Directed bank lending

Remember directed lending? That was in the bad old days post bank nationalisation when banks were told whom to lend, how much and at what rates. Banks in the west are reluctant to lend despite governments infusing capital into them. Lack of funds is killing the real economy. So what can governments do? Incredible as it may sound, FT wants governments to compel banks to lend, using their newly found clout as owners of equity in these banks and, if necessary, by getting full control over them!

If evidence emerges that banks are not lending because they are hoarding cash to pay off the expensive preference shares taken by governments, the rescue can be restructured. One option would be to give governments more control of the banks; another would be to reduce the short-term costs of the capital.

.....But banks, which have always been dependent on the largesse of taxpayers, could be forced to adopt central targets for new lending. This would overcome the problem of no institution wishing to be the first-mover. And banks would have little choice but to obey; if they are unco-operative, they could end up in public ownership

Why blame Mr Chidambaram for leaning on public sector banks to lend? I, for one, would not fault him for that. My only plea is: don't dictate the lending rate as well, leave that to the judgement of the banks. When banks are asked to expose their exposures to particular corporates, then commercial logic dictates that lending rates should rise, not fall.

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.