Relationship driven banking or technology driven banking-which suits financial inclusion?

As retail customers, we have been probably exposed to the automated, technology oriented retail banking side of banking; where the operations management approach is applied to the branch('factory') to maximize flow('loans processed, accounts opened etc). Data mining is used to generate insights and make those offers of 'preapproved loans', 'life time free credit cards'. 'boosting credit limit' etc. Little personalized human insight/attention is given in those decisions.

But on the wholesale side, it all boils down to relationships. Given that the platform('infrastructure') of banks is quite similar nowadays (or can be outsourced easily), the dividing factor boils down to trust and relationships. Even where the balance sheet/financial projections etc may not support a positive credit decision, the relationship may tip the balance in the favour of approval. And given that there is no uniform price/price list for a transaction(there is often a deal RORWA though), there is ample discretion on the client facing executive to structure the deal. Agency problems are mitigated by P&L based bonuses, offloading the risk(thus forcing pricing to be realistic to avoid facign a loss) etc.

So which approach is better? I guess where someone needs credit(in whatever form-prepaid swaps, loans, guarantees etc), they are better off with a personalized approach where someone counsels them on presenting the case better, acts in their interest etc. But for transactional business, relationship managers may just be an unnecessary overhead unless they can leverage their client business understanding to add value.

As a small guy entering the banking door for the first time, I'm probably better off with a relationship manager, than navigating a morass of weird technology platforms. But the reality is that I will not get one, till I'm too rich to need them!! Financial literacy campaigns and outreach centres do help bridge the gap, but they seem a case of too little too late. So in balance, I would support a banking business model which uses technology to build a LOW cost platform, but which vests discretionary power(within limits) in the front office to offer better terms to the client. This may result in some corruption, but overall the financial inclusion objective would be served better.

'Basics of Banking'-or merely 'lazy banking'

Open the annual report of most banks, and turn to the CEO's message. In most cases, you will notice that they profess a return to the 'basics of banking' by focusing on costs, risks, capital, liquidity and what not! The quest for growth has been replaced by a quest for profitable growth. And why not? The pre-2008 ROEs of 15%+ are now projected to be well under 15%, thanks to the stringent capital norms under Basel III. If shareholders need to maintain their expected return, it needs to come by squeezing someone. And that someone is likelier to be external stakeholders(customers, counter-parties, taxmen) than internal stakeholders(employees, directors).Banks are now squeezing customers on terms(more watertight/one sided agreements, higher ROE transactions, collateral, ISDAs etc) and wanting to make profits with little risk.

When banks had cheap funding at near zero prices(cheap deposits, wholesale funding etc) in the post bailout scenario, they did not increase their lending proportionately, but instead used that capital to back their trading activities. That is why the FICC(Fixed Income, Commodities and Currency) derivatives units of banks posted record profits in 2009, before the global risks/capital norms pushed it down in 2010. This did not go down well with politicians, who felt that banks had not fulfilled their part of the bargain by 'priming the pump' and funding businesses. And that is where the phrase 'lazy banking' was applied to banks, who preferred making trading profits to conventional banking income(lending, fees) etc.

Of course, banks stayed oblivious to this, with some CEOs saying that they wished they had not taken the  bailout funds, or that they were 'doing God's work'. The heightened focus on all fronts-regulatory(forced mergers, Basel III), tax(HSBC, UBS severely penalized for helping tax evaders), corporate governance(independent directors, compensation oversight) and economic(pushing more transactions to be done on exchanges-despite the fact that it would lower profit margins)-served as a harsh wake up call.

And that is why banks are keeping their heads down and singing from the same hymn book of 'back to basics'. Of course,  few follow it in spirit. Others use this as an excuse to exit subprime markets(consumer banking, Latam, mortgages) or increase the pricing on existing advances. There still seems no effort towards a paradigm shift in the industry. Already, the 'green shoots' have encouraged banks to restore the pre-crisis pays(albeit deferring the bonuses), and pay mere lip service to moderation. So for those who believe the industry has significantly changed, that may be true sectorally(more in Asia/Infra etc) but not on an aggregate level.

How banks are copying supermarkets via 'loss leaders'

Any visitor to supermarkets would have noticed that they sell certain staples cheap to attract footfalls, which will hopefully result in selling more profitable merchandise. Even in that notoriously zero NPV world of banking, this does happen to be true, as the examples below show

1. Investment banks in India routinely take a pittance(less than $1) to advice on marquee public sector capital issuance. Why? One reason is that they value their place on the league tables, second is that this will give them an 'in' with that issuer for future business. 
2. To attract broking clients, several banks sell the benefits of their 'platform' with thin spreads, quick service etc. In the most liquid markets/currency pairs, banks may even lose money on a standalone basis. But they hope to make up for that via block trades, structured deals etc. 
3. For getting the high margin(because once infrastructure costs are borne contribution is nearly 100%) transactional business like cash management etc, banks do agree to competitively price their loans to clients, give covenant lite loans etc. And that is needed because unlike the banking services where there is competition only from other banks, lenders face competition from alternate capital provides including suppliers, customers, Governments, equity markets etc.

In retail banking, this used to be the case via zero balance accounts, free credit cards etc. But given the cost cutting spree in retail banking off late, these perks(specially in the developed nations) are fast becoming a thing of the past. Now unless the regulator mandates universal banking, the retail products pricing is typically activity based costing related, and not that much predicted on future potential. Thankfully, India is still an exception when it comes to PSU banks, but private banks like ICICI/HDFC/Axis are already going the Western way.

So next time you notice a bank apparently 'losing money', stop and ask yourself what you are missing? Remember they employ very smart people(who CAN make mistakes but those are rare), and so maybe the benefits are not visible to you upfront.

How banks price their loans and products

When I googled this title, guess how many results I got? Zero.zilch.nada. That in itself spurred me on to write something on which there is little organized information. I am not(yet!) an expert on pricing but from what I have seen of the structuring, trading and risk sides of banks, I think I can venture some informed views on this manner. More knowledgeable readers are welcome to comment on this primer in FAQ form.

1. Every business needs to price its products. What is so exotic about banks? Feedback is given to a real world business via market share, inventory etc. But inventory is non existent in banks(OK maybe cash is that if you stretch the definition). And thanks to poor business intelligence, even the market share data is hard to come by.


2. How is risk priced in? We do not have(yet) that one universal calculator which will spit out an integrated figure for all risks. So often the systems are fragmented. Credit risk calculations are often bifurcated into counterparty(interbank/other FIs) and client risk(normal corporate transactions). And there are many ways to splice other transactions. So finally, an excel/other manual systems are needed to make sense of this mess of figures


3. But why does not some one automate it? It is a control issue. Given the high sensitivity of the pricing 'secret sauce', it was historically not brought on the platform except for record keeping purposes! Thankfully, the success of platform driven retail banking has persuaded banks to adopt the IT company mantra of automation. So in the years to come, we should see better practices in this front. 


4. We learn this in marketing 101. Do those principles apply here? Yes and no. Yes because the exact pricing decision will depend on how well the pricer knows the client, which is again related to marketing. But no because the performance management system of banks ensure that the cost of funds charged to the trader, is often determined post facto, and so there need to be relatively accurate and robust models available for trade negotiation and evaluation. And while geeks/quants can design it, the end users need to know the ins and outs of the model, including its limitations, so that for extreme cases they can use modifications. For example, while executing 

Reliance Industries-back to cooking subsidiary books?

Reliance Industries(both brothers) is known for many things, but transparent financial reporting is not one of them. Financial journalists(Hamish Mc Donald, S Gurmoorthy and a succession of others over the years) have revealed many of the accounting, legal and tax tactics used by Reliance, and indeed it is an open secret that many tax plugging provisions(like Minimum Alternate Tax) were brought in to counter the clever structuring by RIL. Though being India's 2nd largest corporate house has rubbed off positively, there is a long way to go. And nothing illustrates the need for continued monitoring than the example below.  Maybe other companies do the same/are worse but as India's premier corporate house, Reliance has a much bigger responsibility to uphold like Caesar's wife!!

Reliance Haryana SEZ has been incorporated to develop and operate Special Economic Zones (SEZs) in the State of Haryana. The project is at start up stage of development. In the 2009-10 Annual Report(http://www.ril.com/rportal1/DownloadLibUploads /8%20Reliance%20Haryana%20SEZ%20Limited.pdf), I noticed this unusual note(Note 8 Schedule O).
During the year the Company has taken steps to consolidate the purchased land, constructed boundary wall around the notified SEZ land, undertaken land development activities, coordinated various government approvals etc. The developed land will be provided to the end users for various purposes, such as industrial activity, residential, commercial etc. Presently the intention of the Company is to provide substantial part of the land on long term lease with upfront lease premium which would qualify to be finance lease as per the requirement of Accounting Standard 19, ‘Accounting of Leases’. Accordingly the Company has been advised that it is appropriate to presently classify the entire land as inventory and also interest and finance charges of Rs.353 37 09 633 incurred during the year have been considered as part of inventory(emphasis added).

I feel this accounting treatment needs some analytical adjustment because given the uncertainty attached to the Haryana SEZ(and consequent likelihood of changes in plans), adding 3530 million Rs in inventory instead of expensing in P&L, does need some extra explanation.

I agree that without access to the underlying records, it is unfair to accuse the company of cooking the books. More so when auditors(whose experience probably exceeds my age!) have signed off on this treatment. But then, this intention driven accounting defies logic, specially of this order. And given that SR Batliboi(Indian affiliate of Big 4 firm E&Y) resigned from the audit in 2009-10,  an heightened standard of scrutiny should be applied. 

To be fair, they took a Rs 121Cr charge by following the prescribed(in an ICAI technical guide) non mandatory accounting treatment in an unrelated issue. But this does not right a mistake elsewhere.

So why do corporates hate jury trials/court processes?

Right from an employment contract to an ISDA agreement, two standard clauses leaps out at you 'waiver of jury trial', and 'arbitration clause'. That dashes any hopes of staging 'The Runaway Jury' type Grishamseque trials, and wheedling out millions of filthy lucre for any supposed offenses. From the corporate's point, you cannot fault it. Typically, their counterparties would be less sophisticated(individuals or SMEs or even other interbank parties at times), and would evoke more sympathy from a jury of their peers. Though one signs away the right to challenge the fairness of contracts etc, when the interpretation of law enters grey areas; when the issue comes about discretionary/punitive damages and emotions come into play, then juries can even ignore the 'true intent' of law and instead apply common commonsensical principles.

The famous Nanavati murder trial in India(1950s) is a classic case where despite a confession, the jury found the decorated naval officer not guilty by way of insanity of murdering his wife's lover. That case(where the jury verdict was declared a mistrial) led to abolition of jury trials, and now common law systems like India rarely have them. Modern corporates have learned at considerable expense(ask any tobacco company!) about how much juries may feel for the underdog. And now judicial activism(judges bend the legal interpretation to achieve their own version of social good over legal correctitude)  is plaguing countries like India. So now, arbitration is the in thing, specially to decide over technical matters/highly specialized issues like construction, finance etc. The advantage of this for frequent users is that the arbitrator(like an auditor) is beholden to the corporates for his appointment, so he may take their side in case of ambiguity. Also, the verdict(called 'award') of the arbitrator cannot be easily struck down for technical grounds(like alternate view possible etc).

High legal costs in the court system are not the only demerits of going to court. The (un)welcome publicity, disclosure of information, interrogation of key executives etc accompanying it; all these are good reasons to avoid court. That is why 'out of court' settlements are quite common, specially where the lawsuit may carry a reputation risk  as in most financial sector related lawsuits.

The logic behind the weird, opaque and unfair bank pricing

Return is proportional to risk taken. This basic 'tenet' of finance is honored more in the breach. How else can you explain these situations?

1. Banks with D/E ratios>>>1 pay less for their borrowings than us low leveraged individuals? 
2. Over collateralized loan(pawn shops) cost the poor more than what an unsecured loan costs those eligible for it!
3. Microfinance, despite benefiting from portfolio diversification(and in certain parts of India-group guarantee via self help groups)[on the asset side] and priority sector treatment[on the liability side] still had very high interest rates, compared with other retail loans.
4. The regulatory accounting treatment for derivative assets(thanks to the netting/collateral provisions) makes this a very profitable business than the less risky lending business.

What goes? Surely, the institutions involved are aware of the mismatch. But these factors play a role IMO:

1. Even if their pricing models are 'behind the times', the final price('interest rates', 'spreads' etc) can always be notched up to charge what the market will bear. But getting internal approvals for charging a below 'model' rate(even if it is above market) is a painful process in some banks. So why not make that call on your own?
2. Also,  the business would much prefer to have risk underpriced in their systems, so that they can  win market share by selectively underpricing, have higher 'risk adjusted' compensation figures
3. Prices often reflect the lack of competition(lead bank relationship, trust built with client, illiquid markets) or information asymmetry(complex products etc). No risk based pricing model can capture this well, necessitating the need for subjective customers. 
4. Point (3) leads us to the conclusion that savvy clients with multiple banking relationships/finance options(greater supply) would get better terms than clients with exclusive relationships with banks. Unfair but often true-even outside the finance world. The housing finance market where benefit of lower interest rates is passed on to new clients(but not to old ones) is an example of this. 
5. Basel II/III has made banks to explicitly consider different types of risks in their pricing/risk management-like operational, liquidity risk etc. Thanks to the dramatically different skills needed to price these risks, it has led to fragmented silos of internal Depts who all build(at times inconsistent) models to price it; and then a centralized manual process clunks out the final price. This is true for wholesale banking where relationships are monitored on an individual basis, but not for retail banking where portfolio treatment and s risk calculations

Hence, the next time you feel ripped off by a bank. Think again carefully. The results may surprise you

So why do borrowers generally pay lower on bonds than on loans?

This was a question which I had for quite some time. My initial reasoning was validated(mostly) but also supplemented and disproved(in parts) during a Debt Capital Markets introductory session held for us interns. Unlike the boilerplate handouts/training material, this one was interposed with live examples, experiences and thumb rules as well, making it an interesting session. And the closed door nature of the session allowed no holds barred questions, which enlivened the whole feel. But lest this sound like a press report of that session, let me push to the topic at hand!

I have pored through several bond prospectuses of USA, UK, Indian & Singapore based companies. While comparing the interest rates/LIBOR spreads for existing debt, the bond coupon has invariably been lower. At first, I attributed this to the difference in sophistication of the lenders-banks when lending on their own account will be as savvy as possible, but bond investors may be too scattered to command such a position. But there are other factors as well:

1. Why bonds should pay LOWER coupon:- Unlike the relatively oligopoly for bank supplied capital, the market for bonds has more supply from buy side investors, shadow banks  etc. So only because SUPPLY of capital is more, the rate should be lesser. 
2. Why bonds should pay HIGHER coupons: Covenants are generally incurrence based(hinge on certain events happening/not happening) as opposed to a maintenance covenant like in loan agreements. Also, bonds are generally unsecured. Investors often cannot conduct a due diligence on the scale banks can(for bank loans). Also, it is usually a bullet payment on maturity, with both put/call options-more often issuer's call options. All these should push up the cost of the bond. 

 In an environment with over supply of funds(as in USA post Quantitative Easing II), the factors for lower coupons will outweigh the factors for higher coupons, while the reverse will happen in a recession. So like most other things in management, one cannot take a firm decision on this.

Will the mandatory industry cost audit spark off a management accountancy boom?

Since independence, the Indian management accountancy body(ICWAI) was always viewed as a poor cousin of its financial accounting counterpart(ICAI). And the reasons were not too far to seek. Chartered accountants(CAs) who had the inroad into the company via statutory audits,were able to cross sell their services for internal audits, taxation etc(either themselves or via affiliates though this practice died down recently after the auditor independence norms were tweaked). Also, audits represent a steady revenue flow for the company and the assignments can be executed using grunt labour(the articled trainees). No wonder then, that the ICWAI also wanted 'cost audits' to be made compulsary for all companies, unlike the company specific orders issued earlier.

For some background, till 2011, financial record keeping was mandated by the Companies act-and so was their audit-for ALL companies. But the cost accounting record keeping, while mandated for most companies in an industry, was subject to audit only when a company specific order was issued. And this would typically only happen when the product/service in question was regulated, inflation sensitive etc.

Two MCA notifications(http://www.icwai.org/icwai/docs/cost-order-02052011.pdf and http://www.icwai.org/icwai/docs/cost-order-03052011.pdf) have mandated compulsary cost audit from the FY2011-12 onwards, for companies in specified industries fulfilling ANY of the 2 conditions below

1. FY 2010-11 Revenues from ALL products/services=>Rs 1000 million
2. Companies listed/in process of listing equity debt security on any stock exchange-in/out of India

So far, the industries affected are

1. Bulk Drugs, Formulations, Industrial Alcohol, Fertilizers, Sugar, Electricity, Petroleum, Telecommunications(for these companies Revenues requirement slashed to INR 200 million OR a networth of Rs 50 million). 
2. Cement, Tyres/Tubes, Steel, Paper, Insecticides. 

The major companies would already have been covered under cost audit scope earlier but now this will bring all the listed companies under cost audit view. And that universe is mind boggling. And once cost accountants get that statutory assignment, they would be in a better position to do(if not in that company but other companies in the industry) internal audits, transfer pricing etc. And given the enhanced entry norms into ICWAI(the exams are no longer the joke they were and the syllabus has been revised), the reduced supply would push up the rewards for those in the sector, specially the more reputed cost accounting firms who will now be sought after by everyone.

On the flip side, this may discourage the formation of inter disciplinary partnerships involving cost accountants, because now they have much more to lose if they permit other professionals to share in that initial lucrative pie for the first 7-8 years. It would be interesting to see the power equations reflected in such partnership agreements. Overall, I did feel that management accountants in India are quite understated. But with the quality of talent in the profession improving etc, they do deserve such professional opportunities now

Update
On 30th Nov 2011, the Corporate Affairs Ministry issued a circular which substantially whittled down the scope of cost audit rules(http://members.icwai.org/members/docs/mca/CostAccountingRecord.pdf). So now is not the time to uncork the bubbly.