Conflicts of interest in academia

I wrote earlier about b-schools and their alleged role in the crisis. One complaint about b-schools is that they don't inculcate the right values in their wards- I have made it clear this is not something I take seriously. Another is that the ideas that came out b-schools are flawed- the glamourisation of financial innovation, the myth of market efficiency and so on. But these ideas didn't emanate from b-schools alone, you might fault the economics profession at large, including the famous Chicago school.

Devesh Kapur, writing in FT, has a more interesting view. He says that academics have developed a vested interest in pushing certain ideas- and suppressing others- because they stand to gain financially in the process. In other words, academic research is susceptible to considerations of pecuniary gain, just as doctors' prescriptions in the US and elsewhere are driven by gifts of various kinds, including stock options in pharma companies.

Many academics, particularly those from institutions that enjoy high prestige and reputation, now have serious business interests and an array of financial ties to the very institutions that their studies address. These interests range from lucrative speaking fees, advisory roles at financial institutions, managerial roles and stakes in private equity and hedge funds to corporate non-executive directorships.

.....There would be little chance of being invited to give a lucrative talk at Citicorp if one were in favour of sovereign debt forgiveness in the 1980s, against capital account liberalisation in the 1990s or against stock options in the 2000s..

...In recent years, the biological sciences have moved considerably to ensure greater transparency where there are potential conflicts of interest between research and financial remuneration, providing mechanisms for whistle-blowers to report conflicts of interest. Regrettably, these requirements are extremely weak in the social sciences and business schools.

There is something to what Kapur is saying. I am not sure, though, that industry and other links influence academic research in economics and business but they certainly seem to influence academics' positions on various issues of public policy, especially in so far as they impact on business.

For instance, there has been much comment about the huge fees earned from financial institutions by Larry Summers, an influential figure in the present Obama administration, and whether these are impacting on the administration's approach to solving the crisis. Academics who take positions that threaten the interests of corporates certainly stand to lose out on consulting and other sources of income and may even be denied visibility in TV and other media.

There is a more serious problem with academics sitting on boards and this has to do with governance more than research. As we saw in the Satyam episode, academics are not above using their board positions to earn consulting fees. There are other instances where academics sitting on boards have wheedled training programs out of the companies. This introduces serious conflicts of interest. Sebi must impose a ban on independent board members earning any kind of consulting income from companies with which they are associated.

Addressing the too big to fail problem

In my last post, I highlighted that central banks and regulators have begun to focus on this issue with renewed interest.

In its Financial Stability Report, the Swiss National Bank suggests three ways in which this problem can be addressed:

There are three basic strategies for resolving, or at least alleviating, the ‘too big to fail’ problem. First, one can impose very strict capital and liquidity regulations on systemically important financial institutions. This can reduce both the likelihood of government assistance being required and the cost of such an intervention. Moreover, strict capital requirements reduce moral hazard, by forcing banks to themselves bear more of the risk of losses, and also reduce the banks’ incentive to inflate their balance sheets. ...

Second, one can adapt the legal framework and the financial market infrastructure to simplify, or make possible,an orderly wind-down of large financial institutions during periods of severe crisis.
......
Third, one can directly tackle the cause of the ‘toobig to fail’ problem by limiting the size of financial institutions. One could consider direct size restrictions, forinstance by imposing a maximum market share or balancesheet-to-GDP ratio, or indirect incentives – as mentioned
above – such as increasingly strict capital requirements for big banks.

Banks- too big to manage?

Governments the world over have rescued banks that are too big to fail- Citibank and Bank of America in the US, RBS and Lloyd's in UK. One fall out is that regulators and central banks are actively contemplating measures to prevent banks from growing beyond a certain size, FT reports.

This is what the incoming head of the Swiss National Bank has to say:

“A size restriction would of course be a major intervention in an institution’s corporate strategy,” Hildebrand, the central bank’s current vice-chairman, observed with masterful understatement. “Naturally the SNB is aware that there are advantages to size. [But] in the case of the large international banks, the empirical evidence would seem to suggest that these institutions have long exceeded the size needed to make full use of these advantages.”

But what would be that size? How do you operrationalise this concept? I haven't seen any concrete ideas on this. I guess one parameter could be the recapitalisation cost as a percentage of GDP in the event the bank fails. But this only leads on to another question: what percentage of GDP? There cannot be an absolute limit across all countries. Much would depend on an economy's fiscal situation. An economy where the fiscal situation is good could afford a failure that costs, say, 15% of GDP. Another- like India's- may not be able to afford even 5% of GDP.

But this creates a piquant situation. Larger economies can afford bigger banks. So can well managed economies. In other words, the size of the economy and the fiscal situation become determinants of competitive advantage based on size.

Should we worry? I don't think so. Because beyond a point, size ceases to confer any big advantage and, in fact, becomes a problem. In India, I would say that any bank with a balance sheet of around Rs 150-200,000 crore has the requisite size to take on competition. For the regulator, the problem is: too big to fail. For bank managers, the focus should be: too big to manage.

That's why I am not enthused by talk of SBI merging with all its associate banks. Is SBI getting the most out of its current size? Does it have the necessary depth and breadth of management at its current size? If not, HRD and systems should be focus, not simply getting bigger.

B schools and the global crisis

This may seem a bit surprising but B-schools have emerged, in popular perception, as among the culprits in the present economic crisis. People think managers are to blame. Some of the high-profile managers in the crisis- Hank Paulson, former US Treasury Secretary, Christopher Cox, former Chairman of the SEC, John Thain and Stan O'Neal- are all HBS products. The conclusion drawn is that B-schools bear some responsibility for the crisis. Whether this is true and what needs to be done is the subject of my ET column, Crisis:are B-schools to blame?

Surprisingly, this view finds acceptance among b-school academics themselves. FT is running a debate on the subject and so is the Harvard Business Review. I must confess I find much of the discussion lacking in substance.

Let us grant that irresponsible managers have had a role to play in the crisis. Partly, this was a matter of bad judgement; partly, it was greed or lack of regard for the stakeholders in a business. Where do B-schools come in? You could say B-school research failed to pick up the warning signs of the crisis. But so did economic research outside B-schools. As for the greed factor, it is not confined to managers but is rampant in every walk of life- law, medicine, accounting, etc. Amongst greedy or corrupt managers, managers with MBAs are a tiny subset.

So, what can B-schools do in terms of revising their curricula? Well, there is a huge debate going on about the relative roles of state and market and, no doubt, B-school research will focus on this and weave findings from this research into revamped curricula. This is fine. The thing that disturbs me is the suggestion that B-schools also have a role in inculcating superior attitudes or ethical values in their students. HBS's contribution is to get their graduating MBAs to take a pledge or oath of ethics!

B-schools have responded to talk of their role in the present economic crisis with courses on ethics and leadership. No problem with that. But, one has to be sceptical about what to expect. To those who wish to create the New Man, I wish luck. I doubt that B-schools can contribute much. There are primary and secondary schools that were set up by saintly figures and began with similar, lofty goals but whose products are indistinguishable from those produced by ordinary schools.

Don't get me wrong.There is a hell of lot that B-schools need to do by way of updating their curricula and make it more relevant. But improving the ethics of their wards is not something that falls within B-schools' core competence. At the risk of offending people, I would suggest that there is a certain presumptousness involved in setting such goals. I mean, who's going to impart ethics to B-school faculty?

TN medical college expose

A TV channel catches the Deputy Registrar of a medical college in Tamil Nadu asking for capitation fee on camera. The HRD ministry, duly outraged, sets up an enquiry. The UGC also jumps in with its own probe. The minister, who is said to be chairman of the board of trustees of the college, dissociates himself from the medical college.

I don't know how one is supposed to react. It's good to have this sort of thing exposed but is it news to anybody? Two facts have been public knowledge for quite some time- and thousands of families who have paid through their nose can testify to these.

i. Hundreds of private engineering and medical colleges in TN, Karnataka, Maharashtra and other places offer admission on the basis of large capitation fees.
ii. Many of these institutions have been promoted by politicians.

I recall a secretary at our Institute telling me how her husband had to fly down to Chennai with around Rs 3 lakh in a suitcase in order to secure admission for her child in an engineering college there. I wondered how the suitcase had passed scrutiny at the airport- didn't the security people ask about such a large amount of currency being transported around?

Capitation fee flourishes despite the Supreme Court ban on it. The government and the quasi-regulatory bodies in education have been mute spectators thus far. (It was interesting to read in the papers that a court actually described the Medical Council of India as "den of thieves". Former minister Anbumani Ramadoss confessed that he had failed to clean up the MCI inspite of trying).
The new UPA government has education reforms high on its agenda. Tackling the menace of capitation fee and donations in various forms must be a priority in education. They render education inaccessible, of course, but they also breed corruption, with doctors and engineers coming out of these places focused on getting the quickest return on the huge investment they have made.

Downgrade in Indo US relations

President Obama's unequivocal endorsement of the two-state solution of the Palestinian problem and his criticism of continued Israeli settlements in the occupied region were undoubtedly high points of his speech and they have rightly attracted attention. For us in India, another point is equally compelling: his suggestion that Israel must be drawn into the NPT before long. If the US is unwilling to make an exception in the case of its staunchest ally, we must wonder where that leaves the Indo-US nuclear deal and the special dispensation it creates for India.

Expect Obama to focus on the NPT as well as the fissile material cut-off treaty. The signs are clear enough: the Obama administration does not attach quite the same importance to India as a 'strategic partner' as President Bush did. Chances are we will be pushed back into sub-continental status with a possible re-hyphenation with Pakistan. Earlier, Hilary Clinton's visit to China signalled that the US sees China as its principal partner in the conduct of international affairs, a view that appears to be getting reinforced with Treasury secretary Tim Geithner's recent visit to China.

The signals coming out from US moves in Pakistan reinforce this view. Relative silence on the release of Saeez Hafeez; a massive aid package for Pakistan in order to reinforce its war against the Taliban; Pakistan upping the ante on Kashmir. The unkindest cut of all: the US state department advisory to American nationals against travelling to India.

In his election speeches, Obama had made references to Kashmir that were not exactly music to our ears. It does appear that he sees the resolution of the Kashmir issue as an important item in his agenda, next only to the Palestinian problem, although he chose to omit any reference to Kashmir in his Cairo speech. The signs are that the US is willing to allow Pakistan to bring Kashmir to the top of the table in return on Pakistani cooperation on Afghanistan and the Taliban.

This must inevitably mean more firing across the LOC and greater infiltration into Kashmir and into India generally in the coming months. This may sound terribly grim but the US advisory does seem to point to an increase in terrorist activity in India in the months ahead. We have been patting ourselves on the back on the improved domestic outlook with the installation of the a stable government at the centre. Not to spoil the party, but it appears the domestic pluses may come to be outweighed by the minuses on the external front.

Anniversary of Tiananmen

The twentieth anniversary of the Tiananmen massacre- and massacre it was, of that there is little doubt- has been marked by ritual on both the western and Chinese sides. Western commentators want Beijing to allow more democracy and they also want the communist regime to come clean on what happened. China has responded with a clampdown- on BBC yesterday, I saw their Beijing correspondent being politely but firmly being shooed away from the Square by Chinese cops.

What has been the outcome of Tiananmen? China is incomparably stronger and more powerful today than it was 20 years ago. But has the communist party maintained its brutal ways and refused to learn? Not really, suggests the newly started Banyan column in the Economist (which is devoted to matters Asian). It responded to the movement in appropriate ways:

It is a commonplace that the party’s legitimacy is built on economic growth. Yet China’s leaders have long considered that to be merely the (simplistic) half of it. After the massacre, the Communist Party set about transforming itself. It launched a vast historical investigation into how political parties fall, and how they stay in power. Everyone was scrutinised, from Saddam Hussein to Scandinavian social democrats. The conclusion: adapt or die.

The outcome is a wholesale reinvention of the party, a process accelerated after Mr Hu stepped up as paramount leader in 2004. Shortcomings that were identified included corruption (a chief complaint of the Tiananmen students), lack of accountability in decision-making, no convincing ideology, and an ossified structure.

..Bright technocrats and entrepreneurs have been recruited. Retirement rules have been revamped (the Soviet Union’s gerontocracy was noted). Party members have gone back to school: three weeks a year and three months for every three years of mid-career training. More appointments are open to peer scrutiny before they are filled. The Communist Party is vastly more able to govern

......This is little comfort to Westerners projecting their hopes for democratic change on to China. Nor is there any sign that Chinese intellectuals identify with the myriad grievances of their poor countrymen, as they did during the Tiananmen protests. And the growing middle class appears more fearful of the great unwashed than of the depredations of a party that once was at war with the bourgeoisie.

FT's China expert, James Kynge provides a slightly different perspective. He questions the very characterisation of the Tiananmen protests as being "pro-democracy". The reality, as always, was more nuanced, more complicated, he suggests:

Almost everything fell within its (the movement's) scope: campaigns against corruption, nepotism, inflation, police brutality, bureaucracy, official privilege, media censorship, human rights abuses, cramped student dormitories and the smothering of democratic urges. But to say the demonstrations were to “demand democracy” is an oversimplification.

The truth is that the students in the square had only the haziest understanding of western-style democracy. To the extent that the protests were directed at abuses of an existing system by an emerging elite, they were motivated more by outrage at the betrayal of socialist ideals than by aspirations for a new system.

In other words, the protesters were asking for reform, better governance, an improvement in the quality of their lives. They were not necessarily asking for more democracy. It appears from the Economist's interpretation that the communist party got the message and responded appropriately.

When the western world pushes for democracy, what it means is the right to vote in a multi-party system. But, if a monolithic party can make itself responsive to people's needs, it can contain disaffection. It appears the communist party has managed this. The world's understanding of Tiananmen and what followed, its continued focus on "human rights" in China and prognostications about the inevitable collapse of communism there, may thus be badly flawed

Agony of Afghanistan

Khaled Hosseini's novel, A thousand splendid suns, richly deserves the accolades it has received. Hosseini is an Afghan, now settled in the US. He gives us a glimpse of the grim struggle for existence that is the stuff of daily life in Afghanistan - or was at the time when the mujahideen were trying to drive out the Russians, when the mujahideen fought amonst themselves for control and, later, when the country came under the control of the Taliban.

The novel' s special contribution is its focus on the plight of women. It deals with the lives of two women, Miriam and Laila, thrown together by reason of having got married to an ageing (in Miriam's case) and aged (in Laila's case) tailor, Rasheed. Miriam is the illegitimate child of a wealthy businessman in the city of Herat. Her father keeps her mother, a cook, and Miriam at a distance. When Miriam's mother dies, her stepmothers get her married off to Rasheed who is from Kabul. Miriam is in her teens and Rasheed in his forties.

Laila's misfortune is even worse. Her family is killed in the shelling of Kabul and she's badly wounded herself. She's nursed back to health by Rasheed and Miriam until Miriam understands the motivation behind Rasheed's concern- he wants to acquire Laila as a second wife. Rasheed is in his sixties then and Laila in her teens.

The novel deals with the humdrum existence of the trio and the two children they have (one is Laila's through her teenaged lover before her life fell apart). It's a grim struggle for existence, unrelieved by anything joyful (except the two children). There is nothing the two women can expect by way of caring from Rasheed. The only reason they have to stay with him- and endure his taunts and his endless beatings- is that there is no way they can survive otherwise. What awaits them outside Rasheed's humble house is even worse. It is a tribute to Hosseini's craftsmanship that he's able to sustain the reader's interest in this colourless existence.

As you read through the novel, you begin to wonder whether there is anything left but despair and wretchedness, whether there is any salvation at all for these two helpless, yet cheerful women, whether such a life is worth living at all. Finally, salvation arrives in the only way it possibly could......the reader is left at once happy and saddened at the outcomes.

Hosseini gives us an idea of what life under the Taliban is like- no music, no TV, no education or jobs for women, women can't even go out unescorted, nothing to life other than what purports to be the pure Islamic way of life. Taliban rule is a return to some barbaric past, except that even in that past, one would like to believe, things were not as bad.

You may have your reservations about America's posture towards Islam in general, its attitude towards Palestinians and Iran, about the so-called clash of civilisations. But, when it comes to the Taliban, there is no room for doubt as to the rationale for the US and its allies waging war against them. A Taliban take over of Pakistan is the ultimate nightmare for that unfortunate country, for India and for the rest of the world.

Indian bashing in Australia

Is the Indian media overdoing the incidence of racial attacks in Australia? There is something about the sheer power of repetition on TV, the same visuals being played by different channels throughout the day and for days together. I tell you, the effect can be inflammatory.

I have no means of knowing what the situation on the ground is. Most cities, including New York and London, have their share of lumpen elements who will bash up or rob anybody who looks vulnerable. Indians must appear as soft targets because of their build but that doesn't quite explain why the Chinese are not similar targets. Colour must be a factor.

The question is how big is the racial issue in Australia. I was there in 2007, visiting Sydney and Canberra. I came back and declared that if there was one white country that was not hostile to brownies, it was Australia. It was friendliness all the way. Of course, these fleeting impressions can be deceptive and it's only when you live somewhere that you get a feel for the place.

But, I have found that the acid test is the immigration counter. There you can sense the hostility or the lack of it. For the first time in my visit to a white country, I encountered a very warm welcome. Very different from what you would experience in, say, New York where, at immigration, every South Asian is presumed to be a terrorist unless proved otherwise.

Another test is the country's airlines. Both on Quantas and the domestic airlines, I experienced a total lack of hostility. Again, these could be misleading. Or it may be well be that the changed economic environment has caused a certain souring of moods.

Budget and reforms

Another budget will be upon us in a month or so. One of my secret fantasies is to flee town and head for some place that lacks TV around budget day. Then, I will be spared the cacophony that erupts at budget time.

Budget time is big money for the media. They create the hoopla around the budget and profit immensely from it. Live budgetary analysis is not terribly educative. You can't react to any of the numbers put out by the FM until you have had a chance to put them on a spread sheet and compare like with like in the previous year. But before people have had a chance to do that, instant wisdom will have been delivered on TV. So heavy is the overkill that informed analysis that comes a few days later in newspapers or journals is lost on the public.

Well, anyway, now that another budget is on its way, the clamour for "reforms" has begun. The argument is that the government could not push ahead with "reforms" the last time thanks to the benighted Left but now there are "no more excuses". Sorry to play spoilsport, but it appears those who clamour thus haven't read the Congress manifesto. It is reformist to my mind but the reforms it talks about are not the ones that pro-market enthusiasts have in mind- cuts in subsidies, labour market reforms, privatisation, financial sector reforms, FDI etc.

The Congress appears to have learnt from the defeat of the BJP and the lesson will have been reinforced by its own performance this time- "reforms" that the media and the business community clamour for are not vote-catching propositions. My guess is that those who are talking up the stock markets in anticipation of "big bang" reforms are in for a disappointment.

More on this in my last column, Redefining the reform agenda.

Winds of change in US board rooms

Whatever else governance reform may mean, I have always been clear about one thing it should mean: independent directors cannot be selected by management; to begin with, at least some independent directors on the board must be chosen by institutional shareholders.

I am not aware of any country where this happens. It certainly does not happen in the cradle of the governance movement, the US. In the US, the majority of companies have provisions that allow shareholders only to vote for directors proposed by management or withhold their vote. This has created a situation where directors get elected even when they do not command a majority of shareholder votes.

As the head of governance Calpers, the California pension fund, notes in a recent FT article, this is set to change. Legislation has just been introduced in the US Congress that allows shareholders to say 'no' to a director proposed by management and to propose their own directors subject to certain clauses intended to keep out frivolous proposals. The legislation also seeks to separate the chairman and CEO rules, another reform I have myself long urged. The SEC, under its new head, is introducing proposals of its own that are consistent with such legislation.

Governance reform is on the agenda of Sebi as well. This is the time for Sebi as well as the government to take the lead to usher in governance reform along these lines in India as well. After the Satyam and Nimesh Kampani affairs, there is concern about the need to protect independent directors from legal actions in matters for which they can hardly been held responsible. Two independent directors are said to have quit every day since Satyam erupted- resignations to date total over 400.

A certain measure of protection for independent directors is fine. But this must go hand in hand with measures to strengthen the mechanism of independent directors. Independent directors who collect huge fees in return for nodding their heads to whatever management wants done is clearly not on.

UK's financial sector

UK has long prided itself on its competitive financial sector and its comparative advantage in that sector. How did this advantage come about? Because of light regulation. In other words, the UK benefited from regulatory arbitrage. To put it more accurately in light of the ongoing crisis, UK bankers benefited from such arbitrage. So, what's to be done about it?

Martin Wolf reviews an astonishing report prepared by a committee that included UK's chancellor of the exchequer, Alistair Darling. The report recommends “ the financial sector be allowed to recalibrate its activities according to the sentiments and demands of the market”. They must be nuts to recommend this after seeing how the market has worked.

Wolf makes a set of eminently sensible suggestions:

First, the UK needs to make global regulation work. It should discourage regulatory arbitrage even if it expects to gain in the short run.

Second, it must, in particular, help ensure that owners and managers of financial institutions internalise most of the costs of their actions.

Third, it must reject egregious special pleading from the industry. The sector argues that moving derivatives trading on to exchangesmight damage innovation. So what? Maximising innovation is a crazy objective. As in pharmaceuticals, a trade-off exists between innovation and safety. If institutions threaten to take trading activities offshore, banking licences should be revoked.

Fourth, while trying to create a stable and favourable environment for business activities, the UK should try to diversify the economy away from finance, not reinforce its overly strong comparative advantage within it.

Fifth, UK authorities need to ensure that the risks run by institutions they guarantee fall within the financial and regulatory capacity of the British state. They should not let the country be exposed to the risks created by inadequately supported and under-regulated foreign institutions. At the very least, they should not undermine other governments’ efforts to regulate their own institutions.

Since "reforms" are the flavour of the day in India today, let me add that some of the above principles should guide banking sector policy in India as well.

A cohesive and stable government?

Those amongst the chatteratti who were euphoric about the mandate for the UPA government must be having to think again, seeing the birth pangs of the new government. The DMK leadership has retreated to Chennai and into a big sulk. Even if compromise is reached on the number of berths, it appears unlikely that the Congress can dictate who the DMK's ministers should or should not be: I doubt that any self-respecting party can concede the point that two of their earlier nominees were inefficient and corrupt.

As for the markets' relief over a patchwork of parties from the Third or Fourth Fronts forming the government and the Left being kept out, it's worth remembering that, in Mamata Banerjee, the Congress has to contend with somebody who was to the left of the ruling coalition in West Bengal. Banking reforms, labour reforms, SEZs- it won't be easy to breeze past Mamata on these issues.

Lastly, I do hope good sense prevails in the Congress and the finance portfolio stays with a politician and doesn't go to a technochrat. It wasn't the pro-reform brigade that helped the Congress do well in the 2009 elections, it was the solid political instincts of the Gandhi family, much of which goes against the spirit of "reforms".

Understanding the results of the 2009 elections

I don't know in which case instant wisdom is worse: the Union budget or the elections. In both instances, it is the idiot box that plays havoc with sober judgement. Even as the news is happening, pundits are ready to shoot their mouths. Whereas in both cases, a careful dissection of data is required in order to arrive at an informed judgement.

Let us consider some of the conclusions that abound in post-election punditry:

1. Regional parties have been shown their place, national parties have regained their dominance: We need always to distinguish between number of seats won and share of the vote. It is possible for a ruling party to become unpopular and see its share of the vote fall. Still, it may win more seats because the opposition vote happened to be more splintered.

In the present election, Yogesh Yadav estimates that the combined vote share of the Congress and the BJP climbed from 48.7% in 2004 to 48.9% in 2009- hardly any change. This translated into a disproportionate increase in total seats of the two parties from 283 to 321, with the Congress gaining 61 seats and the BJP losing 23 seats.

So, the regional parties have retained their importance. It is just that the relative shares of the Congress and the BJP in the national party pie changed so as to place one party in a stronger position than before.

2. The results are a vote for stability and good governance: This implies that regional parties are an unstable factor and the national parties alone can provide stability and good governance. The figure for the vote share of regional parties has hardly changed. Besides, the BJP, which has provided stability and good governance in Gujarat, is a big loser. The Congress benefited from the electoral arithmetic in many ways: for instance, it made big gains in AP because the Chiranjivi factor ate into the votes of the TDP and in Maharasthra, the MNS ate into the votes of the Sena-BJP. A slight change in the electoral arithmetic could once again create instability at the centre.

3. The results are a vote for "reforms" and the Congress-led UPA should, therefore, fast forward "reforms": The Congress benefited from a rise in rural incomes and prosperity driven by growth in agriculture, an area that is least touched by reforms. It also benefited from measures that "reformers" relentlessly fought: NREGA, the farm debt waiver, the Sixth Pay Commission award, an increase in subsidies and OBC quotas.

The one formation that lost heavily from its attempt to push through "reforms" was the Left in West Bengal which tried to usurp farm land in order to push ahead with industrialisation. (SEZs are an important item on the "reforms" agenda). It is fair to say that the UPA benefited from measures associated with the Left while the Left lost because of measures associated with the "reformers'!

4. The nation has rejected the "communalist" BJP: It is said that it was the BJP's attempts to project Narendra Modi as a future national leader and the vitriolic outbursts of Varun Gandhi that cost the BJP dearly. Really? Then, how come Varun himself won handsomely in Pilibhit and the BJP did well in Karnataka which is considered progressive and was out of the BJP orbit until recently?

I'm afraid none of the explanations put forward, such as the ones above, are free from infirmity. There are only three things one can say we can with a degree of certitude. One, regional parties remain a force. Two, the electoral arithmetic can cause the outcome in terms of seats won to diverge significantly from the outcome in terms of vote shares. Three, the only way to combat the anti-incumbency factor is to focus on measures that have a pro-poor and rural orientation.

The rise and rise of regional parties

The great game of searching for alliance partners is on and regional parties are being wooed arduously by the Congress and BJP alike. I hear much tut-tutting over the rise of regional parties. Somehow, there is a perception that regional parties' support or dominance leads to instability and weak governance and only the two national parties, Congress and BJP, can provide stability and good governance. So, take your pick- the secular guy or the commual guy.

Alas, life is much too complex and messy to conform to the preconceptions of the Indian elite. There is no stopping the rise of regional parties, as I note in my ET column, Fear not the regional parties, and, more importantly, there is no reason to get jittery over this phenomenon.

Regional parties have shown themselves more responsive to caste and regional aspirations and this has inevitably eaten into the vote share of the national parties. This will continue until a more homogenised and prosperous nation emerges with the middle-class being truly middle, meaning accounting for, say, more than 5% of the population, as is the case today (depending on what income level you want to take as a cut-off).

As political scientist, CP Bhambhri, writes in a companion piece in ET, regional parties have found it necessary to capture power at the centre in order to better cater even to regional aspirations because, in the Indian federation, the centre still calls the shots. In the process, regional parties are compelled to develop a national perspective. That is the beauty of democracy: it causes political actors to modify their behaviour in ways that generate wider support and hence leads to more acceptable behaviour.

There is much condescension when it comes to regional leaders- they are not as savvy or well dressed as their national counterparts and so the inference drawn is that they may not have the skills to run the nation. Nonsense. If you have run UP or Tamil Nadu and done so more than once, believe me, you have what it takes to run the nation. I quote a distinguished bureaucrat in my column as saying nice things about Deve Gowda. TSR Subramaniam, former cabinet secretary, expresses the same sentiments about Gowda. Outlook editor Vinod Mehta wrote recently that the most impressive performer from the Indian delegation at a Davos conference he attended was Gowda, not one of our high-profile businessmen.

So, let us not deride regional parties and regional leaders. Instead, let us welcome gracefully the changes being ushered in by our marvellous democracy.

Gujarat a star in agriculture

Gujarat has always been a star in industrial performance. It was news to me that Gujarat is a star i in agriculture. Gulati and Shreedhar analyse the phenomenon in an ET article. Agriculture has grown in Gujarat at an astonishing 9.6% in 2000-01, more than the thrice the all-India figure.

One key driver has been the Sardar Sarovar project and the increased availability of water in a state in which irrigation cover is only 36%. One can understand why the project arouses strong emotions in the state. Another driver is technology, especially new varieties of cotton with the private sector taking the lead. Then, good roads, better regulation of electricity for agricultural use and a thrust on extension services have helped.

The authors conclude, "Strong political commitment to promote rural development, a long term vision, and the capacity to implement this are perhaps the key ingredients of Gujarat’s success story".

That must explain Modi's success- there's a lot more to development in Gujarat than the Nano project.

Indian firms in world's 'most reputed' list

Rediff has a story on a list of the world's most reputed firms listed by the Reputation Institute of the US. (I must confess I have no clue who they are). The following are some of the Indian firms that figure (world rank in brackets):

1. Tata group (11)
2.SBI (29)
3. Infosys (39)
4.L&T (47)
5. Maruti (49)
6.HLL (69)
7. ITC (95)
8. Canara Bank (102)
9. Hindustan Petroleum (111)
10. Indian Oil (112)

Interesting omissions are the Ambanis and the Birlas. It's also interesting that Infosys, which has invested so much in building an international brand and HLL, which is a well known brand, rank below Tata and SBI. The top 10 includes four public sector firms.

Shantaram

I finally finished reading Shantaram. I say 'finally' because I am a slow reader and the novel runs into over 900 pages.

Shantaram, which came out in 2004, is penned by Gregory David Roberts, an Australian who was serving a jail sentence for armed robbery in his country. He escaped from jail, landed in Mumbai, spent several years there as part of the local underworld, was recaptured in Germany and, after serving the remaining sentence, got his novel published. He needed to write it thrice because his captors destroyed the first two versions when they found out. Roberts has since made Mumbai his home.

The novel is an epic, along the lines of,say, Gone With the Wind. And it's more than a novel, it's a soul-stirring experience. To think that a man could go through all that, retain his humanity and find the reserves to write a splendid novel! Roberts' mother taught him to appreciate literature and he spent his time in the Australian jail devouring first-rate fiction. It shows in his own writing.

It's impossible to capture the splendours of the novel in one short post. Roberts has said in interviews that the events are real, only the narrative is fictional. There is a charming account of Roberts' six month stay in a village in Maharashtra's interior where he is given his Indian name, Shantaram; a moving description of life in the slum near Cuffe Parade where the locals adopted him as one of their own; great encounters with Abdel Kader Khan, the underworld don, who combines a fine command of the English language with a fondness for philosophical speculation (every week, he and his comarades meet for lofty discussions); Roberts' embroilment in the war in Afghanistan when he accompanies Khan and others on a journey through Pakistan to arm the Taliban in their war against the Russians; and Roberts' falling in love with Karla Saaranen, a mysterious, beautiful and thoughtful American lady of European extraction... (you have to read the novel to know what the mystery is about).

Some of the scenes in the novel will stay with me for a lifetime. On one occasion, Roberts and a small boy (Khan's nephew entrusted to Roberts in order to experience slum life) find themselves attacked by a whole horde of dogs in the slum at night time. They try to fend off the pack with bamboo sticks but it's a losing battle. Then, Kader Khan's bodyguard materialises out nowhere, iron rod in hand. He's a trained martial arts specialist. He leaps into the air in true martial art fashion, swirls and strikes. Two dogs have their brains shattered. The entire pack, stunned at somebody taking the attack to them where Roberts was merely defending, flees.... Roberts is saved.

Then, there is the Colaba police station where Roberts is held for a few weeks. The lucky ones are those behind bars. The others are herded into a small corner leading to a toilet where shit is overflowing.... the weakest have to stand for days in a heap of shit until they drop dead....

One day, the detainees are led out and taken to Arthur Road jail (home to Sanjay Dutt for a while). Roberts is motioned to a corridor. There, the convict warders are waiting with lathis.... Roberts has to run the gauntlet but choses to walk in a gesture of defiance as the blows rain on him. He lands in his cell bloodied. The jail itself is hell with the warders showering blows on inmates at will. It makes your blood boil to think this is what the Indian system has been reduced to. One gets a sense of the daily brutality visited on the weak and the defenceless by the Indian law enforcement system.

What, one wonders, is the IPS brass doing? The only thing you could say in extenuation is that things are not much better in jails elsewhere. In his jail in Melbourne, Roberts was subject to the same kinds of senseless beating and cruelty. Recently, during the G-20 meet, the cops in UK, considered to be more civilised than the rest, were flailing their batons at harmless protesters. I guess it goes with the uniform, the sense of power it gives you. The power to ill-treat and also the power to extort huge sums of money.

The Afghan expedition is a story in itself. It takes weeks of trekking through the mountains to get there, with a maniac as escort. This man has only one mission in life and that is to catch hold of Russian soldiers and torture the life out of them. The return journey is a horror, with Roberts and a few survivors holed up in a snowy cave with no food or water for several days. Roberts makes it to a hospital in Pakistan and then finds his way back to Mumbai. With his heroic role in the Afghan expedition, he becomes a privileged member of the gang, specialising in counterfeit passports. He makes good money out of it.....

I won't narrate more. I will leave you to find out for yourself. Shantaram is being made into a film by Mara Nair. I can't wait to see it (I understand work on the film has stalled because of some problems in Hollywood). Let me just say that the book leaves you shaken and stirrred, to use a famous James Bond line.

I had a post some time back on another book on Mumbai, Suketu Mehta's Maximum City. That is also about the seamy side of Mumbai. But the philosophical approaches of the two books are very different. Mehta is appalled and outraged at the violence and corruption that lie beneath the surface in Mumbai.

Roberts writes with empathy and affection for those on the seamy side. There is understanding and love, an underlying humanity that comes from having experienced the worst of it. Roberts is now off smoking, drinks and drugs and leads the life of a celebrity in Mumbai. I doff my hat in humble salute to the man.

Unconvincing "stress" tests

The much awaited results of the "stress" tests on top US banks is out- the idea is to see how much extra capital these banks would need under fairly realistic economic scenarios over the next couple of years. The estimate: $75 bn in order to be well capitalised by the end of 2010. The biggest requirement is at BofA: $34 bn.Total losses at the banks are estimated at $600 bn. Of this, $363 bn would be recouped through earnings.

What do we make of these figures? Two points. One, these losses come after the accounting standards were tweaked on mark-to-market losses of toxic assets. Two, the IMF had estimated US bank losses at $1.6 trillion over the next couple of years and estimated the extra requirement of capital at around $500 bn. The market is, therefore, likely to perceived the US Treasury as under-estimating capital requirements in order to hide the gravity of the problems at banks. That, in turn, means the chances of raising additional capital from the market would be zero.

Even otherwise, chances of banks raising additional capital are bleak. FT estimates total capital requirements at $55 bn, assuming some banks want to repay capital given by the US government and also some asset sales. This amount is three times total US equity raisings in the last six months. There you are.

Since banks can't raise capital from the market and the US government is unwilling or unable to pump in more, Richardson and Roubini, writing in the FT, say that insolvent banks should be closed down, with creditors taking some of the hit (depositors alone should be fully protected). What about the Lehman effect? The authors argue that market discipline would force banks to change their behaviour in ways that would instil confidence in the market, so credit would become available.

Well, well. For this process to work out would probably take years. So implementing this solution would require some nerve. Academics have the license to prescribe theoretically neat solutions but the global crisis requires a solution here and now because there is real suffering all round. I doubt that there will be any takers for the Richardon-Roubini solution where large banks are concerned.

How real is the Taliban threat in Pakistan ?

I have been following with interest the scare stories about the Taliban being 60 kms from Islamabad and the dire prophesies about Pakistan's nuclear weapons falling into the hands of terrorists. Are things really as bad as that? I came across an article in Asia Times, which made a lot of sense to me:

Pakistan is not an ungovernable Somalia. The numbers tell the story. At least 55% of Pakistan's 170 million-strong population are Punjabis. There's no evidence they are about to embrace Talibanistan; they are essentially Shi'ites, Sufis or a mix of both. Around 50 million are Sindhis - faithful followers of the late Benazir Bhutto and her husband, now President Asif Ali Zardari's centrist and overwhelmingly secular Pakistan People's Party. Talibanistan fanatics in these two provinces - amounting to 85% of Pakistan's population, with a heavy concentration of the urban middle class - are an infinitesimal minority.

The Pakistan-based Taliban - subdivided in roughly three major groups, amounting to less than 10,000 fighters with no air force, no Predator drones, no tanks and no heavily weaponized vehicles - are concentrated in the Pashtun tribal areas, in some districts of North-West Frontier Province (NWFP), and some very localized, small parts of Punjab.

To believe this rag-tag band could rout the well-equipped, very professional 550,000-strong Pakistani army, the sixth-largest military in the world, which has already met the Indian colossus in battle, is a ludicrous proposition.

So, what's behind the hysteria being drummed up in Washington?

To start with, what Washington - now under Obama's "Af-Pak" strategy - simply cannot stomach is real democracy and a true civilian government in Islamabad; these would be much more than a threat to "US interests" than the Taliban, whom the Bill Clinton administration was happily wining and dining in the late 1990s. What Washington may certainly relish is yet another military coup - and sources tell Asia Times Online that former dictator General Pervez Musharraf (Busharraf as he was derisively referred to) is active behind the hysteria scene.

.........Moreover, there are canyons of the Pakistani military/security bureaucracy who would love nothing better than to extract even more US dollars from Washington to fight the Pashtun neo-Taliban that they are simultaneously arming to fight the Americans and NATO. It works. Washington is now under a counter-insurgency craze, with the Pentagon eager to teach such tactics to every Pakistani officer in sight.

There are wheels within twisted wheels. The only thing unexplained above is in what ways concretely the US stands to gain from a military regime in Pakistan. What are the larger designs of the US to which a civilian regime would be an obstacle? And, more importantly, where does India figure in the US plan for Af-Pak?

Global recovery will be slow

A quick economic recovery? Perish the thought. Recovery is going to be slow. The IMF thinks so. So does the RBI.

As the IMF's latest World Economic Outlook makes clear, there are recessions and recessions. The worst are the ones created by a financial crisis, especially a crisis rooted in the banking sector. When recession is globally synchronised, that makes things even more difficult because no country can export its way out of trouble (as the East Asian economies could in 1998). Today, we have a combination of a financial crisis and a globally synchronised recession. So, expect recovery to be a slow affair. Not until 2010, says the IMF, and even then it will be long drawn out.

When you have a crisis rooted in the banking sector, the way out is to fix the banking sector. Sadly, the US administration has been dragging its feet over this for more than a year now. Fixing the banking sector in the US, given the scale of losses, means nationalisation. There is just no other alternative. But nationalisation would wipe out shareholders and too many rich people, including those in the US administration, don't want that. They would like to look for alternatives that preserve shareholder wealth. But every one of these alternatives entails a slow and painful economic recovery.

It won't be a Great Depression for reasons I spell out in my ET column, Don't bank on an early recovery. But it won't be a mild and short recession either.

I wrote my ET piece and sent it off last week as I was due to travel. On my return, I was gratified to note that my assessment accords with that of both Martin Wolf of the FT and the Economist. Wolf writes:

For better or worse, the authorities have decided to bail out their financial systems with taxpayer money. Almost all the affected countries should be able to afford to do this, at least on the IMF’s numbers. So now, having made the fundamental decision to prevent bankruptcy, they must return their financial systems to health as swiftly as they possibly can.

Even so, that will prove to be a necessary, not a sufficient, condition for a return to robust economic health. The overhang of debt makes deleveraging inevitable. But it has hardly begun. Those who hope for a swift return to what they thought normal two years ago are deluded.

Says the Economist:

The worst is over only in the narrowest sense that the pace of global decline has peaked. Thanks to massive—and unsustainable—fiscal and monetary transfusions, output will eventually stabilise. But in many ways, darker days lie ahead. Despite the scale of the slump, no conventional recovery is in sight. Growth, when it comes, will be too feeble to stop unemployment rising and idle capacity swelling. And for years most of the world’s economies will depend on their governments.

Axis Bank theatrics

The curtain has finally been rung down on the succession issue at Axis Bank. P J Nayak staged an undignified walk-out after a stormy board meeting, paving the way for Shikha Sharma from the ICICI group to take over as CEO with board member Prithviraj taking over as interim chairman.

Nayak, going by reports, was completely isolated on the succession issue, with even those close to him for long deserting him in the final moments. Nayak wanted Kaul, an executive director, to succeed him. He has argued in an interview with BS that an organisation should bring in an outsider only if it is weak. Not true. It may need to bring in an outsider also if the insiders are weak (which can happen in an organisation that is strong but has been a one-man show).

Nayak had earlier successfully resisted the RBI's efforts to bifurcate the positions of chairman and MD, saying he needed time to groom a successor. It turns out that he failed to do so even when given adequate time. This is not uncommon- BS had an edit yesterday mentioning the cases of L&T and ITC where the present chairmen seem to think themselves immortal.

The right thing has happened at Axis Bank and this is, in large measure, due to the role played by the nominees of SUUTI who presented a united front on the issue and made the process of finding a successor rigorous. It appears that even in a private bank, it is the government that has to be around to ensure the right outcome. This will not come as a surprise in the present times where the same phenomenon is being seen on a bigger scale in the US banking system and elsewhere.

One last point. Nayak's quitting as chairman in a huff was inappropriate. One could have understood if some legal or ethical issue had been involved. There wasn't any. Nayak left in a fit of pique only because he couldn't have his way.

This isn't done. Banks run on confidence and for an executive chairman to walk away without ensuring a smooth hand over can be potentially harmful. It's a different matter that the Indian banking system is in good shape and that we need not fear such an outcome in the present instance.

Incidentally, I was told that AT Paneerselvam, board member at Axis and former chairman of IBA, collapsed in his car and passed away while on his way to the airport from the seven hour board meeting. Strange that no paper has reported this.

Return of good times for US banks?

Several top US banks including Citigroup and Goldman Sachs have reported impressive results in the first quarter. Some have interpreted this as a sign that the banks are finding their way back to good health and they also see this as good news for the world economy.

Sorry, it ain't all that great. Even if banks start making profits, it only reduces accumulated losses - or helps banks write off bad assets. it does not help increase the quantity of loans- and more credit is what is required to get the wheels of the economy going. The balance sheets of US banks will shrink this way until banks are restored to health. This slow process of recovery helps shareholders who would otherwise be wiped out at one stroke if the US government were to nationalise them- which is why the government, run by ex-bankers and investment bankers, doesn't want to take that step.

Moreover, US bank profits have been helped by regulatory forbearance in several ways as an article in the FT points out:

First was the decision by the Federal Accounting Standards Board on April 2 to modify what many bankers considered the FASB’s onerous mark-to-market rules forc­ing securities firms to write down the value of their assets as they lost value in the in­creasingly illiquid market. (Seems like a reasonable idea to value assets at what they are really worth, no?) The FASB had been reviewing this change and received much commentary from the financial community “that asserted that fair value is not as relevant when financial markets are inactive or ­distressed”.

.....The Federal Reserve has also been listening carefully to the banks’ pleas. It has lowered the cost of money it charges banks – and since all the big Wall Street securities firms are either gone or have become banks, this means virtually everyone – to close to zero.

Then there is the sleight of hand, at least in the case of Goldman Sachs, which, when it converted from a securities firm to a bank holding company last autumn, changed its fiscal year-end to December 31 from November 30. Its first-quarter numbers, for the three months ended March 31 2009, did not include its horrific December results – into which Goldman threw everything but the kitchen sink – of a loss of more than $1bn. During the past seven months – including December (there was Christmas, right?) – Goldman in fact lost $1.5bn.

So much for the good news from the US.

Will banking become boring?

What world of banking can we expect to see once the dust settles down in the present crisis? Regulations will be more stringent and three elements will be central to the new world of banking- higher capital, constraints on financial innovation, restrictions on bankers' incentives. Higher capital requirement in itself spell lower returns and hence lesser rewards in banking. In other words, banks and "shadow banks" will have a presence in the economy that is more consistent with the requirements of the real economy instead of becoming a world unto itself.

This is greatly welcome when you consider the atrocious waste implied by the disproportionate flight of high quality talent towards finance in recent years. Finance and IT are two sectors that have completely distorted the labour market in India- and we should welcome the fact that both are being put in their places.

More on this in my ET article.

Academics in government

There has been much criticism about how the "dream team" of Manmohan Singh, Montek Ahluwallia and P Chidambaram did little or nothing on economic reforms. It's interesting that two of the three members have strong academic credentials. An article in FT echoes the criticism:

The whole reform programme relies on the prime minister himself. Mr Rao and A.B. Vajpayee proved their mettle, despite heavy political constraints. Mr Singh has failed; he should bear much of the blame. The Congress party does not deserve to be re-elected and the dream team does not deserve to continue in office.

It also has some strong things to say about academics in positions of authority:

........Mr Singh has proved a hopeless decision-maker as prime minister. Sadly, he proves the rule that academics should generally be “on tap” but not “on top”.

Lincoln and leadership

Leadership, as I have noted earlier, is, perhaps, the most written about topic in the Harvard Business Review - it's covered even more than that other perennial favourite of management gurus, strategy. I am inclined to believe that if all the literature on leadership has simply led on to more literature, then leadership must be pretty difficult to teach or learn- either you have it or you don't and the only real teacher can be life itself.

This feeling was reinforced by an interview in the latest HBR on Abraham Lincoln and leadership. The interview is with historian Doris Goodwin, whose book, Team of Rivals, is the one book that President Obama said he would take to the White House, apart from the Bible. Goodwin says of Lincoln's secret of leadership:

Lincoln surrounded himself with people, including his rivals, who had strong egos and high ambitions; who felt free to question his authority; and who were unafraid to argue with him.
.....Obama is obviously trying to do the same thing by choosing his chief rival, Hillary Clinton, to be secretary of state; by picking rival Joe Biden as his vice president; and by including powerful Republicans in his cabinet like Robert Gates and Ray LaHood.

But you have to remember, the idea is not just to put your rivals in power—the point is that you must choose the best and most able people in the country, for the good of the country. Lincoln came to power when the nation was in peril, and he had the intelligence, and the self-confidence, to know that he needed the best people by his side, people who were leaders in their own right and who were very aware of their own strengths. That’s an important insight whether you’re the leader of a country or the CEO of a company.

Hmm.... Let me see.... I have worked for several organisations, corporate and academic, served as consultant to and board member on quite a few. How many places can I think of where the person at the top did what Lincoln did- put strong people, including rivals, in key positions and let them fight it out with him? Only one !- and this was my immediate boss, not the CEO.

This was one boss who did not feel insecure about having people superior to him working for him, indeed he openly declared that he was inferior. Did he make it to the top? No way- he didn't last long in the corporate world and ended up as a small farmer in his village.

It may be well be that you need Lincoln's ability to surround yourself with strong people in order to be a super-achiever. But this ability, I am afraid, is rare and I can't see that it is something that people can be taught. That is why Lincoln is Lincoln, one of the towering figures of all time while many corporate and other leaders have ended in the dust-bin of history.

Satyam sale

The sale of Satyam to Tech Mahindra is a morale booster, never mind the ifs and buts as to whether the buyer can make a success of the acquisition. For once, the print and visual media were willing to acknowledge the role played by the government in preventing a debacle and arranging a rescue.

It's an amazing end when you think of how things would have ended in, say, the US. The moment the fraud came to light, the company would have gone into bankruptcy proceedings and it would have been embroiled in litigation. In a software company, value comes from intangible assets- the people and the brand- so there's little that investors can claim from liquidation and litigation.

The only hope is to turn the company around under new management and wait for the stock prices to revive. Those who filed class action suits in the US may well find that they may be better off waiting for the stock price to rise instead of trying to claim a settlement from the new management.

In making the decision that Satyam was too important to go under and that it could and should be revived, the Indian government was spot on. It also acted swiftly in putting in place a new board and the regulatory authorities helped by creating a fresh set of rules for takeovers in such exceptional cases. (This was wrongly derided by some as being anti-investor, overlooking the fact that we are talking of a company that was on the brink of a collapse that would have washed out investors altogether).

What can we learn from this episode? One is that government may need to intervene in the case of any systemically important institution, not just those in the financial sector. The second lesson- driven home already by the financial crisis- is that 'leave it to the market' can be sheer nonsense in such situations.

US gunmanship in Somalia

The US showed what it means to be a superpower when it effected a terrfic rescue of the captain of a ship, a US citizen, held hostage by pirates in the high seas off the coast of Somalia. The only detailed report of the rescue operation I came across was filed by Chidananda Rajghatta in TOI ( in the print edition, I can't trace it on the web, so I'm going to describe it in my own words).

The captain had been seized and held by four pirates after a failed piracy attempt in which the pirates were repelled by the ship's crew. They managed to escape on a motorised lifeboat with the ship's captain and were adrift for five full days. The US navy sent its warships into the area to hem them in and then ensured that other pirate vessels attempting to enter the area were shooed off.

The US navy then engaged the pirates in negotiations even as the pirates' rations and fuel ran out. One ship offered to tow the lifeboat away from choppy waters into calmer ones- this brought the lifeboat within firing range of the snipers on board the US ship. One pirate was taken aboard the US ship to help with the negotiations. President Obama, who was kept in the loop througout, gave the US navy the command to go ahead and shoot if the captain' s life was judged to be in imminent danger.

When the negotiations did not progress and the pirates came within the snipers' cross-hairs, all three pirates on the lifeboat were taken out with one bullet each. The pirate on board is in US custody and the captain is flying home.

The successful end saved President Obama an early security embarassment- Americans don't take kindly to botched military missions or the deaths of US citizens- but the head of the pirates has accused the Americans of treachery saying his colleagues had been ready to given up the captain without ranson when they were shot. Unfortunately, some 200 seamen from other nations and from various ships are being held hostage by various groups of pirates. The pirate chief has also warned of revenge against Americans seen in the waters again.

Reducing risk in the financial system

Naseem Taleb, former trader and something of a maverick in his views on the financial system, comes up with 10 rules for making the world "black swan free'- a black swan is that rare event which can end up destroying an institution or a system. His tenth rule I found particuarly drastic:

Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

His first two rules are also highly sensible but not easily enforceable:

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail. Evolution in economic life helps those with the maximum amount of hidden risks – and hence the most fragile – become the biggest.

2. No socialisation of losses and privatisation of gains. Whatever may need to be bailed out should be nationalised; whatever does not need a bail-out should be free, small and risk-bearing. We have managed to combine the worst of capitalism and socialism. In France in the 1980s, the socialists took over the banks. In the US in the 2000s, the banks took over the government. This is surreal.

Inflated claims at G-20

The headline grabbing item from G-20 was talk of $1.1 trillion in fresh funds to fight the recession. Most analysts were quick to point out that this included funds already committed. What was not noticed was that it includes amounts intended to be committed but which are unlikely to be committed. FT dissects the G-20 claim and finds that the correct figure is closer to $100 bn:

Almost half – $500bn – comes in the form of new money for the IMF so that it can guarantee it has enough money to lend to countries caught up in the financial crisis.

Japan unilaterally gave $100bn last November, while the EU pledged €75bn ($101bn) in March. There were no new commitments from the US, China or Saudi Arabia on Thursday, and instead a generalised pledge for a new financing scheme of $500bn into which all these existing commitments and new money would be placed.

.....If the new commitments to the IMF were conspicuous by their absence, the $250bn of new money in Special Drawing Rights – the Fund’s own currency – was new but not all it seems.

....The policy is significant because it represents new money that poor countries can turn into dollars, euros, yen and sterling but rich countries will get most of this new foreign exchange reserve. The group of seven largest and most advanced world economies will get 44 per cent alone. March.

On trade finance, ........ the $250bn figure fails to stand up to minimal testing. An annex to the communiqué says that the new money committed is only $3bn-$4bn and the $250bn figure is an aspiration for the amount of trade that will be financed over the next two years rather than the amount of new trade finance.

In contrast, the new $100bn of lending by multilateral development banks is much closer to reality.

When all the sums are added together, rather than $1,100bn, the new commitments appear to be below $100bn and most of those were in train without the G20 summit.

Turner Review

A number of committees in several countries are working on proposals for financial sector reform. In the UK, a committee headed by the chairman of the FSA, Adair Turner, has submitted a report, the Turner Review, backed by a Discussion Paper. It has 28 recommendations for regulatory reform along and another four issues thrown open for discussion.

What is striking about the Review is the pronounced swing of the pendulum in favour of tighter regulation and away from reliance on market discipline. The Review does not mince words:

“The financial crisis has challenged the intellectual assumptions on which previous regulatory approaches were largely built, and in particular the theory of rational and self-correcting markets. Much financial innovation has proved of little value, and market discipline of individual bank strategies has often proved ineffective.”

I have a critique of the Review in my ET column, One hell of a page turner. I seriously doubt that any future government can proceed with the substance of the recommendations of the Percy Mistry and Raghuram Rajan reports.

Let me highlight one important point made in the Review. It does not believe that separating commercial banking from investment banking will make the banking system any safer and it also believes that not having complex banks catering to multiple needs across the globe would entail forgoing significant benefits. Some of the arguments it makes in favour of not distinguishing between 'utility banking' and 'investment banking' are:<>

• while it is clear that the securitised credit model evolved in a fashion whichundermined the initial proposition that it would prove lower cost and lower risk, it is important to recognise that, if more effectively regulated and supervised, it could have thosenarrow banking, whose severity might have been reduced if an appropriate form of securitised credit trading and credit insurance had been in place.
• Furthermore, any idea that risky trading activities in institutions outside the utility banks, can be allowed to grow in an unregulated fashion, subject only to the market discipline that they will not receive LOLR or fiscal support in crisis, is not credible in a world of interconnected markets. Bear Stearns was not involved in any significant way in utility banking activities; but when it was on the verge of failure, the US authorities rightly identified it as systemically important.
• Finally, it is important to recognize that ‘narrow banks’ focusing almost entirely on classic commercial and retail banking activities can be extremely risky. NorthernRock,WashingtonMutual and IndyMac were all ‘narrow banks’.

G-20 protests focus on bankers

The G-20 meeting in London is attracting protests in the City of London. The target of the protesters' ire this time is not globalisation or climate change but banks. Entirely understandable given that banks are perceived to be at the root of the present chaos in the world economy and that several bankers have had no qualms about pocketing bonuses even when their banks were being bailed out by tax payer money. Sir Fred Goodwin, the erstwhile CEO of RBS, has had his home in Scotland vandalised.

FT carries a story on the protests:

Four marches, led by representations of horsemen of the apocalypse, converged on the Bank in the Financial Fools’ Day protest as demonstrators chanted “storm the banks”.

...Some of the banners read: “Balls to the Bankers”, “Eat the Bankers”, “Capitalism Isn’t Working” and “What a Load of Bankers”. One group of protesters urged people watching from the top of Santander bank to “jump”.....Olivier Dale, a 28 year old attending the demonstration said: ”I am sick of these bankers and this greed. It has got to stop. We have to make a stand. But we want it to be peaceful.”

...Most big employers – including the global investment banks and law firms – told employees they were expected to come into work as usual. But those near locations where demonstrations were held told staff to dress inconspicuously and avoid drawing attention to themselves.

Financial sector assessment programme

The RBI has finally unveiled its document arising from the financial sector assessment programme. Here is the link to the PPT and the report. It is, on the whole, an upbeat assessment of the state of Indian banking. Commercial banks are in good shape. Cooperative banks, regional rural banks and NBFCs constitute the problem areas.

There are clear signals in the document that the RBI will tread warily when it comes to financial sector reform- and especially in areas such as capital account convertibility, foreign banks and securitisation. No serious student of Indian banking afford to miss this report of the RBI.

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.