Libor-rigging: acquittal of two bankers

Post the Global Financial Crisis (GFC), the banking sector- and bankers- came under the scanner. The public was outraged that these men and women had laid low the entire global economy. (Never mind that the US Federal Reserve had contributed with its decision to let Lehmann Brothers fail).

The public demanded accountability. "Why are bankers not getting jailed?" was the general clamour.

In the numerous investigations that followed, the authorities discovered that the Libor rate, which was the reference rate for interest rates on various products, was being manipulated. This is how it happened.

Banks were required to submit their borrowing rates in the inter-bank market. The top 25% and the bottom 25% of the submissions would be left out and the rest would be averaged out to get the Libor rate. It turns out that bankers made incorrect submissions in order to benefit their trading positions. This was called the 'Libor-rigging' scandal. Harsh sentences were handed down on several bankers, quite low in the hierarchy but extremely well paid. The Libor rigging had little to do with the GFC but then this was all about throwing a few bankers to the wolves.

Two of the bankers convicted were Tom Hayes and Carlos Palombo. Hayes got a 14-year sentence, which was reduced to 11 years. Inmates his at his jail assumed he was a child sex offender given the severity of his sentence. Five and a half years later, Hayes has been acquitted. So has Palombo.

The Supreme Court of UK overturned their sentences recently on a technicality. The lower court judge, while giving directions to the jury, had said that taking commercial considerations into account while submitting Libor rates was a dishonest thing to do. The Supreme Court ruled that that was a matter for the jury to decide. For the jury to have taken that as a given meant that Hayes had faced an unfair trial.

Mind you, the Supreme Court did not exonerate Hayes of the charges. On the contrary, it said there was "ample evidence" to secure a conviction. However, since the process was flawed, he had to be acquitted. The Serious Fraud Office has said it will not appeal against the judgement. Hayes is now a free man. Other bankers similarly convicted are now planning to appeal.

The case is not about particular individuals. It is the banking sector that was on trial. The manipulation of submissions was widespread in the banking sector. Top management knew about it as did the regulators. It was what is called 'industry practice'. Nobody batted an eyelid when bankers manipulated the rates to suit their trading positions to benefit themselves and their banks. In proceeding after a few bankers, the Serious Fraud Office was seeking to satisfy the public's cry for blood consequent to the GFC. It has now covered itself with mud.

Dodgy practices continue to abound in the banking sector. There is a push once again for 'light touch' regulation instead of the stringent regulations that came about after the GFC. Will bankers, regulators and politicians ever learn? Perhaps not. The power of vested interest triumphs.

Banks don't have to fear fintech

For some years now, we have been hearing about the fintech threat to banks, including large banks. It was said that these banks would use the internet or mobile to gather deposits and make loans. Thereby, they would dispense with the need for expensive brick and mortar branches. Moreover, they would provide a vastly superior customer experience- lightning fast transactions, bill payments and shopping that would work far more smoothly than anything the big bank had to offer.

Nothing of the sort has happened thus far, as this article makes clear in the case of the UK. (The UK experience is not unique; fintechs have not unseated banks anywhere). Very few fintechs make money, most of them are burning investor cash in garnerning customers. The three leading fintech ventures in the UK have been Revolut, Monzo and Starling. Ten years  after they started off - and ten years is a long time- only Starling  has turned a profit in the year ended March 2023. The other two hope to make profit in the next accounting year.

These three fintechs may have brought in a decent number of customers but they customers use them only to put through transactions on which the banks make a fee. The fintechs have yet to register a meaningful presence in the core banking functions, namely, making deposits and loans. People are not ready to place their savings in a meanginful way with the fintechs- one sure sign: the fintechs have a very low share of salary accounts. Large banks with their brick and mortar visibility inspire more confidence than fintechs. 

If you cannot take care of the funding side, you can't do much on the lending side either. Without low cost deposits, there is little competitive edge to lending. The ones they can lend to are customers whom the traditional banks won't entertain, that is, high-risk customers. Some fintechs claim to have cracked the problem with analytics and stuff but their high level of non-performing assets tells its own story. 

Finally, banks have not been idle in the face of the supposed fintech threat. They have invested hugely in technology and improvements in the customer interface. Some have got into collaboration with fintechs whereby the banks get the benefit of fancy technology and the fintechs collect a decent fee. 

The bottomline: the threatened disruption of the banking industry has not happened at all. If I were a depositor, I would go with a large bank for a simple reason: I know the authorities will not allow it to fail, so my money is safe. With a fintech, I have no such assurance. If the price I have to pay is that it takes more four seconds more to put through a transaction, I can live with that. 

US regulators push for higher bank capital

 

The regulatory direction for banks is clear enough: more capital rather than less. Bankers have been pushing back for reasons that, to me at least, defy comprehension.

Bankers say higher capital will mean higher borrowing rates, lower credit growth and diminished investor interest. They are wrong. We need banks to be better capitalised in order to protect ourselves against bank failures, banking crises- loss of economic output that stretches out for several years.

It’s heartening to see that American regulators have seen the light and are pushing for higher capital norms for banks under Basel 3 regulations. 

My article in BS, Will bankers ever learn?

Will bankers ever learn?

T T Ram Mohan

Jamie Dimon, the chief executive officer of J P Morgan Chase, is that rare banker who doesn’t hesitate to take on regulators and lawmakers. He was severe in his criticism of the Dodd-Frank Act that led to stricter regulation of banks in the US after the global financial crisis (GFC).

Now, Mr Dimon has trained his guns on the Basel III “end game” rules for banks planned by American regulators. These are the final rules related to the implementation of the norms widely agreed upon after the GFC. The new rules will mean higher capital requirements for banks. While Mr Dimon may be gutsy in taking on regulators, it doesn’t   mean he’s right.

US regulators are proposing several changes in the way capital requirements are determined under Basel III. They want all banks with assets exceeding $100 billion to use standardised models, instead of internal models, for providing capital for credit risk and operational risk. For market risk, these banks will have to calculate risk-weighted assets using both standardised approach and model-based approaches and use the higher of the two. In addition, banks will have to reflect unrealised losses or gains on available-for-sale securities. These and other proposals will cause bank capital to increase, and that’s what we need.

Requiring the use of standardised models for risk assessment is a huge shift. In standardised models, risk is assessed based on the average risk experience. Under Basel II rules, which were in place until Basel III came into force, the focus was on capturing risks specific to a bank using Internal Risk-Based (IRB) models. Banks that effectively managed risk would end up having a capital requirement lower than that required under standardised models, resulting in a higher return on equity.

Only banks that could demonstrate the robustness of their risk models would qualify for use of the IRB approach. The very fact that a bank had been approved for the use of the IRB approach signalled to the markets its superior prowess in managing risk.

Regulators are now having second thoughts on the use of IRB models. During GFC, it turned out that many of the banks that used IRB models just did not have the necessary capital to cope with losses. In drawing up the Basel III norms, regulators judged that placing too much reliance on IRB models was unwise. They decided to supplement the earlier capital requirements with a simple leverage ratio, defined as Tier I capital to total assets, of 3 per cent. This translates into a debt-to-equity ratio of 33:1. If this seems an absurdly high level of leverage, remember that banks were even more leveraged earlier.

With the latest Basel III proposals, American regulators are changing tack. They would rather not rely on banks’ internal models at all. They aim to do away with internal models for credit risk and operational risk and play safe with models for market risk. The Reserve Bank of India (RBI) has been moving towards estimating credit loss based on IRB models. It may now want to revisit the proposition. 

The underlying principle driving the new US proposals is simple enough: For banks, more equity capital is better than less. Mr Dimon opposes the move based on arguments we have been hearing from bankers for years now. Two American academics, Anat Admati and Martin Hellwig, have devoted a whole book to showing up the fallacies in these arguments (TheBankers’ New Clothes).

Mr Dimon says more equity capital will translate into higher lending rates for borrowers. This is based on the premise that equity is costlier than debt, especially when we take the tax shield   for debt into account. In banking, that is true only because bank debt is hugely under-priced.

Lenders to banks know that a large bank will not be allowed to fail (“too big to fail”) and are willing to lend at a lower rate than would be dictated by the level of debt. There is thus an implicit subsidy received by banks considered “too big to fail”.  This is a cost that is borne by the taxpayer. It is only when we ignore this implicit subsidy in bank debt that it appears as cheap as it does today. To ignore this is to pave the way for more bank failures and bailouts by taxpayers.

Mr Dimon also contends that investors find bank stocks unappetising if capital requirements go up and return on equity falls. That is not true either. The share price of a bank is a multiple of the price/earnings ratio (P/E) and earnings per share (EPS). Higher equity requirements tend to cause the EPS to fall but they result in a higher (P/E) ratio as investors perceive banks with higher equity as safer and re-rate bank stocks with higher equity capital.

Which of the two effects above will dominate? Bankers seem to think it is the (P/E) effect that will dominate and result in higher valuations. What else can explain the fact that the capital adequacy ratios at the best-performing banks have raced far ahead of the regulatory minimum?

In the US, capital adequacy at an International Monetary Fund (IMF) sample of banks averages over 16 percent, while the requirement stands at around 11 per cent for most banks and slightly higher at 16-17 per cent for very few large banks. The averages in the UK, Switzerland and Sweden are 22, 20, and 23 per cent, respectively. In India, private banks operate at a capital adequacy of 19 per cent, even though the regulatory requirement is just 12 per cent. If higher capital is going to cheese off investors, how do we explain the fact that banks with higher capital than average also command the highest valuations?

Bankers must be aware of this, so why do they set up a howl every time the regulatory requirement goes up? One explanation put forward is that bankers are paid bonuses based on return on equity. The solution, then, is for boards to change the metric for performance awards from return on equity to return on risk-adjusted capital.  Allowing a high level of debt so as to show higher return on equity is certainly not the solution

The regulatory trend is in the direction of increasing capital requirements for banks. That is good for both banks and the economy. The question is: Will bankers ever gracefully accept this reality?

FRB review of the failure of Silicon Valley Bank

The US Federal Reserve Board has published a review of the failure at SVB. The lessons are pretty straightforward. Regulation and supervision have to get tighter. Boards have to do a better job. Managerial incentives need to be aligned to risk-adjusted returns, not nominal returns. With respect to boards, I would add: we need an overhaul of the mechanism of independent directors- we can’t leave it to promoters and CEOs to decide who the ‘independent’ directors should be.

The RBI may want to commission a similar review of the failures at IL&FS and Yes Bank. Regulators unilaterally subjecting themselves to public scrutiny is good for good for the regulator’s credibility and standing- and good for bank stability in the long run.

My article in BS, Anatomy of a bank failure

Anatomy of a bank failure

A radical change is necessary in the appointment of independent directors in India in light of the extensive failures in oversight and management of banks in the US

 

T T RAM MOHAN

 

Silicon Valley Bank (SVB) and its holding company, Silicon Valley Bank Financial Group (SVBFG), failed last March. This resulted in the immediate failure of Signature Bank and, with a lag, of First Republic Bank. More mid-sized banks may follow.

 

The US Federal Reserve Board (FRB) has been quick to commission and publish a review of the failure of SVB. Even more creditable, the review pulls no punches in apportioning blame. The bank’s management failed. The board of directors failed. The supervisor failed. Regulations turned out to be inadequate. Everything that could go wrong went wrong.

 

The Fed review should be compulsory reading for bankers, bank boards, regulators and supervisors. The report will help drive home an important point: It is futile to expect “market discipline” by itself to take care of banking stability.

 

Let us begin with management and board failures. SVBFG’s assets tripled in size between 2019 and 2021. Deposits flowed in. The technology sector was booming, so lending expanded rapidly. Any growth in loans that is way above average loan growth in the sector is a recipe for trouble, a point often lost on managements as well as boards. Management does not have the bandwidth to assess risk properly. Internal controls and systems cannot keep pace with runaway growth.  Reliance on volatile wholesale deposits tends to increase. 

 

Managerial incentives are often linked to profits without adjusting for risk. For CEOs, the temptation to quickly grow the loan book is irresistible. The onus is on the board of directors to apply the brakes.  Rarely does this happen. Boards tend to be mesmerised by CEOs who show dazzling performance for a few years. They find it hard to tell a performing CEO, “Sorry, this is not on.”  

 

At SVBFG, the board was not even responsive to supervisory warnings. The FRB report remarks acidly, “Moreover, the board put short-run profits above effective risk management and often treated resolution of supervisory issues as a compliance exercise rather than a critical risk-management issue.” That could be said of many boards. 

 

Starting in July 2022, SVBFG failed its liquidity stress tests repeatedly. Management moved to increase funding capacity but the necessary actions were not executed until March 2023 when it was too late. Management chose to mask liquidity risks by changing the stress test assumptions. 

 

Interest rate risk too was poorly managed. The bank had breached its interest rate risk limits on and off since 2017. Instead of reducing dependence on short-term deposits, management fiddled with assumptions about the duration of deposits. Hedges on interest rate risk were removed in the interest of boosting short-term profits. Management was massaging earnings by hiding the underlying risks. The Risk Management Committee of the board should have picked up these lapses. It failed to do so, again not a huge surprise. 

 

The supervisors did not cover themselves with glory either. For governance, SVBFG got a “Satisfactory” rating, despite repeated supervisory observations about inadequate oversight.  The bank had large, uninsured deposits that were volatile, yet managed a “Strong” rating on liquidity. Despite breaching interest rate risk limits repeatedly, it got a ‘Satisfactory’ rating on the item.  Clearly, supervisors in the FRB set-up were hard to displease. Banks in India must pine for such a supervisor; they find the Reserve Bank of India (RBI) almost impossible to please. 

 

What accounts for these supervisory failures? The report says joint oversight by the FRB and the 12 Federal Reserve Banks is a factor. The Board delegates authority to the Reserve Banks, but Bank supervisors look to the FRB for approval before making a rating change. Getting a consensus is time-consuming. 

 

But that was not the only reason. In 2018, heightened supervisory standards were made applicable only to banks with assets of more than $100 billion. Moreover, supervisors were under pressure to reduce the burden on banks and to exercise greater care before reaching conclusions or taking action

 

Finally, there were the failures of regulation. The Dodd-Frank Act, passed after the Global Financial Crisis (GFC), provided for stiffer prudential standards for banks above a threshold of $50 billion. In 2018, the Act was amended to raise the threshold to $250 billion. For banks in the range of $100-$250 billion in assets, the Fed was given the discretion as to what standards to apply. When SVBFG reached the threshold of $100 billion, it was subjected to less stringent regulations than would have applied before 2019. Had the dilution in regulations not happened, SVBFG would have been compelled to enhance liquidity and capital before it was too late. 

 

The problem is fundamental. The philosophy of “light touch” regulation and supervision hasn’t quite lost its hold on the US system. Multiple regulators and supervisors are another problem. There is also the “revolving door” syndrome -- regulators join private banks, then jump back to the regulator in a senior capacity. The relationship between regulator and banks is too cosy for comfort, which may explain the kindness shown to SVB. 

 

The RBI, as your columnist argued last month, is well ahead of the regulatory and supervisory curve in the West. Its intrusive approach is a better safeguard for banking stability than the light touch elsewhere. However, supervision can only be a third layer of defence against bank instability. Regulations are the primary layer, followed by the board. The RBI must find ways to get bank boards to do a far better job.   

 

A radical change would be to alter the way independent directors are appointed at banks. At present, the promoter or CEO has the dominant say in the appointment of independent directors (at both private and public sector banks). The RBI may want to insist that, for instance, one independent director be chosen by institutional investors and another by retail shareholders (from a list of names proposed by the Financial Services Institutions Bureau). Until we have independent directors who are distanced from the promoter and management, it’s unrealistic to expect board oversight to improve. 

 

The RBI is hosting a conference for bank directors later this month. Here are two suggestions.  One, in the interests of transparency and accountability, the RBI may want to commission a review of the failures at IL&FS and Yes Bank. Two, it may prescribe the FRB’s review of SVB’s failure as one of the “readings” for the conference. It may also include the report of the UK's Financial Services Authority on the failure of Royal Bank of Scotland during the GFC. At least, bank directors can’t say they weren’t warned.

 

 

 

 

Recent bank failures

 The question pops up again: what was the board of directors doing at the spectacular bank failures we have seen recently?

An article in FT is informative. Only one of SVB's directors had banking expertise and he didn't sit it on the Risk Management Committee (RMC). The bank's RMC included a director with considerable experience in the premium wine industry. SVB did not have a Chief Risk Officer (CRO) for months and when the CEO appointed one, it was considered a big enough achievement to be a factor in his outsized bonus. At Silvergate Bank, the CRO happened to be the son-in-law of the CEO.

Questions need to be asked also about governance at Credit Suisse as it hurtled from one scandal to another over several years. Even if they are, we are unlikely to get lasting answers. It does seem that the board of directors of a company is amongst the most unreformable institutions in the world.

Global economic crisis? Banks are unfazed

 

The world economy faces, perhaps, the worst shock since the global financial crisis (GFC). But the world’s global banking system seems not have noticed! How come?

During GFC, regulators banks woke up to the realization that they did not have the capital (in particular, equity capital) needed to survive a major shock. Governments everywhere blew up enormous amounts of tax payer money on saving banks.

After the GFC, the Bank for International Settlements (BIS) put in place higher capital requirements. These were pretty modest. For instance, core equity capital (what we understand as equity in accounting terms) requirement was raised to just 4.5 per cent of risk-weighted assets.

Bankers howled at the time. The cleverer ones realized quickly that the market rewards banks with high capital adequacy through higher valuations. So they built up capital buffers well above the regulatory requirements.

The global average for CET 1 (or core equity capital) is now 14.1 per cent, well above the 4.5 per cent mandated by regulation. This means that we can have an economic crisis but that won’t translate into a banking crisis. Banking crises are the most difficult to get out of, so that’s good news for the world economy.

Not to pat myself unduly on my back, but students of my banking courses at IIMA (SPB and MFI) will remember that I had emphasized that higher capital was crucial to competitiveness and valuation in banking post the GFC.

My article in BS, Global Banking is a bright spot.

 

Global banking is a bright spot

 T T Ram Mohan

The Ukraine conflict poses the biggest challenge to growth since the global financial crisis (GFC) of 2007. The world economy will grow at 3.2 per cent in 2022 and 2.7 per cent in 2023, says the International Monetary Fund (IMF).  Growth in 2023 will be the lowest since 2010, leaving aside the pandemic year of 2020.

Slow growth and rising interest rates are bad for banks. Slower growth spells an increase in bad loans. Rising interest rates translate into losses in the bond market.   

The astonishing thing is that it appears that the global banking system does not face any high risk of collapse even in these trying times. There is thus hope that the global economy can get back to normal after 2023. Assuming that we escape nuclear annihilation.

The world’s financial system faces an intimidating set of challenges, apart from slowing growth and rising interest rates. The IMF’s Global Financial Stability Report (GFSR, October 2022) lists these challenges:

• China’s housing market woes: Stringent lockdowns in China have impacted home sales. Buyers do not want to make advance payments for the purchase of properties. As a result, developers face liquidity pressures and many have gone bankrupt.   Banks’ exposure to the property is 28 per cent of total loans. (In India, a bank exposure of more than 10 per cent to the property market is considered risky). The IMF estimates that, in a sample of Chinese banks it looked at,  15 per cent (mostly small banks) could fail to meet the minimum capital requirement.  
• Poor market liquidity: Central banks are tightening monetary policy and shrinking their balance sheets. This has meant less liquidity in the market. Investors would like to sell securities when interest rates rise.   When liquidity is limited, the fall in prices can be steep. Investors trying to exit their holdings of securities end up incurring losses that can trigger panic. 
• Corporate debt at risk: Rising interest rates pose challenges for firms with high debt. The composite picture across advanced and emerging markets is not pretty. The IMF’s sensitivity analysis shows that under conditions of stress 50 per cent of small firms would have difficulty servicing debt. Banks are bound to be impacted. The IMF warns that government support may be required to contain bankruptcies at small firms.
• Leveraged finance under pressure:  Leveraged finance is lending to companies with high debt or a poor credit history. It is, therefore, of the high-yield variety. An increasing share of leveraged finance in recent years is “private credit” or credit that is outside the regulated bank market and the financial markets and is of poor quality. As a result, in the US today, more than 50 per cent of leveraged finance is composed of firms with a B rating or relatively higher risk of default. The leveraged finance market is under increased risk in the present conditions.
• Housing price declines: Rising interest rates could trigger a steep decline in housing prices worldwide. The GSFR estimates that in a “severely adverse scenario”, housing prices could fall by as much as 25 per cent in emerging markets over the next three years; in advanced economies, the fall could be 10 per cent. These orders of declines will have adverse implications for banks.

 

Now, that is a pretty serious set of risks that banks are exposed to. One would think that, in combination, these could spell disaster for banks. The big surprise in the GSFR report is that the world’s banks seem well-placed to cope with the very worst.

All growth forecasts at the moment are predicated on economic conditions continuing pretty much as they are today —that is, the Ukraine conflict remains at the present level, oil prices will be around $92 per barrel, inflation starts coming around to normal levels in the next couple of quarters, etc.

But what if conditions worsen? What if the Ukraine conflict escalates and the US and its partners impose secondary sanctions?  What if the risks listed above materialise together as a result? 

Obviously, global economic growth will be severely hit.  The IMF looks at a nasty scenario. Growth drops from the baseline projection of 3.2 per cent to below minus 3 per cent in 2023 before recovering to around 3 per cent in 2024. The global Common Equity Tier I ratio (the pure equity component) in banking falls from 14.1 per cent of risk-weighted assets in 2021 to 11.4 per cent in 2023 and 11.5 per cent in 2024. These are all well above the regulatory minimum of 4.5 per cent. 

Banks in emerging markets would face a serious problem: Banks accounting for a third of banking assets would lack the minimum capital required. Globally, however, banks that fall below the 4.5 per cent minimum would account for no more than 5 per cent of global banking assets. 

Suppose global growth turned out to be below the IMF projection of 3 per cent plus in 2024 in the adverse scenario. Even then, on the average, one can expect banks globally to be well above the regulatory norm. 

How do we explain these outcomes? Well, there has been a big change in the banking system following the GFC. Bankers have come to realise that it pays to have capital way above the regulatory norm. The market rewards them with higher price to book value ratios because it sees these banks as less susceptible to failure. As a result, banks have raced well ahead of the regulatory curve when it comes to capital adequacy. That is standing the banking system in good stead in these difficult times. 

That is true of the Indian banking system as well. Except that, far from being under stress like their counterparts elsewhere, Indian banks today appear to be on song. The 12 public sector banks together have reported a second quarter increase of more than 50 per cent in profit after tax (PAT) over the previous year. Private banks have reported a growth in PAT of over 65 per cent in the same period. Loans in the banking system are growing at 17 per cent. If the global economic outlook is grim, Indian banks haven’t noticed it!

Privatisation of PSBs: why 'big bang' is not feasible

 

Those pushing for aggressive privatisation of public sector banks (PSBs) in India must keep three points in mind.

One, the evidence on the superior performance of private sector banks over PSBs over a long period is not unambiguous- indeed, there was a trend towards convergence in performance until the first decade of the 2000s.

Two, the sale of PSBs is fraught with practical problems given RBI’s norms for private and foreign ownership.

Three, as a recent paper put out by RBI points out, ‘big bang’ privatisation of PSBs is not desirable as it could create a void in financial inclusion.

My article in EPW focuses on points one and two.

Comparisons between PSBs and private banks are distorted by the fact that the comparisons do not eliminate “survivorship bias.” The PSB sample includes more private banks that have failed (25) and have got merged with PSBs than the number of private banks that failed (11) and were merged with other private banks (Ghosh and Kumar 2022).  

Secondly, the divergence in performance between PSBs and private banks happened after the global financial crisis (GFC) of 2007–08 and became glaring only post 2011–12. In 2010, the gross NPAs/gross advances ratio were 2.3% at PSBs and 3% at private banks. By March 2020, the position had changed dramatically: the respective numbers were 11.3% and 4.2%.

The divergence happened because PSBs lent massive to infrastructure (power and telecom) and related sectors, namely, mining, iron and steel, textiles, and aviation. These five sectors accounted for 29% of all advances at PSBs and 14% of advances at private banks. Such lending was not on account of poor underwriting skills at PBS. The Economic Survey of 2016–17 noted,

the vast bulk of the problem has been caused by unexpected changes in the economic environment: timetables, exchange rates, and growth rate assumptions going wrong.

As to the mechanics of privatisation, we need to be clear answers to the question: whom do you sell the PSBs to? You can't sell them to corporate houses, RBI policy does not allow corporate ownership in banking. Foreign banks are either not interested or are not willing to enter the country via the subsidiary route as mandated by RBI. The larger private banks have large enough networks and don't want to be saddled with the legacy issues at PSBs.

That leaves you with FIIs, including private equity. The RBI is willing to allow only a maximum stake of 15 per cent for such entities. They will want a controlling stake, preferably 51 per cent and with zero government presence. That is not a condition that can be easily met.

Then there are the legislative amendments needed to the Bank Nationalisation Act, on which Parliament has to sign off.

So, you see, in the very nature of things, PSB privatisation can't be accomplished in a hurry.

Credit Suisse woes: can banks be cured at all?

Can banks be cured of their penchant for taking excessive risk? Or is banking an ailment for which there is no cure?

The question is prompted by the astonishing confession of the Chairman of Credit Suisse, Axel Lehmann:

It has become clear that the challenges of the past were not solely attributable to isolated poor decisions or to individual decision makers,” he (Lehmann) told the Swiss lender’s shareholders. “Within the organisation as a whole, we have failed too often to anticipate material risks in good time in order to counter them proactively and to prevent them.

Well, if a bank can't anticipate material risks, what are its executives getting paid for? The problem, I suspect, is not lack of awareness of material risks. It is the way incentives operate in banking: heads I ( the bank manager) win, tails you (the shareholder) lose. If a banking bet goes hugely wrong, the shareholders and bondholders are left holding the can. The manager, at worse, will lose his job. He won't starve as a result: he will enough millions to live off for the rest of his life. As long as there are no penalties, including criminal penalties, for irresponsible decision-making and as long as banks are leveraged the way they are, it seems futile to expect bankers to behave. 

Credit Suisse has got singed on account of exposures to high-profile collapses. It lost $5.5 bn on account of its exposure to the disgraced fund, Archegos. And its clients have  $10 bn of their money trapped at a failed fund, Greensill Capital. 

An investigation carried out by law firm Paul, Weiss at the instance of Credit Suisse remarked that the bank's losses that the losses were the result of a "fundamental failure of management and controls" at the bank and a "lackadaisical approach to risk".

Makes you wonder. If this is the quality of risk management at the one of the best known names in the world of banking, what does it say about the efficiency of foreign banks? What does it tell us about the functioning of the boards of top institutions? Is corporate governance an illusion? Does it make sense at all to talk of foreign banks coming in and acquiring underperforming public sector banks in India? 

I leave it to you to ponder.

HDFC Bank-HDFC merger: euphoria is misplaced

After the initial spurt in stock prices after the announcement of the merger of the HDFC duo, prices have fallen back. There is a better appreciation of the realities.

Yes, the merger was required, more so by HDFC because of the obvious difficulties in sustaining earnings growth. But that doesn't mean that the new entity is going to produce fabulous returns. The chances are that returns of the merged entity will be lower than that of either entity before the merger. 

The issues are:

• The statutory requirements that will apply to the liabilities of HDFC
  
•  The difficulty in cross-selling deposits to HDFC customers
•  The managerial challenges of merger, including managing a more complex entity than before
• The problems with growing earnings on a larger base
• The prospect that the competitive landscape will have changed by 2025 when the presumed benefits of the merger will start kicking in

I elaborate in my article in Bloomberg Quint.

For those who can't access it, here it is:

HDFC Bank-HDFC merger signals goodbye to the halcyon days

T T Ram Mohan

HDFC Bank reported a return on assets (RoA) of 2.3 per cent last quarter and earnings growth of over 18 per cent. These are numbers that should make analysts and investors salivate- internationally, even an RoA of 1.25 per cent is considered very good.

Yet, the price to book value ratio of HDFC Bank was just 2.3 before the recently announced merger with HDFC, way below the multiples that the bank commanded at lower returns. The stock has underperformed the index over the past year.

Why so? Clearly, investors did not think that HDFC Bank could sustain high earnings growth.  

One reason surely was the bank’s low exposure to home loans: these constitute only 11 per cent of HDFC Bank’s portfolio.  A reasonable share of home loans in the overall portfolio of a private bank would be 25 per cent. Post the merger, management expects home loans will constitute 33 per cent of the overall book.

Right since the bank’s inception, not being able to have adequate home loans in its book has been an issue for HDFC Bank. The bank had the distribution capability but could not have its own home loan book because that would mean competing with its parent.  This did not matter much in the initial years because there was enough scope to grow through other products.

A few years down the road, HDFC Bank entered into an arrangement whereby the bank would sell HDFC’s home loans for a fee. It would also have the right to acquire 70 per cent of the home loans it had distributed as mortgage-backed securities. These securities would have the yield of home loans minus a servicing charge for HDFC. This gave the bank a product with a decent margin. But it wasn’t quite the same thing as being able to finance home loans on its own.

Analysts could see this clearly. So they would keep asking Aditya Puri, the former CEO of HDFC Bank, when the bank would do the obvious thing, namely, merging with HDFC. If memory serves correctly, Mr Puri had to tell analysts that that was the one question he didn’t want to hear any more! Mr Puri told analysts that the merger would happen when the timing was right.

The timing was never right in Mr Puri’s time because there was no way that Mr Puri would settle for a position that was less than that of the CEO. It would have been difficult for the parent’s top brass to settle for less either. There is little doubt, therefore, that the personality issue came in the way of the logical thing for HDFC Bank, namely, merger. The argument that interest rates have declined, so the cost for HDFC of complying with statutory liquidity ratio requirements is less onerous is correct. But high interest rates were not the principal hurdle to the merger.

Now, Mr Puri is no longer at the helm at HDFC Bank. Keki Mistry, Vice Chairman of HDFC Renu Karnad, Managing Director are both in their late sixties. There is no difficulty in their making way for the relatively youthful CEO of HDFC Bank, Sashi Jagadishan.

Without its own home loans, growth in recent years at HDFC Bank has come from MSMEs and the unsecured book. These are high-yield products but risky. Home loans have a lower yield but serve the purpose of lowering overall portfolio risk. Investors would prefer a bank whose growth was driven by the latter.

For HDFC, the parent, there was no problem in sustaining growth in the loan book because the potential for home loan growth remains huge in India’s under-penetrated market. The problem was being able to sustain its current margins in the face of tighter regulations.

Non-banking finance companies (NBFCs) have the disadvantage of not having access to low cost savings and current accounts. They had advantages. A big one was not being encumbered by the liquidity and priority sector obligations that banks face.   This is what is called ‘regulatory arbitrage’.

In October 2021, the RBI moved towards bringing regulatory norms for the larger NBFCs broadly in line with those for banks. In particular, the liquidity requirements for larger NBFCs were made the same as for banks with effect from 2025. The RBI’s intent is clear: the larger NBFCs must convert into banks.

The larger the NBFC, the greater its dependence on bank borrowings. Large NBFCs are thus a source of systemic risk. Better, then, that they submit themselves to the tighter regulation that applies to banks. There was no way that HDFC could have kept growing without considerable pressure on its margins. The answer was to access the low-cost funds available to HDFC Bank.

Mergers are touted as great strategic coups. Markets fall for this line and respond by boosting the stock prices of the two entities involved after  a merger  announcement. This has happened with the HDFC Bank- HDFC merger. For that reason, CEOs love mergers.

The prosaic truth is that mergers are confessions of failure: the failure to grow earnings on an organic basis. As our analysis shows, the HDFC Bank- HDFC merger is no exception.

Mergers are expected to reward investors through synergies and cost savings.  Alas, a large proportion of mergers- in some sectors and economies, the majority- fail, that is they failed to enhance the combined shareholder value of the two erstwhile entities. That is because the supposed benefits are overwhelmed by the complexity of the  larger entity. Every merger thus represents the triumph of hope over experience- every CEO hopes that his adventure will belong to the successful minority.

What of the HDFC Bank-HDFC merger? The two entities belong to the same family. HDFC’s employees are a small fraction of that of the bank but there is still the task of integrating the senior management of HDFC and resolving issues of who reports to whom.

Analysts talk of the benefits of scale. But these economies kick in at a much lower scale than that of the behemoth that will be created in the present merger. Beyond a certain scale, there is little to be gained.

Then, there is the potential for cross-sell. HDFC Bank can certainly push home loans in a bigger way to its customer base than before. Selling deposits of HDFC Bank to HDFC’s customer base is a more challenging proposition. HDFC’s customers would have their own banking relationships and switching from one bank to another is not easy. Had it been easy, HDFC could have  sold the bank’s deposit products all these years and collected a fee from the bank.

The merger is to be completed in 2024. The presumed benefits will happen in the years thereafter. The banking landscape then is unlikely to be the same. The newly consolidated public sector banks will have got to their acts together by then and may pose stiffer competition on both the liabilities and the asset side. Some of the NBFCs promoted by industrial houses may get the nod to convert into banks. Who knows what other changes are in store? The gains of the merger are thus subject to considerable uncertainty.

What is certain is the negative impact, post-merger, of the SLR and priority lending requirements against HDFC’s deposits. The returns of the enlarged HDFC Bank will fall as a result.  It Is not clear whether the RBI will allow HDFC Bank to directly hold the numerous subsidiaries of the merged entity. If the RBI insists on a holding company structure, that again will impose costs and returns will fall.

In sum, the merger is the answer to slower earnings growth faced by the two entities. We will have a giant that can be expected to do better than either entity would have done sans the merger. However, it is unlikely that the glorious past of either entity can be recaptured on a much larger base.  It does appear that the halcyon days of the HDFC duo  are over.

(Disclosure: The author is on the board of directors of IndusInd Bank Ltd. ttrammohan28@gmail.com)

Citibank exit from Indian consumer business

Citibank's decision to exit the consumer business in India (except for wealth management) is no surprise. There have been several exits of foreign banks from the consumer business in India- HSBC, Bank of America, RBS, to name a few. 

Foreign banks lack the branch presence needed for retail business. Many of them have no more than a couple of dozen branches. This limits access to low cost funds and it limits access to retail borrowers. There is no way they can match either the public sector banks, with their large branch network inherited from the past, or the private banks that have rapidly expanded their branch network in recent years and continue to do so.

Foreign banks were restricted for long in expanding their branch network by reciprocity agreements under the WTO. In November 2017, the RBI announced 'national treatment' for foreign banks, that is, they would be treated on par with domestic banks for the purpose of branch licensing and in other respects, subject to their setting up a wholly-owned subsidiary in India.

But foreign bank subsidiaries are subject to onerous requirements. The governance requirements include such as having a board of directors with at least 50 per cent locals, one-third independent directors, etc. This is undoubtedly a deterrent for foreign banks that would like complete control over their local boards. Besides, a retail presence in India would entail a large commitment of capital. Ever since the global financial crisis of 2007, foreign banks have found it difficult to access capital or have developed a preference for conserving capital for their home markets. 

We are thus in a curious position today. After putting enormous pressure on the Indian government to open up to foreign banks, these banks have suddenly lost appetite for the Indian market. The RBI's policy of allowing domestic private banks to enlarge their presence before letting in foreign banks- a policy authored by Y V Reddy when he was RBI governor- has worked.

Archegos debacle: do banks know what risk management is?

There we go again. Archegos, a hedge fund, has blown up and it's causing huge holes in the balance sheets of banks that were exposed to it. Credit Suisse is due to disclose losses, running perhaps into billions of dollars, due to its exposure to Archegos (and a finance company, Greesnsill). The head of risk at Credit Suisse is among the executives who will depart, reports FT.

LTCM all over again? Well, it's not quite as catastrophic in its impact as LTCM but it does reflect poorly on risk management at banks.

As in the case of LTCM, banks were exposed to Archegos through loans and derivatives, with the difference that the loan and derivatives exposures were intertwined in this caes. Banks made large loans to Archegos. Archegos invested these in stocks and entered into a total return swap with banks. Under the arrangement, banks would be paid a fee plus interest on their loans. The capital gain on stocks would belong to Archegos. As long as the stocks appreciated, no problem. But if they didn't, there could be a problem.

As it turned out, the stocks owned by Archegos did lose value. Banks thought they were protected by cash collateral. They also thought they were protected because the stocks were highly liquid. But we do know from LTCM that when any one entity has a large exposure to a security, liquidity can vanish quickly. As the stocks lost value, banks demanded more collateral. Archegos tried to sell its stocks to raise cash but the positions were so large that the very act of selling caused prices to fall steeply. This meant more margin calls, more sales... and then bust. Exactly as in LTCM.

In LTCM, the problem was that banks did not know the cumulative bank exposure to LTCM. The reform that followed was that banks' exposure to Highly Leveraged Institutions came to be monitored closely. Why didn't that work here? It appears that Archegos was run as a family office and did not have the same disclosure requirements. But if that was the case and banks had no means of monitoring total leverage at Archegos or total counterparty exposure to Archegos, they should not have got heavily exposed to it in the first place. There can be no excuses for the lapse after the lessons said to have been learnt from LTCM.

Archegos represents a colossal failure of risk management. If 14 years after the worst banking crisis in a century, this is the state of risk management at the world's leading investment banks, one has to despair. The fundamental problem at private banks hasn't gone away: incentives are asymmetric. If gambles taken by bankers work out, they gain enormously. If the gambles fail, it's the shareholder- and, often, the tax payer- who is left holding the can.