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.