Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Indian banks: quiescent shareholders and activist regulators

The Indian central bank or other government agencies have been instrumental in effecting a change of management in three under-performing private sector banks (ICICI Bank, Axis Bank and Yes Bank) in recent months. While much has been written about the functioning of the boards and of the central bank, the more fascinating question is about the dog that did not bark: the quiescent shareholders of these banks. They have suffered in silence as these banks have surrendered the enviable position that they once had in India’s financial system. The void created by the wounded banking system in India is being filled by non bank finance companies. So much so that one of these non banks (Bajaj Finance) trades at a Price/Book ratio 3-4 times that of the above mentioned three banks and now boasts of a market capitalization roughly equal to the average of these three banks.

The question is why has this not attracted the attention of activist investors. One looks in vain for a Third Point, Elliott or TCI writing acerbic letters to the management seeking change. The Indian regulatory regime of voting right caps and fit and proper criteria has ensured that such players can never threaten the career of non performing incumbent management in Indian banks. The regulators have entrenched incumbent managements and so the regulators have to step in to remove them.

Incidentally, the securities regulator in India has been no better. It too has ensured that the big exchanges and other financial market infrastructure in India are immune to shareholder discipline, and over the last several years many of these too have performed far below their potential.

Indian regulators do not seem to understand that capitalism requires brutal investors and not just nice investors talking pleasantly to the management. Capitalism at its best is red in the tooth and claw.

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The FED’s bite is worse than its bark

If any emerging market thought that the US Federal Reserve is a paper tiger whose bark is worse than its bite, the last few months have shattered that illusion. Already, the bite is hurting a lot more and the tiger still appears to be hungry and on the prowl.

The comparison below is actually biased in favour of a bigger effect for the bark because it focuses on the Fragile Five who were the worst sufferers during the barking phase. I have left out Argentina and China who have suffered only or mainly in the biting phase.

The FED’s bark (Taper Tantrum: April-July 2013)

The data is from Barry Eichengreen and Poonam Gupta, Tapering Talk: The Impact of Expectations of Reduced Federal Reserve Security Purchases on Emerging Markets. Following Eichengreen and Gupta, I have measured the exchange rate pressure by the percentage increase in the nominal exchange rate (units of domestic currency per US dollar), though ideally it should be the decline in the inverse of this number. Unlike Eichengreen and Gupta, I have simply added the percentage exchange rate change and the percentage reserve loss for a crude measure of the total effect. For a blog post, I am too lazy to weight the two measures by the inverse of their respective standard deviations (and I am also quite happy with improper linear models).

Depreciation Reserve Loss Total
Brazil 12.52 1.69 14.21
India 9.98 4.77 14.75
Indonesia 3.58 13.61 17.19
South Africa 8.96 5.42 14.38
Turkey 7.61 8.20 15.81

The FED’s bite (Ongoing since April 2018)

The following data is what I have been able to put together from easily available sources on the internet. The currency depreciation is from Yahoo Finance and covers the period from April 16, 2018 to September 13, 2018. The reserve loss is from end March (or mid April where available) to the latest date for which I could get data clicking through to the data links on the National Summary Data Pages (NSDPs) of the IMF’s Dissemination Standards Bulletin Board (DSBB). Except for Turkey, the data for the rest of the countries is not hopelessly out of date, and for Turkey, the reserve loss is totally swamped by its currency depreciation.

If you have better data, please free to provide that in the comments section.

Depreciation Reserve Loss Total
Brazil 22.22 0.26 22.48
India 10.46 5.90 16.36
Indonesia 8.02 6.35 14.37
South Africa 21.36 -0.00 21.36
Turkey 50.86 8.15 59.01

Self-serving self-censorship in a crisis

In a crisis, the only thing that is not censored or self-censored is the market (provided it has not been regulated out of existence or into meek submission). That is the lesson that we can learn from a rare candid admission from a well known columnist at one of the most respected financial newspapers in the world. In his latest “The Long View” column (link behind paywall) in the Financial Times yesterday (September 9, 2018) John Authers writes:

It is time to admit that I once deliberately withheld important information from readers. It was 10 years ago, the financial crisis was at its worst, and I think I did the right thing.

There was a bank run happening, in New York’s financial district. The people panicking were the Wall Streeters who best understood what was going on.

All I needed was to get a photographer to take a few shots of the well-dressed bankers queueing for their money, and write a caption explaining it.

We did not do this. Such a story on the FT’s front page might have been enough to push the system over the edge. Our readers went unwarned, and the system went without that final prod into panic.

There are many things going on here that are worth pointing out:

  1. If we go back to 2005 or 2006, the financial elite was as clueless as anybody else about the crisis that was round the corner.

  2. However, during (or even just before) the crisis, the financial elite had a pretty good idea of the most vulnerable entities in the system. I remember when I discussed the matter with smart finance people back in 2007 and 2008, we could all agree on which banks (both in India and globally) were at grave risk and which were sound. In retrospect, those judgements were largely correct. At the same time, outside of finance, this understanding was often lacking.

  3. This phenomenon was not peculiar to the global financial crisis of 2008, but was true in earlier crises like the Asian Crisis of 1997.

  4. Self censorship is the main reason why the common knowledge of the financial elite does not percolate to the general public. Many factors play a role here:

    • We all fear retribution from the state which can easily accuse the messenger of sedition or treason.

    • There is the risk of defamation suits from the affected entities which might not have enough money to repay their debt, but are never short of money to pay their lawyers.

    • Our views are often based on inferences rather than hard facts, and we shy away from making sweeping statements in public without objective data.

    • Like John Authers, we might worry that what we write might become a self fulfilling prophecy.

  5. But Authers’ story also points to a very uncomfortable fact, that our self censorship is self serving. We might hesitate to write about what we know, but we do not hesitate to act on that knowledge. Authers writes that he shuffled his money around so that he would not lose much if Citi failed. I recall that every company on whose board I served took preventive action to protect the company’s cash surpluses.

This means that, in a crisis, the general public cannot expect the elite (regulators, media, academics) to warn them or to tell them the truth. Meanwhile, the rich, powerful and well-connected are duly warned, and are able to protect themselves. Is it any wonder that the general public listens to wild rumours rather than to mainstream commentators?

There is one place where the public can learn the truth, and that is the financial markets. In the build up to the crisis, the markets are as complacent as everybody else. But during the crisis, the market is the fountain head of information. If I could make sensible judgements during 2008, it was only because I was tracking many different markets. Of course, one needs to know where to look: sometimes the most valuable information is in the spread between two arcane markets.

The governments and regulators know this very well and work overtime to ensure that the markets become uninformative. After Lehman failed, I had two blog posts on how successful government around the world had been in doing this (Towards a market only for buyers and More on market for buyers only).

Months before Lehman failed, I wrote this:

I believe that this crisis has shown the power and utility of financial markets. Policy makers have had at least a year of lead time to deal with the problems in the real economy. Without mark to market and without liquid ABX markets, the crisis would have become evident only when mortgages actually defaulted. By then it would have been too late to act.

It is difficult to persuade people about this in today’s context, but even today it is true that with all their imperfections and tendency to malfunction during crises, financial markets are the closest thing that we have to the crystal ball that reveals the future. Everything else is backward looking.

After reading Authers’ confession, I would add another clause to the last sentence: “Everything else is self-censored.”

Why does the Indian Government mandate proprietary software?

One of my pet peeves has been about the Indian government forcing citizens to buy or use proprietary software to enable them to perform their statutory obligations. Things have got better in some government departments, but worse in others.

  • Income Tax is one place where things have become better: many years ago, the official tax preparation utility was in Microsoft Excel which compelled me to boot into Microsoft Windows and run Microsoft Excel. A few years ago, a Java utility became available, but initially, this ran only in Oracle Java, and I wrote unhappily about this two years ago. I was happy to find that I could run the latest version of the utility under OpenJDK 8 and OpenJFX. At last, I do not have to use proprietary software to file my income tax return. My only complaint is that the Income Tax department’s official website still says that the Java Runtime Environment (JRE) can be downloaded from http://www.oracle.com/technetwork/java/javase/downloads/index.html. Is it too much for a free citizen of a free country to demand that this link should instead point to http://openjdk.java.net/ which is the home of the open source project? (The OpenJDK site does provides a link to the Oracle site for those who prefer that.)

  • The Ministry of Company Affairs (MCA) has become a lot worse and it is now an absolute nightmare for proponents of open source software. Everything to do with Company Law now requires an e-filing. And the first thing that the MCA portal says is that you must have a computer with Windows 2000 or later installed, and you must also have Adobe Acrobat 11. As long as this portal affected only corporate filings, I did not care too much, because I know from bitter experience that the corporate world consists largely of unreformed Microsoft junkies who care two hoots about open source software. But now the government requires individual directors also to use this portal. Last month, like many other independent directors in India, I had to e-file a DIR-3 KYC. This uses a PDF Form that opens only in Adobe’s PDF reader and not in any of the numerous open source PDF readers that are installed on my Linux machine. Adobe discontinued support for Linux a few years ago. So the only thing to do was to fire up my licensed copy of Windows in a Virtual Machine and fill up the form.

In my opinion, it is a gross abuse of the sovereign powers of the state to compel a person to buy and use Windows in order to be a director of a company. Actually, I seriously considered resigning as Director rather than do this, but then that does not solve the problem as different departments of the government are moving in the same direction of e-filing with uncritical dependence on proprietary software.

No, we need to change incentives in the government to prevent the Indian state from becoming a marketing agent of powerful software companies. I think there are many arms of the government itself that can help bring about this change:

  1. Central Vigilance Commission (CVC): The CVC could declare that going forward, it would regard a government action that forces unwilling citizens to buy software from private companies as an act of corruption (on the ground that it provides a benefit to a private party and is also against the public interest). The reality is that the government outsources software development to large software developers who also act as authorized resellers for a large number of software product companies, and have every incentive to push the sales of these products on to their clients. This is fine when all these costs are evaluated as part of the total cost of the project during the bid evaluation. But when the government official allows the vendor to sell software to ordinary citizens using the coercive power of the state, that should count as an act of corruption. The CVC could allow existing applications to be grandfathered with a sunset clause, but it should not permit any new projects.
  2. Competition Commission: As explained in the previous point, the whole business of government software development involves giant software companies using their market dominance in the enterprise market to gain unfair and unlawful market power in the retail market using the coercive power of the state. The Competition Commission can and should investigate all authorized reseller agreements for such anti-competitive conduct.

  3. National Security Advisory Board: Widespread use of proprietary software in critical government applications can pose a threat to national security, and with the increasing threat of cyber attacks on India from some of its neighbours and other countries, this is also a reason for reconsidering the design of government applications like the MCA Portal. For example, under the so called Government Security Program the Microsoft Windows source code has been shared with Russia and China which are both associated with large scale state sponsored hacking activities. This means that when you and I use Windows, the hackers can see the source code, but you and I cannot. With open source software like Linux, the hackers can read the source code, but so can you and I. It is important that the national security apparatus in India takes these risks seriously and start advising other arms of the government to move away from proprietary software in citizen facing applications.

  4. Law Ministry: If rapid technological change and product obsolescence leads to Adobe going bankrupt and the Adobe Reader being discontinued, the government might find that it cannot read any of the PDF files that constitute the source documents for its entire database. Many people of my generation have old Wordstar files which are almost impossible to read because the Wordstar software is now defunct: truly desperate people do try to buy the old Wordstar diskettes on EBay and then try and find a disk drive that can read the diskettes. For those readers who are too young to remember, Wordstar was the undisputed market leader at its time, just as Adobe is today. The law ministry should recognize that storing critical source documents in a proprietary format is an unacceptable legal risk.

Until one or other of these branches of the government steps in and forces a redesign of citizen facing government applications, we will be doomed to pay money to rich multinationals to use insecure software to interact with our own governments.

Long hiatus ending soon

This blog has been on a hiatus for the last five months due to some disruptions on the personal front. This phase is now getting over and I hope to start blogging again soon, hopefully, early next month.

Corporate pivots and corporate ponzis

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.

Do we need banks?

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.

Is there a bank-sovereign feedback loop in India?

Between early October 2016 (shortly before demonetization) and today, the Reserve Bank of India (RBI) has cut its policy rate twice (October 4, 2016 and August 2, 2017) to bring the repo rate down by 50 basis points from 6.5% to 6.0%. But the ten year Government of India bond yield is roughly 100 basis points higher than it was in early October 2016. Apparent monetary easing has been accompanied by a substantial tightening of financial conditions. This looks like a reverse of Greenspan’s Conundrum of 2005 in which the concern was that 150 basis points of rise in the US policy rate was accompanied by a falling trend in the long term yield.

Is it possible that the Indian situation could be a mild form of the bank-sovereign feedback loop?

  1. A deterioration of the health of the public sector banks (non performing assets) causes fiscal stress because the sovereign has to recapitalize the banks.

  2. The enhanced borrowing requirement of government causes a rise in government bond yields.

  3. Rising bond yields cause more stress in the public sector banks because they hold a large amount of long term government bonds (unlike the private and foreign banks who tend to hold shorter term bonds). Rising bond yields may also act as a drag on the economy and worsen the non performing assets of the banks. In either case, the deterioration of the health of the public sector banks takes us back to Step 1 and the cycle can begin all over again.

If this analysis is correct, what can be done to break the bank-sovereign feedback loop? Several possibilities come to mind:

  • The government could take duration risk out of the banks with a giant interest rate swap that immunizes the banking system from rising government bond yields. This turns a significant fraction of government debt into floating rate debt.

  • The RBI could take a leaf out of the Yield Curve Control policy of the Bank of Japan, and set monetary policy to prevent a rise in Indian government bond yields. In essence, the policy rate would no longer be the repo rate but the 10 year government bond yield.

  • The government could accomplish a massive pre-emptive recapitalization of the banking system that breaks the loop decisively.

  • The government could turn many of the public sector banks into narrow banks (or even shut them down) to eliminate the feedback loop.

The bank-sovereign feedback loop should not be a big problem for a currency issuing sovereign. This does not require any appeal to MMT, but is simply a reflection of the fact that banking sector liabilities are all nominal liabilities, and a currency issuing sovereign should not have any problem in backstopping these liabilities. If we still see evidence of such a loop, it should reflect some degree of mismatch between monetary policy, fiscal policy, and the bank recapitalization framework. And it should not be hard to fix the problem.











Can radical blockchain transparency decrease banking frauds?

During the last week, the Indian financial sector has been gripped by the $1.8 billion fraud at Punjab National Bank (PNB). Fingers have been pointed at bank management, at the auditors and at the regulators, but finger pointing and angry denunciations do not solve problems. We did not solve the problem of unfriendly bank tellers by shouting at them; we solved it using technology (Paul Volcker once remarked that the most important financial innovation that he had seen was the ATM). That is probably the route we must take again: we cannot change human nature, but we can change the technology.

The blockchain technology that underpins cryptocurrencies like Bitcoin has the potential to reduce large banking frauds drastically because it enables radical transparency. Every transaction on Bitcoin is public and you do not even need a Bitcoin wallet to see these transactions. Many websites like https://blockexplorer.com/, https://blockchain.info/, https://www.blocktrail.com/BTC, https://btc.com/, and https://live.blockcypher.com/btc/ allow anybody with a web browser anywhere in the world to see every single transaction as it happens. We can use the same technology to allow the whole world to see every large financing or guarantee transaction (above some threshold like a billion rupees).

The shibboleth of bank secrecy can be discarded for large financing transactions because many of them become public anyway:

  • Borrowers disclose a lot of information in their financial statements.
  • Many lenders (mutual funds for example) disclose large bond holdings as part of their portfolio disclosures.
  • All secured lending is entered in a public register of charges under company law.

We could extend this into a uniform requirement to make large loans public:

  • Any large lending (say above a billion rupees) by a financial intermediary.
  • Any lending (regardless of size) to a large borrower (say, with aggregate liabilities to the financial sector of over 10 billion rupees).

The natural medium for such a disclosure is the blockchain. The alternative idea of using a credit registry has been an unmitigated disaster (just think of Equifax), and these agencies create more opaqueness than transparency.

If the PNB fraud pushes us to use the blockchain to make finance more transparent and therefore safer, $1.8 billion may end up being a price well worth paying.

Are banks too opaque to manage?

Fabrizio Spargoli and Christian Upper have a BIS Working Paper with a different title: “Are Banks Opaque? Evidence from Insider Trading” with the following findings:

Our results do not support the conventional wisdom that banks are more opaque than other firms. Yes, purchases by bank insiders are followed by positive stock returns, indicating that banks are opaque. But banks are not special as we find the same effect for other firms. Where banks are special is when bad news arrive. We find that sales by bank insiders are not followed by negative stock returns. This suggests that bank insiders do not receive bad news earlier than outsiders. By contrast, insider sales at non-banks tend to be followed by a decline in stock prices.

My interpretation of the result is quite the opposite: banks are so opaque that even insiders cannot see through the opacity when bad things happen. Sometimes, as in the case of the London Whale, a market participant outside the bank has greater visibility to what is going on.

It appears to me that the findings of Spargoli and Upper are evidence that banks are too opaque to manage. Even a very competent chief executive can be clueless about some activities in a corner of the bank that have the potential to bring down the bank or at least cause severe losses. That would be an additional argument for moving from bank-dominated to market-dominated financial systems.