The Vexed Issue Of Independent Directors

The recent Corporate Governance fiasco at Satyam raises some interesting issues about the Economics behind the law and policy of corporate governance in India. It shows how these issues from behavoural economics remain unaddressed or imcompletely unaddressed under the compliance driven mandate of clause49.

In this piece I argue that the rule based nature of clause 49 makes the framework underinclusive to address the issues similar to those that arose in Satyam.

An analysis of the underlying theme of clause 49 makes it clear that the term "Independent Director" is defined in the context of her proximity to the promoter/promoter group/BOD. That proximity is seen in two contexts: a) familial association b)Association arising from sustained and repetitive interaction.

This theme is a hedge against moral hazard issues. So far so good. The problem however is that, clause 49 does not address the issue of moral hazard entirely.

It fails to address the issue of moral hazard that arises from being repeat players in the same business segment. Let me try and explain this argument:

If an Independent Director has to be professionally competent (and reason demands that he ought to be competent in the vertical that the firm operates in), then the market for Indepedent Directors includes professionals, and academics well known in that vertical. Now, entrepreneurs, precisely because of their lengthy association with the particular business vertical are more than likely to know these actors. Now the extent of affiliation would differ; in some cases, the affliation will not be more than casual; in others, It could go deeper ( For example, It is likely that the academic was earlier a Ph.D. guide of the entrpreneur or a college senior perhaps). Without going in to the specifics then, it is fairly reasonable to imagine that fact matrices may exist where individuals otherwise qualified within the meaning of clause 49 are "Non Independent" by virtue of moral hazard that arises from being repeat players inthe same business segment and also the sorts that arises from associations that are not familial or professional and yet have decided trappings of affinity.

The other side to this argument is that outside of Directors related to the promoter/promoter group, this is the only set of people that have the skill sets to become directors on the Board of companies operative on that vertical. (Say, for example, Vinod Dham on Satyam).

So, if clause 49 were to include this residuary class as well, acute demand supply mis matches msy arise in the market for independent directors. This again may have its own set of problems; It is reasonable to imagine for example that sitting fees might see an upward revision across the spectrum bringing with it assorted problems of agency costs and issues in Directorial remuneration.

Clearly, the quest to have an optimum SOX in India is far from over!

I Got There First!

Thenewgegrotius on October 13, 2008 had advocated that the ECB Norms be eased; well, the revised and liberalised ECB policy is out and there is secular raising of the "All in cost" ceiling. For borrowing from 3-5 years, the raise is by 100 Bps; For the mezzanine slab that is from 5-7, the raise is 150 Bps and the longer maturity slab too has been upped by 50 Bps to 500 Bps.
Now you know why it should help to read me more often. Cheers!

The Curious Case Of "Going Forward"

You hear this phrase when you tune in to CNBC often, Dont you? "Going Forward Mr..... Where Do you see the Market Bottoming Out?" Or may be, "Going Forward, we see a lot of opportunities in ........ space";
My guesstimate is that "Going Forward" and "Upfront" could be the most used terms daily in the Business Circles. So, this post musing about these peculiarly "Finglish" term... " Going Forward"

Let me like put up a list at why " Going Forward" could be so frequently used one.

(you sure know that there is no lack of these "Heuristics" for a finance guy. Take your pick from " Corporate action", "Deal" etc etc.)

1. Think "Going Forward" gives the person a sense of security amidst volatility; When you are uncertain about the time, When the interviewer asks you to take a directional call and you have no clue, you invariably say, "Going Forward...." So, in Structured finance parlance, its like "hedging" yourself against uncertainty ( Much like you buying Options, a volatility product)!

2. It has a lot of strategic sense; generally, you will find this term in MDA section; where the management is tryin to comply and yet not comply :) ( you know, that can be done, So, this is not an Epigram)! So, you want to fool your owners and yet not be held laible in Derivative suit litigations, you use "Going Forward".

3. It is suitably democratic! in the sense that, even if you are a journalist who has little or no exposure to finance earlier but still want to sound as one of the gang, you blurt, "Going Forward. to my mind......." basically, going forward ensures that you have safe haven to park your ignorance in and yet sound meaningful as a prophet.

Gtg Now guys! Bye 4 now... BTW, Going forward, it does look like a lotta posts are coming your way from thenewagegrotius....

By The Way....

Dani Rodrik makes this interesting point in his October 12 post and places the cause of recent Credit squeeze at the doors of the United States treasury not bailing out Lehman Brothers Holdings. Rodrik contends that the treasury should have bailed out Lehman as immediately after that decision Short term paper spreads rose beyond reason and credit markets seized up. Rodrik cautions there is another "Perfect Storm" coming our way. the whole piece can be read here.
http://rodrik.typepad.com

ECB Norms Should Be Eased

hmmm.. thenewgrotius believes another 50 basis point rate cut is in order so far as the CRR is concerned...Anywayz, given that we are still on course for a 7% growth this fiscal, and given that there are little concerns for the real sector as such, think its high time that the RBI and the Finmin take tweaking the ECB " All in cost" seriously. At present, the " All in cost" ceilings are pegged at too low a level to make the ECB window meaningful for Corporates;
The ECB all in cost for a borrowing with a Average maturity of 3-5 years is pegged at 200 basis points above the six month LIBOR. And the same for the Average maturity bracket of 5 year onwards is pegged at 350 basis points above the Six month LIBOR. As we know the ECB end-use includes acquisitions overseas. With recession looming in US, Inorganic growth options have opened up for EM Corporates. But Given the global liquidity crunch, Borrowings have become dearer with the result that it is difficult to peg the "All in Cost" (which besides the Coupon payable, includes all that is foreign exchange expenditure including fees to keep the Credit lines open and other fees payable in foreign exchange).
What that means is opportunities of inorganic growth westwards are denied in times when valuations are dirt cheap! It is time to increase the "All in cost" to make it in sync with the global realities and facilitate domestic expansion and overseas acquisitions...

In The Mean While....

A full 100 basis point cut! Surely if this does not expand demand, nothing will! Anyway, For all those who have exposure to ICICI stock, my commiserations! But am told the stock has not seen bottom yet. Must say the RBI measure of cutting CRR might shore it up; For now, Chanda Kochhar's assurance yesterday seems to be of no avail.

Should The RBI Cut Rates?

The TOI today carries an interesting poll question; Should India follow the US and the EU and cut rates. I am not too sure the ayes and the nays generated from such polls carry any weight, but the question is nonetheless thought provoking. Should we follow suit? Here are a few reasons why we should NOT FOLLOW SUIT;
1. For starters, the real sector in India is not facing recessionary expectations as the real sector in the US is; the US is hardly keeping up to its 2 % GDP growth whereas we are relatively beter off even with the revised conservative estimates of say around 7%. Rate cuts make sense in a recessionary universe to try and up the growth; Our real sector (with the exception of Realty, where prices were due for correction anyway) are doing well.
2. We should be vary of inflationary pressures; yes, even with crude showing a downward bias in recent times, we are not out of the inflationary rut. Inflation demands monetary tightening to the extent possible , because injecting liquidity in the market means more money chases limited supply of goods, we are better off without the rate cut for now. the CRR cut of 50 basis points ( that will be effective from the week starting October 11th), is good for now. Indirectly, it creates liquidity and therefore incentives demand and that has positive implications for growth. Think this should be enough for now.
3. We should be conservative so far as financials are concerned for now; rate cuts might make the Share holders of the ( battered) Banking Cos. happy and a HDFC or an ICICI scrip may look up, but that might lull the banks in to lending aggressively ( in order to cover up the earlier losses), that way the Economy risks accumalation of bad debts in the longer run. We are nowhere nearer to having a good bankruptcy law in plac; So it is better to play safe than sorry.
4. The Fed Res policy of cutting rates has more to do with bridging the trust deficit that has manifested in recent times than with sound fundamentals; the catch is, if they dont do anything about the meltdown, Bernanke would be "Nero who fiddled while Rome burned"; So, they should be seen to do something to shore up growth. On the other hand, the Fed Res has only limited space in manipulating this policy tool ( the threat of Inflation rules out cuts in the 0- sub zero range). Its more to invoke a " At least they tried" response from the tax payer, who is ultimately goin to bear the burden. We are better off without following this inarticulated measure; (the truth is, the Fed Res should sit back and let the loss lie where it should. The FDIC and not the Fed Res should be more of a player these days in the US).
Let us see what the new Governor does; He is not seen to be as conservative as Mr. Reddy was; Am punting on a status quo though
Ciao for now!

The Sub Prime Primer

http://www.scribd.com/doc/2190705/CDO-Powerpoint-SubPrime-Primer
Visit the link aforementioned. Its an amazingly lucid take on the Sub Prime saga.

OF CDS & CDO

Hmmm... Its been a long long time since I posted the last one; which was around the time Bear Stearns had fallen; Now Wall Street has seen another biggie fall and Another taken over yet another nationalised. Reason enough for the newagegrotius to wake from his Slumber. The newagegrotius sadly notes the end of an era at Wall Street and let us hope some sanity is restored in this new ( hopefully more regulated! ) era.

As Always then the Big Bear Buffet has the last laugh. In his letter to the shareholders of Berkshire Hathaway, he had labelled financial Derivatives "Weapons Of Mass Destruction" and how true his words were! I am sure a lot of you might want to decode the info on CLOs and CDOs and CDS. But random Googling will only lead you to jargon and more jargon; Thenewagegrotius believes in Democratizing the World Of Structured Finance and so this attempt to explain the logic behind the jargon that CLO, CDO, CDS has become in plain English!
Let us take the simplest first:
CDS aka Credit Default Swap:-
This is innovation on the Standard Securitisation Structure with one diffrence in that the reference asset is not transferred from the books of the originator and the risk of the asset defaulting is transferred merely; the buyer of Protection pays a premium to the seller of the protection. ( A bit like Insurance, this solution is, with one major diffrence that is the buyer need not have any " insurable interest"in reference asset he is buying). The "Insurance" is brought on a notional principal and the premium is paid thereon. On Default ( the trigger event could be liquidation, reorganisation bankruptcy of the reference asset ( in plain English, the Borrower Co.). , the buyer sells the reference asset to the seller of Protection or the seller pays the loss to the buyer.
These Swaps are a good portfolio diversification device and also a way to work around regulatory capital requirements. This may be illustrated as follows:
Say Financial Institution has heavy exposure to Steel and wants to increase its exposure to another space, say retail loans ; it simply sells protection to the FI active in the retail loan Space and itself buys protection on its Steel heavy Portfolio. It transfers its risk on the Steel space and hence does not have to make provisioning for that space; Since it is selling protection on the retail loan space, its like synthetically creating exposure in the retail loan segment. Thus it has now to provide for the loan default on the retail loan segment. In effect therefore, the portfolio is no longer comprising merely of Steel Sector, it is inclusive of retail Space as well. Thus the FI has achieved portfolio diversification without actually lending to the retail Space. Also note that since the loans in the Steel sector are already provided for, ( the risk of default is transferred to the seller ofProtection), the provisioning for the same need not be done. this frees regulatory capital and allows the FI to create more assets. This is the way a vanilla CDS functions. more exotic versions exist; but this is the most used Credit Derivative.
CDO aka Collateralised Debt Obligations:-
A CDO issues securities to the investors and itself invests in a portfolio of assets. This portfolio is called the reference portfolio and may comprise of basket of reference assets like Loans, bonds; ( if the underlying is loan, it is termed "CLO");Sometimes the reference asset may be a CDS ( what this means is that the CDO will sell protection to the buyer for a receivable ; as we saw earlier this is the " Premium"). The receivables on the portfolio are used to redeem its own Securities and to pay coupon on them. So, a CDO is not unlike a bank that lends long , borrows Short and pockets the coupon Difference.
Generally, the Manager of CDO will slice the securities in different classes ( called " tranching"); Senior, First Class, Second Class and the last equity layer. the higher layer security holders are protected and get a correspondingly lower coupon and the later tranche holders carry a proportionately higher coupon to compensate for riskier exposure that they take. The reference asset(s) are a basket that should ideally have low Co relation ( Co relation signifies the probability that one reference asset will default given that one reference asset has defaulted; Obviously, if the reference basket has assets from same sector or related sectors, there is high probability that if one defaults, the other defaults; therefore Ideally, the reference basket should be diversified. It is clearly inferred however that the equity tranche holders will prefer high Co relation because of the higher coupon that it carries as High Co relation port folios are more volatile for obvious reasons and the senior tranche holders will prefer low Co relation).
More on CDOs will follow but for now the newagegrotius will take your leave!

Not Such A Rock Anymore!

It’s been three weeks since I posted the last one. The past weeks have seen lull in capital markets In India followed by a slight rally. The budget is a bit of red herring really; I am still punting on a non-populist budget; (there is another one next year before the Country goes to polls, I reckon the populism would be saved for then!)
Across the frontiers, the world of finance especially Banking is passing through quite a turbulent time; what with trouble brewing both sides of English Channel!
On the English side the saga seems to be nearing completion with the Chancellor taking the decision to nationalize the troubled Rock.
Such nationalization is quite rare in England that has taken pride in its Darwinian traditions and in the past has let the most prestigious symbols of British finance to die when it became clear that their death would not have any systemic effects; (remember Barings). Two issues need to be high lighted.
Firstly does Northern Rock have a claim over the assets it hived off to Granite via a securitisation deal?
While nationalization undoubtedly hurts the shareholders ( it should), if the nationalized institution does not have strong portfolio, it pinches the tax payer as well. (In the case of Northern Rock, the Government is all along maintaining that the mortgage lender has a strong asset base- A Claim that might not stand scrutiny. In fact, the bank has hived off its best assets to SPV Granite through securitisation. Which means that entity is bankruptcy remote and it cannot be affected by the bankruptcy of Northern Rock, the originator). If its a true sale, (such transactions generally are) the entire port folio is lost; although technically, the SPV has no assets to manage and is a mere conduit. Equitable doctrines might thus fetch Northern Rock its strongest portfolio.

There is an additional perspective to State intervention, the one having anti trust implications- If Northern Rock is going to run by the state, this acts as an incentive for the depositors to park the funds with it. This has anti competitive effects and tends to create a monopoly for the bank as the “ State Run” tag acts as an implicit Credit enhancement. Clearly other mortgage lenders are not amused. To my mind, it does look that the Authorities might find themselves foul of the “Promote Competition” covenant of EU law.

Clearly we are not through yet. Watch this Space!

Is YV A Party Pooper?

Hmm, I am posting this a good 13 days after the last post. So, there is a lot to talk about. In the meantime, "Big Bull Bernanke" has cut interest rates ( confirming that the United States is indeed in a recession cycle), Y.V. Reddy has maintained them steady; Societe Generale has been given a lesson by " Leeson II"; and the UK treasury is considering a law that will obligate Bank Of England to provide secret liquidity to Banks in the red so that any possibility of a bank run is foreclosed.

This post am goin to talk about the recently unveiled review of monetary policy of the Reserve Bank. The policy came " against the run of play" so to speak, everone including the Finance Ministry wanted the Bank to cut rates and many punted that YV would go the "Big Ben" way. But as with most central Bankers, the Governor is a cautious man. There was no rate Cut; instead the Bank adopted a policy of moral suasion to convince Banks to lend more.( at present excess liquidity that Banks have is invested in low yield low Risk government securities).

The message is clear enough.Inflation is low because of the artificial suppressing of oil prices. Inflationary tendencies and curbing them is topmost priority. With the OPEC indicating thst it would oppose any demand for more oil in the markets, oil prices will continue to spiral and money would be required to service that.

In the process, the central Bank also underlined its autonomy from pressures of the Finance Ministry ( populist measures like Rate cuts will win you votes and Brownies, but "its the Economy stupid!"that is more important) and its emphasis to fashion itself based on Indian conditions. Yours truly also thought that the Bank would take a leaf out of fed's book but was (thankfully) proved wrong.

That does mean lull in Realty and Banking stocks. ( these are rate sensitive industries) hitherto the former has been providing momentum. But this is small price to pay for a more stable financial system in the long term.

So, is YV the party pooper? Only a fool would say that.

Should Central Banks Be Generous?

These posts have spoken earlier about the Sub Prime Crisis and how bearish Central Bank made sure we remained insulated from the Crisis. ( how far the De Coupling theory stays true is anyone's guess however!). the Sub Prime Crisis is a Black Swan event and like all Black Swan events, it has brought winds of change in public policy in general and banking regulation in particular. it is time that we reflect on these winds of change and so this post I revisit a related issue;
Should Central Banks act pro-actively to save banks and other Financial instiutions from goin down under? Are there good reasons to intervene and inject liquidity in a failing bank? The answer to the first question till last year would have been a straight No, but after the battering systems received last year, the present system seems to be leaning towards interventionism.

So should we have a system where the Bank Of England or the Reserve Bank intervene and inject liquidity, the moment it sees a bank is in the red? or should we have a system where decisions are taken by Central banks on a case to case basis, intervening only when it foresees that failure of banks has systemic effects. It is interesting to note that the Central Banks Of England and United States till very recently followed a " systemic effect" intervention policy in keeping with the laissez faire nature of the economy in those states while bank regulation in our Country has been based on a multi factor test, inter alia including Depositor interest and public interest and stability of banking system.( These factors cannot be simulataneously balanced; indeed some are antithetical to each other. for example, a particular bank might not be systemically important and so it might not be in public interest to bail it out; however acting in public interest here is directly prejudicial to depositor interest as they stand to fail if the bank is not protected).
the recent Crisis has however as i earlier pointed out brought out interventionist thought in laissez faire thinking.( See how Mervyn King did a volte face and decided to bail out Northern Rock; his early speeches were an eulogy to " systemic effect intervention").

My understanding however is that this change in policy does not augur too well for the Economy. the Economics of bail out suggests that the tax payer pays for share holder apathy. and a sustained policy therefore subsidises risk taking by unscrouplous bank Boards and incentivises further apathy by the share holders. In the long run , market discipline suffers and no one is happier. Rather all Central Banks should return to the " systemic intervention" plank and restrict their altruism to that factor alone. that way owners will monitor banks effectively, agents will have less incentives to self deal substantially reducing agency costs.

It is not my case that the intervention policy is wrong; it is however emphatically my case that it must only be followed this one time; till the crisis is over.

Darwin was not a evil man was he?

Should Banks be Held Liable For Excesses Of Recovery Agents?

These posts have hitherto been talkin about the macroeconomic policies that India ought to follow. So, this post I take a break and talk about a problematic issue in microeconomic area.the problem of recovery agents and the excesses they commit in the course of recovery of loans from retail borrowers has been in news of late. Recently, the National Consumer Commission delivered a verdict that held a reputed private bank responsible for the excesses committed by its recovery agents. the Bank was held responsible for "deficiency in service". the media generally welcomed the judgment and the general consensus was that it was a welcome step that struck a blow for consumer movement in the Country.

this post I look at whether banks should be so held responsible for the excesses committed by its recovery agents. Of Course, if we take a " law as principle" approach inspired by worthy notions like justice, there are no two ways about it. the judgment puts the onus on the banks to ensure that recovery practises are fair; and indeed the liability is rightly , a few would argue, upon the person who has the resources to avoid the damage.
Scratch the surface however and a different pixture would emerge. here's how!

Banks and other financial Institutions forever grapple with the Problem of "sticky assets". Loans that go bad and do not pay returns. The problem is compunded by the fact that the country has no proper restructuring mechanisms and there is government intervention by way of compulsary priority Sector lending. Couple that with the fact that the CRAR ratio-the Capital Adaquecy ratio that they have to maintain is 9%- 1 % higher than the Basel standards that are globally accepted.

let us look at the fall out of this judgment-
banks will be ultra conservative in lending practices. Credit would not be cheap; so,if you are a 20-sth. looking to buy that first house, you buy credit at a higher rate. and you need collaterals and guarantors. The Sub Prime class in India that currently buys credit with the interest rates that range from 25-60% would be the worst hit. I have a belief that these borrowers would be denied credit absolutely. Already poor in terms of income, they would have no recourse to capital.

Additionally, holding banks responsible for the excesses of their agents has reputation costs. Retail borrowers would be less inclined to approach banks for fear of recovery agents; and also because, they are any way not entertained there. They would then look to specialised loan providers like say housing finance Companies and other less prudent entities to finance their needs. these institutions are not diversified (hence risky) and rely on specific sectors for asset creation. Increased sub prime load on their balance sheets mean they become prone to failures themselves.

Thus, while banks have responsibility in ensuring that fair recovery practices are followed, the problems compound when they are held liable. the problem needs policy instruments like Securitisation and more leeway to banks in terms of managing their port folios. Hap hazard innovations by the judiciary will only stall the momentum of the India growth story!