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A blog on financial markets and their regulation
Companies that repeatedly pivot from one business to another (more glamorous) business could be indulging in a ponzi scheme designed to hide business failure and lead investors on a wild goose chase for an ever elusive pot of gold. There are some very large companies in India and in the United States about whom one could harbour such a suspicion.
The question is how can one distinguish these corporate ponzis from genuine pivots. After all it makes sense to change your business as situations change. Warren Buffet’s Berkshire Hathawy pivoted from the textiles business to insurance and finance and if its next elephant size deal is like its last one, it could pivot again to a non financial conglomerate. In India, Wipro became a software giant after a pivot from vegetable products.
One indicator of a ponzi is that the pivot typically chases a prevailing stock market fad rather than any particular competence or competitive advantage in the new business (unless one counts cheap capital as a competitive advantage). But even that is not determinative as the case of GE makes clear. As a Financial Times FT View pointed out a couple of months ago “In the dotcom bubble, GE was valued as a tech stock; in the credit bubble, it was valued like a leveraged debt vehicle (which, in large part, it was).” To which one could add that till recently it was trying to position itself as a leader in the industrial Internet of Things. That makes GE a stock market opportunist, but not a ponzi. Even after returning to its old industrial roots in the last few months, GE remains a valuable business.
The corporate ponzis that I worry about are something else altogether. This kind of company is a graveyard of serial failures, even though the future always looks rosy. In the heyday of each of these failed businesses, the market would not have bothered about current losses, because it would have valued the business on multiples of current or future revenues. After the company pivoted away from the business, the market would not bother about the losses (and revenue collapse) in the old business because the market is always “forward looking”. The corporate ponzi’s challenge is to find the next big thing (and make it bigger than the last big thing). When their luck runs out and the corporate ponzi finally fails, everybody wonders why nobody saw through the fraud earlier.
More than a decade ago, in the days before the Global Financial Crisis, I asked a provocative question on this blog: “Had we invented CDOs first, would we have ever found it necessary to invent banks?” (I followed up in the early days of the crisis with a detailed comparison of banks with CDOs).
I am revisiting all this because I just finished reading a fascinating paper by Juliane Begenau and Erik Stafford demonstrating that, banks simply do not have a competitive edge in anything that they do. Specifically, the return on assets of the US banking system over the period 1960-2016 was less than that of a matched maturity portfolio of US Treasury bonds. This is a truly damning finding because banks are supposed to earn a return from two sources: maturity transformation (higher yielding long term assets funded by cheaper short term financing) and credit risk premium (investing in higher return risky debt). What Begenau and Stafford found is that their actual return does not match what you can get from maturity transformation without taking any credit risk at all.
That raises the question as to why banks have survived for so long. Another finding of Begenau and Stafford can be used to provide an answer: maturity transformation (even without any credit risk) with typical banking sector leverage is not viable in a mark-to-market regime. The banking regulators have acquiesced in the idea that the loan book of the banks need not be subject to mark to market. Making illiquid loans and taking credit risk is the price that banks have to pay to become eligible for hold-to-maturity accounting of their loan book. Banks are able to undertake maturity transformation with high levels of leverage without wiping out their equity because the loan book is not marked to market.
Hold-to-maturity accounting allows banks (and only banks and similar institutions) to carry out leveraged maturity transformation. This competitive advantage means that banks are able to make money on maturity transformation. However, they are so bad in their credit activities that they lose money on this side of their business. This offsets some of the returns from maturity transformation, and so they underperform a matched maturity portfolio of risk free bonds.
It is important to keep in mind that credit risk earns a reliable risk premium in the bond markets. Therefore, if banks manage to earn a negative reward for bearing credit risk, it is clear that either their credit risk assessment must be very poor or their intermediation costs must be very high. Interestingly, Begenau and Stafford do find that maturity transformation using risk free bonds has no exposure to systematic risk (CAPM beta), banks have CAPM betas close to one. The credit activity of the banks creates risks and loses money; in short, banks are really bad at this business.
I have always been of the view that banks are an obsolete financial technology. They made sense decades ago when financial markets were not developed enough to perform credit intermediation. That is no longer the case today.
This is particularly relevant in India where we have spent half a century creating an over-banked economy and stifled financial markets in a futile attempt to make banking viable. The crisis of bad loans in the banking system today is a reminder that this strategy has reached a dead end. As I wrote nearly a year ago:
India needs to move away from a bank dominated financial system, and some degree of downsizing of the banking system is acceptable if it is accompanied by an offsetting growth of the bond markets and non bank finance.
After the recent multi-billion dollar fraud at a leading Indian public sector bank, there has been a chorus of calls in India for privatizing state owned banks. We would do better to shut some of them down. Time and money are better spent on developing a bond market unshackled from the imperatives of supporting a weak banking system.