A less profitable banking sector

Banking in the industrial world will be less profitable in the years to come than in the past. This is even after those economies recover- whenever that happens. One reason is that capital requirements will go up as regulators push banks towards lower leverage. Another is that high-risk products will come under the scanner and banks won't find it easy to hawk these.

Of course, there will be a shakeout and capacity will shrink. But that doesn't mean survivors will have easy pickings. Demand too will shrink - a whole range of securitised products and derivatives will find very little demand. An article in FT notes:

According to analysts at Citigroup, European banks earned a return on equity of 18-23 per cent between 2003 and 2007 compared with 12-15 per cent in the mid-1990s.This shift mainly reflected more borrowing: European banks’ leverage – the value of their assets as a proportion of their equity – rose from 24 times on average in 1995 to 39 times in 2007.

What about the banking sector in India? Here too, expect banks to be operating at a capital adequacy of around at least 15%. But volume growth will be strong- 20% or so- and margins are still higher than those elsewhere. Besides, the massive churn in thinking occasioned by the present crisis will mean continued caution in opening up to foreign banks, which are potentially the most potent threat to the profitability of domestic banks.

In short, over the next five years, expect the banking sector in India to be almost as profitable as in the recent past- and an outperformer in the Indian economy.

CIA chief's visit to India

The new head of the CIA, Leon Panetta, was in India in the period March 18-20 and then went to Pakistan. During the course of his visit, he met home minister P Chidambaram. This has come in for some comment because the heads of US security agencies had, until recently, confined their contacts to their counterparts in India. In Pakistan, they have access to everybody including the President and the Prime Minister. But, then, India is not Pakistan- or so one would have thought.

B Raman, writing in Rediff, notes the changed equations:

The Indian intelligence has been having a liaison relationship with the CIA since the days of Jawaharlal Nehru. This was handled by the IB till September, 1968, and thereafter by the R&AW. Many CIA chiefs had visited India in the past. Their visits used to be graded as top secret. Their programme in New Delhi used to be restricted to professional discussions with the heads of the IB and the R&AW and a courtesy call on the prime minister.

This was for security and political reasons. Before international terrorism became a major source of concern, the security reasons mainly related to possible threats to the physical security of the visiting CIA chief from the intelligence agencies of the Communist countries. After the collapse of the USSR and other communist regimes in East Europe and after the normalisation of the US relations with China, this concern is no longer there.

But, since the late 1980s, terrorism has become a major source of concern. CIA officials responsible for the security of their director and their officials posted in India for liaison purposes used to prefer that the visits be kept secret. Indian agencies too preferred secrecy because they were rightly concerned that if the visits were open, jihadi terrorist threats to India and to US nationals and interests in India, including to the US diplomatic and consular missions in India, might increase.

This position started changing when Atal Bihari Vajpayee was the prime minister. The visit of George Tenet, the then Director of the CIA, to India was kept a secret, but the visits of the No.2 to Tenet were publicised. L K Advani, the then home minister, came to be associated with the visits of CIA officials to New Delhi. Their programmes included a courtesy call on the home minister. Not only that, Advani too, during his visit to the US in 2002, reportedly called on Tenet in his office.

A new job for Montek?

Nicholas Stern, former Chief Economist of the World Bank, suggests a new institution for warning against sources of instability in the world economy. He says the existing institutions- WB, IMF, BIS- are unsuited for the purpose because there is interference all the time from representatives on the board of various countries. (How very interesting!- so treat the next IMF country review with the utmost scepticism).

Stern thinks such an institution could be created without huge costs:

With 100 high-quality staff and outstanding leadership, such an institution could be very effective. A budget of $20m (€15m, £14m) per annum would be sufficient. An endowment of $500m would give it the independence it needs for 30 years or more. Its board would be advisory, non-resident and meet not more than twice a year. The board would have the power to appoint the head (for, say, a seven-year term) and ensure its finances are well managed. It would have no power to interfere with, or comment on, its assessments.

Stern says that a requirement for independence of such an institution is that it should preferably be headed by somebody outside the G-8. He lists several candidates. One is our own Montek Ahluwalia. So, if the Congress/UPA does not return to power, there is still hope for Montek.

'Stocks are best for the long term'

That's how stocks are sold to the public. In the long-term, it is said, stocks outperform other assets. The trouble with this statement is that the long-term can be much too long- longer than one's life span. Secondly, in the active period of one's life, one can find that stocks have done worse or no better than other assets. I have written about this, citing various sources of data. An article in the FT revisits this theme:

Anyone who started saving 40 years ago, when the postwar “baby boom” generation was just joining the workforce, has found that stocks have performed no better than 20-year government bonds since then, a forthcoming article by Robert Arnott for the Journal of Indexes shows......To find a period that does produce an outperformance requires a span reaching back a lot further. The 2009 Credit Suisse Global Investment Returns Yearbook shows that since 1900 US stocks have averaged an annual real return of 6 per cent, compared with 2.1 per cent for bonds – while in the UK, equities have beaten gilts with a return of 5.1 per cent against 1.4 per cent. The problem is that they can perform worse than bonds for periods longer than a human working lifetime.

..Last year, most equity mutual funds failed to beat their benchmark indices, even though their managers had the freedom to move into cash and to pick stocks. Mr Malkiel points out that of the 14 funds that had beaten the market in the nine years to 2008, only one did so last year. Both efficient-markets and behavioural economists say it is better just to match the index, with a tracking fund, and avoid the fees incurred in unsuccessful attempts to beat the market.

International Criminal Court

The ICC has issued its first arrest warrant against a ruling head of state. Sudanese president Omar Hassan al Bashir faces charges war crimes and crimes against humanity. The ICC is one of those noble ideas that have been subverted by powerful vested interests. The idea of the ICC is to ensure that tyrannical regimes do not get away with visiting crimes on their people by claiming national sovereignty.

Unfortunately, the ICC is likely to remain a paper tiger because it has not been ratified by and cannot operate against several countries including the US. Indeed, the US allowed the ICC to come into being on the understanding that its own forces operating abroad would be exempt fro the purview of the ICC.

In an article in TOI, Ramesh Thakur places the ICC's verdict against the Sudanese head of state in perspective (the four verdicts given so far are all against Africans). One cannot but conclude that the ICC merely reinforces what we already know about the rule of law: one set for the rules for the powerful and another set for the powerless:

Yet, no senior US general or cabinet member is likely to face international criminal prosecution for Abu Ghraib, Guantanamo or other abuses. Does the world not eserve an honest accounting of what happened in Fallujah in April 2004 how many were killed, and whether any criminality was involved, including the use of chemical weapons prohibited under international humanitarian law? Nuremberg was supposedly about who started the war, not who lost; we know who started the Iraq war and we know they have not been called to account for the crime. What of charges of war crimes by Hamas and Israelis in Gaza earlier this year?

Unlike Bashir or any of the other Africans in the dock, whose alleged atrocities were limited to national jurisdictions, the George W Bush administration asserted and exercised the right to kidnap suspected enemies in the war on terror anywhere in the world and take them anywhere else, including countries known to torture suspects. Many western allies colluded in this distasteful practice of rendition. No westerner has faced criminal trial for it. In a surreal twist worthy of Kafka, western governments send terror suspects to be tortured to countries which they then brand as human rights abusers. Consider the ad hoc International Criminal Tribunal for former Yugoslavia. It has tried several Serbs, but no NATO national. Might it have something to do with the tribunal being located in a NATO country, its budget being paid mostly by NATO countries and its reliance on NATO for collection of evidence and enforcement of warrants.

Siachen Glacier

We approach the silver jubilee of the Indo-Pak confrontation over the Siachen glacier. EPW carries a detailed analysis of the background to the conflict by Col Pavan Nair, a retired army man.

As the Colonel points out, the war is not so much over the glacier as over the Saltoro ridges that dominate the glacier. India did in Siachen exactly what Pakistan attempted in Kargil- occupy positions that give a commanding view of the movements of the opposite side. The difference is that the Pak intrusion into Kargil clearly violated the LoC. In Siachen, the Indian violation is not as clear, although Nair himself believes the decision to occupy the Saltoro ridges was a blatant violation on India's part of the Shimla Accord.

The demarcation point in the map in the agreements signed between India in Karachi in July 1949 and Suchetgarh in December 1972 ends at a place call Khor, with the remark that the line would run "thence north to the glaciers." According to Nair, "The last part of the line, that is Khor and beyond was not made inclusiveto either party.....The Indian claim is based on the watershed principle. Since the last demarcated point NJ9842 lies on or near the Saltoro
watershed, the line should follow the watershed that is the Saltoro Ridge line which runs in a north-westerly direction.".

Whatever the rival claims to the Saltoro ridges, Nair argues that no strategic interest is served on either side by controlling the area. It is in the interest of both to withdraw. Staying on the Siachen costs India Rs 1000 crore every year. Over a 1000 Indian soldiers have died, mostly on account of the hostile weather conditions. Nair says the Indian military leadership had intended the occupation of Siachen as a temporary show of force and did not imagine that the Indian army would be stuck there. Some army generals have even urged unilateral Indian withdrawal, saying that Pakistan would not gain anything by occupying the ridges.

What do we laymen make of the situation? Money is precious and so is every human life. But Rs 1000 crore and 40 lives lost per year do not appear prohibitive in the national scheme of things. Unilateral withdrawal is politically unthinkable especially after Kargil. No government could survive if it withdrew from Siachen only to find that Pakistan had moved in.

As for Nair's contention that there are no strategic gains to be had, you have to remember that military technology and thinking keep evolving. It may not be possible to use the heights to any purpose today. But, with a higher level of technology and if we are under pressure on other fronts with Pakistan in a future war, who knows? That's perhaps why the army balks at the idea of even demilitarising the zone.

The gloomy inference must be that Siachen by itself is unsolvable. It can only be part of a larger Indo-Pak settlement. And that, alas, is hardly in sight.

Rethinking financial sector deregulation

Writing in BS, Jaimini Bhagwati observes:

Further, in the last few years some commentators have called upon policymakers and regulators in India to push for the following: (a) the central bank to adopt inflation targeting as its principal objective; (b) move speedily towards capital account convertibility; (c) raise foreign direct investment ceilings in the Indian banking sector; (d) move from defined benefit pensions schemes to defined contributions and favour larger investments in equity markets; and (e) establish Mumbai as an International Financial Centre (MIFC).

We need to pause and reconsider all of the above propositions

Readers of this blog will have no difficulty in appreciating that I share Bhagwati's scepticism about the proposals listed above. My guess is that the sub-prime crisis effectively ensure that a big chunk of the report on the MIFC and the Raghuram Rajan report on financial sector reforms will remain in limbo in the near future.

Bhagwati, now India's ambassador to the EU, Belgium and Luxembourg, was part of the liberalisation brigade earlier. So he surprises me when he says that, "....no amount of overhauling of the regulatory and credit rating processes can reduce systemic risk in the financial sector unless it is accompanied by a clipping of compensation packages to make these comparable to other sectors.".

I have highlighted here the link between top management pay and sytemic risk in the financial sector. But I have refrained from advocating absolute limits on pay. I am more concerned about the design of incentives. It could well be that once we accept the principle that variable pay must be based on return on risk-adjusted capital, levels of compensation in the financial sector will automatically fall from the present levels. But, I would not start out with the notion of caps on pay.

More on shareholder value

I had a post earlier on shareholder value maximisation and how Welch's criticism of this principle was unfounded. Those who criticise shareholder value maxisation say that it allows managers to focus on short-term value at the expense of the firm's long-term interests. But this reflects market inefficiencies. We should redouble efforts to increase market efficiency- through regulation, governance, better microstructure, etc.

Secondly, managers can get away with short-term results only as long as their incentives or rewards are linked to such results. The way to get them to focus on the long-term is to design incentives accordingly. There is growing consensus now that stock options should vest only over a long period- say, 10 years.

It's not the focus on shareholder value that needs to be remedied. The things that need remedying are the effectiveness of boards, executive pay and, above all, the concentration of powers in the CEO. If corporations are to create sustainable value, we must end corporate dictatorships. More on this in my ET column, Shareholder value's not the issue.

Asia's conservative capitalists

Kishore Mahbubani crows over the relative solidity of Asian economies in the present crisis in a recent FT article. He ascribes it to their refusal to blindly imitate Anglo-Saxon capitalism and to a deeply ingrained caution among Asian policy makers. It is notable that China has been as wary of financial deregulation and innovation as India:

The desire for an orderly society is deeply ingrained in the psyche of all Asians, which helps explain why virtually all Asian states hesitated to copy America in deregulating their financial markets. Instinctively, they felt government supervision remained critical. This was equally true in India’s democratic system and in China’s Communist party system.

It is telling that, while Y.V. Reddy, India’s former central bank governor, was occasionally vilified by his country’s media for holding back on deregulation, he has now become a national hero. His stance saved India from the worst effects of this crisis. China was equally wary of deregulation. Indeed the Chinese leaders may have understood earlier than most that America was building a house of cards with its reckless creation of derivatives. Gao Xiqing, an adviser to Zhu Rongji, then Chinese premier, said in 2000 that “if you look at every one of these [derivative] products, they make sense. But in aggregate, they are bullshit. They are crap. They serve to cheat people.” Mr Gao said all this while Alan Greenspan, as chairman of the US Federal Reserve, was waxing eloquent about the economic value of derivatives.

Regulatory lessons from sub-prime crisis

I list 10 early lessons from the sub-prime crisis in an article in the latest issue of Economic and Political Weekly.

US largesse for foreign banks

There is outrage in the US over bonus payments at insurer AIG, a company that has received billions in tax payer money. AIG paid nearly $165 mn in bonuses and New York's attorney general has launched an investigation into these.

But the more significant revelation is about how bail-out funds went into the coffers of foreign banks that happened to be counter-parties to derivatives and other contracts with AIG. Total payments to foreign banks were a staggering $50 bn. More than 20 foreign banks were beneficiaries. FT reports:

The biggest winners were French banks, with Société Générale receiving $11.9bn and BNP Paribas $4.9bn. Deutsche Bank of Germany received $11.8bn and Barclays of the UK $8.5bn....UBS, the Swiss bank, received $5bn from US taxpayers via AIG – dwarfing the $780m it agreed to pay the US government last month after admitting to helping US clients avoid taxes.

Goldman Sachs received nearly $13 bn. The pay outs to foreign banks were unavoidable because it would have been difficult to honour commitments to local parties and not to foreign ones. Besides, the impact on global banks of not honouring commitments would have been significant and would have inflicted huge costs on the world economy. This highlights an important regulatory issue: monitoring of cross-border transactions of domestic entities that are considered too big to fail.

Subsidies for newspapers?

No, I'm not talking about Indian papers, many of which survive on government ads. The failure of several newspapers in the US and elsewhere in the present crisis has prompted a debate on whether newspapers need to switch to a different business model from the present one that relies overwhelmingly on ads, says an FT report.

In the alternative model, newspapers would be subsidised either by private endowments or by the state. If you regard them as a form of public service, like educational institutions, then such an argument could be made. According to estimates, the New York Times would require an endowment of $5 bn to cover its newsroom costs. The total endowment required for all US papers would be $114 bn.In France, the government is stepping in to support papers by doubling government expenditure on ads- no doubt, a unique form of fiscal stimulus.

Government subsidies for the press are always an uncomfortable matter. As for private endowments, that could create an uneven playing field between papers supported by endowments and those that operate commercially. Besides, as the FT report notes, papers supported by endowments are not insulated from commercial papers- the Christian Science Monitor has closed its print edition.

Another option is charging for the online editions. But other than a few papers such as the Wall Street Journal and the Financial Times, not many papers have met with success in charging for their online versions. Part of the solution, as the FT notes, must be attacking the cost structures. Newspapers are still not disciplined enough in terms of weighing expenditures on coverage of news stories- Rupert Murdoch must be an exception in the game.

Pakistan a 'failed state' ?

For me, the big item in today's news about the turmoil in Pakistan was the resignation of Sherry Rehman, the information and broadcasting minister in the government.

Given the sketchy reporting that, alas, has been all too common in the Indian print media, I had some difficulty making out what precisely had prompted the resignation. One paper said it was in protest against the ban on Geo TV. That is absurd because the channel continues to broadcast. Another paper said it was in protest against restrictions placed by President Zardari on the channel's coverage of anti-government protests. That sounds more plausible. Remember, Geo TV is the channel that lost a courageous correspondent to terrorists in the Swat region.

Rehman's resignation is an act of great courage and conviction. It is not that she herself is responsible for any lapse. She has resigned in the cause of freedom of the media. When was the last time any minister in India resigned on an issue of principle?

To me, Rehman's resignation shows how passionate the elite in Pakistan's civil society is about democracy. In the recent past, several sections of civil society have displayed such passion- the media of course, but also lawyers, the judiciary and various political parties. As I have noted earlier in my blog, Pakistan's media remains remarkably vibrant and varied in its expression of views. I used to marvel at the courage that columnist-turned- politician Ayaz Amir displayed in his writings in the Dawn in the regime of General Musharraf. To his credit, Musharraf gave plenty of latitude to the media although he brought about his downfall by showing an inability to tolerate similar independence in the judiciary.

I am also impressed by the vibrant literature that Pakistan has produced recently in the English language - Mohammed Hanif, Kamila Shamsie and Daniyal Moenuddin are some of the names that figure prominently.

All of which makes me wonder how much substance there is to the talk of Pakistan being a 'failed state'? Can a country with such a committed civil society be possibly regarded as a failed state? The international community would like to think so because Pakistan is a breeding ground for terrorists. Many in India would like to subscribe to this thesis because they find in it a refutation of the 'two nation' theory.

I am not persuaded. We do not regard India as a failed state on account of insurgencies in Kashmir and the North-East and the Naxalite problem in about a quarter of all districts. The key difference between the two countries is that India has managed to keep the army in its place whereas in Pakistan, the army calls the shots whether it is running the country or not. Another difference is that the Indian judiciary has come in the way of any attempts at amending the Constitution that change the character of the Constitution.

The judiciary in Pakistan is capable of asserting itself, as events in Musharraf's time showed. So the fundamental challenge in Pakistan is rolling back the pervasive hold of the army. Given the support of the international community, Pakistan's elite may be capable yet of putting democracy on a solid foundation.

Bankers, watch your lifestyle

This is a time when bankers are apt to be lynched ( no pun on the now-defunct investment bank). So, bankers had better watch their lifestyle- the slightest sign of lavishness will be pounced upon. There's a telling anecdote from FT:

In different times, the offer from the check-in attendant would have been accepted with alacrity. But in the midst of the worst economic downturn since the Great Depression, with an angry public, populist politicians and an aggressive press baying for a crackdown on Wall Street’s “excesses”, the senior banker paused for thought when he heard those usually welcome airline words: “Sir, you have been upgraded to first class. Please follow me.”

Finally replying, “I am fine in coach, thank you”, he gave up the better seat and opened another chink in the armour of beliefs and practices that corporate America had built and spread around the world over decades.

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Flawed b-school ideas

It's interesting that there has been much finger-pointing towards b-schools in the massive debate on capitalism prompted by the present crisis. In the Satyam episode, some of the outrage stemmed from the realisation that two b-school dons were on the board.

As I have pointed out in earlier blogs, I don't really buy the stuff about 'excessive' focus on shareholder value and how b-schools have gone wrong in overemphasising this aspect of capitalism. For a change, I came across something more sensible in this article by Richard Layard of the LSE's Centre for economic performance. Lord Layard points out three b-school ideas that need to be questioned:

Three ideas taught in business schools have much to answer for. One is the theory of “efficient capital markets”, now clearly discredited. The second is “principal agent” theory, which says the agents will perform best under high-powered financial incentives to align their interests with those of the principal. This has led to excessive performance-related pay, which has often undermined the motive to work well for the sake of doing a good job and introduced unnecessary tension among colleagues. Finally, there is the macho philosophy of “continuous change”, promoted by self-interested consulting companies, which disregards the fundamental human need for stability – in the name of efficiency gains that are often not realised.

Corporate reforms

Leave aside the big talk of 'reforming capitalism'. That means all things to all people. Concretely, what can one expect by way of reforms in the corporate world? From a recent story in the FT, I flagged the following:

• The US Congress has voted to give shareholders an annual vote on executive pay, although this will be a non-binding vote
• Shareholders may get the right to nominate candidates to the board- and to remove non-performing directors. These have been management's prerogative so far
• Redesign of executive compensation with less liberal stock options for people at the top.
  
• An improvement in the composition of corporate boards- board members will need to demonstrate better expertise than playing golf.

Is that good enough? Well, it's a good start. But I am a bit of a radical when it comes to corporate reform. I happen to think there is a fundamental problem with the modern corporation: excessive concentration of powers in the CEO.

The world over, democracy has gained ground at the level of nations. But the corporate world remains the last bastion of dictatorship. Greater diffusion of powers and more participative decision-making are what companies lack - and which is why they are prone to disaster. Serious reform is making these things happen.

Jack Welch lashes out at focus on 'shareholder value'

'Capitalism in crisis' is the lament of the day. Heaven knows there's a great deal of reconstruction that needs to be done now, most importantly in the realm of financial regulation. But we have to be careful to sift out populist rhetoric and plain inanity from serious proposals for reform. To put it bluntly, in today's distressed situation, there's a lot of rubbish that is sought to be palmed off as great wisdom by the high and mighty.

When I read in the FT that former GE CEO Jack Welch had condemned the focus on share price, I nearly fell off my chair. This is the father of the 'shareholder value' movement, the man who ruthlessly downsized and restructured in order to enhance shareholder value. Now, safely and comfortably ensconced in retirement- Welch had helped himself to some post-retirement perks that later proved controversial-, the man now pontificates about the evils of shareholder value maximization.

I wouldn't have minded if he had put forth sound arguments for his contention. I can't see any. Welch says:

On the face of it, shareholder value is the dumbest idea in the world,” he said. “Shareholder value is a result, not a strategy . . . Your main constituencies are your employees, your customers and your products.

Tell me, does that sound terribly original? Has any worthwhile CEO claimed that shareholder value creation was a strategy? Not at all. CEOs merely focus on it as the objective. Now I know that lots of academics and practitioners think there is something terribly wrong with this objective- I wrote about this in an earlier post. But none has come up with a worthwhile substitute for it.

Of course, management must focus on employees, customers and products. Of course, they must focus on innovation. And, sure, they must behave in socially responsible ways. But if the share price does not capture these dimensions, if the stock market is not efficient enough, then what would be the measure of performance and who is to do the measuring?

Let Welch tell us how we are to know whether management is adequately focused on employees, customers and products- other than by watching the share price. I will then take back what I have said here.

PSUs a hit at IIMs

Well, well, well. Who would have thought this was possible? The top recruiters at the IIMs have turned out to be PSUs. I had to pinch myself in disbelief when I read that Union Bank of India had made 18 offers at IIMA, followed by Bank of Baroda, IOC and BPCL. PSUs hired a total of 41 students out of 235 candidates at IIMA. The public sector banks have substituted for the high-profile investment banks with their fancy offers.

What does this mean? Well, it's clearly not a trend. Those who were set on banking and finance careers would not have had other options. And public sector banks do provide a good training ground. So, most of the grads will take up these jobs and wait for the glamorous part of the market to open up. Mind you, at the kind of levels of which PSUs are willing to take IIM grads, the starting packages would not be unattractive.

The challenge for PSUs is not getting IIM grads in. It's keeping them for a while. Maybe they cannot keep them for a lifetime. But there should be a clearly thought strategy to get the best out of them in, say, three to five years. One way is, of course, putting them in positions where skills in PSUs are most lacking. The other is using them as change agents to bring about a cultural change in the organisation- to give public sector employees a sense of how young execs from the best schools think and act.
PSUs need not have a huge complex about attrition among IIM recruits. It happens to the best of institutions these days. Firm loyalty is passe. The trick is to make sure that such attrition is consistent with the business model- IIM recruits should not be money down the drain.

Consultant, heal thyself

Business Standard carries a front page story on how the top consulting firms are yet to get into the black after years of operating out of here. They really can't say they are in it for the long haul or that they are investing for the long term because they have been around for much too long now. McKinsey had a loss of around Rs 2 crore in2007-08, Accenture netted a minus of Rs 18.6 crore in 2006-07 and Bain showed a loss of Rs 16 crore in 2007-08. BCG is marginally in the black as is Deloitte.

There is little doubt that foreign consulting firms are unable to shed the high cost baggage of all foreign firms. Everything about them is expensive- their staff costs, the places they rent (five star hotel rooms often operating as offices for months on end), their travel, flying in experts from overseas offices at huge cost.... All this is passed on to the clients and yet the firms make no money.

Makes you wonder: how do they justify year-end bonuses? And if consultants can't mind their businesses properly, how can we expect them to advise others to mind theirs?

Return of the prodigal

Over a 100,000 Indians will return from the US in the next 3-5 years, ET reports. The estimate comes from a study done by multi-university team headed by an Indian, Vivek Wadhwa.

With India Shining until recently, the urge to migrate had weakened somewhat. The downturn in the US will weaken it further and enhance the domestic pool of talent with returnees.

"With the economic downturn, my guess is that we'll have over 100,000 Indians and as many Chinese return home over the next three-five years," says Wadhwa. "This flood of western educated and skilled talent will greatly boost the economies of India and China and strengthen their competitiveness.

...... Until recently, America has been the prime destination for the world's best and brightest immigrants. "Immigrants have made tremendous personal sacrifices," said Wadhwa. "They would leave behind relatives and friends and accept second-tier status in American society.

"Now countries like India and China are providing equal career opportunities and a better quality of life. So the most highly educated and skilled are often returning home."

I recall with amusement the heated debates we used to have about the 'brain drain' and how to stop it. All sorts of prescriptions were given (eg compulsory home service before migrating, an exit fee for those departing from schools like the IITs, etc). None of this is required. When growth accelerates and creates opportunities, brain drain ceases to be an issue. Growth may not the complete answer to poverty but it is certainly an answer to brain drain.

Old wine in old bottle

Gary Hamel has an article in the HBR of January 2009 on how we need to reinvent management. The article came out of discussions among a group of scholars and practitioners. There is nothing wrong the ideas- some two dozen of them- but I wasn't bowled over because these aren't new. eg. management being more democratic, more transparent and, not least, being focused on nobler objectives than shareholder wealth maximization.

The last is not new at all because Peter Drucker wrote extensively about it. In one of his books, he said management could never win legitimacy as long as it focused on such a narrow objective. Management needed to focus on something loftier. He proposed making people productive as the declared goal of management. But Drucker was writing at a time when the market was far less efficient than it is today. Are we saying that the market cannot judge whether a company is doing enough with respect to, say, innovation and people development? Then, the right question, perhaps, is: how do increase the flow of information on these matters to the market?

My problem is: how do you operationalise such goals? How do we measure performance in ways other than shareholder value? Drcuker never answered this question. He left the definition and measurement of management performance as an important challenge for corporations.

True, shareholder value leads to distortions in managerial actions but at least the market is an impersonal judge. Are we to substitute the market's judgement with that of some independent personalities who will come up with appropriate measures? Well, I hope these personalities are not independent directors!

More thoughts on this in my last ET column, A new paradigm for management?

Management guru

The Economist carries a profile of Ram Charan, a management guru who may not have a high profile in India but who is pretty well known internationally. He has authored books on leadership and board room governance and combines lecturing and writing with consulting. At 69, Charan has an enviable capacity for travel:

Another thing that makes Mr Charan unusual is that few people would want to sign up for the punishing life associated with being both a sage-on-stage and a confidant of many chief executives. A one-man band, Mr Charan is constantly on the move, notching up some 500,000 miles (800,000km) on aircraft last year and spending most of his nights in hotel rooms. To minimise the amount of baggage he lugs around, assistants at his office in Dallas send fresh clothes to him via courier and his laundry is returned via the same route. Until a couple of years ago, the peripatetic Mr Charan did not even own a home. He has since bought an apartment in Dallas, he says, but he has barely stayed there since he bought it.

That bit about the laundry had me foxed. How much does it cost to courier laundry across the world? Maybe it makes sense to courier suits instead of buying these but I wonder whether it makes sense for other apparel. Is it cheaper to use the courier than to use the laundry services of five star hotels where, presumably, Charan would stay?

The downfall of RBS

FT carries a gripping account of the rise and fall of Royal Bank of Scotland under its former CEO, Fred Goodwin. After grabbing Natwest and some lesser financial institutions, RBS launched and won a bid for ABN Amro, deciding to plough ahead even after the onset of the global financial crisis in 2007. That one deal finished RBS. It is now virtually under UK government ownership after having received huge dollops of capital. I just heard on TV that the bank has declared $34 bn in losses in 2008- that's Rs 150,000 crore.

The one lesson from failures such as RBS and Lehman seems to be: when CEOs begin to show clear signs of megalamonia, investors had better watch. Such megalamonia manifests itself not just in a hunger for asset growth but in many other ways:

Within the bank, he fostered an intense management culture that prized discipline and attention to detail. Senior executives were set annual income and profit targets and challenged on whether they were meeting them. The chief executive exercised control through a daily 9.30am meeting where he would quiz managers about their divisions and openly question their competence. One morning he reduced a senior executive to tears. “It wasn’t a positive or healthy atmosphere,” says a former executive. “You have to wonder about the decisions people make in that environment.” ......

The chief’s attention to detail extended to attire and furniture. When RBS presented its results, Sir Fred and team would wear white shirts and matching ties with an RBS logo. The bank shipped chairs and carpets around the world so that each of its offices would have the same interior.

Shortly after the Natwest deal, he started planning a new group headquarters near Edinburgh airport and, former colleagues say, was involved in every aspect of the construction. Modelled on Santander City, the Spanish bank’s head office outside Madrid, the £335m building was opened in September 2005 by Queen Elizabeth in a ceremony that included a fly-past of four Tornado jets from a nearby RAF base.

How do companies and their boards indulge such CEOs?

Nassim Taleb on bank bonuses

Taleb, writing in FT, highlights a point familiar to readers of this blog: the heads-I-win- tails- shareholders-lose syndrome among bank managers taking risks with other people's money. Taleb says even the Obama administration's proposal for caps on pay not be enough:

The Obama administration has been trying to set compensation limits for banks under the troubled asset relief programme. But this is insufficient. We need to remove the free option. Beware the following situations.

First, those who are taking risks even outside Tarp or society’s protection can still be gaming the system – since their risk-taking can result in a collapse, with the taxpayer having to step in. For instance, Goldman Sachs, the US bank, might want to avoid the limits on executive compensation for its managers. That should be fine so long as society does not have to bail out Goldman Sachs (or, worse, its creditors) in the future.

Second, Vikram Pandit, Citigroup’s chief executive, while claiming to want to earn one single dollar a year in compensation unless the bank returns to profitability, is still getting a free option given to him by society. He does not partake of further losses; we do.

Third, leveraged buy-out companies used the free option by borrowing heavily from the banks and taking monstrous risks: they get the upside, banks (hence we taxpayers) get the downside. These partnerships made fortunes in the past on deals that society will have to bail out. They too should have their past profits clawed back.

IIMC fee hike

IIM Calcutta has raised its fee to Rs 9 lakh from the present figure of Rs 5 lakh. The fee hike will apply from the batch of 2009-11. IIMA and IIMB had both effected steep increases last year. IIMC had not followed suit and, in fact, had claimed the high moral ground saying that its then fee structure was adequate to generate a surplus.

So, what's changed now? Maybe revenue from training programmes has declined steeply and this necessitated a fee hike? The least IIMC should have done was to explain why it resiled from its earlier stand. The explanation given, namely, that the revised fee merely helps the Institute recover costs is not adequate because last year the Institute had said that was not the line it would like to take.

IIMC's chairman, Ajit Balakrishnan, was a member of the IIMC review committee which submitted its report last year. The committee, while leaving it to IIM boards to decide the fee, had recommended that a particular formula be used for determining the fee. Has IIMC used that formula? Or does chairman Balakrishan differ with review committee member Balakrishnan?

IIMC has not covered itself with glory on the fee hike issue. Market-minded people would say it has merely ended up being behind the curve in raising its fee.

US diplomatic etiquette

I've been reading Jaswant Singh's memoirs, A call to honour. I am not ready to review it yet but I thought I'd share one or two tidbits about American diplomatic- if that's the right word- behaviour.

Singh writes about the build-up to the Pokhran II nuclear tests. The then US ambassador, Richard Celeste, is a bit uneasy about the BJP's intentions. He calls on Singh and tells him he's going away on a longish vacation. He hopes that nothing 'disagreeable' would happen during that time, which would mar his vacation. In other words, India's nuclear plans must be hostage to His Excellency's vacation!

Shows how American diplomats and members of government and also their army commanders are used to throwing their weight around. After the blasts, Secretary of state, Madeline Albright, tells Singh bluntly," You betrayed us".

Strobe Talbott has a slightly different version of the encounter in his Engaging India. He quotes Albright as telling Singh, "You lied to us and that's not what democracies do to each other". Singh has a way with words and was able to hold his own, telling Albright there is a difference between secrecy and deceit!

Singh is honest enough to say that the nuclear option had been kept open by all governments and it was only a matter of when India would test. Narasimha Rao, while demitting office, told Vajpayee that he couldn't do it and he hoped Vajpayee would.

As Singh makes clear, two events more or less clinched the issue in favour of a blast: the indefinite extension of the NPT in 1995; and the commencement of CTBT talks in 1996. Had the CTBT been signed by the US, India would have had to fall in line and that would have foreclosed our nuclear option.

The BJP's achievement was not so much going in for the nuclear tests as managing the fall-out. It was able to persuade the Clinton administration that a nuclear India was not a threat to the US but an asset and that the nuclear capability along with India's economic advancement made India an appropriate partner for the US in Asia. Of course, several other factors contributed to this changed equation, including the end of the Cold War and the rise of China. The Indo-US nuclear deal, negotiated by Manmohan Singh and George Bush, merely built on the formidable groundwork done by Vajyapee and Jaswant Singh.

Nationalising US banks

Nouriel Roubini of Stern School believes nationalisation is the best of all options open in the present crisis. That's exactly what I have been saying. Roubini argues in a Business Standard piece that other options- such as recapitalisation, creation of a "bad bank" to house toxic assets, guarantees for private purchase of toxic assets- all face the problem of government or the tax payer overpaying the private sector and subsidising shareholders of insolvent or distressed banks.

With bank nationalisation, shareholder and bondholder losses can be immediately recognised and any upside on revival belongs to the tax payer. What about the cost? Roubini estimates losses at $3.6 trillion about half of which is in the American banking system. That means the US governemnt having to fork out $2 trillion.

It's still worth it because of the time factor. Any involvement of the private sector will be long drawn out, its outcome uncertain and losses will mount. Had the government stepped in earlier, it would have probably written a smaller cheque. It all boils down on how long we want the crisis to stretch out.

Responses to readers' comments

1. Subiksha- The question is asked: if it's an unlisted company, why should directors owe anybody an explanation for quitting? Well, I believe directors' responsibility should be viewed in broader terms- they have obligations towards all stakeholders, not just shareholders of the company. Investors in ICICI Venture might want to know what went awry; lenders in Subiksha too would be interested. When directors quit, especially when they do so en masse, citing reasons is a good idea.

2. First Global- My limited concern was about the linkage between the Tehelka exposure and the crackdown on First Global. If First Global or Shankar Sharma violated any securities laws, that is a different matter which I, for one, am not competent to judge. I also hold no brief for any political party and I accept that misuse of investigative and law-enforcement agencies has not been confined to any one party or coalition.

And now Subiksha

Subiksha, the Chennai-based retailer, is in bad shape. That's not a big deal in itself. The retail story has gone awry with the downturn and also because of firms having overextended themselves when real estate prices were sky high.

The big deal, if any, is about the accounts of Subiksha. Business Standard reported yesterday that ICICI Venture, which has a 23% stake in Subiksha, has written to the RoC asking for an independent audit of the company's accounts.

Subiksha MD R Subramaniam holds 59% of equity but he apparently contends that the company is actually controlled by ICICI Venture because the latter has the right to appoint a majority of directors. This is an interesting twist because it would imply that if there were accounts or audit issues at Subiksha, ICICI Venture would be responsible.

Incidentally, four of the high-profile directors resigned last week- Renuka Ramnath and Rajiv Bakshi of ICICI Venture, Rama Bijapurkar and Kannan Srinivasan (a Carnegie Mellon prof). What do these resignations imply? We do not know. That is why I have argued that when independent directors quit, they should be asked to furnish reasons.

Our sins, their sins

Today's papers showed Rahul Gandhi nodding off during the finance minister's budget speech. Apparently, he was not the only MP guilty of this. Take heart, my fellow Indians, politicians elsewhere are capable of worse.

Japan's finance minister is due to resign after having appeared drunk at a recent G-7 news conference. The minister denies he was drunk. He ascribes his performance- he slurred and appeared to fall asleep at one point- to cold medicine.

Well, even if the man had too much sake, you can't really blame him, can you? The Japanese economy turned its worst performance in 35 years, shrinking by 3%. Enough to make any finance minister hit the bottle.

'IT industry facing unprecedented crisis'

That was a headline in Indian Express today. The quote was acribed to Nandan Nilekani of Infosys. I read on to see what was meant. Nilkeani is quoted as saying:

....the compounded growth rate was 30 per cent and more and now it is reduced to 20 per cent due to economic slowdown.

Well, I guess that's the sort of 'crisis' most industries would love to have!

I do not, by the way, wish to understate the impact of a slowdown of this magnitude on the jobs market in India, especially the impact on the fresh crop of graduates from engineering colleges this year.

Anatomy of a witchhunt

In March 2001, the BJP government presented what many regarded as the real "dream" budget- I remember one industry spokesman ecstatically giving it a perfect score of 10. Unfortunately, the stock market did not think so. It tanked.

Hell hath no fury like finance ministry scorned. It was convinced that the market fall was engineered and it was determined to find out who was behind it. Ten days later the Tehelka corruption expose emerged and it turned out that one of the journal's promoters, Shankar Sharma of First Global Stockbroking, had short positions in the stock market.

The law enforcement agencies descended on Sharma. He was arrested and jailed for a long period without any charges being established against him. In September 2002, Sebi cancelled Sharma's stockbroking license. Eventually, Sharma was acquitted of all charges. Sebi's order was set aside by the Securities Appellate Tribunal in 2004.

There was much scepticism about the charges against Sharma even then. Sharma recently used the RTI to obtain the trading data for the relevant period. It turns out that First Global was not even among the top 50 short sellers ! Business Standard has strong words on the way the Sebi conducted itself:

It has long been suspected that the cases against Mr Sharma and his company were not a result of wrongdoing on their part, but as punishment for having been involved with Tehelka. The fact that the cases were dismissed (one on technical grounds) supports this view of what happened. Further evidence to buttress this view has now been produced by Mr Sharma, suggesting that the stock market regulator had no reason to suspect the activities of First Global in the first place. Using the Right to Information law, Mr Sharma has obtained the trading data maintained by Sebi for the period in question. These data show that First Global does not even figure in the list of 50 largest sellers, from the middle of February to the middle of March 2001. That raises the question as to why this data was ignored by Sebi before it passed orders against First Global. Indeed, the prosecution lawyer was so unhappy with the case being made out that he withdrew from the case, in itself a telling comment.

If so, several questions arise. On what grounds did Sebi take action against First Global? Why do the concerned people show reluctance to address the issues that have been raised? Sebi’s continued silence on this matter will only undermine its standing as an independent regulator that acts without being influenced by the government’s political motives. Cases of state vendetta against individuals are not unknown, but this is the first case where the political authority seems to have influenced stock market regulators. Is it coincidental that First Global received Sebi’s adverse verdict during the tenure of the Vajpayee government? And that the appellate tribunal set aside that Sebi order a few months after the Vajpayee government completed its tenure?

Tribunal for private educational institutions

The government plans a National Teachers Tribunal (NTT) to look into grievances of teachers and students at private educational institutions, Outlook reports.

The ministry has set up a committee headed by higher education secretary R.P. Agrawal to finalise the blueprint for the project that officials admit is likely to meet opposition from private educational institutions, who could see it as government intervention in what they consider their internal affairs. According to sources, the tribunal is expected to adjudicate in cases involving employment and selection of teachers and admission malpractices and unfair labour practices.

This is a welcome move. But much depends, as Prashant Bhushan points out, on the quality of people appointed to it. Malpractices abound in private educational institutions and teachers and students alike are at the receiving end. For instance, teachers are forced to sign pay slips for amounts in excess of what they get; they are often not paid on time; and capitation fee is a thriving cottage industry. Part of the reason these issues have not been addressed is that many of the institutions, especially professional colleges, are run by politicians themselves, so there is no serious interest in reform.

I am not sure, though, that such an authority should be only for private institutions. Public institutions too could be covered by them- it is not as if all is hunky-dory there and there are appropriate grievance redressal mechanisms. For the central educational institutions, such as IITs and IIMs, it may be a good idea to mandate the setting up of CAT (central administrative tribunal)- like bodies with a defined composition and clearly specified powers.

However, such an authority cannot mix teacher and student issues- that would be too much to handle. Let us have the NTT for teachers and a regulator for education as the NKC has recommended, which can look into admissions, fees and other issues.

How the mighty have fallen!

Guess whom IIT Bombay is looking towards to bail out placement? PSUs! Until last year, the top graduates there were targeting investment banks and private equity. The financial crisis has changed all that. ET reports:

Seeing the poor response by traditional recruiters in the first month of placement, public sector units such as IOC, ONGC, GAIL, BPCL, HPCL, BHEL, MTNL, NTPC and SAIL are being contacted by the student placement cell of IIT Bombay, inviting them to visit their campus for recruitments.

Placements on the IIT campuses across the country, which began in January, have suffered due to the economic slowdown, with even IIT Bombay, a much sought-after institute among most companies, seeing lukewarm response from the private corporate world so far. The trend is evident with placement dates being extended till April. Earlier, the placement process at the IIT Bombay used to get over within two to three days.

A reader comments that the report appears to apply to the Management school at IIT Bombay rather than the campus as a whole. But the situation for engineers cannot be a lot better. We are seeing similar problems at the IIMs where recruiters are asking that the placement fee be waived. Many FMCG and manufacturing companies long disdained by the IIM fraternity are taking their time responding- I guess they have a point to make. The IIM average salary, for long artificially inflated by the dollar-paying overseas segment, will now look a lot more modest.

I believe the corrections to the excesses that are now taking place are entirely welcome. Both the financial sector and the IT sector had created huge distortions in the graduate markets. Manufacturing companies and public sector companies were the big losers in the talent contest and we had the ridiculous spectacle of whole batches from engineering colleges veerring towards IT as though none of the other engineering disciplines mattered.

The debacle among banks and investment banks has taken the fluff out of the financial sector. The slowdown on the American economy and the Satyam episode is causing a reassessment of the IT sector. After the Sixth Pay Commission, government and public sector jobs, with their combination of decent pay, housing, job security and post-retirement benefits are beginning to look attractive. Whatever the problems it may have created, we should thank the financial crisis for restoring balance to the Indian job market and to aspiring young Indians.

US curbs on bankers' pay

The US will cap bankers' base pay at $500,000. Big deal. They will still continue to receive variable pay in the form of stock options. Moreover, the cap applies only to about 25 firms that have received extraordinary emergency assistance. It also does not apply to people down the line. This is just tokenism. I guess it's necessary tokenism given public fury over tax payer money being lavished on failed banks. Besides, if you are under part government ownership, you must accept government pay scales.

Base pay has always been a relatively small component of pay payckages on Wall Street. The real moolah is in variable cash and stock option payouts. My quarrel has never been with the absolute size of these payouts. It has always been about the design of compensation schemes.

Performance in a bank can never been accurately measured at a point in time. What is performance can be known only over the entire business cycle. It follows that variable pay should never be handed out in full at the end of the year. Only a portion of the variable cash component can be paid out- the rest goes into an account. If there is a loss in the next year, there will be a negative entry in the CEO's account. And so on for a period of seven or ten years, which is the length of the typical business cycle. At the end of the period, variable cash pay will be handed out. Similarly, stock options can vest only over a very long period- say, 10 years.

Remember, Lehman and others recorded their historical best peformances in the years preceding their downfall. Making bonus payments in all those years was absurd because that so-called performance also contained the seeds of future downfall.

The salary cap apart, there is much drama being enacted in the US over executive use of corporate jets for travel. For the forthcoming Congressional hearings, top bank execs are going to extraordinary lengths to avoid courting controversy. FT reports:

Weary travellers trying to negotiate New York’s La Guardia airport on Tuesday night or Wednesday morning should not be surprised to bump into Goldman Sachs' Blankfein or Morgan Stanely's John Mack.

Vikram Pandit, Citigroup’s chief executive will also be on one of the NYC-DC air shuttles. After being castigated by the US Treasury for wanting to take delivery of a $50m jet – a decision subsequently reversed – Citi is in no mood to antagonise its government benefactors.

As for Jamie Dimon, people close to the JP Morgan Chasechief did not disclose his means of transport other than to say it will be public.

The banks’ spin doctors argue that commercial travel is often the preferred choice for New York-based executives because of the frequency of flights between the Big Apple and the nation’s capital.

But even John Stumpf, who runs San Francisco-based Wells Fargo , is going to have to stand in line at security before he embarks on his coast-to-coast jaunt.

Ken Lewis, the Bank of America chief who is trying to sell three corporate jets and an helicopter acquired with the takeover of Merrill Lynch, will cover the 400 miles between Charlotte, North Carolina, and Washington by train.

Banks under pressure to lend more

I just don't get this. Credit has grown by 24% over the year. This is also the target for credit growth the RBI has set for the coming year. Yet, there are complaints that banks' aren't doing enough.

For the coming year, let's assume GDP growth of 6%. Add an inflation rate of 4%. That gives us nominal GDP growth of 10%. Is credit growth of 24% not adequate to support nominal GDP growth of 10%? Alright, I understand that various other sources of funds have dried up- the capital market, overseas borrowings etc. But RBI data show that in the year to date, total flow of resources to the commercial sector is only 3% lower than in the same period last year. I'm not sure that qualifies as a 'credit squeeze'.

The RBI's credit policy statement shows that credit growth has been high only for public sector banks. Credit growth in PSBs has risen from 20% last year to 29%. Private banks and foreign banks show an appreciable deceleration in credit growth- from 24% to 12% at private banks and 31% to 17% at foreign banks.

Either the private players are market-savvy and are right in slowing down credit - as many have always claimed they are- or they are more risk-averse than public sector banks. Which statement is true? Again, there has meaningful decline in lending rates only among PSBs. Rates remain rigid for private and foreign banks. This again underlines the fact that, in a crisis, even if you want to stimulate credit growth, it helps to have government ownership. Governments in the US and Europe are rediscovering this truth.

Government and industry want banks to lend more and reduce rates (which in itself is a bit of a contradiction). There are structural limitations to both credit expansion and rate reduction. I elaborate on this in my latest column, Should banks be lending more?

RTI, RIP?

The Right to Information Act was a revolutionary step towards strengthening Indian democracy. There is a lot of good that has come out of it and it does carry a great deal of promise. But, I have always wondered how long the system would put up with it. Some recent developments do give cause for concern as to whether the spirit of the RTI will be observed in all instances:

• The Supreme Court contends that information on assets provided by judges to the Chief Justice need to be made available to the public and also it need not be disclosed whether all judges have disclosed their assets to the CJI.
• The PMO now contends that declarations by ministers are held by the PMO in a fiduciary capacity and need not be made public.
• The CIC itself holds that information commissioners are not obliged to declare their assets- this is, perhaps, the unkindest cut of all.

RTI, RIP? Let's hope and pray.......

Is there a credit squeeze in India?

They say that Indian firms face a credit squeeze because non-bank sources of credit, including overseas sources of credit, have dried up. Banks are lending more than they did last year: commerical credit grew by 24% in the period upto Jan 2009 compared with growth of 22% last year. But, it's the lack of funds from other sources that's the problem- so we hear.

Well, the RBI's latest credit policy statement has comprehensive data on total flow of funds to industry, from bank as well as non-bank sources, including financial institutions, NBFCs, capital markets, ECBs, FCCBs, ADRs/ GDRs, FDI and short-term credit. In 2007-08 (upto Jan 4), total funds to the commercial sector was Rs 499,000 crore. This year, it was Rs 484,000 crore- a shortfall of 3% with respect to last year. How does this qualify as a squeeze that is throttling Indian industry? Somehow, the numbers don't bear out the sense of a huge credit crisis.

There is one possible explanation, though, one that I ventured earlier. Some portion of what appears as bank loans could be merely 'loans recoverable' against mark-to-market losses of firms. This is not really credit for productive purposes. To that extent, official figures for bank credit growth would overstate supply of credit.

I have said that the RBI needs to quantify this item. Only then will we know how real is credit growth- and, of course, we will also have some idea of what sort NPAs banks are likely to face on account of firms' mark-to-market losses. Much of this has gone into litigation or is being sorted out through negotiations.

A historian's olution to the banking crisis

A few things kept me away from blog over the past few days.... I return with the recommendations of historian Niall Ferguson on how we might tackle the banking crisis.

Ferguson thinks government spending in the US is not the answer because it will take the budget deficit past the danger mark of 10% of GDP. He proposes instead that:

• Government recapitalise banks after losses are fully written down and bond holders take a hit of about 20% or convert debt into equity. This is fine but the solution still involves government spending, doesn't it? For some reason, Ferguson would call this 'restructuring' not 'nationalisation' with a commitment to re-privatise after 10 years. If nomenclature will solve the trick, ideologues can please themselves. To me, it's nationalisation.
• Mortgages be reset at lower rates. This will revive customer confidence. Yes, but it involves a huge hit for banks and holders of mortgage-backed securities. It will also imply a bigger government infusion of funds than otherwise.
  

Ferguson writes, " The best evidence that we are in denial about this is the widespread belief that the crisis can be overcome by creating yet more debt." Will somebody explain to me how Ferguson's proposals will avoid creating more debt? Or has he made calculations that show that the debt increase in his scheme would be lower than in the Obama scheme?

Will bank bosses never learn?

I guess you have to give up at some point. Citigroup had to be told by the office of Tim Geithner, the new US Treasury secretary, to cancel a pending $50 mn purchase of executive aircraft at a time when it is on government support. Citigroup was apparently adamant about going about the purchase and its people had to have their arms twisted before they saw sense.

This comes after the news of the $3-4 bn bonus payout at Merrill just ahead of the closure of the acquisition by BofA. Merill's CEO, John Thain, had no qualms about blowing up $1.2 mn on renovating his office (including a $30,000 spend on a commode- one does not know whether this particular purchase was warranted by Thain's heightened nervousness over the future of Merrill under BofA management). Thain has just been issued a subpoena by NY's attorney general which is probing the accelerated bonus payout and to what extent BofA bosses knew about it, FT reports.

Just to round off the bad news on financial firms, Nomura is reeling under the purchase of Lehman - it has posted a loss of $3.9 bn for the last quarter, which includes losses on exposure to Iceland and to Madoff.

Bonus for non-performance

Do these guys have no shame? It turns out that Merrill Lynch paid out $3-4 bn in bonuses just three days before the closure of its sale to Bank of America. This happened just as BofA sought an additional $20 bn from the US government to help it close the deal.

Merrill's boss, John Thain, was about to seek $10 mn in bonus for himself but changed his mind. No doubt, this was for Merrill's operating loss of $21.5 bn in the fourth quarter. He had also spent lavishly on renovating his office- a fact to which President Obama referred in a speech yesterday. Thain won't be around to enjoy his sparkling office- BofA chairman Ken Lewis has given him the boot.

Citigroup board make over

Citigroup has acquired a new chairman. It is also in the process of a general board makeover. Two of its present directors will leave after putting together a combined 59 years on the board of Citi and its predecessor companies. Incredible! The US limits the president to two terms of four years each but the US corporate world doesn't seem to believe in fixed tenures for directors.

It's not as if these two guys bring invaluable banking expertise to the board- one is a former chairman of Chevron, the oil group, and another ran the Ford Foundation. A third director, coming up for retirement, is a former CEO of AT& T. Maybe the US Fed could borrow a leaf or two from the RBI with respect to the appropriate composition of bank boards, fixed tenures for directors (eight years for banks in India) and "fit and proper" criteria for board members.

Indian banking looks sound

Three private banks- Axis Bank, HDFC Bank and IndusInd Bank- have reported earnings growth of over 40% in Q3. This, at a time when banks worldwide have collapsed and there is an earnings debacle forecast for non-financial firms in India. How come? Is this sustainable?

Well, the Indian banking situation is very different from that in Europe and the US. There, banks' distress is the cause of the economic crisis. Here, it is a consequence. The Indian economy is hit on two counts- exports have slowed down and so have capital inflows because of international conditions. Indian banks are not directly impacted by the financal crisis because of their low exposure to the sub-prime market.

The slowing down of the economy impacts on banks. But, you have to remember that economic growth of 6% is still pretty good for any banking system. Through the nineties and until 2003, that sort of growth brought about the turnaround in the Indian banking system.

We don't know what nasty surprises the financial crisis will throw up next. But, Indian banking looks pretty sound- and we can expect it to be an outperformer in the Indian economy in FY 2009-10. More on this in my ET column, Banking remains a bright spot.

To nationalise or not?

Governments in the US and Europe have lent support to banks but (in most cases) stopped short of nationalising them. The reasons are partly ideological (government ownership is evil) and partly fiscal (it brings a huge amount of liabilities onto the government's balance sheet).

The problem with muddling along without nationalising is that private banks simply won't lend in the present conditions- risk aversion holds them back. Willem Buiter weighs the pros and cons of nationalisation in his blog:

There are two ways of resolving this problem and of incentivising the capital-deficient banks to lend again. The first is to make the capital cheap (gratis, in the limit) and to minimize the onerousness of the rest of the conditionality. This is the road taken in the US. The US Treasury injected capital into Goldman Sachs at less than half the cost to Goldman Sachs of a capital injection by Warren Buffett a few days earlier. AIG got a tough deal from the Fed and the US Treasury at first, but obtained much sweeter terms less than a month later. The latest capital injection into Citi by the US Treasury (preferred stock with a dividend yield of eight percent) is very cheap.

By throwing cheap money with little conditionality at the banks, the Fed and the US Treasury may get bank lending going again. By subsidizing new capital injections, they reward bad porfolio choices by the existing shareholders. By letting the executive leadership and the board stay on, they further increase moral hazard, by rewarding failed managers and boards that have failed in their fiduciary duties. All this strengthens the incentives for future excessive risk taking.

There is a better alternative. The alternative is to inject additional capital into the banks by taking all the banks into full public ownership. With the state as sole owner, the existing top executives and the existing board members can be fired without any golden handshakes. That takes care of one important form of moral hazard. Although publicly owned, the banks would be mandated to operate on ordinary commercial principles. Managers could be incentivised by linking remuneration to multi-year profitability. The incentives for excessive liquidity accumulation and for excessively cautious lending policies that exist for partially nationalised banks and for banks fearing nationalisation would, however, be eliminated.

In addition, full public ownership of the banks would greatly facilitate the creation of a ‘bad bank’ that would hold on its balance sheet all the toxic assets (illiquid assets of highly uncertain value) currently held by the high street banks. The key problem with any bad bank proposal is the price it pays for the toxic assets it acquires from the banks. If all the banks, and the bad bank, are publicly owned, this problem goes away. The toxic assets are simply moved to the balance sheet of the bad bank. They could be valued at anything from zero to their notional value or historic cost (or even higher). It would be a redistribution of wealth from one state-owned entity to another state-owned entity.

A comprehensive failure of regulation

There has been a comprehensive failure of every one of the three pillars of regulation: disclosure to ensure market discipline, adequate capital and effective supervision, says an article in FT.

The author used public domain data in October 2007 to estimate losses for banks. He says he came up with estimates that turned out to be pretty accurate. For Citigroup, for instance, the form 10 Q statement filed with SEC by the bank showed that Citibank’s tier one (equity) capital at the end of the third quarter of 2007 was $92.3bn and the subprime exposure accounted for 242 per cent of tier one capital! Neither market analysts nor regulators used the data to form a coherent picture of the full magnitude of the crisis- so much for market efficiency.

As for regulation and capital adequacy, all the banks that failed were compliant with Basel II. Which clearly means that Basel II is simply not upto the job of containing risks exposed by the sub-prime crisis.

Finally, bank supervision proved inept. In January 2008, the IMF estimated bank losses at $1 trillion. But it took the collapse of Lehman for regulators to wake up to the enormity of the crisis and respond to it.

Clearly, we will need a radical rethink of the entire regulatory architecture. Here's one disconcertingly radical thought: perhaps, as in the Indian banking system, it would be in the interest of systemic stability to have some component of the banking system owned by the state.

Demise of Citigroup?

A $2 trillion bank being allowed to fail? Seems impossible to contemplate. But analysts are beginning to think the unthinkable: the possible demise of Citigroup. The bank's share price is down to $3.5, its market cap of $20 bn is less than its wage bill. How much longer before it goes bust?

Right now, Citi is waging a grim battle for survival. Losses for the year came to around $ 19 bn, taking total crisis losses to a staggering $100 bn, almost the size of ICICI Bank's balance sheet. Last week, it sold a 51% stake in Smith Barney, its brokerage arm, to Morgan Stanley.

It has announced that the company will be split into two separate companies, one housing sound assets of approximately $ 1.1 trillion and another housing bad assets of $850 bn. The idea is to reassure investors about the viability of the core part of the bank. The bad part is to be eventually sold off. The key word is "eventually". Until buyers are found- difficult until as long as the crisis drags on- the bad part will continue to bleed the bank.

A new chairman will be in place soon, according to media reports. CEO Vikram Pandit may make way for a seasoned commercial banker.

Does this add up to a rescue plan? Not by a long chalk. With problems spreading to the real sector, it is a moot question whether the good part of the bank will remain insulated from problems for long. Capital raising is next to impossible- more capital can come only from the governemnt, which has already given $45 bn in addition to guarantees.

If Citi cannot convince the market that it can soon be viable, the last option would be nationalisation. But will the government be willing to pour more capital into a bank that does not hold out the promise of a quick revival?

The prospects look very bleak indeed. Unless buyers emerge for a big chunk of the bad assets and the US economy turns around more quickly than most people expect, the odds are against Citi surviving.

And now Satyam's EMRI service

Troubles come in battalions. Perhaps because the company's chips are down, its vaunted emergency services are coming under fire. (Kiran Karnik, recently appointed director of Satyam, was on the board of this organisation along with Krishna Palepu, K V Kamath and other distinguished personalities).

ET reports that the NGO is being sued along with 11 state governments for anti-competitive practices.The charge is that it grabbed Rs 3800 crore of contracts without proper tendering being done:

The PIL in the SC, however, has been filed against EMRI, its ex-Chairman Ramalinga Raju and 11 state governments. The petition alleges that: “The process of award of contracts (for running ambulances) is being effected without following the due fair process. The respondent states have either already entered into or is considering awarding the contracts or have tailor-made the EoI to suit EMRI in the name of saving lives using funds under the National Rural Health Mission (NRHM).”

On a different note, FT's Lex column makes the point that the impact of Satyam is not confined to the IT sector (where Infosys has gained in value and Wipro has lost). Family-owned businesses are also feeling the impact:

It is telling that neither Ambani brother has emerged with the market’s vote of confidence. Shares in Mukesh Ambani’s Reliance Industries are down 21 per cent since last Tuesday; those in Reliance Communications, the telecoms group controlled by his younger brother, Anil, have fared even worse, slumping 29 per cent.

It is worth mentioning that SEBI has ordered an independent review of the financials of the Sensex and Nifty firms. Investors should keep their fingers crossed.

Independent directors and consulting fees

Krishna Palepu, HBS professor who served on Satyam's board, was characterised as 'non-executive' director in 2007-08. Presumably, he could not be called 'independent' director because, in addition to hefty sitting fees and stock options, he collected a huge fee for running training programs for Satyam staff. His total fee came to Rs 92 lakh- not bad even for a HBS prof, eh?

What I would like to know was whether Palepu was inducted originally as 'independent' director. If yes, then he should not have accepted any consulting assignment from Satyam. An 'independent' director is defined as somebody who has not had a pecuniary relationship with the company in the recent past. It would be absurd to construe this to mean that a pecuniary relationship in the present is somehow acceptable.

In the Enron and other scandals, independent directors collecting fees (other than sitting fees) was found to be part of the problem, exactly as auditors doubling as consultants was. I do not know if this practice was outlawed thereafter but certainly there was agreement that this was not consistent with good governance.

Perhaps, the time has come to make the legal position clear: if you are independent director, you cannot collect consulting fees from the company whose board you serve on. For a start, let Sebi write to all companies asking them to disclose if any of their independent directors have had a consulting relationship with them and the fees paid. The list of independent directors involved should be made public.

Satyam's ex-independent directors

The plight of Satyam's ex-independent directors must cause other independent directors to shiver in their shoes. They face a show-cause notice from the Company Law Board, probes by SEBI and law-suits in the US. The damage to their reputations has been immense. Let's see..

• M Rammohan Rao has had to quit as director of the Indian School of Business. He has also withdrawn from the panel to select the Dy Governor of the RBI.
• Krishna Palepu, it is reported, is under pressure to quit the board of Dr Reddy's Labs.
• T R Prasad, former cabinet secretary, stuck to his directorship even after all the revelations. He has suffered the ignominy of being booted by the government of India, the very government he had served all his life.

At this point, one needs to distinguish between the aborted investment in the two Maytas companies (which the independent directors approved) and the accounting fraud. So far as the latter is concerned, we have to await the outcome of the investigations to establish if there were any failures on the part of independent directors.

The reason these guys are being pilloried is that they did not oppose the Maytas investments- and there is a presumption that if they could be so supine in that instance, they could not have been effective generally. Had any of the independent directors opposed that move, it is possible that they would have been given the benefit of the doubt in respect of the accounting fraud.

I notice also that most of the fire is focused on the two b-school academics, Rammohan Rao of ISB and Krishna Palepu of HBS. The two other academics (Dr M Srinivasan, former faculty in American universities and V S Raju, director of IIT Delhi) are not facing the heat to the same extent. I guess there is a feeling that b-school academics, who preach good management and governance to the rest of the world, must be held to higher standards. B-school profs on other boards had better watch out!

Incidentally, on the Net, what we are seeing is not just criticism of the independent directors, but abuse, plain galis. Liar, cheat, rascal- these are among the kinder expressions being used. I will refrain from reproducing the harsher ones.

In yesterday's Indian Express, Sandipan Deb has a comment that captures the sheer depth of sentiment against the independent directors and particularly the b-school profs:

His official CV states that “in the area of corporate governance, Professor Palepu’s work focuses on how to make corporate boards more effective, and on improving corporate disclosure”. Among the executive programmes he teaches is “Audit Committees in a New Era of Governance”. “He also co-led Harvard’s Corporate Governance, Leadership, and Values initiative, launched in response to the recent wave of corporate scandals and governance failures.”
A friend of mine wrote to Palepu. “Evidently,” he wrote, “you are guiding US-based global corporations in such matters. However, in your ‘home’ country, you are helping organisations like Satyam steal shareholders money. My question is simple—does this make you a traitorous hypocrite, or merely a greedy criminal? I’m inclined to the latter, but as an eminent Harvard professor, perhaps you can guide me on the correct terminology? Look forward to your response.”

Guess what? Palepu has not replied. “Greedy criminal”, I would think.

Satyam fall out

There is the possible collapse of the firm and its impact on over 50,000 employees; then, the possible folding up of PricewaterhouseCoopers if anything is proved against them. The loss to shareholders of Satyam. There is the impact on brand India and the IT sector, the impact on capital flows into the country especially if any other scandal erupts. All this has been talked about. What else? Well, a few things:

• The future of Hyderabad Metro: this deal was won by Maytas Infrastructure in the face of strong criticism from Delhi Metro chief E Sreedharan, who indicated it had all the makings of a land scam. The project is meant to be a feather in the CM's cap, so he's going to have some sleepless nights over this.
• The Byrraju foundation: this is not your run-of-the-mill NGO. It's a huge thing involving 200 villages and covering one million people, according to some reports. The foundation's CEO recently sent out a letter that says that Raju has thus far contributed Rs 300 crore from his own funds to the foundation.
  
• The 108 emergency project: Raju had signed contracts for PPPs with several state governments to provide emergency services. I heard these are running well. The state governments invest in ambulances and other hardware. Raju takes care of the operations including software, back office and control rooms.

Incidentally, Forbes.com has a nice backgrounder on the rise and fall of Raju.

Satyam fraud: how do we overhaul governance?

In my ET column, I list some governance reforms that we could think of in the wake of the Satyam fraud.

This is not a collapse triggered by the sub-prime crisis but the disclosure of the fraud may not be entirely unnconnected with the crisis. There is pressure on volume growth and margins in the current environment. That would have caused Ramalinga Raju to give up hopes of closing the gap of Rs 7000 crore on the balance sheet.

But this is very different from the collapses of financial firms that we have seen. In those cases, you could argue that they were all highly leveraged institutions intrinsically prone to failure, that they dealt with complex products that neither management nor the board could fully comprehend. This is a collapse that has occurrred in the IT sector and entirely on account of internal fraud.

One of the regulatory lessons being drawn from the financial sector crisis is that large institutions need to be regulated, whether they are banks or non-banks. I think the basic principle may have to be applied to all large firms, irrespective of the whether they are in the financial sector or not.

If you are large, you are systemically important. Not that we have will have the entire panoply of regulations that we have in the financial sector. But a second layer of audit that I propose in my column is essential. For banks, there is regulatory audit in addition to statutory audit.

One fall-out of the Satyam affair, as indeed of the ongoing financial crisis, is that we are beginning to see the virtues of public sector companies. You can be more sure of accounts in a PSU than in a private firm- there are fairly elaborate checks and balances on fudging of accounts. Being an independent director on a PSU is less tension-ridden than being one on a private company- and you can also be more independent because independent directors are appointed by the ministry, not PSU management.

Above all, in a PSU, you have the one thing that Indians still prize above everything else at the workplace- job security. Think of the 50,000 employees of Satyam and the worthless stocks and stock options many must be holding. Do not be surprised if, on a long view, there is a re-rating among investors and employees alike of the relative merits of the private sector and PSUs.

CJI not exempt from RTI

A three member bench of the Central Information Commission has ruled that the Chief Justice of India is not exempt from the purview of RTI, TOI reports.

An RTI activist has asked to know whether SC judges had been regularly declaring their assets to the CJI since 1997, as rquired by an apex bench resolution at that time. The SC had taken the position that the information was not with the registry but with the CJI's office and the CJI himself was exempt from RTI, hence the information could not be provided. The CIC has rejected this contention as well. It has ruled:

“If any information is available with one section of the department, it shall be deemed to available with the public authority as one single entity.”

This is a valuable ruling indeed because no government institution can now withhold information on the ground that the particular department or official from which information is sought does not have keep the information- if information is available anywhere within the institution, it has to be provided.

Significantly, the application to the SC had not sought copies of declarations of the assets themselves. This is a more thorny issue. On this, TOI reports, the CJI has taken the position that this is information obtained by the CJI in a "fiduciary relationship" and that it was "personal information", hence details of judges' assets need not be made available to the public.

How international are US universities?

The US outperforms other countries in the international student market, the Economist reports, with a share of 22% of international students. But foreign students are just 3.5% of total students on US campuses although the absolute numbers are large. There is scope for raising the latter number. Apparently, it has not happened because US universities are averse to soliciting custom by appointing agents. Universities in other countries have no such qualms, so agents lead students to non-US universities.

The story does not mention this but US universities are also not disposed towards going overseas. The top b-schools do not have many overseas locations. Resistance to foreign entry may be one factor but a more important reason could be that US universities think the best students will come to them anyway, helped by generous scholarships. Another reason could be that faculty and education quality may be difficult to maintain over dispersed locations.

Woes of independent directors

Independent directors at Satyam came out with their reputations tarnished. M Rammohan Rao of ISB has since resigned from the search committee to select the Deputy Governor of RBI. But these reputation effects are small beer compared to what can happen when things go seriously wrong with a company.

Nimesh Kampani, chairman of JM Financial and a highly respected figure in the Indian financial community, faces an arrest warrant for having served on the board of Nagarjuna Finance, a now defunct Hyderabad-based NBFC, in 1999. The company defaulted on a fixed deposit after he resigned. But the Andhra Pradesh police will have none of it. Presumably, Kampani is being held responsible for FDs collected in his time.

The ET report on this yesterday mentioned the Supreme Court rulings to the effect that independent directors cannot be held responsible for lapses in day to day management. It could also be argued that in matters such as default on fixed deposits, any liability should be civil, not criminal unless mala fide intent or culpability for misuse of funds ( in the sense of illegal use) is established. I mean, companies, including NBFCs, can go under. Does this mean independent directors should face criminal charges?

Gujarat govt scheme fails at GNFC too

I noted in my last post that a resolution authorising the company to donate upto 30% of pre-tax profit to a social sector fund proposed to be created by the state government, a Gujarat PSU, had failed to muster the necessary shareholder support. The same thing has happened at GNFC, a company in which the Gujarat government has an indirect 41% stake.

Sandeep Parekh has the details at his blog.

Gujarat government charity schme fails at GACL

ET today reported that the proposed move to use 30% of pre-tax profit at PSUs in Gujarat has failed to get the shareholders' nod at GACL. The proposal required approval of three-fourths of shareholders. The proposal failed to muster the necessary votes at GACL thanks mainly to opposition from institutional shareholders.

There has been criticism of the charity move on the ground that it is inimical to the interests of non-government shareholders. But the state PSUs hardly have the profile of a Satyam, so the coverage of the issue has been rather small.

Citi execs to forgo bonus

Citigroup CEO Vikram Pandit, advisor and director Robert Rubin and other senior executives are to forgo bonuses this year, FT reports. I can't see why this makes news. The group has announced huge losses and has been kept afloat by a $300 bn government bailout. The terms of the bailout require the US government to approve bonus packages.

But, perhaps I am being too naive. In the top banks and investment banks, the firm as a whole may be making losses but individuals can still get rewarded if their divisions have made profit of they, as individuals, have made profit. The culture is that you can't penalise high performers because others have stumbled badly; if you don't handout bonuses to performers, they will leave.

The FT report only mentions that some senior execs will forgo bonuses. It is not that there will be no bonuses at all. So, the 'culture' stays, even if there is some departure from it in these troubled times.

I was a little surprised to see mention of a 'clawback' clause in compensation schemes. But this refers to only to bonuses obtained through false information, not to bonuses being clawed back when people do badly in a given year after having done well in the previous years. As readers of this blog would know, the scheme I have urged is that just as there are bonuses against profit, there should be clawbacks or negative bonuses against losses. The adjustments of pluses and minuses should be made over the business cycle with the residual payout happening at the end of the cycle.