Saturday, November 29, 2008

Mumbai attack and its aftermath

The recent terrorist attack on Mumbai is being called India's 9/11. In sheer audacity of design, that is true. The US, whose mainland has never been attacked, could not have imagined that a set of planes could be transformed into enormous bombs. Nobody in India thought of a sea-borne invasion of Mumbai- the attackers are said to have hijacked a fishing trawler, steered it towards the Mumbai coast and then landed on motorised dinghies. Not just out-of-the box thinking but meticulous execution has been in evidence in both the cases.

In 9/11, the attackers targeted the World Trade Center, beloved symbol of America's financial capital. In the Mumbai attack, the targets were two high-profile hotels and a Jewish centre in India's financial capital.The objective was the same: to cause dislocation and mayhem in leading financial centres in ways that would capture the world's attention. Smoke billowing out of the WTC is one image that is etched in our minds; so will that of the Taj Hotel in flames. The Mumbai attackers have certainly met their objective.

9/11 changed America. Unilateralism and the doctrine of pre-emption became central to American foreign policy. There was the bombing of Afghanistan and invasion of Iraq thereafter.Also less noticed transgressions of international law such as a missile attack on Sudan, the bombing of a suspected nuclear site in Syria and missile and bomb attacks on terrorist hideouts in Pakistan. T

The US has made clear that it will not be bound by the UN or international law when it comes to the protection of its intersts. The US has also gone after terrorists in several countries and spirited them to other locations for interrogation and incarceration. It did this in Italy a few years ago- an Imam was seized by CIA operatives. An Italian judge has issued arrest warrants for the CIA operatives, a warrant that has no chance of being enforced.

Within the US, the full financial might and technological capability of the country has been brought to bear on preventing infiltration of terrorists. The issue of visas has become more stringent, there is far greater scrutiny of visitors (including strip searches) at airports, stepped up surveillance at home and abroad and an abridgement of civil liberties under the Patriot Act. These have ensured that no terrorist attack has occurred in the US after 9/11.

There have been comparable measures in the UK after its own 7/11. Surveillance through closed circuit TV is so pervasive that the Orwellian prediction of 1984 seems to have come true in the UK. On top of this, tapping of phone calls and monitoring of email has been stepped up- the American journalist Seymour Hersh has said that he would never use pay phone in the UK because there was little chance of the call being confidential.

One other country that has had success in the war of terror- in the sense of limiting attacks on its soil- is Israel. But Israel is unique. Not only can it pour huge finanicial and technological resources towards securing itself, it is willing to use the most draconian methods. A whole wall has been created between Israel and the occupied territories and entry through it into Israel tightly regulated. Palestinians have been beaten into quiesence in the most brutal ways.Above all, there is the intense determination of the Israeli people, military conscrption for all young people and the fact that Israel is a small country.

Where does India stand after the Mumbai attack? One, there is no question that security measures in key places, including hotels, will be at a higher level hereafter, causing no small inconvenience but that is something that people will come to accept.

Two, it's hard to see how the pressure to enact tougher terror laws can be resisted- even PM Manmohan Singh had to mention this in his address to the nation after the attack. This does mean a certain curtailment of civil liberties.

Three, there will be profiling of communities and a crackdown on suspects within these. These will create more alienation and hence a greater susceptibility to domestic terrorism.

Will terrorism decline in India in response to strong-arm measures as happened in the US and Israel? One must be sceptical. We do not have comparable funds or technology but that is not the only problem. We must reckon with the country's size and diversity. Above all, there is the problem of corruption and poor governance.

Key institutions of the state, notably the police and the judiciary, suffer from both corruption and poor governance. Strong anti-terror laws, in such a situation, will simply become weapons for persecution and extortion.

Vulnerability to terrorism, it is worth pointing out, is an aspect of corruption and an indifference to the rule of law. The political class will not prosecute or pursue high-profile cases of terrorism; businessmen will maintain links with the underworld; the police is more concerned with collecting bribes than with maintaining law and order;the media has no qualms about lionising celebrities who have been convicted in important cases. When a political party moots the idea of giving a Lok Sabha seat to the key suspect in the Malegaon case, that is confirmation that India in many ways has the traits of a banana republic.

Without an overhaul of governance, without greater accountability, it is hard to see how terrorism can be fought effectively. It is the democratic process and the rule of law that need to be strengthened for these to happen.

Unfortunately, the knee-jerk reaction to heightened terrorism is in the opposite direction- the abridgement of liberties, greater powers to the police, a contempt for politicians and the political process. On TV, I saw a bunch of ad-men pouring scorn on politicians and asking them to keep their hands off the law-enforcement machinery. That is a prescription for fascism.

The gloomy conclusion that emerges is that India will try to emulate the tough methods adopted by countries such as the US and Israel without having the commensurate governance or enforcement capability. This can only lead on to a downward spiral where terrorism is concerned.

Friday, November 28, 2008

Citigroup- too big to succeed

Citigroup has received a government bail-out, so it lives to fight another day. This has been described as a $306 bn bail-out but that is not entirely accurate. The terms of the rescue are:
  • The US government is essentially providing insurance on $306 bn of troubled assets with teh first $29 bn of losses being borne by Citigroup. This is conceptually not very different from any medical or car insurance contract where the first level of losses is borne by the customer.
  • In return for this insurance, Citigroup will issue the government $7 bn in preferred shares carrying a dividend of 8%- this is the premium it pays on the insurance the government provides plus $2.7 bn of warrants
  • The government will inject another $20 bn in preferred shares (not commn equity) into the financial group.
So, the government or the tax payer stand to lose only if Citigroup's bad assets decline more than 10% in value. If the markets recover- and this is a big if- the government is okay and the bail-out is fine. If not, there will be huge costs to the tax payer. Citigroup has $2 trillion in assets and it could under for reasons other than the identified $306 bn in troubled assets.

Citigroup may survive but can it really deliver in its present form? This is a bank with a long history of problems. Ddeveloping country loans, internet bubble, telecom bust- you name it, the bank has been in the thick of every problem in the past couple of decades.

The trouble with firms such as Citigroup, quite simply, is not just that they are too big to fail, they are too big to succeed. It's impossible to sustain good earnings growth on this kind of asset base. Managing $2 trillion in assets is crazy- no CEO or set of executives is equal to the challenge. The complexity is simply too overwhelming.

That's why we had Chuck Prince (the CEO, whom Vikram Pandit replaced) asking his CFO whether everything was ok, only to be told it was- and this when the bank had over $40 bn in toxic assets.The board's great idea was to replace Prince with Pandit, an ex-Morgan Stanley guy with no banking experience. We read that they were on the verge of replacing Pandit too until a Saudi prince affirmed his faith in him. How about replacing the board first?

Banks need to decide what is an optimal size for them. More than $100-200 bn seems to be extravagant. I have also never bought the stuff about universal banking- I once wrote an article deriding the idea as 'universal bunkum'. The idea that one entity can manage everything under the sun- banking, investment banking, insurance, etc - and that it can do a great job of this through cross-selling products is plain stupid. Citigroup never quite managed it. It goes against the idea of 'core competence'.

This is also why I have steadfastly been sceptical about the idea of bank consolidation in India. My contention is simple: if you can't deliver performance at your present size, forget about doing it when things get bigger and more complex.

Monday, November 24, 2008

PSU pay hike

The government has approved the Justice MJ Rao report on pay packages for PSUs. Good. But why does the media get hysterical about pay rises in the public sector? When the central government pay hike was announced, media reports talked of an increase of "over 40%". I showed through my calculations that the increase was 13%. I am inclined to believe that the media prejudice against all things governmental is so great that they are just not happy to see any pay rise in government.

Now, I have been seeing reports about 100-200% pay hikes for PSUs. Rubbish. The chairman of ONGC will get a basic salary of Rs 1,25,000 per month. Is this five times his earlier pay of Rs 25,000. Yes, but only if you compare basic with basic. What happens in government pay revisions is that the basic and DA get merged and there is an increase over that, with DA starting from zero all over again. This is the increase (new basic plus DA versus old basic plus DA) one must look at- and it comes to 20-25% in PSUs. And this increase is happening after 10 years whereas in the private sector, the annual increment would be 25%.

Of course, there are performance-linked incentives in the new scheme of things but these apply mainly at the top. There is an improvement in public sector pay but it will still lag behind that in the private sector in cash terms. The real benefits in the public sector are of the non-cash variety: job security, pension, medical benefits and housing and the sheer richness of the job.

Should pay in the public sector improve a great deal more? Not necessary. One consequence of the ongoing turbulence is that people here are going to re-evaluate the relative merits of public and private sector jobs- and my guess is that there will be a better appreciation now of the former.

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.

Saturday, November 22, 2008

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.

Thursday, November 20, 2008

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

Wednesday, November 19, 2008

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.

Tuesday, November 18, 2008

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.

Friday, November 14, 2008

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.

Friday, November 07, 2008

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.

Thursday, November 06, 2008

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.

Wednesday, November 05, 2008

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.