or two off. Some employees may avail of it for family reasons; others might want to try out a new job. This sort of voluntarism is useful- provided it is truly voluntary.

I must confess, however, that I am not bowled over by Infosys' suggestion that employees take time off in order to devote themselves to "altruistic" activities, say, working for NGOs. One report indicated that Infosys was even considering paying upto 50% of salary for those taking a year off.

If the intention is to incentivise certain kinds of leave, then giving 50% of pay to those joining NGOs makes sense. But if the intention is simply to cut costs, then why would Infosys want to specify what employees do with their leave? How does it matter to Infosys whether somebody joins SEWA or Oxfam during his or her leave period or the film industry? It's a good idea not to confuse "altruism" with shareholder wealth maximisation.

Improving bank governance

I have written earlier about how the collapse of big financial firms marks a disaster in governance. The world's leading bank boards did not have a grip on risk management, indeed many boards lacked banking expertise. FT carries an article that proposes radical overhaul of bank boards:

• Board should discuss risk exposures
• Boards should disclose their approach to managing risks

These two roles boards may be called upon to play even now even if they are not done properly. The author adds two more:

• The regulator should have the right to interview non-executive directors to discuss their risk assessments and publish transcripts of these- the idea of these "fiduciary risk reviews" is to give investors an idea of how conversant boards are with their firm's risks
• Regulators should have the right to appoint two or three public representatives as observers on boards so that the tax payer is represented in some way. These public representatives would report to the regulator on how well they think the board has handled risk.

What to make of these proposals? First, they would require a much higher degree of expertise on risk management than most boards today have. Secondly, non-executive directors undertaking such onerous responsibilities would have to be properly remunerated.

In India, I am glad to say, the basic framework for such mechanisms exists.The RBI requires bank boards to have a Risk Management Committee to monitor risks. The minutes of these meetings would be available to RBI inspectors. There is also room for public representatives on boards of public sector banks although these, more often than not, end up being hand-picked by management. There are also officer and employee representatives on PSB boards.

This entire structure, to my mind, is preferable to what the FT article oposes- interviews with non-executive directors conducted by the regualator seem inquisitorial and may not be productive. Besides, the article misses the point about board room reform: independent directors need to be truly independent.

This can happen only if some independent directors at least are appointed by institutional shareholders. You can't have an independent board if all the members are selected by management. It is the lack of independence on the part of the board, not so much lack of expertise, that explains there has been a governance failure in the financial sector.

We must have board members appointed by financial institutions and at least one by retail shareholders. Employee representation on the board is also a healthy check on management- after all, it is employees who best know what is going on in the bank.

Unless and until we have truly independent boards, corporate governance will remain pretty much a farce.

Goldman Sachs practises abstinence

Goldman Sachs top executives will forgo their bonuses for the year, says a report in BS today. That would be in order. The firm is due to post a loss for the coming quarter. Even otherwise, as part of the troubled financial sector, the firm's top brass would have come under fire had they dare to make bonus payouts this year.

Is it enough to forgo bonuses? Goldman is one of the recipients of equity from the US government. It was allowed to turn itself into a bank, giving it access to unlimited central bank liquidity. Surely, there is a cost to be assigned to this? There should be "shadow" costs for subsidies for these kind which should be factored into a firm's annual profit/loss figures. If there is a loss, there is a case for top executives to pay back some of their ill-gotten gains of the earlier years.

This would not be revolutionary in today's context- UBS is said to be contemplating a move get its senior executives to cough back their bonuses from the past. Incidentally, UBS is the first investment bank to implement a model that I have consistently advocated since the outbreak of the crisis- bonuses when the firm is making profitsl and paybacks to the firm when there are losses. Here is the relevant excerpt from an FT report:

For next year, compensation for the group’s top 2-3 per cent of staff will be revised to put more emphasis on long-term performance. Under the changes, bonuses in cash and shares will be staggered over a period of three years. The bonuses will also be adjusted to take into account losses as well as profits. Mr Kurer said the system would set a trend.

Off balance sheet hit for Indian banks?

Indian banking, we have been told, is insulated considerably from the sub prime crisis. The FM has reeled off figures for bank exposures to sub-prime and other international assets- these are extremely low in relation to the size of the Indian banking system.

Are we safe, therefore? I am not so sure. I have been going through RBI data and I am beginning to feel that some of the liquidity crunch we are experiencing now may the result of the impact of off-balance sheets items on banks. It is the subject of my last ET column, Mystery of missing liquidity.

Most people think that there is a credit shortage because corporates are substituting Indian credit for credit accessed abroad as foreign funds have dried up. This is, of course, true. But it may not be the only reason for the credit crunch. I notice that in the last three months, there is a huge surge in credit ($37 bn) -quite unusual in a non-busy season. In the same period, there is a huge forex outflow- $53 bn out of the financial year's total outflow of $56 bn.

The international financial crisis is not recent, so why the sudden surge in Indian credit and the corresponding forex outflow? My guess is that the credit surge is dollar-related. And it is not just going towards servicing imports earlier met through suppliers' credit. Much of the growth in credit, I am inclined to believe, is on account of the crystallisation of off-balance sheet obligations in the balance sheets of banks.

Banks have sold forex and other derivatives to corporates left, right and centre. Corporates would incur mark to market losses on thesee. On banks' balance sheets, they would show up as loans to be recovered from corporates. There would be forex outflows relating to settlement of transactions on maturity. There would also be heavy forex outflows involving banks remittting funds to their overseas branches. These would also show up as loans on domestic balance sheets.

Off balance sheets obligations in the Indian banking system have grown exponentially- from 56% of balance sheet in 2004-05 106% in 2007-08. In new private banks, the growth has been larger- from 173% to 301%. Foreign banks had off balance sheet obligations of 1800% of balance sheet in 2007-08. I wonder how the RBI overlooked this sort of growth in contingent obligations. Some of them appear to be coming home to roost.

In the sub-prime crisis, contingent obligations are at the root of banks' problems. There, the exposures were mostly towards securitisation vehicles and credit default swaps. In India, these obligations seem to be more in the nature of forex derivatives. Banks abroad face losses as a result of their exposures; Indian banks are seeing an 'involuntary' expansion in loans.

But the end result is the same: a shortage of credit with all its malign effects on the real economy. We need to quantify the impact of contingent obligations on Indian banks. It would be the ultimate irony if the Indian banking system, which is said to be insulated from the international crisis, were to get infected in a big way by contingent obligations.

Public sector banks and customer service

I had meant to write something under this heading but couldn't proceed beyond writing up the title because my blog got jammed for several days. The title without any write up itself drew several comments- including one saying that the title in itself was a comment!

Wrong. I had meant to compare the public sector favourably with the private sector when it came to private service, quoting from an FT article:

The sheer inefficiency of UK bank bureaucracies in their domestic operations can be compared with public services at their worst. Public services at their best now outperform the banks – so government ownership could actually improve bank performance. The banks should be made more accountable to the public, as public services already are.

Examples come from my own experience but are matched by that of others. Banks use the internet as little as possible to avoid fraud; instead they use the post, in which letters are lost or stolen, and the telephone, which is overloaded and often fails to give results after interminable waiting times.

My bank has three times posted an unwanted cheque book to me in the past year, in spite of being asked not to after a postal theft led to a £2,500 fraud. Alternatives to the Royal Mail are a delusion, because the Royal Mail still does their doorstep delivery – as often as not to the wrong address.

The author correctly identifies cost reduction and the use of channels other than the traditional bank branch as responsible for the decline in service quality. In many private banks in India, it is impossible to meet anybody to discuss a complaint- you can only discuss with an operative at a call centre.

Secondly, public sector banks find themselves obliged to respond because various public functionaries- such as MLAs and MPs and even municipal corporators- will forward complaints. The customer himself or herself has a strong sense of ownership because it is public sector. And public sector banks still rely on branches for customer interaction.

Government versus RBI?

Today's Business Standard has a strong edit on how some recent moves by the government of India have the effect of devaluing the RBI:

First, a new governor of Reserve Bank of India was appointed and, in a symbolic departure from past practice, the new incumbent went across directly from the finance ministry. Then, a new ‘liquidity committee’ was set up, chaired by the finance secretary. Now, a new economic advisor with a strong background in finance has been appointed in the Prime Minister’s office. A day later, the finance minister calls the heads of the state-owned banks with the intention announced in advance that he wants bank lending rates to drop. On cue, immediately after the meeting, one bank chief after the other announces interest rate cuts.

If you thought the country’s monetary authority was RBI, may be it is time to think again. The pattern is too obvious not to be noticed—the real decision-makers are now in the central secretariat in New Delhi. RBI remains the statutory authority, but it is an open secret that the man in charge is P Chidambaram. A peskily independent RBI governor has retired, and a strong-willed finance minister has made sure that he will not be faced with another situation where his views are either ignored or not acted upon....

<>...... With Dr Reddy not on the scene, with Mr Chidambaram having wrested the freedom to impose his writ, and with economists in place who belong to the integration-convertibility school of thought, it remains to be seen how much short-term currency management will swing around, and to what degree longer-term policy will change in the six months that the government has before elections become due. Whatever the answers to these questions, and irrespective of which ideological position anyone may hold, RBI’s autonomy is the casualty of the new constellation of forces and the new institutional arrangements.

<>

BS is right. The government's moves do appear to be intended to cut the RBI to size. This is sad given that the RBI has received so much credit for its success in insulating the economy from the international turbulence- and various people in government too have expressed this view. It cannot be that you give the RBI credit for this and then behave as though the RBI does not know how best to handle the impact on the Indian economy of the present liquidity size.

Subprime crisis: who are the real villians?

I argued in my last post that sub-prime loans per se - and the entire apparatus that made it possible, including low interest rates engineered by central banks, were not primarily responsible. Deregulation was by far the bigger villain.

Ben Heinemann, senior fellow at Harvard's Kennedy School of government and Law School, argues that there has been a serious management failure at financial institutions:

But can there be any question that the root cause was the failure of financial-industry leaders to provide the balance between risk-taking and risk management needed for sound, sustainable growth? In short, there was a failure to fuse high performance with high integrity.

No one made these companies pile on leverage, create incomprehensible financial instruments, sideline robust risk assessment, fail to stress-test portfolios, assume housing values would only go up and award gargantuan compensation for churning paper.

Why did CEOs and business leaders so abjectly fail? Why did good corporate governance, which at its core is about checks and balances, fall short in financial services?

Obviously, public and government trust in industry decision-making has eroded. Now corporate leaders must honestly discuss their mistakes and propose how checks and balances can work before the slow process of rebuilding trust can begin.

Don't blame it on sub-prime loans

That's the title of my column in ET today.

The present crisis has been called a 'sub-prime crisis'. This does suggest that sub-prime loans- loans to not very credit borrowers or financial inclusion- underlies the present crisis. Once you take this view, there is a whole cast of villians available- the US Fed which flooded the world with liquidity; greedy borrowers; greedy bankers; political pressure for financial inclusion.

This, I argue in my column, is rather simplistic. There have been housing bubbles earlier, banks have extended themselves in making housing loans but we have not had a global financial crisis. To complete the chain of causality from a housing bubble through sub-prime loans to a financial crisis, you need to bring in a vital link: the 'marketisation' of loans, that is, conversion of loans into traded securities.

This 'marketisation' was made possible by incorrect credit rating. The securities passed into the hands of non-regulated or lightly regulated entities such as investment banks and hedge funds. These institutions face mark-to-market accounting on their securities portfolios whereas bank loans are not marked to market. This sort of accounting tends to exaggerate losses especially where illiquid portfolios are concerned.

If the financial system had been exposed only to sub-prime loans, we would not have had such a big problem. It is their exposure to sub-prime loans through sub-prime related securities that has created havoc. So, the problem is not financial inclusion, it is poor regulation.

Financial regulation: west on trial now

Kishore Mahbubani, former foreign minister of Singapore and currently Dean of Lew Kuan Yew, University, makes the point that the quality of regulation in western economies will now be closely watched by Asian regulators.

In the past, Asian governments expected western counterparts to be role models of good governance. One story illustrates how times have changed. This year, a European banker consulted the Reserve Bank of India to learn how to get a banking licence in India. He was briefed on the conditions and told that the Indian authorities would also assess his regulator. The European banker smiled and said: “No problem. We have excellent regulation.” The Indian officer replied: “After subprime, we are not sure of US regulation; after Northern Rock, British regulation; after Société Générale, French regulation and after UBS, Swiss regulation.”

This is very different from the times when banks from Asian economies were considered suspect until proved innocent.

Responses to comments

1. Abi: Thanks for the pointer to Brad de Long's blog about multiple objectives for the US Fed

2. Shailender Birla: asks what criteria would be adopted for appointment of non-government nominees of the pan-IIM board. (The board will have five government nominees and 10 non-government nominees). Well, here is the relevant extract from the report:

4.18 The Pan-IIM Board may consist of 15 members. Of these 5 should be nominees of the Central Government. They need not all be serving Government officers. The rest should be made up of independent professionals of eminence and record of success, living in India or abroad. Other things being equal, preference should be given to IIM alumni for appointment to this Board. One third of the Board would retire, by rotation, at the end of each year. A member would be eligible to be re-appointed, provided his/her total period on the Board does not exceed 6 years. Future vacancies would be filled by the Board itself, through recommendations made by a nominations committee of the Board, consisting of four non Government members.

4.19 The Chairman of the Pan-IIM Board should be nominated by the Prime Minister.

Multiple objectives for the US Fed

Stephen Roach of Morgan Stanley argues in favour of the US Fed having multiple policy objectives. In addition to price stability and full employment, the two objectives it has at present, there should be a third: financial stability.

By adding “financial stability” to the Fed’s policy mandate, I am mindful of the pitfalls of multiple policy targets. However, single-dimensional policy targeting does not cut it in a complex world. As such, the Fed will need to be creative in achieving its mandated goals – using monetary policy, regulatory oversight and enforcement and moral persuasion. Just as the Fed has been reasonably successful in its twin quests for price stability and full employment, I am confident it can rise to the occasion with the addition of financial stability to its mandate.....

In times of asset-market froth, I favour the “leaning against the wind” approach with regard to interest rates – pushing the Federal funds rate higher than a narrow inflation target might suggest. But there are other Fed tools that can be directed at financial excesses – margin requirements for equity lending as well as controls on the issuance of exotic mortgage instruments (zero-interest rate products come to mind)

The methods Roach advocates in the second para above are ones that the RBI has not hesitated to use. And the RBI has long had multiple objectives, including financial stability. I wonder what the Raghuram Rajan committee has to say now about its insistence on price stability as the sole objective for the RBI!

Goldman's overture to Citi

It appears that Goldman Sachs CEO Lloyd Blankfein spoke to Citi's head Vikram Pandit about a possible merger between the two companies. This was soon after the US Fed announced that Goldman and Morgan Stanley would be given banking licenses. Goldman's approach was rebuffed.

This led the US Treasury to include the two in the recapitalisation plan announced soon after. Which, of course, reflected the Treasury's perception that the two would otherwise meet the fate of Bear Stearns and Lehman Brothers.

Soon after the two companies were given bank licenses, I wrote saying that this was intended to send out a signal that the US Fed was solidly behind them. It did not imply at all that the two could successfully convert themselves into banks. The sequence of events described above bears out my conclusion.

Bhargava committee report- at last!

I was getting a little fed up with the tit-bits about the Bhargava committee report on IIMs appearing in the media, so it was a pleasure to finally get hold of the report and read it in full.

Let me highlight what I believe are the most important recommendations:

• Creation of a pan-IIM Board: It will have 15 members, 5 of whom will be government nominees and the others persons of eminence, including IIM alumni. The chairman will be appointed by the PM. This will be the principal goal-setting and monitoring mechanism for the IIMs. It will approve IIM business plans and review performance every two years.
  
• IIM boards to have powers to select director, set fees and propose chairman's name to pan-IIM board.
  
• IIM boards to be reconstituted and comprise 11 members (instead of the present 25 or so). Initial board appointments to be made by ministry, subsequent vacancies to be filled by boards themselves.
  
• Appointment of faculty on contract basis with the freedom to pay market-related compensation.
• IIMs A, B and C to increase PGP intake to 500 by 2011.
• Consulting income of faculty to be limited to 15% of salary

There are many other recommendations and observations. The report requires detailed treatment.

My immediate response is that the creation of a pan-IIM board is a constructive suggestion. The committee observes that with responsibilities being divided between the ministry and the Boards, accountability has become a casualty. In the ministry, officers keep changing and managing six IIMs (with several more to come) is well nigh impossible. The Boards themselves, the committee notes, have not lived up to their monitoring role for a variety of reasons mentioned in the report (one being the perception in the Board that it's the ministry that finally calls the shots).

So some mechanism for setting objectives and monitoring performance in the IIM system is required. A pan-IIM board with the secretariat housed in the ministry is the proposed answer. One of the ticklish issues to be sorted out is the demarcation of roles of the pan-IIM Board and the IIM Boards.

The report says that the pan-IIM Board should not be involved in day to day management of the IIMs. Well, nor should the IIM Boards. A Board's role is primarily in the areas of strategy and monitoring of performance- and both these responsibilities will now be vested in the pan-IIM Board. So, will the IIM Board be confined to selecting the director and other members of the Board and giving approvals to financial proposals that exceed limits delegated to the director?

The reduction in the sizes of IIM boards to more optimal levels is welcome; so also the proposal to limit board memberships to a maximum of two terms of three years each. To me, the puzzle is that the IIM fraternity itself did not make these proposals all these years. Did it require a government committee to make these eminently sensible suggestions?

Bhargava committee on IIMs

The report of the Bhargava committee on IIMs is yet to be released. We have to be content with snippets appearing in the press. The latest bit will not please the IIM fraternity at all:

The IIM Review Committee has suggested that the pan-IIM board’s secretariat should be within the HRD Ministry. It has slammed IIMs for not “reacting to the market need quickly enough”, said that IIM Board directors and chairmen have failed to be effective CEOs, pointed at a ‘lack of mutual confidence and trust between the IIM and the Government’, and recommended that a common interview be held for all IIMs.

Regarding faculty, the committee has called for fixing of “higher level base salaries”, though it has put a cap on the consultancy and executive training programmes. The committee has recommended that time spent on these by the faculty should be limited to 90 days in a year with not more than 40 days during the nine month period when the institute is running post-graduate programmes.

The recommendation on consulting caps it not clear. Does the committee mean a total of 90 days in a year for all faculty or 90 days per faculty? If the latter, that would actually be a relaxation of existing norms which limit faculty to 53 days' consulting.

The committee faults IIM boards for not doing their jobs. These boards, be it noted, include representatives of the central government (and, in some cases, the state government). The committee has judged that one reason for the ineffectiveness of these boards is they are too large- with 25 members or so- and poor attendance on the part of board members. It recommends that the size of the board be pruned to 11 and also that minimum attendance requirements be laid down. That would mean that government nominees on the boards should also take their jobs more seriously.

ICICI Bank draws judiciary's ire

ICICI Bank marketing agents apparently made the fatal mistake of bothering some Delhi High Court judges with their marketing calls. A lawyer, who had been similarly bothered, approached the honourable High Court - and found the judges sympathetic to her cause.

ICICI Bank faces contempt proceedings in the State Consumer Commission, having ignored earlier court injuctions about unsolicited marketing calls. Justice Sen had some strong words:

“I receive calls at all time of the day from ICICI Bank,” Justice Vikramjit Sen said. “I do not know what business you get out of such calls.... You are a nuisance and have to face the music for making these unsolicited calls.”......

Do you think you are above the law?” the judge asked. “Who is your highest ranking officer in northern India... bring him here; let him explain these calls.”

The Express story adds:

On December 26, 2006 the consumer commission had levied a Rs 12.5-lakh penalty on the bank for making nuisance calls. Though the High Court subsequently stayed the Commission’s decision on September 11, 2007, the court had warned the bank against making “unsolicited marketing calls”.

Et tu, Goldman?

Goldman Sachs finally joins the ranks of firms that will slash jobs- a 10% cut in workforce is planned, FT reports. The axe will fall heavily on fixed income and investment banking. Nobody should be surprised- Goldman's reputation for invincibility has been badly dented in the present crisis. Bad news for India's top B-schools, I guess.

And now for British govt support for manufacturing!

I read this piece by FT's manufacturing editor with some disbelief. It is nothing but a thinly disguised call for industrial policy- the targeting of particular sectors in manufacturing by the British government. The author argues that government ownership of UK banks provides just the right basis for such an approach:

The government will have the power to put representatives on the boards of the three banks most affected by the debacle – Royal Bank of Scotland, HBOS and Lloyds TSB. In reviewing these institutions’ lending policies, the government should ensure they take a proactive approach to supporting companies in the manufacturing sector......

There should be an emphasis on lending to youthful, poorly capitalised businesses attempting to commercialise new technologies – especially in promising fields such as zero-carbon energy production, lightweight construction materials and low-power electric motors. In the next 20 years, more UK-based customers will require specially tailored manufactured goods – in fields from home heating systems to aerospace parts – that on the grounds of transport costs and order times are made locally rather than shipped in from China. The new policy should help those UK production companies that have the skills to meet the new demands for short-turnaround “customised” manufacturing.

This is not just industrial policy but a form of directed lending. Maybe the British government can turn to the RBI for advice?

Preview of Bhargava committee report on IIMs

Apparently, the ministry of HRD is close to making available the report of the R C Bhargava committee report on the IIMs. Indian Express carried a story yesterday which offered a preview of key recommendations. The report is right in suggesting that these are unlikely to go down well with the IIMs:

• Creation of a Pan-IIM board
• Reducing the size of IIM boards to more manageable proportions (from 24 or so to 11)
• Initial appointments of boards to be done by a committee comprising Secretary, MHRD, and three professionals
• Annual intake of PGP to rise to 750
• IIMs operating for more than five years to limit their operational surplus to provide for infrastructure and scholarships
• IIMs to go slow on executive training and consulting
• Separation of administrative and teaching functions of faculty

I would not like to comment on the report until I have read it myself. Just a few quick repsonses to the story.

One, what would be the role of the pan-IIM board? Two, chairmen of IIM boards are even now made by the MHRD, so what is proposed would not be much of a departure. Reducing the size of IIM boards makes sense- indeed, I had suggested this myself to the Bhargava committee. No point in having boards where half the members fail to show up for meetings.

Quote from Montek Ahluwallia

BS quotes Planning Commission Dy Chairman Montek Ahluwallia as saying:

The belief that the financial markets are somehow very efficient and that the American financial system invented all kinds of new instruments that were bringing about tremendous efficiency gains which deserved to be emulated..... I think this view has been totally discredited".

Hmmm.... so what does this bode for the Percy Mistry and Raghuram Rajan committee reports on financial sector reforms?

Ahluwallia's views are a bit of a revelation considering that the Rajan committee was sponsored by the Planning Commission.

Treasury funds for US banks

So Hank Paulson has finally bit the bullet. The US Treasury will put $250 bn in capital to banks as part of the $700 bn bail out. Clearly, asset purchase alone will not impress the markets. In the first staeg, $125 bn will offered to a list of banks that reads like a who's who of survivors, mind you, not the battered ones: Bank of America, JP Morgan Chase, Wells Fargo, Citigroup, Merrill, Goldman, Morgan Stanley and two others.

What does this mean? Well, the word 'strong' is a highly relative term in today's context. Bank of America and JP Morgan Chase, Wells and Citigroup which were in the business of acquiring weak banks, are now certifiably in need of capital.

The banks would question this saying they never asked for capital and could have ridden out the storm. But the Treasury wants the top banks to do more than sit out the crisis. It wants them to lend so as to keep the economy from going under. So, this bout of recapitalisation is not so much about preventing bank failure as preventing a serious downturn arising from what the Treasury regards as inadequate capital.

The coupon rate of 5% on convertible preferred stock for the first five years, incidentally, involves a subsidy at today's rates.

Soros' plan for US bail out

Soros spells out details of how he would like the US's Tarp (troubled asset relief programme) to work:

• The regulators must work out how much capital banks would need to meet 8% capital adequacy
• The government must infuse required capital through 5% convertible preferred shares
• Fed should guarantee interbank borrowings by banks eligible for recapitalisation
• Capital adequacy requirements should be lowered to facilitate fresh lending
• Home mortgages need a plan to limit foreclosures

This is pretty much along the lines of what the UK has done. I am not sure that lowering capital adequacy requirements is desirable until the storm has blown over. Banks must have enough capital to prevent another bout of loss of confidence in the event of some fresh problems.

Bank nationalisation in UK

The UK government stands to own up to 30% of equity in the top four banks- not very different from the level of 33% recommended by the Narasimham committee for public sector banks in India. We are not talking of small, insignificant players. The banks include: LLoyds TSB, Royal Bank of Scotland and Barclays. So far, HSBC, Banco Santander and Standard Chartered have said: thanks, no.

The British government intends to have its nominees on boards of banks where it will acquire an equity stake. It could end up being the biggest stakeholder in these banks. And it has already said it will have limits on executive pay and bonuses.

Somebody, please tell me: is this beginning to look like the Indian banking system or not?

PS: After I put up this post, the details of the capital injection have been finalised. The government will inject 37 bn pounds into RBS, Lloyds and HBOS (the latter is being acquired by Lloyds). The move would give the UK government a 60% stake in RBS and 40% in the combined Lloyds-HBOS. The Treasury is expected to appoint 3 new RBS directors and 2 directors to the board of the combined Lloyds-HBOS. There will be restrictions on dividend payments until the banks have repaid 9 bn pounds in preference shares they are issuing to the Treasury.

ICICI Bank's woes

ICICI Bank is paying dearly for its international forays and for its reputation for aggression in general.

I have long been sceptical about the merits of Indian banks going abroad. I have always contended that banks need to make the most of domestic opportunities and develop a solid repertoire of skills before thinking of an overseas presence.

Setting up a subsidiary abroad as ICICI Bank has done would involve tapping into the following opportunities:

• India-related retail opportunities: NRI remittances and deposits, for example, and investment in Indian stocks, mutual funds and real estate
  
• Corporate banking: serving Indian companies with an overseas presence
• Local market in overseas location: selling mortgages and other products to locals, Indian and non-Indian

India-related retail opportunities can be catered to without a foreign presence. They can be handled through correspondent relationships with overseas banks. Corporate banking does present opportunities but major ones such as overseas funding for acquisitions can be better done by foreign banks. As for grabbing a slice of the local market, what strengths do Indian banks bring to the table? Can they offer a higher rate on deposits or a lower rate on loans? How?

When you look at it very carefully, the Indian market growth is so high and the margins so attractive that going abroad does not seem attractive. There are also significant downsides to going abroad.

One, the overseas subsidiary may get into risky investments that happen to be the flavour of the moment (as in the case of ICICI Bank). Two, the regulatory risks can be high- it's hard for management in India to be keeping tabs and if there is a slip-up, there would be a heavy cost in reputational and other terms. As a result, the overseas operation can make disproportionate demands on management time.

ICICI Bank had set a target for international operations of 20-25% of overall revenue. What was the proportion in terms of profit? Going by its last annual report, PAT for the bank was Rs 4158 crore. ICICI Bank, UK, earned a mere Rs 155 crore while ICICI Canada and ICICI Bank Eurasia were in the red. Losses on investments in the sub-prime crisis can be expected wipe out the cumulative profit of ICICI Bank's overseas operations to date. It is not obvious that the international foray has been worth it.

ICICI Bank's general reputation for aggression is also part of the problem. That sort of reputation is a double-edged sword: at the top of the business cycle, it can boost your price-earnings multiple but, on the downside, it can undermine confidence. Many no doubt think that ICICI Bank, with its reputation for taking risks, is concealing more than it has revealed. This concern may be misplaced but it's there. The bank is heavily dependent on wholesale deposits. These would be the first to flee at the sign of trouble.

Interestingly, the bank's CEO, K V Kamath, has ruled out international acquisitions given "global challenges". Only a few weeks ago, top management was saying it was scanning the horizon for such opportunities.

Depressing times for Modi baiters

Heaven knows there is enough depression out there in the financial world but baiters of Gujaratr CM Narendra Modi have more reasons to crib.

First, the Nanavati commission report on the Godhra riots. The commission made two very important points:

• The fire in the train was the result of a conspiracy, it was not a reaction to teasing carried out by kar sewaks after the train arrived at Godhra
• There was no indication that the post-Godhra riots were planned. They appeared to be the result of outrage caused by media reports.
  

Both these contentions undermine the entire basis for the denunciation of Modi for his alleged role in the riots and of Sangh parivar in general. To be sure, there are judicial commissions and judicial commissions and people are selective in which report they want to accept. The Nanavati report has been castigated by many. But that does not alter the findings of the officially constituted probe into the riots.

The other blow is the Tata group's decision to locate Nano in Gujarat. The photo of Ratan Tata and Narendra Modi with their arms wrapped around each other while announcing the decision cannot have gladdened Modi's critics. What will they do now? Will they dare to criticise Tata's decision? They should spare themselves the trouble. Long before the Nano project, several businessmen, including Tata, have forged close ties with Modi over several Vibrant Gujarat summits.

Soon after the Godhra riots, the CII attempted a mild condemnation of Modi. There was a revolt in the Gujarat chapter. Tarun Das of CII had to rush to Gandhinagar to make amends and he was seen embracing Modi at the time. As Modi himself has pointed out in an interview with ToI today, businessmen's preference for Gujarat has little to do with which party is in power. But it is also true that businessmen are not going to be deterrred by what social activists think of a particular government.

Chew over this one!

The sub-prime crisis is producing its own genre of funny and unfunny stories. Here's one I read about Lehman Brothers in London.

When news came of the firm's bankruptcy,its staffers collected their belongings, of course,and carried these out in cartons. The financially more alert souls also made sure they encashed their pre-paid 100 pound cards at the in-house vending machines for candy- you never know, the machines might be empty later.That must have translated into hundreds of bars per capita- no doubt, it gave the staffers something to chew over.

Didn't the staffers pause to ask what all that candy might do to their systems? We know the people there missed some financial risks but one would have thought they might have been a little more wary about cardiac risk.

Bail out of the real sector too!

I quoted in my post yesterday (Rethinking government ownership) from an article in FT that urged government to extend its ownership to the real sector as well. The writer needn't have worried: it's already happened in a small way in the US.

Somewhat unnoticed in the current financial storm, the US has extended a $25 bn loan guarantee to the Big Three in the automotive sector- General Motors, Ford and Chrysler. The Economist reports:

The Big Three have been hit by petrol prices pushing towards $4 a gallon, by more demanding federal fuel-economy rules and by the credit crunch wrecking consumer finance. But the federal government came to their aid this week when George Bush signed an energy bill that includes $25 billion in loan guarantees to ease their pain. Supposedly this is to allow the Big Three to retool their factories to produce more economical vehicles.....

The rules are still being worked out, but the deal means that car companies—blessed with the government guarantee—should get loans with an interest rate of around 5% rather than the 15% they would face on the open market in today’s conditions.....

The logic of bailing out Wall Street is that finance underpins everything. Detroit cannot begin to make that claim. But, given its successful lobbying, can it be long before ailing airlines and failing retailers join the queue?

On a related note, Goldman Sachs is not the only firm to benefit from legendary investor Warren Buffett's munificence. GE is getting a timely infusion of $3 bn from him. It can use the money given the problems arising from GE Capital:

Most of GE’s recent problems have come from its financial arm, GE Capital, which it has belatedly decided to shrink somewhat. As well as some exposure to subprime mortgages and problems in its vast credit-card portfolio, there are growing concerns about its exposure to commercial property, which has been pretty solid so far but is vulnerable to a sharp economic downturn. Investors have also worried about what would happen to GE’s hybrid industrial-financial business model if it lost its cherished triple-A rating. Happily S&P, one of the leading rating agencies, said Mr Buffett’s investment and the decision to raise more cash reinforced the triple-A rating.

UK bail out plan

Britain has unveiled a bail out plan that commentators recognise as more comprehensive and hence more likely to succeed than the US plan. Two distinctive elements:

• Recapitalisation of British banks upto 50 bn pounds.
• A 250 bn pound guarantee on wholesale funds raised by banks

The latter is important because provision of short-term liquidity by the central bank is not enough. Banks have a serious problem with getting term finance.

The first step is even more critical. Shoring up bank capital is critical to protecting them against failure and ensuring that credit flows resume. The US plan attacks this problem indirectly by putting a floor on their assets. But banks will need more capital- and it may take time for private investors to regain confidence in banks. So government recapitalisation must be a critical component of any bail-out plan in today's conditions.

This should have happened much earlier. If it had, the turmoil in the financial system would not have been as great. But, in the western economies and in the US particularly, there is a huge mental block against government ownership. There is also the issue of how much capital can be given to which private party. That's why governments have dithered.

In contrast, recapitalisation of India's banks has not posed a problem because they are predominantly government-owned. The government's readiness to recapitalise as required plus the fact of government backing of deposits are two reasons why the Indian banking system today stands out in today's crisis.

Rethinking government ownership

The pendulum is really swinging the other way, isn't it? The present financial crisis has focused minds on regulation, alright, but it is also causing a rethink of sorts on government ownership in the financial sector. At a minimum, people think that, in a crisis, government takeover troubled banks is okay.

Richard Sennett, writing in FT, goes further. He wants government to infuse equity into real sector firms in order to safeguard employment in the western world. He even writes approvingly of the role of public investment in certain sectors in India:

We are entering a period of financial socialism, by which I mean that the government is buying enterprises which cannot survive in the free market – Fannie Mae and Freddie Mac, the $700bn credit bailout in the US, Northern Rock and Bradford and Bingley in the UK. Most observers look at such financial socialism as an emergency measure – and a bad thing. To me it is a good thing; indeed, public ownership needs to be extended from the financial sector to the manufacturing and service sectors.The reason for this is that Europe and the US have many industries and service businesses which cannot survive in the global economy....

Regulation, of the kind the financial sector is now experiencing, is largely irrelevant to expanding the number of jobs. The point is not to restrain risky action, but to encourage investment and innovation. That agenda requires money, more money than can be justified by the austere calculus of the market. This extra cash is where public investment comes in.

If this seems too much to swallow, consider India. Much of its construction, information technology and healthcare sectors have been – on a western calculus – over-staffed and inefficient, supported by government grants. Public investment has, however, developed these industries and as they have grown the need for government aid has declined.

Is it really a bail out?

Writing in Business Standard, Percy Mistry contends that the Treasury plan cannot be called out a bail out because the Treasury stands to make profits ultimately on the assets it buys. Assets will be bought at distress prices. Asset prices should improve later. Hence the profit. Banks that have provided for a higher loss than indicated by the Treasury's purchase price can write back provisions. So, it's win-win for Treasury and the banks. Where is the bail out, he asks?

Well, we are quibbling here, aren't we? When we talk of a government bail out, what we mean is that, absent government intervention, firms would fail. A bail out is any move that saves firms from failing through the operation of market forces. By this definition, the Treasury's initiative certainly constitutes a bail out.

If we go by Mistry's interpretation, there was no bail out of LTCM by private parties in 1998- the parties ultimately ended up making a profit on their investment. More to the point, the Indian government's investing Rs 20,000 in public sector banks in1992-93 and the subsequent infusions into Indian Bank and UTI do not constitute a bail out because the government has made a handsome profit on these investments.

On a different note, what is the cost of a banking crisis? Government purchase of assets or infusion of equity capital may not constitute costs to government because these are eventually recouped. Besides, once a loss happens in the banking system, government infusion of capital is merely a transfer- it is not an additional cost because the cost has already happened.

The true cost of a banking crisis is the loss of an economy's output. So, you compare potential output without a bail out with the cost with a bail out and measure the difference. It cannot be Mistry's case that the US economy will not suffer a loss of output if government does not intervene.

Outsider as head of Unilever

Here in India, Unilever gets a great press- cradle of star managers and all that. Interesting, then, that the firm has decided to pick an outsider as its new CEO, somebody who worked for rivals P & G and Nestle.

FT has a story in which it notes:

The news came as a welcome surprise to investors used to complaining, as one puts it, of an “insular executive team” that ran the business “like the civil service”. It was even more startling to those who know the group from the inside. After years of underperforming its peers, had Unilever finally found the man to return it to its former glory?

Unilever has been something of an underperformer in India too lately. But that doesn't keep its managers from getting rave reviews in the media. Incidentally, I remember reading that M S Banga and Harish Munwani were in the running for the top job. They seem to have lost out as Keki Dadiseth had earlier.

A kind word or two about investment banks

Wall Street fact and fiction. That's the title of my last ET column. I explore some of the loose comments on investment banks in the media, especially the belief that they were undone by high leverage. No, high leverage in itself is not a correct measure of financial risk in financial firms. It was the combination of high leverage, illiquid assets and dependence on short-term funds that proved fatal. I explore other misconceptions as well.

Now, readers of this blog would know that I am no starry-eyed admirer of the go-getting culture of investment banks, no believer in their superior risk-taking skills or their repertory of talent. But I do think they had several things going for them.

• They had a more egalitarian culture than most firms. Managing directors were to be found hundreds in Morgan Stanley and other places. You did not a big budget and an army of people under you to be called Managing director. The amount of business you did and the profit you raked in was enough. A star trader hooked to a terminal could be an MD.
• They had greater employee ownership than most firms- at Bear Stearns, employee stock ownership was around 40%, at Lehman's 30%. As I have said earlier, the stock options schemes might have been better designed, they ought to have vested over longer periods. But the principle of large numbers of employees (down to secretaries) being owners is a good idea (although it's not such a great idea, from their point of view, to have all one's savings in one's own firm).
• They were quite sensitive to operating costs (other than employee costs where they went overboard). Otherwise, business divisions operated on the principle of return on capital allocated. Since their bonus numbers were linked to this, they went all out to slash costs wherever possible.
• They were more meritocratic in their orientation than firms in other sectors. Performance was recognised quickly and rewarded. Two reasons for this. Performance was easily recognisable- if you brought in an investment banking deal, everybody knew what that translated into; traders' profits are easily measured (although not always the capital to be allocated to them). Secondly, firms could not afford to disregard performers- they would simply leave in what was a highly competitive market for people.
  
• They had high burn-out rates among employees and the work-life balance was terrible. But these places gave you at least a theoretical chance of quitting when you were 40 or so and turning to other things- collecting art, kayaking, setting up a nursery. And many did.
  

Who gained, who lost in sub-prime crisis?

I've been travelling a bit, hence this lull in posts on the blog.

There's a lot of stuff on losses and gains in the sub-prime crisis. Let me explore two contentions.

1. Executives of financial firms are big losers, they have been punished heavily for their sins: The point being made is guys like Richard Fuld of Lehman and Jimmy Cayne of Bear Stearns have seen their personal fortunes in the form of stocks tied up in their own firms plummet in value, so it's not as if they have not been punished for their follies.

Well, yes, they have suffered losses on their stocks. But, this is not the complete story. These are people who base pay is huge- say, upwards of $20 mn. Many executives also get cash bonuses. Last, many have cashed out some portion of their stocks. One needs to add up all these to get an idea of the accumulated rewards. The value of their stock holdings at the time of their firms' demise, while large, is only one component of their overall reward. Now, this total is not small in absolute terms. It could typically amount to over $200-300 mn- no mean sum f0r destroying shareholder value.

The short point: top executives will be big losers only if base pay is kept smaller and variable pay comes in the form of stocks that vest over a very long period, say five to ten years.

2. Shareholders of firms such as Fannie Mae and Freddie Mac have paid a price because they've got nearly wiped out, so it's not that they gained from implicit government support: As a shareholder in such firms, you would be wiped out only if you invested at the beginning and held on till the end. Let's say one set of shareholders, who bought at the beginning, sold out at the peak. They would have made huge gains. Another set of shareholders who bought from the first at the peak would have lost heavily.

Shareholders as a class would have made zero gains (not a loss) but that does not mean that individual shareholders did not make huge gains when the going was good.

NRI profs head for IITs

Outlook magazine has a story on how several NRI profs are beginning to take up jobs at the IITs. The numbers are impressive, very impressive indeed:

In Delhi's IIT, 25 of the 40 faculty members appointed in the last one year are foreign-returned. Mumbai has 40 and the others IITs are recording anywhere from 2-5 faculty members who have come back to serve in India.

What accounts for this sudden surge in interest on the part of NRIs? Outlook lists several reasons:

• They feel culturally more comfortable to live and work in India
  
• There are research opportunities comparable to the west
  
• Greater involvement of industry in R&D means better funding
  
• IITs have a research focus: encouraging environment, space and facilities
  
• The NRIs fee being a part of brand IIT is creditworthy worldwide

Some of the profs interviewed in the story emphasise the facilities and funding for research. It does appear the IITs have done a commendable job on this front. I would that 'India Shining' is part of the motivation- the fact that things are looking up in India, that you no longer are in queue for years to get a telephone or gas connection and also serious consulting opportunities. The IITs' campus environment and decent housing must also count. I also think the salary revision that will happen consequent to the Sixth Pay Commission will make jobs in IITs/IIMs more attractive.

If this trend continues, the newer IITs may not find it that difficult to get faculty- the NRIs will join the established ones while entrants in the doctoral market will head for the newer IITs. The trend is interesting given that the government pay structure has long held to be a factor responsible for the faculty shortage at some of our better known institutions.

Some of the premier institutions have long insisted that as long as they are part of the government framework, along with the salary constraints, they cannot attract quality faculty. Prominent personalities have even contended that quality institutions can hereafter come up only under private aegis because the private sector can pay a lot more (and charge its students a lot more).

As readers of this blog would know, I have always been sceptical about these contentions. It is the overall ambience that counts- and the security, dignity and academic freedom that go with being part of the government framework far outweigh the supposed disadvantages.

Reliance SEZ

I don't know whether the papers carried the report but Outlook magazine has a story on the referendum carried out on the Reliance SEZ in Raighad district of Maharashtra. In the referendum, the first of its kind on an SEZ, the proposal to create a 10,000 hectare SEZ covering 25 villages was apparently voted against by 80-85% of the people who cast votes.

Interesting, since the impression I had got earlier from newspaper reports was that Reliance had made a very attractive offer (Rs 10 lac per ha) and that villages were dying to part with their land. Most of the villages are not willing to provide even conditional consent under which Reliance would pay Rs 1 crore per ha, provide a 12.5% share of the developed land to affected farmers and take the land on a 99 year lease.

Outlook says the vote is not binding on the Maharashtra government. Why not a similar vote in Singur- at least that will tell us where the affected parties stand.

Death of a police inspector

I was among those deeply moved by the story of the death of Delhi police inspector Mohan Chand Sharma in an encounter with terrorists on September 19. It was heart-trending to see the photos of his grieving wife and two children.

Now, it appears this was a 'story' in more senses than one. M J Akbar in his column in TOI today and Outlook magazine in its latest issue cast doubts on the official version. Akbar and the Outlook make several points.

• Sharma was said to have been shot in the stomach but a photo captures him being helped out of the house where the shoot-out took place, with a heavy patch of blood on his upper arm. He had managed to climb down several flights of stairs, which would have been difficult had been shot in the stomach.
  
• An official release later clarified that he had died of a heart attack caused by loss of blood. There are also murmurs in the police establishment that he was killed by 'friendly fire'.
• Outlook mentions that Sharma had gone up to the apartment where the terrorists were said to have been holed up, posing as a telecom salesperson. He then asked his colleagues to join him. So, this wasn't exactly the storming of a hide-out. Lastly, the police claim to have killed two terrorists and said the other two had escaped. Escape was difficult considering there was only one exit which was under police watch.
  

So, was this a staged operation in which innocents were killed? We may never the truth. What we do know is that in the 'war against terror' plots will be busted, 'terrorists' will always be found and jailed or killed.

The test of success, I guess, is whether the police are effective in preventing further acts of terrorism. Israel has shown it can do it. So has the US post 9/11. Not to defend the record of these countries in their dealings with Muslims. The point, however, is that unless the Indian police is able to reduce the level of terrorist attacks, we must remain sceptical about encounters and the resulting deaths or capture of 'terrorists'.

While on the subject,it's worth noting that the government case againt SIMI, supposedly a terrorist Muslim organisation, was thrown out by the special CBI court (headed, as I recall, by a lady judge). The judge said the government had failed to produce evidence. The matter is now pending in the Supreme Court where the government has challenged the lower court verdict.

Biggest bank failure in US history

Washington Mutual has been acquired by JP Morgan Chase for $1.9 bn. Morgan acquires all assets and deposits but not equity and debt claims. In other words, equity holders and non-deposit lenders get wiped out.

This wasn't a straight acquisition- WaMu was seized by the regulators and then sold. JP Morgan pays $1.9bn to the regulator, not to the existing shareholders. It isn't clear why the regulator is getting paid because there are no costs of deposit insurance the regulator is bearing.

WaMu had assets of $307 bn- far in excess of the $40 bn held by Continental Illinois which failed in 1984. This makes it the biggest bank failure in US history by a wide margin.

Bonuses for Lehman's European staff

Nomura, which has acquired Lehman's equities and investment banking business in Europe, is setting aside $1 bn in bonuses for Lehman staff, FT reports. This is for 2008. For 2009, it has promised a bonus pool as large as the one in 2008, although some of it will be in the form of restricted staff.

Were Lehman staff, who seemed orphaned until the other day, not available in the present environment without such incentives? And what implications do guaranteed bonuses have for future financial stability? If we accept that the design of compensation schemes had something to do with the present financial crisis, Nomura's offer does not seem very responsible.

In UK, the Financial Services Authority is said to be contemplating higher capital norms for firms whose bonus payments are not linked sufficiently to long-term performance. In the US, Congress is contemplating limits on bonuses as part of the bail-out plan. UK's PM, Gordon Brown, has said the present compensation schemes are "unacceptable". Nomura needs to do some explaining.

Responses to comments

I haven't had a chance to respond to some of the comments on my posts on investment banks. I thought I would devote a small post to these instead of putting them in the comments section.

1. Jaipm: asks about Alan Greenspan. This is a vast subject, really. But briefly, I am not persuaded that he was wrong in easing monetary policy or that he did it for too long. Easy monetary conditions helped create one of the best economic booms in the world in recent decades and India was among the beneficiaries. The argument is that the boom led to the present bust. I am not sure.

What the central bank can do to head off asset bubbles is not very clear but the answer cannot be something that slows the entire economic- sector-specific responses (such as increasing risk weights for real estate, favoured by the RBI here) are a bette idea. In other words, better regulation could have helped prevent the worst excesses and the ensuing problems. So, I would say Greenspan wasn't very wrong on monetary policy but he did stumble on regulation.

2. Stevie commenting on the RTC says that distressed assets lose value with time. Not true. The earlier RTC during the S&L crisis made money eventually; so did the consortium of banks who bailed out LTCM in 1998. It's a matter of using public resources to ride out a temporary storm.

3. Adorable guy: sees the RTC as injecting capital into the system. No, it erodes capital because banks will take a hit against the assets they sell at a discount. What it does is to put a floor to the hit- before the RTC, it appeared that asset prices would go sink indefinitely. So the RTC will help contain erosion in bank capital and it will also create the conditions for fresh money to come in

Investment banks, RIP

Well, the inevitable has happened- Morgan Stanley and Goldman Sachs will cease to be pure investment banks. This won't be news to readers of this blog.

The two firms were issued licenses by the Fed to commence banking operations in what must be record time. The Fed acted with alacrity because any delay could have resulted in Morgan and Goldman meeting the same fate as Lehman- the share prices could have quickly tumbled to zero. The ban on short selling may not have saved the two firms. Now that markets have sensed that the investment banking model was doomed, the bottom would have fallen out of their share prices.

This does not mean that the firms can succeed on their own as banks. Not by a long chalk- I can't see that happening without their having a branch network. No, the permission to convert to banks was meant to be a signal to markets: hey guys, please don't view these firms as investment banks, they are going to be banks soon, so there is hope yet. The odds are that both Morgan and Goldman will merge with some bank or find a bank as a strategic partner.

What happened to all those who proclaimed that these two firms had done a better job of managing risk and would survive? All this talk was baloney. All the top banks were dangerously leveraged, dangerously exposed to toxic securities. That one was more dangerously exposed than another is neither here nor there.

So, the short sellers were right in latching on to Lehman and then to the others. But that does not mean that short-selling of financial stocks in such an environment is justified. This cannot be justified on grounds of price discovery or discovery of information. After all, a central bank may know that a bank is in bad shape but it would certainly not think it necessary to broadcast the news to the world. In times of financial crises- as in times of war- the normal rules of reporting stand suspended. So the temporary ban on short-selling of financial stocks is justified.

One final thought. You could say that the Fed acted with commendable despatch in ensuring that Goldman and Morgan did not meet the fate of their peers. But cynics may take a different view. US Treasury secretary Hank Paulson was CEO of Goldman before moving into government. Does he still own a lot of stock in Goldman? If so, the cynics may take a different view of the Fed's decision......

Resolution Trust Corporation

The US proposal to create an RTC has helped stabilise markets today- or so it seems for now. The RTC would buy bad assets from banks at an appropriate price.It would auction those assets later once markets have stabilised. What does this achieve? It helps stabilise the value of assets of financial firms and prevents the collapse of highly leveraged institutions. Hopefully, the RTC will make a profit later; if not, the government incurs a cost equivalent to the losses on sale of assets the RTC has bought.

Writing in the FT, Raghuram Rajan argues that this is not the right proposal because it ends up rewarding institutions that have taken wrong decisions at a cost to the tax payer. He says it won't address the basic problem which is lack of capital at financial institutions. He suggests intead that these institutions be asked to withhold dividend payments; and stronger firms be asked to make rights issues.

It's doubtful this will work. Shareholders of existing firms lack the incentive to subscribe to rights issues until then are sure that asset prices have stabilised. Secondly, capital will be ready to flow into today's distressed institutions once investors are reasonably sure that the firms' asset values will not decline further.

So, the RTC is indeed the way out. Yes, there is moral hazard. But the world is falling apart, that's not the time to think of moral hazard.

Investment bank fade out

Three of the top five US investment banks have disappeared. Until yesterday, some commentators were insistent that there is still room for investment banks, that the survivors, Goldman Sachs and Morgan Stanley, will actually do better now that competition is less keen.

Well, today's news should cause them to think again. Morgan Stanley is said to be in merger talks with Wachovia Bank and Goldman also exploring possibilities. I argue in my ET column, Wall Street model crumbles that the standalone investment banking model is doomed.

The combination of high leverage and investment on own account in illiquid assets has provd lethal for investment banks. High leverage increases the chance of insolvency; so does dependence on wholesale markets for funding. Alright, say the defenders of investment banks, let's limit leverage through regulation. But, if you take away high leverage, returns in investment bank may cease to be attractive. So, you have to marry leverage with a stable base of funds- and that's where banks come in. That's what the mergers of investment banks with banks are all about.

Not that such mergers don't pose problems. There is clash between the risk-averse culture in banking and the risk-loving approach in investment banking. But, if we accept that the appetite for risk in investment banking will be noticeably lower in the years to come, this gulf can be bridged.

You could argue that investors will not pay a premium for banks diversifiyng into investment banks- corporate finance tells us that what firms can do, investors can do better on their own. So, investment banks will continue to interest investors. But this argument could be applied to diverisification by investment banks too- there should be investment banks specialising in each area: brokerage, advisory services, trading and private equity. Why have full scope investment banks that combine the lot?

Not that every bank will an investment bank will do a great job- JP Morgan Chase may be a success and HSBC too but not Citigroup and UBS. But, at the end of the day, Citigroup and UBS are still standing on their feet while the investment banks have disappeared.

From a regulatory point of view, having investment banks under the roof as commercial banks is looking desirable. After all, banks that are subject to tight capital and other regulatory norms are not the source of the problem today; the problem has arisen in the unregulated part of the financial system featuring investment banks and others.

Can the US afford the bail outs?

Writing in the FT, Harvard Prof Kenneth Rogoff estimates that the US government will end up coughing up close to a trillion dollars in bail-outs for its trouble financial sector. Upto now, the cost is around $200-300 bn. Can the US afford this kind of cost? Rogoff thinks it is very steep and will impose costs in terms of higher interest rates, inflation and lower growth.

We should be careful not to get carried away. A trillion dollars is under 8% of US GDP. That is big but still falls in the lower end of bank recapitalisation costs consequent to economic crises- the range is 5-45% of GDP.

US public debt, at $ 4.4 trillion, is 32% of GDP, pretty much on the low side considering that the limit for EU economies under the Maastricht Treaty is 60% of GDP (India has over 70% of GDP in debt). That means there is room for another $4 trillion of US debt. So, even if the bail-outs were to amount to $1 trillion, the US and the world economy can take that cost in their stride.

AIG blows up

John Gapper of the FT expresses the financial market watcher's anger and utter surprise over how some of the large financial institutions have been managed:

But AIG takes the biscuit. Here was a huge multinational insurance group with a reputation for solid underwriting and risk management that decided to diversify from insuring risks it knew well – car crashes and fires – to covering derivatives it did not understand.

Of course, it thought it understood them. In presentations to investors this year, it emphasised how thoroughly its AIG Financial Products arm assessed the risks of insuring CDOs. It ran all the data and decided that, in the worst case, it risked losing $2.4bn on the portfolio.

Well, $24bn of write-downs later – a mere 10 times its maximum estimate – the company has burned through its equity, spread financial chaos to all corners of the earth and humiliated the US Treasury. The job of insurance companies is to guard others against catastrophes, not cause them.

The word “irresponsible” does not begin to describe AIG’s behaviour

Is higher capital the answer in investment banking?

There is a sense that investment banks too will become subject to requirements of regulatory capital- at present, only commercial banks are subjected to the requirements imposed by Basel I (and hereafter Basel II). FT doesn't think this is a great idea:

There will now be renewed calls for more regulation, and understandably so. But it is naive to think that the right regulatory response is obvious. From poor governance to flawed incentives, incompetent risk management to foolish strategies, the failures of the financial system have been so widespread as to ren­der a coherent regulatory riposte impossible. The likely outcome is that tight capital requirements will be forced to serve as a catch-all res­ponse to risk. If so, the banking system will look more like that of the 1960s – a low-risk, low-return utility business. The ambitious and the avaricious will no doubt seek more exciting hunting grounds with hedge funds and private equity groups.

FT's criticism is misplaced. Many of the problems the quote above mentions- flawed incentives, poor governance, bad risk management- have their roots in high leverage. In the face of high leverage, managers will take all kinds of bad decisions- they will take excessive risks, for instance, knowing that the payoffs will be large if they succeed and costs to themselves pretty low if they don't.

So, while a great deal needs to be tackled by way of regulation, higher capital is an important starting point.

'The worst crisis in the last century'

The quote is from Alan Greenspan. And there is no dearth of other doomsayers. But how bad is the economic situation following the collapse of Lehman and the sale of Merrill? Just a couple of quick points.

First, failures in investment banking and also banking are inevitable (although it is mainly the smaller banks that will be allowed to fail). In key products such as sub prime mortgages and securitisation, demand has shrunk and we will never see anything like the old volumes again.
That means that capacity must also shrink. This happens through bankruptcy or consolidation.

Two, I take heart from the US authorities' decision to let Lehman fail. (It's said that the US treasury secretary was adamant on this issue but I imagine the Fed chairman backed him). The decision reflects confidence in the managers of the US financial system as to the ability of the economy to withstand the fallout.

Let's face it: the US economy is in better shape today than most people had expected at the beginning of the year. (Greenspan was amongst those saying the probability of a recession was higher than 50%; now he's quoted as saying the chances are under 50%). A big chunk of banking losses has already been made good through fresh infusions. Major participants have had enough time to unwind risky positions.

Putting these two points together, the financial markets should stabilise in the near future and the survivors will emerge strengthened by the fall of rivals. So, it's not quite the end of the world.....

Lehman in dire straits

Lehman Brothers, the 158 year old investment bank, is battling for life. Perhaps its future will be known by the time the weekend is over.

Lehman must find a buyer quickly or declare bankruptcy. Finding a buyer is complicated by the fact that the US government is said to be unwilling to provide support to a rescue- as it did with JP Morgan's acquisition of Bear Stearns. Moreover, the authorities are less intimidated by the prospect of bankruptcy than they were in the case of Bear Stearns- they reckon that the fallout can be borne by counterparties because these have had enough time to prepare.

Well, we shall see.... it looks as through the government's reluctance to support a rescue will eventually push Lehman towards a sale at a very low price- bad news for its shareholders including executives holding stocks and stock options in the firm.

And to think that only a few months ago, analysts and media commentators were singing the praise of Lehman and waxing eloquent about how well its CEO had handled its problems, including the challenge of 'communicating' with the markets. When the chips are well and truly down, communication isn't of much help, I guess.

Looking ahead, the big question markets will be asking is: who next? Lehman is not such a big player itself but the message now is that no one is really safe. It's not Lehman's disappearance so much as the possibility of bigger players going under that will give the markets jitters in the weeks to come.

US opts for nationalisation!

Nationalisation and government ownership may be dirty words in the US but this is not time to fuss about ideology- the crisis in the financial markets required drastic action. So the two secondary mortgage institutions - Fannie Mae and Freddie Mac- will go under "conservatorship" which, for all practical purposes, means government owernship.

The government will infuse equity as required and it will also provide debt finance by subscribing to the mortgage backed securities floated by the two institutions. Banks and financial institutions are holding paper issued by the two, so a collapse would have had serious consequences for the already troubled financial sector. The housing market would have seen another fall. Hence the government is stepping in.

FT estimates the cost of the rescue at around $200 bn - or nearly 1.5% of GDP. S& P places the cost at 2.5% of GDP. That's smaller than the $300 bn (in today's terms) that it cost to save savings and loans institutions in the US in the eighties. Still, the amount is not exactly small change. In India, the government has spent a total of $7.5 bn to recapitalise the banking system- or under 2% of GDP. But this was roundly condemned at the time. The same editorial writers (in India) are lauding the US government for its rescue act today- what's good for the US is evidently not good enough for us Indians.

The rescue should calm frayed nerves in the US banking system and elsewhere. It should also help put a floor on housing prices for the US. So it's good news for the world economy. The US economy has grown against all odds in the first two quarters and it increasingly appears that it's the UK economy that stands to suffer most in the present crisis, not the US.

Nuclear deal- is it such a coup?

The media seems convinced we are on to a terrric deal- I refer to the NSG waiver given to India. This is one of those issues where it's really hard to make an accurate judgement. The key is the right to test in future. Now, it's not that we have abjured the right to test. But, the terms of the Indo- US accord are such that the economic costs could turn out to be prohibitive.

I read that the US and other suppliers may ask for all equipment and materials to be returned. If so, the cost would be sufficiently high to deter Indian policy makers from going in for a test. The tricky part is whether in the evolving world scenario, the US and others will want to enforce those terms, given that India will have grown in stature and is also perceived as a reasonable player that will not test without reason. So, I guess this is one of those things that time alone will tell.

A second issue is that we don't seem to be getting full cooperation in the nuclear energy field. Brahma Chellaney has some caustic remarks to make in Rediff.com:

Today, there is not even the pretence that the deal offers 'full civil nuclear energy cooperation' or that India is to 'acquire the same benefits and advantages' as the US. But why blame the US? In his desperation to secure the deal, Prime Minister Manmohan Singh [Images] has repeatedly moved the goalpost.

For example, he has breached his assurance to Parliament on August 17, 2006 on 'the removal of restrictions on all aspects of cooperation and technology transfers pertaining to civil nuclear energy'. He had added: 'We will not agree to any dilution that would prevent us from securing the benefits of full civil nuclear cooperation as amplified above'.

Dr Singh also has reneged on his July 29, 2005, promise in the Lok Sabha: 'We shall undertake the same responsibilities and obligations' and 'we expect the same rights and benefits' as the US. As is apparent, the NSG waiver is neither clean nor unconditional. If anything, it is messy. Yet Dr Singh was quick to hail it as 'a forward-looking and momentous decision', even claiming that 'It marks the end of India's decades-long isolation from the nuclear mainstream and of the technology-denial regime'.

He again pegged his newfound interest in commercial nuclear power to 'environmentally sustainable economic growth' and to meeting 'the challenge of climate change', although one of the first things to be knocked out of the US-drafted waiver text at the earlier August 21-22 NSG meeting was Section 1(e), which read: 'recognize the world's need for clean and reliable sources of energy for sustained growth and prosperity'.

Not many NSG members buy the spiel that nuclear energy can help reduce global CO emissions or be a cost-effective answer to the growing electricity demands. The path to energy and climate security lies through carbon-free renewable energy, which by harnessing nature frees a nation from reliance on external sources of fuel supply. Yet such is the nuclear power hype that few Indians know that their country today generates much more wind power than nuclear energy.

Olympic medals

Reams have been written about the stellar performance of countries such as China and the US at the Beijing Olympics and the lacklustre performance of others, including India. Economist Gary Becker highlights the determinants of Olympic success in his blog, based on a journal paper:

The article "A Tale of Two Seasons: Participation and Medal Counts at the Summer and Winter Olympic Games", published in 2004 in the Social Science Quarterly by Professor Daniel Johnson of Colorado College and a co-author, examines the determinants of how many medals were won by different countries in the summer and winter Olympics since the end of World War II. Their regression analysis shows that two very important variables are the total population and per capita incomes of different countries. Also important are whether a country has an authoritarian government-such as communism- a country's climate, and whether a country is the host country for a particular Olympics. These five variables taken together predict closely the total number of medals won by different countries in the winter as well as summer Games.

Rising interest rates? Not to worry!

Most forecasters have lowered their forecasts for Indian economic growth for 2008-09. The RBI thinks growth will end up slightly under 8%. The PM's Economic Advisory Council projects growth of 7.7%. Many investment banks think growth will be even lower.

These forecasts rest on two things: the adverse global economic environment and lower global growth; and rising interest rates in response to inflationary trends.

Yes, weaker global growth will moderate India's growth but higher interest rates, I think, are not such a big worry. This is the subject of my ET column, Interest rate rise not a big worry.

Why do I say this? Briefly:

• Lending rates have risen but remain below levels in the nineties.
• Corporate leverage is much lower than in the nineties, so higher interest rates do not threaten corporate profit to the same extent
• Consumer borrowing has been impacted but housing demand should revive once property prices correct
• Banks' capacity to make loans remains unimpaired despite four years of rising interest rates. Even NPA levels in the aggregate are not a problem because five years of high growth are causing past corporate NPAs to revive, far from adding to fresh NPAs in a big way.
  

Novel on Zia ul Haq's death in air crash

I've just finished reading A case of exploding mangoes, Mohammed Hanif's novel based on the mysterious air crash that killed Pakistani rules Gen Zia ul Haq. Also killed in the crash were a Lt Gen in the army and the US ambassador to Pakistan. Hanif is a former air force office now residing in the UK.

It's a terrific read, a thriller of sorts. Hanif is South Asia's answer to John Le Carre, I daresay. The story cuts between the interrogation of a suspect in the assisination plot and Zia's own life in the months leading up to the crash. The protagonist, an air force officer, wants to assasinate Zia in reprisal for the murder of his father, a former Colonel in the Pak army.

Col Shigri was a key figure in the funneling of arms and money to the Afghan militia in their war against the then Soviet Union. The sums involved were large and a good deal went into the pockets of Pak army men. Shigri inteferes- and is found hanging in his own house. For the record, his death is described as a suicide.

The novel shows that the CIA wanted Zia out of the way and ambitious army officers were eager to carry out its bidding. It shows that the US diplomat's death in the crash was the result of a mishap but probably the sort of price that people in Washington are willing to pay when they want a job done. A Major Kiyani figures prominently in the story- I wonder if that is the present Chief of the Pak army.

Zia's paranoia makes for hilarious reading. The novel is tightly written, with a wry humour that never fails to find its mark. The murky goings-on in the Pak army are well chronicled. I said to myself after reading the novel: if a former Pak air force officer can write with such ironic detachment and so well about his country and the armed forces, there must be something very right with that country. Pakistan a failed state? No way, if this novel and its author are anything to go by.

Raghuram Rajan Committee

The Raghuram Rajan committee on financial sector reforms, constituted by the Planning Commission, submitted its draft report sometime ago. I have a critique of the banking sector reforms proposals contained in the report in EPW (Aug 9-15, 2008).

A few things I would like to highlight:

• The report does not recommend privatisation on all public sector banks. It is rather more cautious than, say, the Percy Mistry report. It urges experimenting with sale of a few under-performing PSBs to foreign banks.
• On opening up to foreign banks, the committee does not favour a level playing field with domestic banks right away. It wants abolition of branch licenses for domestic banks, followed by extension of the same to foreign banks with a lag of a couple of years or so.
• It prefers reform of PSBs through overhaul of governance. But some of its proposals, such as the government not appointing top management and leaving this to an independent board, are unlikely to fly. With good reason. 'Leave it to an independent board' sounds very lofty but it risks creating a dangerous governance vacuum where we can least afford it- the banking sector. And now is the not the time to be singing the praise of independent boards in the financial sector-see what has happened to some of the best known names worldwide in the sub-prime crisis.
  

Changing face of the Indian bureaucracy

I must thank Abi of Nanopolitan blog for pointing me to this article by S Narayan, former finance secretary, on how better representation for the backward castes is turning out to be a force for good in the Indian bureaucracy. I get a chance to meet several bureaucrats and I keep asking them: is there any truth to the contention that the bureaucracy is going to the dogs, thanks to reservations?

Generally, what I hear is that there is nothing wrong with the candidates selected- they may not speak immaculate English and you may fault their accents but they have competence and motivation, alright. The problem is that political interference has increased. This will happen regardless of who gets into the services.

I have every hope that reservations at IITs and IIMs will achieve the same thing that Narayan suggests it has acheived in the bureaucracy: making the corporate world more representative of and responsive to the large mass of Indian people, instead of being elitist in character. The price that critics say we pay- dilution of standards - is, even if it is true (I have never bought this), small compared to the benefits in terms of social harmony and equity.

Here is an excerpt from Narayan's article:

The character of the All India Services has changed in my lifetime, and in my view, the new entrants are far more representative of the aspirations of the “inclusive growth” view. Bright and hard-working, yet from families that know the meaning of hardship, these are the youngsters most likely to be able to administer from the heart, not just from the book. I have also seen a complete social transformation in the composition of the services, a transformation, though painful, which has brought up people much more representative of the diversities in our society. In the South, especially in Tamil Nadu, it has taken almost 70 years to get here, and I do believe that the rest of India must follow, and it may perhaps take far less time. Though one had to compete all the harder to succeed, I am a strong votary of affirmative action to provide preferential opportunities, especially education, to those who don’t have them.

I can hear sceptical readers wondering: Will the new dispensation be ethical and fair? I cannot say. When I teach these students, I see the core of goodness and fairness—what the real world of politics and bureaucracy will do to their hopes and aspirations is yet to be seen. I like the fact that the collector’s office is not a mysterious, forbidding place for citizens — that they can see their own kind sitting there. Will he be fair? As in economics, the laws of supply and demand will operate. Let’s hope the citizenry wants fair deals — I am sure that the new class will deliver.

Zardari's mental health

FT carries a story about the man who aspires to become president of Pakistan:

Asif Ali Zardari, the leading contender for the presidency of nuclear-armed Pakistan, was suffering from severe psychiatric problems as recently as last year, according to court documents filed by his doctors.

The widower of former prime minister Benazir Bhutto was diagnosed with a range of serious illnesses including dementia, major depressive disorder and post-traumatic stress disorder in a series of medical reports spanning more than two years.

......In court documents seen by the Financial Times, Philip Saltiel, a New York City-based psychiatrist, said in a March 2007 diagnosis that Mr Zardari’s imprisonment had left him suffering from “emotional instability” and memory and concentration problems. “I do not foresee any improvement in these issues for at least a year,” Mr Saltiel wrote.

.....Mr Hasan, a long-standing political ally and friend of the Zardari/Bhutto family, told the Financial Times on Monday that Mr Zardari had subsequent medical examinations and his doctors had “declared him medically fit to run for political office and free of any symptoms”.

“You have got to understand that while he was in prison on charges that were never proven, there were attempts to kill him,” Mr Hasan said. “At that time, he was surrounded by fear all the time. Any human being living in such a condition will of course suffer from the effects of continuous fear. But that is all history.