Interest rates and growth

This article by Rohan Chinchwadkar of IIM Tiruchi made me happy for more than one reason:

  • It is from a faculty member from one of the newer IIMs
  • It is well and simply written. It does not try to overdo its point
  • It sources a recent piece of international research
  • It shows a faculty member who is in touch with contemporary reserach. Good for students
  • It was well timed – on the eve of the RBI Monetary policy meeting
  • It presented a paper that had turned conventional wisdom on its head

Not much can be asked of an op.-ed.

Kudos to MINT for publishing it.


Why and how Finance sucked up (or, sucks up) engineering talent

I had posted the following comment in response to this article in FT:

Much of the comments on this article focused on the micro behaviour of individuals who chose to join financial institutions and hence were, for the most part, defensive about their behaviour and hence, critical of the article. But, that lens is the wrong one.

The article points to a paper that highlights the attractiveness of finance to engineers as opposed to other jobs that were more suited to their education. It is a social phenomenon and the responses have to be in the policy domain, if it is established that there has to be a policy response. As individuals, engineering graduates who joined the banking industry were doing the sensible thing for themselves and their families. This commentator and Andrew Hill would have done the same, in all likelihood. But, we need to move away from that frame.

Why did finance attract so much talent? A corollary question that poses itself is why was finance able to pay so much that talent flowed to it? Well, finance made so much of profits that it was able to pay. Actually, the attraction of talent, high wages and profits became mutually reinforcing trends later. But, what was the source of profits?

Finance, in modern times (post-1980s because that is when financial liberalisation, de-regulation and liberalisation of capital flows started in right earnest), has not been doing anything unique in comparison to the past.  It facilitated much secondary trading of financial securities. But, the compensation for it has come down considerably and the fees for active asset management have, for the most part, proven to be wasted and wasteful compensation. So, what was the source of it?

Andrew Haldane, in his contribution to the volume, ‘The Future of Finance’ published by the London School of Economics in 2010 (‘Contribution of the Financial Sector: Miracle or Mirage’) has pointed out that finance generated extraordinary profits because it wrote deep out of the money options (think Credit Default swaps and sub-prime securitisation). Deep out of the money options earns premium for the writer but once in a while these options get in the money and the writer has to pay up to the options owner. That is what happened in 2008.  Second source of profits was that much of the profits were risk-unadjusted. One source of risk is that many assets were valued as per models and hence shown at fair value. Second source of risk is high leverage ratios in investment banks’ balance sheets. The third arose out of creating products that, willy-nilly, drew the buyers into the web of financial leverage. In fact, that is where the engineering talent was needed.

High profits were required to maintain stock valuation in deference to the pressures exerted by institutional investors. Second, compensation of higher executives was linked to stock price performance. Hence, showing consistently rising profits was an obligation. That required generation of complex financial products which, though based on complex mathematics, were essentially built on unsuspecting clients assuming financial leverage. Developing these products required engineering talent. Ergo, the phenomenon that the paper and the article cover.

Now, the question for policymakers is whether any of this is welfare enhancing. Evidently, they are not. Their welfare-destruction was evident in the crisis of 2008. Have the policy responses changed the demand for engineering talent and the attraction of finance to such talent? Not much, if at all.

So, this is a socially negative phenomenon even though it is positive at the personal level, somewhat like the paradox of thrift that Keynes had discussed, in a different context.

In this context, it is worth noting that Bloomberg reported last evening that bonuses in Wall Street reached their highest level since 2006.

The Indian banking purgatory – policy proposals – 3/3

I wrote part 2 on March 10. I have been wanting to excerpt Dr. Y.V. Reddy’s extarordinarily candid lecture on February 1st. It contained some definitive recommendations. I copy and paste them below.

In addition, he has spoken about the proximate and underlying causes of India’s bad debts problem in the banking system, etc. He is even questioning if the leitmotif for nationalisation of banks remains relevant nearly fifty years later. You should read the full speech if you are interested in Indian banking.

  1. The first step for improving our banking system is a commitment to reduce SLR and CRR to global levels as soon as possible. We cannot have a globally competitive economy with an over-burdened banking system.
  2. The current policy of ownership and governance in banking needs to be reviewed urgently to correct the outdated and distorted policies. This should be done before our banking system passes on to foreign owners, irrevocably.
  3. A high level internal enquiry within the RBI should be undertaken to fix the responsibility for excesses in NPAs in recent years and, more important, to suggest and adopt measures to improve the system as a whole.
  4. In view of the large amounts of public money involved, the government may put in public domain action taken on Fourteenth Finance Commission’s recommendation for improving the financial system with economical use of tax payer’s money.
  5. A White paper on the future of Public Sector banking may be placed before the Parliament at the earliest in view of their criticality for efficiency in financial sector as a whole, to be able to serve a globally competitive economy.
  6. In brief, the current approach of treating Banks as special and bank depositors as special must be continued, and an assurance to this effect may be extended by the Government.
  7. In view of global developments and emerging Indian economy, there is a case for RBI to internally review the current policy of annual transfer of surplus after determining the needs for addition to reserves and adopt a new policy after due consultation with Government.

The first two parts on Indian banking are here and here.

The Thiruvadanthai trilemma

Although my friend Srinivas Thiruvadanthai did not mean to pose the question as such, I thought I would credit him with a ‘Trilemma’ that, I hope, will remain for posterity! His blog post triggered the following thoughts:

Another thoughtful and thought-provoking post as usual, Srini. The last paragraph of the post has been the rallying cry of BIS economists from White to Borio (including Cecchetti or not?).

I found the paragraph on the ‘ex-post criticism’ of the Fed not being easy enough in mid-2008 to be particularly insightful. Hindsight is a gift for critics that is denied to policymakers in real time!

The blog post can be considered a formulation of ‘Thiruvadanthai Trilemma’ between free-market finance, financial stability and economic stability. You can have two of the three but not all of them.

Notice that I have taken interest rates out of this trilemma. That is deliberate. In other words, the problem that there is no one single interest rate that stabilises the financial economy and the real economy at the same time disappears if (a) we remove the paradigm that ‘markets know best’ particularly for the financial sector and for financial markets (in a sense, I believe, the comments by Ms. Carolyn Sissoko reflect that) and if (b) the relevant horizon to evaluate the correctness of the monetary plolicy setting was long enough.

Let me take up my point (a) above. The question is whether regulating finance alone is both necessary and sufficient to enjoy both financial and economic stability at the same time. Yes, some would say.

That is what Ms. Caroline Sissoko has said in her coments on his post. But, is that really the case? We will never know because two things were at work in the post-Great Depression period and, in particular, in the post-WW II period. Economic growth was a low-hanging fruit. Therefore, it is possible that, regardless of how the financial sector or financial markets behaved, sustained high growth would have washed away all sins – with or without tight regulation. We will never know.

Therefore, it logically follows that in the era of slower growth that we face now, the case for financial sector and financial market regulation becomes stronger and not weaker.

Critics would object that this would further jeopardise the already lower growth. Well, the IMF has the answer. In a paper that is now a book, ‘Too much Finance’, the authors argue that financial development in advanced nations has already crossed the theshold at which it is beneficial for economic growth.

So, financial sector/financial market regulation will take care of the ‘Thiruvadanthai Trilemma’.

Fortifying that will be a monetary policy setting that chooses its relevant horizon more carefully than what central bankers have done in the last three+ decades. It should be longer than the business cycle so that it encompasses the financial cycle. I am merely paraphrasing the arguments made regularly by BIS economists. That is my point (b) above.

In a long enough time horizon, the dilemma, of fixing a high enough rate that handles financial market exuberance without hurting real economic activity or a low enough rate that allows financial intermediation to repair or to resume while the economy is overheating, solves itself.

In recent times, I beleive that the former dilemma has imposed much bigger long-run costs on the economy and on the society than the latter dilemma, in the above paragraph.

If unelected and technocratic policymakers optimise their decision over a reasonably long time frame, then the need for (or, the impossibility of) multiple policy rates is avoided or obviated.

If they cannot do that in practice that easily, then another approach is to have the domestic economy counterpart of ‘unremunerated reserve requirements’ that is applied to regulate capital flows. There can be a counter-cyclical credit surcharge (or discount) that the central bank, in its capacity as a banking regulator, prescribe for credit allocation, on the top of the policy rate. There can be times when this surcharge (negative or positive) can be zero. In that case, the policy rate works both for the financial economy and for the real economy. This can be on top of (and not in lieu of) countercyclical capital buffers that regulators now want to impose on banks.

Leveraged loan volumes

From John Plender in FT on March 6, 2018:

Credit protections such as restrictions on the borrowers’ rights to dispose of assets, degrees of leverage and dividend payments are sacrificed in the manic search for yield. The biggest uses for such loans are the refinancing of existing debt together with funding for mergers and acquisitions.

Evidence suggesting an escalation of risk-taking in this area comes from the Institute of International Finance, a global financial services industry representative body.

It points out that issuance of US leveraged loans rose nearly 50 per cent in 2017 to more than $1.3tn, which is well above the pre-crisis peak of $710bn in 2007. The numbers in more bank-dependent Europe are smaller at more than $290bn in 2017, rather below the level of $330bn in 2007.

The share of covenant-lite loans in these totals has soared to nearly 50 per cent in the US and 60 per cent in Europe, much higher than before the crisis. [Link]

‘Leveraged loans’ are loans extended by one or more banks to entities that already have a good proportion of debt in their books.

One quibble with the article:

Against that background the transition from Janet Yellen to Jay Powell at the head of the Federal Reserve is potentially momentous because the scope for policy error over the next 18 months is considerable. On Capitol Hill last week, Mr Powell made it clear that the risk of an overheating economy may now become the focus of monetary policy.

The juxtaposition of the two sentences is problematic making it sound look as though policy tightening would be a mistake. Quite the contrary. It is never too late to stop such risks from becoming bigger and wider.

Indian banking purgatory – 2/3 (the Dharma of blocking the defaulter)

The amendment to the Insolvency and Bankruptcy code (IBC) to bar the defaulting promoter from bidding for his own assets was, on paper, a reasonable one. After all, it is like rewarding either stupidity or dishonesty or both. He defaults. His asset comes on block. The banks realise whatever value possible and write off the rest of the loan. Now, if he comes and buys the asset, he gets rid off the loan and he keeps the asset and the hair cut (loan that is written off) now is a subsidy given to him by the rest of the taxpayers. So, stop him for bidding for his own assets. The amendment also stated certain conditions for the ‘cleanliness’ of the other bidders.

Now, look at the consequences it has caused. Borrowers are now spinning legal webs around bidders and are either preventing or delaying the sale of assets and resolution. No one wants to let go off their prized assets even as they do not wish to settle or cannot settle the loan. See the article for the various hurdles that have cropped up in the sale of assets.

The intent was reasonable: block the guy who defaulted from being his own asset back at a throwaway price and have his liability cancelled too.

But, translation into execution? See how difficult it is.

Who is to be blocked, how and for how long? Where does one draw the line on all these questions?

Well, good to keep tweaking but keep tweaking quickly. Learning by doing should not come in the way of ‘doing’.

It also raises the question with no one-answer-for-ever:

Is it good for the government to learn to live with some imperfections in the system than create more complications in the hope of preventing all chances of ‘bad guys’ winning and laughing all the way to the bank?

What is the yardstick for such a trade-off? Whose value systems define that trade-off? The political leader’s, that of the bureaucrat in charge who drafts it or actually is it that of their grandparents, parents and uncles who shaped the value systems?

In the process of ensuring that no wilful defaulter bids again for the asset that he owned, if loan resolution and economic recovery are delayed, then has public interest been served well?

The MINT article says:

Although it is only two months since the code has been amended, it is time to tweak it to ensure that genuine bidders aren’t shut out. For example, the code should clearly specify whether past associations with disqualified entities are relevant and for how long. Another could be to clearly specify what kinds of relationships are relevant instead of an all-encompassing definition of related parties and connected parties.

A friend wrote that this indicated sloppiness in the original drafting. He wrote,

I’m very unsympathetic to a Ministry which made regulations without paying attention to such basic details – how could they have not foreseen the problems with not having to define the kinds of association with disqualified entities and its duration. This is just as naive as their original regulation that did not anticipate and did not contain some basic safeguards to ensure that promoters do not bid again. I would say failure of the bureaucracy.

Yes, sloppiness cannot be ruled out. Perhaps, equally possibly, the original promoters will have somehow ensured that the assets did not go into anyone else’s hands. I recall Arundati Bhattacharya recounting the story of how no industrialist bid for the assets of Mallya’s mansion in Goa when SBI brought it to the market.

Also, read how the process was stayed in the courts by Mallya’s legal team and with the assistance of some government officials too. This was her interview with Shekhar Gupta’s ‘Walk the Talk’.

And borrowers have access to enormous legal talent.

I do not discuss accounts, but because there is so much public attention, probably it is known we have been fighting (against Vijay Mallya) in the debt recovery tribunal from 2013. We have had 81 hearings there.Various cases have been filed by him and we have filed counter-claims. There are 22 cases we are fighting here, and overall there have been 508 hearings. The number of adjournments is more than 180.For one particular villa (Mallya’s villa in Goa), which we were trying to get possession of, the high court passed an order saying it should be done in three months. The order was issued to the collector. The collector, in turn, held eight hearings and then went on leave.

This is the Goa government’s collector?

Normally, collectors are supposed to take possession, not hold hearings. But this person held eight hearings.We approached the attorney-general and said we need to really take up (Kingfisher Airline’s loan default) in the highest court. We were told we had to go through debt recovery tribunal.

The next day we moved the tribunal, which did not provide any relief. We went to the high court, which remitted it back to the tribunal, which did not give us the relief we are seeking. We need his assets under oath. [Link]

Also, recall what the former Shipping Secretary Michael Pinto wrote about the bidding for the fourth terminal at Jawaharlal Nehru Port Trust (JNPT):

Much has been said about the laid-back manner in which the government has gone about the task of attracting private investment into the maritime sector. While much of the criticism is valid, policy makers do have to deal with a number of extraneous factors. … In all fairness, it must be recognised that this, like some other delays, was outside the control of the authorities.

When, in pursuance of a policy that was intended to encourage competition and prevent near monopoly conditions in the port, one party was debarred from bidding, they approached the high court, alleging discrimination. Their plea was rejected first by a single bench of the high court and then, in appeal, by a division bench of the same court. Against this the party went in appeal to the Supreme Court and here they were successful. The SC ruled that they should be allowed to bid along with other short-listed parties. It was here that the story took an interesting twist. Instead of celebrating victory in a nearly two-year court battle by offering a competitive bid, the party stated that, having established their point in the long legal proceedings at different levels, they were no longer keen to participate in the bid.

The question that immediately arose was why they fought such a desperate court battle to establish their rights to bid for a project in which they were not really interested. By way of explanation we were told that, on studying the detailed tender terms and conditions, the party felt that they were too onerous and that bidding in such a tender was not worth their while. This did little to quell doubts that had been raised because it was beyond belief that a savvy, commercially oriented party would fight such a long court battle without even being sure if the prize to be won was worth fighting for. Instead, speculation was rife that by delaying the project for the two-year period over which litigation was spread, other less attractive terminals in other ports were able to develop and consolidate in a manner that would not have been possible if work on JNPT’s fourth terminal had commenced. [Link]

The Machiavellian machinations of the private sector and the corrupt ways or the over-zealous regulatory instincts of the government – which drives the other?

The fact that everyone seems to have some ‘tainted’ history (real or contrived – I was told that JSW Steel had a rather creative objection to Tata Steel bid for Bhushan Steel), it brings up an interesting ethical question. Which of us is really pure? Everyone seem to have some association with someone somewhere who has defaulted or has some record against them or have been associated with someone who has been involved in some controversy. Everyone is living in the glass house including the politicians.

So, is the best thing to keep it simple? Just bar the promoter and his immediate family from bidding for the assets. Even if the Act specified the ‘relevant relationships’, will that not be gamed easily?

Or, just not bar them at all? Then, rewarding immorality and bad ethics!! What a dilemma?!

Andy Mukherjee had argued for no ban on the original promoter, to keep it simple. Wonder if he was right.

Isn’t the road to hell paved with good intentions? It is always an occupational hazard with public policy. The ban on promoters bidding for their own assets is a classic case study of that public policy axiom.

(Postscript: Tata Steel appears to have won the bid to buy Bhushan Steel. Is that a done deal?)

The Indian banking purgatory – 1/3

In the very early hours of 6th March morning (12 past 12, to be precise), I had shared with my mailing lists a long article by Tamal Bandyopadhyay on how the Indian banking system is being actually changed even as the ‘stone-throwing’ and hand-wringing continue. It was a well written article and one that gives a sense of perspective on the state of affairs in Indian banking and the government’s (and the regulator’s) response to it. Much is being done. As I wrote in MINT on the 6th March, Indian banking system is making progress one fraud at a time.

There is a lynch-mob mentality out there. People are casting their net in partisan waters to catch the fish from the other side and swallow it. I am unconvinced that RBI should be blamed or, for that matter, even the Board of Directors. Yes, one can attach moral responsibility to both bodies. But, honestly, being on the Boards of few companies, I can say with confidence that unless flagged either by the Internal Auditors or by the Statutory Auditors, the Board cannot, on its own, find out operational errors and frauds.

Let us say that the Board, after reading an RBI circular on how banks must reconcile SWIFT with ‘Core Banking’, creates a RBI-Compliance checklist. The Board can and will take up the checklist and ask the management to present status reports on the checklist. If the management said that it has been done and presents audit reports to show that nothing has been flagged, it would be very difficult for the Board to dig deeper into one specific area. If it happens, it must be mostly an extraordinary coincidence and a matter of luck too.

For the most part, it is a Management responsibility. Clearly, multiple layers of management must be involved or, alternatively, multiple layers were asleep at the wheel.

Check out parts of the speech by the former Deputy Governor Mr. K.C. Chakraborty in 2013:

Even in instances where investigations are concluded, there is a tendency to hold only the junior level officials involved in post disbursement supervision accountable and ignore the lapses on the part of higher officials who were involved in sanctioning of the advances, unless of course, the case becomes a high profile one or if some personal vengeance is involved. Our experience is that the accountability examinations do not comment on lapses of sanctioning officials even while the fraudulent intentions of the borrower might have been overlooked by the sanctioning officials ab initio.

Of course, in the same paragraph, he goes on to hold the Board/Top management too responsible for ensuring that systems are in place,….. But, even then, that is a 10,000 feet altitude recommendation. Quite specifically and actually on the ground, the Board can recommend and insist on a framework, can ask for reports on how the framework is monitored or complied with, etc. But, if layers of management were a party to the fraud, these reports and monitoring would come across as ineffective, ex-post.

In his speech on February 1 – that speech deserves to be blogged separately – Dr. Y.V. Reddy stressed the role/culpability of auditors in the emergence of Non-Performing Assets/fraudulent transactions:

An unexplored area is the role of auditors / Company Secretaries in blurring the distinction between genuine transactions and fraudulent transactions, perhaps, contributing to NPAs. [Link]

Rhetorical questions about what Raghuram Rajan was doing as RBI Governor, etc., are really roads to nowhere. Similarly, someone had flagged this article that shows that the UPA government had allowed private jewellers to import Gold in May 2014, five days before the new government took office. There may be many things wrong with this including, most obviously, cronyism, etc., but quite how the move could be made responsible for the bank fraud escapes me. The NDA government had scrapped it in November of that year, as the article says and all restrictions on gold imports were lifted for all.

Again, Mr. K.C. Chakraborty has this to say on what RBI does on a regular basis:

On its part, Reserve Bank promptly shares information with all banks detailing the modus operandi of fraud cases reported by any bank together with details of the entities involved in the perpetration of such frauds in the form of confidential caution advices. This also serves to encourage periodic review of existing guidelines, identify loopholes on the basis of caution advice, if any, and initiate corrective steps. Reserve Bank has also issued instructions requiring banks to report negligence or involvement of entities like Chartered Accountants, valuers and advocates resulting in perpetration of frauds, to their professional oversight bodies for appropriate deterrent action.

A final point: just as it is impossible for the regulator – RBI in this case – to do transactions based supervision, there are considerable limitations to the Board doing transactions based supervision too.

To sum up, it is really about the Management and the owner who appoints them! – the Government of India. To the extent that management performance and accountability are a function of the culture that government ownership brings about, the owner is equally culpable. Frankly, the government’s letter to RBI sent two to three weeks ago is a case of ‘passing the buck’.

That brings us to the central theme of Tamal’s piece. Much is being done. But, is enough being done?

Is what is happening in Indian banking a paradigm shift? It is and it is not. IBC (Insolvency and Bankruptcy code) and the NCLT (National Company Law Tribunal) auctioning off assets are paradigm shifts. But, management arrangements, selection, Board Composition, Board accountability, De-linking political nexus, etc., not even a minute particle has shifted yet.

This is a ‘wonderful’ occasion – a crisis is a gift to reformists-change agent-policymakers for the Government to sweep out the old and bring in the new retain parts of the old while blending something new. Or, at least, contemplate something like that. But, the door has been repeatedly shut on such possibilities, let alone do them.

The conclusion?

Much has been done under difficult circumstances by this government. No doubt. The Economic Survey has written somewhat cryptically about the ‘stigmatised capitalism’ being the reason for the difficulty in the Government coming around to grappling with the bank NPA issue. Of course, it is also true that Mr. Jaitley was on record in the initial days of the government that the NPA problem was not a big deal or something to that effect. But, those notwithstanding, the government has taken several decisions. It deserves credit.

It is also true that both NDA-1 and NDA-2 have done the cleaning up of the mess that they had inherited on multiple fronts. NDA-1 did inherit a banking NPA problem. It did the nuclear test in 1998 and faced the fallout. It faced 9/11 and the global recession. It endured two droughts (or, more?). But, the twin balance sheets – banks and corporations – were in fine fettle by 2003 and that is what facilitated the massive re-leveraging that happened between 2003 and 2008, facilitating a period of high growth. Also, it was Jaswant Singh who brought in SARFAESI. Yashwant Sinha liberalised the administered interest rate regime and partially succeeded. That was a very difficult reform, then. How difficult it is can be gauged from the fact that it still remains incomplete. Not much progress since then.

But, perhaps, much political capital is expended in these efforts that the reforms are never taken to their logical conclusion (as discussed above, with public sector banking).

It is not a criticism but an observation. So, what happens is that the door is still left open for fresh thieves to enter and burgle the house. That is what happened in 2004 and that might yet happen.

Alternatively, even if it is the same government that returns to office, the longer one stays in office, the greater the likelihood that they would cultivate bad habits that the Congress governments had practised.

That is why, perhaps, India should have one six-year term stipulation for all Prime Ministers so that they get the right things done in a hurry. May be?

Much remains to be done while it is also very true that much has been done.

I will end on that note. But, I have two more parts coming on this – one on a question raised by a friend if the expansion of the RBI Balance sheet was responsible for the rise in bad assets and the third one on Dr. Y.V. Reddy’s speech on 1st February. That piece should include comments made by former Mr. Qureishi, the former Chief Election Commissioner on election funding.