Is it fair for DCB to extend ESOP exercise period due to strategic change?

A niche private sector bank DCB(Development Credit Bank) was named by Motilal Oswal in its annual wealth creation study as a potential 100x bagger, subject to management validation :D

In Oct-15, they announced an ambitious plan(http://corporates.bseindia.com/xml-data/corpfiling/AttachHis/22B0BC71_2E4B_42AF_8CE5_3CABA08280AE_171649.pdf)  to double their branch network in 12months. They had even stated upfront that this investment would pay back only in 3-4 years. Unsurprisingly, despite their detailed planning, the stock market punished them by hammering down the stock by ~50%. Then the management rolled back the plan and said they would consult the analysts going forward  http://corporates.bseindia.com/xml-data/corpfiling/AttachHis/6577829A_1250_4D5C_AE43_DF6253C10D48_080642.pdf

Things settled down and the stock has nearly returned to its earlier levels. However, while reading the annual report, I came across this nugget indicating repricing of stock options 

http://www.bseindia.com/bseplus/AnnualReport/532772/5327720316.pdf

During the year under review, the Bank has extended the exercise period from 5 years to 8 years from the date of vesting for all the unexercised options in force, as on July 1, 2015

I could not locate any specific shareholder approval for this measure, and it appears this was done to protect employees from their underwater stock options(remember the shares as at Mar 31,2016 was trading at ~Rs 70/share vs earlier levels of 140). This is quite sad that the 3yr extension was given without revising the exercise price upwards. Where is the skin in the game for the management to feel the pain like equity shareholders? Ironically, this extension happened even when the stock price was way above the weighted average exercise price of Rs 47(as at 31 Mar 2015), and hence most options would not have lapsed. 

Dr Vijay Malik has explained the volte face of the management very beautifully in his blog post
http://www.drvijaymalik.com/2016/05/steps-to-assess-management-quality-before-buying-stocks-moneylife-session-part-3.html

Investment bankers and auditors-more simillar than different

At first blush, the two could not seem more different. How can one compare a highly paid media savvy investment banker, with a lower profile 'backroom' auditor? However, when one starts to go beyond the surface and probe, there are surprising parallels

1. Regulators/Government authorities outsource work to both:-Merchant bankers are supposed to file a due diligence certificate for a capital issue(atleast in India) while auditors certify financial statements. Both these functions would otherwise come under the regulatory domain
2. Both deal in their reputation:-A reason for the famed 'IPO day1 gains' is claimed to be that merchant bankers want their reputation preserved, so they deliberately underprice the issue! But jokes apart, reputational capital is big for both auditors and investment bankers, as investors look for big brands when they invest
3. Both are mandatory-For any capital issue in India(except rights issue under Rs 50lakh i.e presently $1MM under ICDR Guidelines 2009 as amended), one needs to engage a merchant banker, while company regulators, banks and others mandate corporates and others to get an audit done for their own satisfaction
4. Both are categorized statutorily:-Be it the capital based SEBI classification based on networth or the experience/headcount based empanalment by RBI/C&AG etc, regulators and government agencies have their own categorization of these entities
5. Code of Conduct:-Both have a code of conduct, although that for auditors is much more tightly enforced.

Of course, there are differences which are there like compensation, conflict of interest etc but still these are minor imo compared to the above points

1.  

What banks can learn from the retail industry

I Googled this title and related phrases and while I found quite a few good articles and research reports, not many covered all the points I wished to, and so this blog post. The stimulus of this blog post was an interview answer I gave recently, where I said that banks should learn from best practices in other sectors such as talent management in the ITES industry, supply chain management from FMCG and a lot from retail. The main learnings in my view are below

1. Retail banking-the low hanging fruit:- Retail banking has retail in its name-what more similarity can you want! Essentially, learnings like location, merchandising, targeted advertising
2. Focus from branches to Points of Sale:-FMCG industry always harps on its points of sale(POS) instead of stores, and banks are slowly moving to non branch models like business correspondents, full fledged ATMs, multiple touch points etc too.
3. From 'commodity focus' to 'experience focus':-The greatest of retailers be they Sam Walton or Kishore Biyani know that even though low price/wide selection is necessary, what is more important is to design the store with an inviting ambience for its target customer, and to have customer friendly policies in return/payment(something Nordstrom is famous for). 
4. Loyalty programs:-This is something missing in the retail segment(except for maybe high end customers) but which corporate bankers implicitly do in their relationship banking. Agreed that bank pricing cannot be made so transparent to allow loyalty programs, but the bank should strongly communicate that it values customers who maintain long banking relationships with them. Also, tieups with other industry is prevalent in the credit card segment, maybe banks can do this for tieups with preferred service providers like auditors, valuers, chartered engineers, insurers etc, provided the respective regulators/professional bodies do not see red
5. Talent Management/Non monetary motivators:-In retail, the salaries are not the best especially at the store level, resulting in attrition yet the management does their best to keep staff motivated. As the banking regulators clamp down on high pay, banks must increasingly learn how to keep their personnel motivated even without that promise of a $MM payday. 
6. Pricing to explictly recognize loss leaders/market penetration/activity based costing:-Retailers have done this kind of pricing for decades, but bank pricing models are nowhere near this level yet, with some arbitary model adjustments done for 'relationship' reasons. 
7. Selling outside brands as well as private labels:- Banks focus on their proprietary products aka 'private labels' but they are slowly realizing that they need to offer third party products as well to ensure better infrastructure utilization and better customer service. While the tussle for 'shelf space'/'sales force attention' will always be there, there is no reason both cannot coexist.

These are just a few points, am sure readers can think of more. 

Commissions not float-the hidden goldmine in debit cards and mobile banking

I wrote an article for the blog ideasmakeamarket which can be reads at http://www.ideasmakemarket.com/2012/02/commissions-not-float-hidden-goldmine.html. The article's summary is that while debit cards and mbanking have been discussed threadbare, few  articles I've seen have highlighted this point, or even the similarity between these prepaid business models, which survive on commissions rather than on float

How the RBI prevents banks from being 'too connected to fail'

Post the 2008-date financial crisis, there is increasing recognition that besides size, risk and profitability, interconnectedness of banks is another key consideration for the banking system to consider. In his speech titled 'Indian Banking- Journey into the Future', at the Bancon-2011 at Chennai on November 6, 2011(http://rbi.org.in/scripts/BS_SpeechesView.aspx?Id=660)  the Deputy RBI Governor Anand Sinha made a host of interesting points amidst which I focus on this aspect. The points in bold italics are made by him, with my following commentary.

1. prudential limits on aggregate interbank liabilities as a proportion of banks’ Net Worth:- This measure ensures that banks do not lend to each other and create a chain. That is why even equity investments in other banks is deducted for the purpose of calculating regulatory capital.
2. restricting access to uncollateralized funding market to banks and Primary Dealers with caps on both borrowing and lending:- Repo lending is asset backed, but unsecured lending could pose problems later. Hence, these restrictions force banks/PDs to solve their problems using the capital markets instead of subjecting other banks to their systematic risk
3.  increasingly subjecting NBFCs to more stringent prudential regulations:- NBFCs and banks increasingly compete for the same customers, investors and depositors. Yet, NBFCs are not regulated to the same extent, most importantly when it comes to priority sector obligations and branch audits.
4. restricting banks’ exposure to NBFCs to contain regulatory arbitrage:- Banks used to view NBFCs as a easy way to fulfill their priority sector lending. That is why microfinance companies and gold loans companies profited from the access to assured cheap funding till the AP crisis/RBI diktat respectively
5. Financial Stability and Development Council (FSDC) monitoring inter-alia, financial conglomerates:-Since issues with one arm of the conglomerate may cause run on the banking arm, RBI prefers to go for integrated monitoring and ring fencing via Bank Holding Company structure etc. Also, it aims at improving financial sector regulatory coordination to reduce arbitrage, and thereby lower the risk of interconnectedness. 

All these are noble goals and good tools, so I hope they stand the test of time.

Debt financing with equity risks-infrastructure finance, film funding, SME lending

One may be surprised how can debt financing carry equity risks. But in each of the examples mentioned above, even debt financing is quasi equity as explained below

1. Infrastructure finance:-The RBI Deputy Governor Harun R Khan delivered a speech on  'Infrastructure financing-progress and prospects'  at the  Diamond Jubilee International Conference on Frontiers of Infrastructure Finance 2011, held at IIT Kharagpur. In that speech(http://rbi.org.in/scripts/BS_SpeechesView.aspx?Id=655), he pointed out the manifold risks ranging from financial closure to operating/political risk. Not all these risks are random, thus making it difficult to trade them off against return. For instance, political risks/legal force majure/land title etc are risks which are quasi equity and yet lenders are heavily exposed to it in the infra space
2. Film Funding:-As I understanding during the 2nd year elective on 'Contemporary Film Industry' taught by Kandaswamy Bharathan, film funding is fully backed by intangible assets, and the market for the final product is not clear. Even with the promoter having skin in the game, that does not ensure a success. While the no-guarantee of success argument holds even in other fields, it may so happen that even big budget productions with stars and no cost overruns, still come up dud at the box office. Unlike other areas of business, 'professionalizing' the process does not increase the success unless creative talent is not impaired in the process. 
3. SME lending:-To meet the public policy requirement of inclusive growth, SMEs are classed under the priority sector, eligible for collateral-light loans, directed lending and interest rate subvention. Yet, smaller enterprises do have a higher failure rate, and the banks are often not comfortable with the accounts/audit/governance-even appointing auditors does not remove that problem totally. Hence, banks can legitimately grouse about unsecured lending to SMEs, where they are exposed to risks like PEs are, but without the manifold upside.

The above post was just a humble effort at connecting the dots, comments welcome.

What do Chief Operating Officers do in banks(& why)

Most of this post is based on my reading of bank strategy notes/analyst reports/articles, as well as my own analysis, discussions with a COO and some staff, and banking internships. Seeing an increasing trend towards operations as the value driver(also discussed generally in this post http://iimaexperiences.blogspot.com/2012/02/hr-law-and-operations-next-hot-things.html), I thought this article needed to be written.For some background, Wikipedia has a gem of an article on the COO position(http://en.wikipedia.org/wiki/Chief_operating_officer), and gives an insight that The COO is responsible for ensuring that business operations are efficient and effective. While it seems BGO(blinding glimpse of the obvious and vague), it would encompass all back end/middle office functions in banks. Of course, generalizing is risky since each organization tailors the COO role according to the wish of the Board and CEO, but the below observations would throw some insights.

1. In Jan-11, Citi named its first COO since 2007. The person was John P. Havens, the head of the investment banking division, appointed for his managerial acumen etc. That shows the importance Citi gives to this role
2. Banks are increasing mentioning 'cost efficiency', 'cross selling' 'international network optimization', 'consistent operating models' etc. All that entails explicit focus to operations, as a way to improve Cost Efficiency Ratio-the other way is to increase revenues without additional costs i.e leveraging platform better
3. Increasing focus on Cost Efficiency Ratio(CER)-which goes beyond compensation cuts, and leads to operational excellence mission for back end outsourcing/setting up COEs etc.
4. With regulation becoming more complex, time to market is even more of a differentiation, as banks hesitate to launch new products before getting it perfect(as regulators need just an excuse to crack down in many jurisdictions for playing to the gallery). Hence, those banks able to navigate the labyrinth of internal systems and external approvals, will realize the pot of gold for a longer time. And this is where streamlining internal procedures without losing out on compliance and risk management, becomes much more important  
5. COO is a link between the front end and support functions, to ensure the business is built and run efficiently.

Supply Chain Finance-a new version of off balance sheet liabilities?

In the ICWAI Feb12 edition of 'The Management Accountant', I read the description of supply chain financing in an article on transaction banking. The description reads as follows
However during the last few years, there has been an increasing reliance by corporates to adopt the recent innovation in the industry called ‘Supply  Chain Finance’ to cater to their open account transactions with their counterparts. One of the typical trends in the industry is to adopt a ‘anchor-supplier’ model. One variant of this model involves the large global player having a tripartite arrangement among the global player, their trade partners and the bank wherein the banks can finance the large global player’s counterparties at a cheaper interest rate by relying on the ‘balance sheet strength’ of the global player. This arrangement would act as an effective ‘cost optimization’ strategy for the large global player besides ‘win-win’ situation for all the three parties.

Stripped of the jargon, it means that the global player is lending its balance sheet to guarantee the dues of its counterparties, in return for favourable terms. An explicit way to account for this transaction is to recognize the resultant discount as 'financing income'/'Guarantee Fee', and take some provisions for that till the loans are repaid. However, companies would not prefer this model because it reduces operating profit(as finance income is considered in 'other incomes') unless they redefine their proforma metrics to include financing income as done by some consumer durables firms which book their lending subvention income as operating profit. Also, in that model, investor multiples based on EBITDA etc would assign lower valuation to the firm, and investors may assign negative value for the added financial risk.

Hence, unless IFRS specifically puts the spotlight on these transactions, it is feared that companies's trade payables will assume the nature of debt, without being characterized as such.
 Update
Mr Robert Kramer's comment would indicate that the buyer merely confirms its own payables(which may then be reclassified as short term debt etc). But that would not entail taking on any additional liabilities outside the amounts anyway due. So I stand corrected to that extent. But some financial risk would remain because in case of supply disputes, the question stands to whether the bank will invoke the guarantee or adjudicate itself. 

Will the RBI guidelines on bank staff compensation lead to spur in FRM demand?

In Jan-2012, the RBI(India's banking regulator) announced the Indian version of the Financial Stability Board(FSB) guidelines of 2009, which set principles for banking compensation that aims to align risk with return, ensure independent director oversight etc. The principles can be read here(http://rbi.org.in/scripts/NotificationUser.aspx?Id=6938&Mode=0) and are effective from the Mar12 fiscal onwards.

While the principles come as no surprise for risk taking staff(clawback/deferral etc), what is interesting is the recomendation for higher base pay for control function staff, as can be read below.

2.2 Guideline 4: For risk control and compliance staff

2.2.1 Members of staff engaged in financial and risk control should be compensated in a manner that is independent of the business areas they oversee and commensurate with their key role in the bank. Effective independence and appropriate authority of such staff are necessary to preserve the integrity of financial and risk management’s influence on incentive compensation. Back office and risk control employees play a key role in ensuring the integrity of risk measures. If their own compensation is importantly affected by short-term measures, their independence will be compromised. If their compensation is too low, the quality of such employees may be insufficient to their tasks and their authority may be undermined. The mix of fixed and variable compensation for control function personnel should be weighted in favour of fixed compensation.

2.2.2 Subject to the above, in devising compensation structure, banks may adopt principles similar to principles enunciated for WTD/CEO, as appropriate.

The above principles would imply a high base pay, skewed towards fixed amount. The last time the compensation of employees was delinked from their business unit performance(as happened for equity research analysts whose bonus was delinked from investment banking revenues), that did not reduce the pay much as banks still set bonus in a black box type approach, which DOES consider investment banking revenues as well. But because RBI has plugged the loophole of high bonuses in its guidelines, it should ensure a good fixed pay. 

Qualifications like FRM are not as popular(yet) as CFA in India, because the risk function is still not as respected/well paid. But with such remuneration norms coming in place with the elevation of the rusk function, this should change. One of the reasons Goldman Sachs has been relatively unscarred by any crisis, is the competence and organizational profile of its famed control function. The sooner other banks realize this, the better it is for the industry and for risk management professionals.

Understanding how do banks work-some FAQs for investors

The inspriration for this post came from the fact that banks are difficult to understand, and even more difficulty to invest in. For this, I referred publicly available documents like RBI master circulars, NCFM banking sector module(http://www.nseindia.com/content/ncfm/ncfm_bsme.pdf) amongst others.

1. What does a bank do? The basic functions are intermediation and payment services. Any other services like advisory etc are icing on the cake.
2. What do investment banks invest in? They do not themselves invest(atleast thats not an essential attribute) but act as an intermediary between issuers and investors, for which they can often get fees/commission from both
3. Why do banks eventually become conglomerates offering A-Z financial services? Though banks claim that this allows them to service the customer better/have all services under one roof, the real reason in my view is the benefit of cross selling, economies of scale and the wider scope for knowledge management. For example, a commercial bank may have an excellent knowledge base on some industries, which can be leveraged into good research reports for the investment banking/broking arm. Or the same online banking platform can be used as single sign on login to give the customer access to other services, without incremental customer acquisition cost. And more the products per customer, the higher should be the customer retention rate. 
4. Explain the CAMELs model to evaluate a bank's performance: This model is implicitly used without acknowledging in many banking analyst research reports, but I notice that they often miss out on the liquidity and asset quality aspects, which came back to haunt the sector in the later part of 2011, with power sector NPAs, defaults in farm loans/student loans, more CDRs etc, all culminating in the downgrading of some banks by the credit rating agencies. Anyways, CAMEL is
1. Capital Adequacy;-This is a measure of financial strength, in particular its ability to cushion operational and abnormal losses. It is calculated based on the asset structure of the bank, and the risk weights that have been assigned by the regulater for each asset class. Post the subprime crisis, I think we should give bonus for "Too Big to Fail"
2. Asset Quality:-This depends on factors such as concentration of loans in the portfolio, related party exposure and provisions made for loan loss
3. Management:-Management of the bank obviously influences the other parameters. Operating cost per unit of money lent and earnings per employee are parameters used. In Indian context, I think implicit government guarantee for PSU banks, is a +ve here.
4. Earnings:-This can be measured through ratios like ROA, ROE, NIM
5. Liquidity:- In order to meet obligations as they come, the bank needs an effective asset-liability management system that balances gaps in the maturity profile of assets and liabilities. However, if the bank provides too much liquidity, then it will suffer in terms of
   profitability. This can be measured by the Loans to Deposit ratio, separately for short term, medium term and long term.
   
5. What does financial inclusion imply for bank business models? It means that if the banks want to open more branches in metros/cities, they better focus on the unbanked. This is over and above their 30% lending requirement to priority sector
6. Basel III/Volcker rules:-A classic example of bolting the stable after the horse has escaped. It makes banks hold more capital, measure risk more conservatively, cap their pay and a whole host of measures to ensure banks bear some of the costs they impose on others. This debate is clouded with acronyms and technicalities, but that is the essence of it. To avoid regulatory arbitrage, major financial centres should implement these measures consistently, and that is what holds up the implementation of these rules.
7. What differentiates NBFCs from banks? They do not have access to cheap bank deposits from the public (in the form of savings account, current account etc.although they can accept fixed deposits. Their cost of funds being higher than banks, their lending is costlier.
8. Why do people borrow from NBFCs at costlier interest rates? Because they are unable to mobilise funds from banks, or to fund their requirements beyond what banks would give. NBFCs are particularly active in consumer finance and personal finance, as they are flexible, have laxer credit standards, and often give higher loan to value ratio on secured asset financing(cars etc).
9. What are scheduled banks? Banks which meet specific criteria are included in the second schedule of the RBI Act, 1934. These are called  scheduled banks. They may be commercial banks or co-operative banks. Scheduled banks are considered to be safer, and are entitled to special facilities like re-finance from RBI. Inclusion in the schedule also comes with its responsibilities of reporting to RBI and maintaining a percentage of its demand and time liabilities as Cash Reserve Ratio (CRR) with RBI.
10. Why this whole debate on government stake in PSU banks falling below 51%? Other sector PSUs do see this. Even in other sectors, the privatization debate is kicking and alive as the respective sector ministry sees the PSUs as their turfs to implement populist policies, promote loyalists and generally display their power. In banking, while the finance ministry(the owner) itself favours divestment, others do not because that would reduce the power of government and politicans to direct PSUs on lending, CSR etc. For example, no private sector bank would have given Kingfisher Airlines such a long rope as SBI had given, some attribute this to the political influence of the owners. Even industrialists prefer PSU banks for their riskier loans! Of course, the arguments against this are couched in terms of valuation, affecting financial inclusion etc.
11. Why SBI has not merged with its subsidiary banks? There are labour issues because the main SBI staff have better terms of service than those of the subsidiary banks, and hence integrating the workforces is an issue. This issue had cropped up in AI-IA merger also.
12. How big are Indian banks versus global banks? Not very big in terms of assets. But then, they are more profitable and 'safe'.
13. Where do I get reliable data on the Indian banking sector? The RBI releases reports and statistics on the sector, which can be downloaded from its website. For example, the FY11 reports are available at this link. Generally, Mint and other financial newspapers analyze those reports on the day of/soon after their release.
14. Why are voting rights per shareholder capped at 10%, what would this imply for the valuation? Well, the RBI and other financial sector regulators do not want economically important entities like stock exchanges, banks, insurers etc to see concentration of ownership. Hence, the 10% rule leads to broadbased ownership. While there is no study on what is the valuation impact, one could argue that the voting stake beyond 10%, should be modeled as a Differentiation Voting rights share with economic benefits w/o voting rights! That model would invariably lead to a discount. 
15. What is this whole financial inclusion furore? Thanks to challenges of geography, income inequality, logistics, technology etc, it is not practicable to profitably operate one branch in each of India's 600000 villages. Instead, it is proposed to use para banking(MFIs, banking correspondents, NBFCs) and  existing retail outlets( post offices, village knowledge kiosks) as outlets, use multi-language technology platforms via mobile phones etc. An unsaid fear is that while moneylenders can counter populist politician calls to voters of not to repay loans, banks constrained by the code of conduct and slow legal process, are helpless in the event of such political interference, which brought the MFI industry in Andhra Pradesh on its knees. 
16. What are priority sector lending norms? Why does that encourage specialized institutions like MFIs and gold loan companies? The RBI currently mandates domestic commercial banks operating in India to maintain an aggregate 40.0% (32.0% for foreign banks) of their adjusted net bank credit or credit equivalent amount of off-agriculture, small enterprises, exports and similar sectors where the Government seeks to encourage flow of credit for developmental reasons. Banks in India that have traditionally been constrained or unable to meet these requirements organically, have relied on specialised institutions, better positioned to or focus on originating such assets through on-lending or purchase of assets or securitised pools to comply with these targets.
17. What are the larger implications of the sector? Money talks bigtime. One of the obstacles cited for slow growth of organized retail/farm credit etc, is that farmers are indebted to the traders/landlords/rich farmers for their personal loans/crop loans, and are thus compelled to sell their produce to them for lower rates, and buy inferior inputs at higher rates. It is hoped that micro loans and rural credit will break the financial dependence of small farmers. Once this is done, one can explore reforms like rural warehouses for grains, retail reforms etc.
18. How do many big banks manage to release their audited accounts before even a month elapses from year end? Thanks to the multiplicity of audits(concurrent, internal, inspection, RBI inspection, systems), the bank internal control systems are generally current. And the existence of core banking and sophisticated internal control systems ensures that the records are reasonably uptodate. That is why balance sheet audit of just test checking major accounts balances/revenue streams is in vogue.
19. Non fee income:-More is better as it insulates a bank from the competition induced squeeze on NIM. But if these profits come from derivatives trading, then the quality of earnings may actually be lower and thus the bank riskier! Unfortunately, few banks disclose the true extent of their non fee income dependence on such activities. 

Phew! that ended a longish post. Depending on the response and my time constraints, I'll follow this up. 

Why DCF fails on valuing banks

In his research paper on valuation of financial firms(http://people.stern.nyu.edu/adamodar/pdfiles/papers/finfirm.pdf),  the NYU Stern Professor and renowned valuation authority Prof Ashwath Damodaran gives a few insights on why DCF is not practical here. Besides the heavy regulatory dependence(on revenues, costs, leverage), banks also suffer from the handicap of classifying cash flows. Simple looking metrics like interest, capex, debt all need to be abandoned or redefined in case of banks.

But DCF has been the holy grail of valuation, so even if we abandon it how can we take anything else without some base? Well, for a going concern, the book value is the very minimum that the share price can fall to. Not coincidently, one of the most common metrics used is price to book value, where the excess>1 is defended based on intangibles, earning power, P/E and other factors. But it is agreed that these all are relative, and you won't see a DCF for a bank anytime soon. So is that model fundamentally flawed? Given that valuation is inherently subjective, this is not too bad a bargain.

Analyzing banking stocks? Don't overlook this useful accounting information.

Standard banking equity analysis looks more into ratios(ROE, ROA, NIM, NPAs, CRAR, business ratios) than into any specific qualitative information. Thanks to the Indian banking regulator(RBI), all banks need to disclose standard information in their annual reports. The Master Circular(http://www.rbi.org.in/scripts/BS_ViewMasCirculardetails.aspx?id=6542) has a laundry list of information, which does some in handy at times. Do read it and get some insights of what matters to the RBI, but for now I suggest take a closer look at these ratios while analyzing any banking stock

1. Concentration of Deposits, Advances, Exposures and NPAs:- The RBI mandates disclosing the percentage of top 20 depositors/borrowers(as % of total advances/total exposures/deposits) of the bank. This allows a bird eye view of concentration risk, and the risk of lowering pricing/bank runs. 
2. Disclosure of Penalties imposed by RBI:-Few banks will trumpet this in their presentations, so this information is only in the annual report, and allows assessing the operational risk of the bank, and the contingent liability for later lawsuits. For instance, the RBI has fined a few banks recently for misselling deriavtives-you can be sure that the defaulting counterparties will use this as ammo in court to have those transactions declared void.
3. Details of Single Borrower Limit (SGL)/ Group Borrower Limit (GBL):-  While this may be totally innocuous and to reputed parties(for example SBI exceeded this limit for a bluechip Reliance Industries), it does show that if the funding is suddenly reduced/withdrawn, it make adversely affect either party. Also, in case secondary market crashes affect that overextended borrower, then the bank stock may also tank in sympathy. 
4. Disclosures on risk exposure in derivatives:- This note demands that besides MTM/Credit exposure details, the bank should also disclose Likely impact of one percentage change in interest rate exposuress and currency derivatives. This allows a very rough cut sensitivity analysis in case currency/interest rates fluctuate 

There are other useful information also, but this looks good for starters.

Financial pricing-illogical, opaque and unfair?

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 and other leverage 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! The poor pay more for gold loans than a salaried person pays for unsecured loans.


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 etc.


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

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? Other businesses may view increased volumes as a success of their pricing strategy. But for a bank, a spurt in volumes may merely mean that is pricing model is broken, and that others are taking advantage of that till the bug is fixed! Hence, risk pricing is error prone, yet important.
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 prices, and the subjective adjustments needed, there is a limit to everything-even for flow trading! 
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 a large trade which will move the ALM curve and the market, the liquidity adjustments among others would need to be made upfront. 
5. Floating or fixed rate? Depends totally on the risk appetite of the bank and the relationship/focus on that client. For example, Indian banks give fixed rate education loans to IIT/IIM/other top colleges students, while the ordinary student is exposed to floating rate risk.

HDFC(the FI not the bank) the LCC of banking

HDFC Bank has the employer branding of low paying but with a solid work ethic. This philosophy seems inherited from its parent HDFC Ltd, India's premier housing finance corporation, which has now diversified into insurance, student loan lending etc. Consider these facts

1. As mentioned in the FY11 AGM speech, to print a 152 page annual report(http://www.hdfc.com/pdf/Annual_Report_2010_11.pdf) costs HDFC just Rs 26.16/copy, which seems quite frugal to me. 
2. Cost to Income ratio hovers around 8%(this year is was 7.7%), among the lowest in Asia. This however, is because only 16% of its loans are directly originated(which need branch/employee costs etc). The remaining loans are through DSAs/affiliates/HDFC Bank, which bear their own overheads. The brokerage which HDFC pays them(partly towards organization costs) are not included in this Cost to Income ratio, but are set off against interest income. Still, considering that HDFC does all the credit appraisal, monitoring and followup itself, this ratio is quite commendable. 

This cost focus is perhaps why HDFC can afford a 43% dividend payout ratio.

While there is an explanation for the low cost/income ratio, I cannot imagine why a reputed printer like Infomedia18 would charge so low for the annual report. Professionals in the IR dept of companies, please comment on this number whether it is on par or lower than normal!

Lending agreements-increasing trend of outsourcing monitoring to professionals

Conventional financial theory holds that financial intermediaries(like banks) add value('spread'/NIM) by aggregating deposits and lending them to qualified borrowers. For these loans to be profitable, banks should have the expertise in credit risk assessment and monitoring. But the past few years(decades?) trend seems to be negating this theory. While banks are focusing their energies on gathering deposits(more channels, multiple access mechanisms, marketing) and processing loan applications faster('retail loan factories'), their response to scams seems to outsource that monitoring function to a professional. For example

1. Some banks give 0.25%-0.5% interest rate discount to their SME borrowers with credit ratings. 
2. Stock audits/financial audits(where not otherwise done) are made mandatory for those with working capital/other operating facilities.Incidentally, this is the mainstay of many a SME practice.
3. For borrowers with multiple bank relationships('consortium lending etc), RBI has mandated a compliance certificate to be issued certifying governance issues, no fund diversion etc. Interestingly, this circular also contains a best practice of different statutory/internal auditors for group companies, where facilities cross Rs 50crores.
4. Often, the audit clause contains a 'Big 4' auditor appointment insistence-this is true of the Indian private sector banks, but this trend seems going down though. 
5. In additional to the general purpose financial statements, auditors are often asked to sign a compliance certificate(under the lending agreement) which contains proforma ratio calculations, covenant compliance affirmation etc. When the auditor is tasked to do this(albeit for extra fees), he is in reality doing the monitoring function of the bank.
6. Auditor/CAs are often asked to certify the utilization of the earlier sanctioned funds, before the next disbursal is approved. 

 Conceptually, there is little quarrel with the proposition of 'bundling of services' or delegating to experts. When the auditors/credit rating agency are expected to know the client well and perform their tasks with due diligence, then the bank is entitled to rely on them. The only possible issues with this, is that the processing fee/interest rates should reflect this reduced risk, as well as reduced costs for bank. Otherwise, the benefit from these activities directly flow to the bank's bottomline. Btw, the professional referred to in this are practising CAs/CSs/CWAs-most of whom can do the above work. Still, the statutory auditor is preferred for most of this.

Converting Capex to Opex-can infrastructure lessons work in finance?

During my Transport Infrastructure(TI) classes here at IIM-A, Prof G Raghuram introduced the class to a framework of analyzing infrastructure as three distinct segments, each with its own risk-return tradeoffs, competition characteristics and investment rationale. They are Terminals/Right of way/Rolling stock. This is further elaborated below(note that essentially they have the principle that specialist operators take over capex headache, and charge opex to the users).

1. Right of way:- Getting the license to lay cables/fly airlines/build towers. Typically, this involves liasons with regulators/local authorities/government. Usually a legal monopoly, and if a private sector player gets it, it becomes a natural monopoly due to the poor economics of duplication.
2. Terminals:- These are the fixed departure/termination points between which rolling stock(vehicles etc) moves. They supply all the operating infrastructure and deftly schedule competitors. 
3. Rolling Stock:- Planes, buses, coaches, wagons, ships fall in this class. They are the actual revenue earning assets, which depend on the first 2 segments for being able to operate. There is no voluntary open access at all here, and maximum customization/differentiation is possible. Usually unregulated(wrt returns) and the sweet spot for private players due to low cost of entry, low entry barriers etc. 

 The above framework applies to nearly all infrastructure sectors whether it be telecom(laying wires/towers/handsets-spectrum), rail(tracks/stations/coaches), ships(flags/ports/ships). The underlying principle at play is that asset ownership/operation, and asset utilization require drastically different competencies. While fixed asset management would need maximum utilization(open access), efficient cheap service etc; its utilization would depend on competitive dynamics and the ease of entry for market players. Earlier, regulators used to bundle the license('right of way') with the necessity to set up one's own physical infrastructure('terminals'/'rolling stock'), but now the realization has set in that operating the asset may not need physical assets-sharing agreements can take care of that. Hence we have toll collection companies, MVNOs etc, who bring their expert skills to get the best out of the infrastructure.

In case of banking/finance, this paradigm is slowly getting in place. Take the following examples:-

1. Hedge funds can now use their intellectual capital('rolling stock') to access the prime broking infrastructure of their investment banking competitors
2. Insurance companies/mutual funds can piggyback on their banking partners to sell products, instead of taking the pain to set up branches. 
3. For expanding the access of retail banking, RBI suggests bank agnostic banking correspondents, who will have machines able to operate any bank's account.
4. The idea of intraprenuers within organizations/financial supermarket in a retail bank branch, hinges on the idea that creative ideas/cross selling can best utilize the infrastructure already in place. 
5. ATMs('terminals') are now nearly open access due to the number of free transactions(5/month) for ALL banking customers. Hence, new banks(aka 'rolling stock'!) can devote less resources to this aspect and focus on customer service and innovation
6. Incubation centres/Industrial parks/business centres/single window clearances(presently non banking scenario only) focus on this same principle of relieving headache of the formalities/heavy investments. 
7. Outsourcing trend seen in financial services(IT/Manpower/office space/accounting) and elsewhere, is reflective of this trend,\

This post IS a bit random but should hopefully spark some thinking

How vunerable are banking jobs to being replaced by technology?

A famous quote reads 'Lead, sell or get out of the way'. In today's world, that would probably be 'Lead, sell, risk manage or get out of the way'-considering the immense workloads on compliance, audit, risk, tax etc. Industries like type writers, travel agents, brick and mortar book sellers have virtually been wiped out by the internet/technology alternatives-which have essentially replaced recurring operating expenses(opex) by covert capital expenditure(capex). I say 'covert capex' because few capital budgeting calculations can accurately capture all relevant costs like training, business disruption, maintenance, redundancy etc.

Like how media enhanced the reach of sporting/entertainment superstars(thereby ballooning their incomes), technology amplified the reach of the banking super stars(traders, sell side investment bankers), who could now access more markets, trade more asset classes, do cross border huge mandates etc. All that did lead to the increase in compensation, compared to retail banking, where the technology led to more customers going the online/contact less banking route thus lowering the need for staff.

In my view, the only functions which cannot be replaced by technology are sales, general management, technology support and creativity. Analytical/Administrative functions are at risk of being replaced by technological alternatives. In my view, some at risk functions are

• Daily report preparers
• Arbitrageurs
• Stenos/secretaries-unless they upskill to becoming executive assistants. 
• Flow traders.

So how to prevent your role from being truncated/cut? Well, my two bits on this would include

• Coming up with creative ideas and implementing them-with net profit/cost savings to the company
• Embracing efficient technology solutions for personal work-Google Docs, apps etc. 
• Building strong relationships-internal and external
• If in an analytical role, being in the 'tacit knowledge' domain as long as possible-which would imply coming up with new and better ways of number crunching. 

FAQ on Basel II

1.     Why do the developed countries care so much about global capital/accounting norms? Should they not keep that competitive advantage with them? It is NOT a competitive advantage for a single country per se, unless everyone else adopts. Else it becomes a source of competitive advantage, where some national banks may need to set aside less capital than others, and may report higher profits also due to different accounting rules.

2.     Why would some assets have a risk weight over 100%(for example 150% risk weight when provisions are less than 20% of the outstanding amount of the loan)? After all, is not the maximum loss 100% of exposure? Well, when there are derivative positions, liability to fund cash calls etc, then the maximum exposure can top 100%. That is why the weights are there.

3.     How to convert off balance sheet items to credit exposure equivalent? Use credit conversion factors(CCF). These use behavioural finance and subjectively estimated caps.

4.     Why do wholesale banks care so much about accounting? From the capital perspective, banks raise very little capital organically and so depend heavily on capital markets for raising debt/equity. These capital markets look at the financial reporting numbers since that is what they have access to. Other industries(barring highly levered ones) can sustain on organic growth w/o capital markets funding but banks cannot. On the demand side also, areas like hedge accounting affect the type of transactions which risk averse companies will authorize their Treasury function to enter into. That is why banks take an active interest in IFRS.

5.     Why treat the same instrument differently in banking book/trading book? It IS illogical but the presumption is that there are significant constraints on the ability of banks to liquidate banking book positions and value them reliably on a daily basis, and so capital treatment should be difference. Also, the intention driven IAS 39 would account for these instruments differently, and from a risk perspective, market risk is presumed to impact trading book more than it does banking book.

6.     Why do home regulators look at the entire consolidated entity? Is it not going beyond their scope? Not really, they need to capture the risk of the whole banking group for which they need to regulate a consolidate entity.

7.     Why do new banking models initially allow for lesser capital requirement(albeit with a lower cap)? structured to provide incentives for banks to  adopt more sophisticated practices quicker and voluntarily.

8.     Among Potential future exposure (PFE), expected exposure (EE), and expected positive exposure (EPE), why is EPE preferred? By using EPE, transactions with CCR are given the same standing as loans with the goal of reducing the capital treatment’s influence on a firm’s decision to extend an on-balance sheet loan rather than engage in an economically equivalent transaction that involves exposure to CCR.

9.      What is the logic of alpha and Beta scaling factors while converting EPE to EAD? To be consistent with the Revised Framework for credit risk, the EAD for instruments with CCR must be determined conservatively and conditionally on a “bad state” of the economy. To accomplish such conditioning in a practical, pragmatic, and conservative manner, the internal model and standardised methods proposed in this note scale EPE using multipliers, termed “alpha” and “beta”, respectively. This proposal sets alpha at 1.4 for the internal model method and beta at 2.0 for the standardised method

The rationale behind certain banking rules/regulations

Even the best brains at times, get baffled by the intent behind certain banking rules. Given that this is the only industry which uses money as a raw material to create more money out of no where, there are restrictions imposed on it. And some of them are explained in the post below. You are encouraged to read the original texts(wherever linked), but then if you could maybe this post is not for you! Without much ado, I proceed.

1. Why are intangible assets, deferred revenue etc excluded from regulatory capital calculations? Regulatory capital intends to capture the readily available cash in a crisis to take the loss. So the calculation tends to favour tangible assets over intangible assets(even valuable IPR!)
2. Why are investments in other similar companies(banks/NBFCs) excluded, or given a haircut? In times of stress, systemic risk will probably hit all companies in the same sector. Given this, regulators frown upon cross holdings in companies doing the same business, because there is less diversification then. Also, unscrupulous companies may use this as a way to 'round trip' deposits and prop up the balance sheet position. For that reason, exclusion is justified. 
3. Why exclude investments in group companies? Any non arms length deal(actual or presumably so) is frowned upon, because in case of a crisis, it may not be realized to the fullest value.
4. Balance sheet is 'end of year' but some notes disclose averages, min/max position during the year. Why? End of year numbers may be window-dressed using repo deals(Lehmann 105), sale and lease back, short term loans etc. The other numbers(mean/min/max) portray a realistic picture and act as a signal towards companies which cook their books. 
5. When transfers outside 'Held To Maturity' portfolio exceeds a certain percentage(5% or so) of the total portfolio value, then why do the reporting/accounting rules tighten? Held to maturity securities can be recorded at book value, and thus can be used to cover up losses. If companies decide to sell some of HTM securities early to monetize unrealized profits, they should be willing to record unrealized losses also, because then the 'intent' is in doubt. This tainting position applies in IAS 39(till it is revised atleast) under IFRS, and the RBI mandates disclosing HTM market value, if the 5% ceiling is crossed.
6. If just one loan facility has defaulted/been restructured, why do ALL borrower accounts need to classed at NPAs? Legally, the borrower may have a legitimate dispute with the bank or may have ringfenced the remaining assets from the defaulting loan. But still, this may be an early warning signal for those other facilities, and also signify the intent of the borrower. That is why this clause exists
7. Why do regulators insist for not doing insurance departmentally? SPV ensures that risks involved in insurance business do not get transferred to the NBFC and that the NBFC business does not get contaminated by any risks which may arise from insurance business. This would imply not giving guarantees, capital infusion schedules etc. This also holds true in a milder version for infrastructure. 
8. Why should the RBI regulate 'non deposit' taking NBFCs, where no public money is involved like in other NBFCs? In 2006, in view of the systemic risk arising from access to public funds such as bank borrowings, CPs, etc, by NBFCs, and their interconnectedness with the financial system, the focus of regulatory concern widened to include non deposit taking NBFCs also. Hence, certain large NBFCs are also covered under this ambit(http://rbidocs.rbi.org.in/rdocs/content/PDFs/31CANN020711.pdf) 
9. Why are tax concessions and bank loans for land/property contingent on purchase/contingent within 3 yrs? It is a public policy thing. Govt wishes to give tax breaks/bank loans only for augmenting the supply of serviced land and constructed units, and not for merely sitting on acquired land banks. Also, 3yrs period ensures quick re-cycling of bank funds for optimum results
10.  Why does RBI restrict loans to non corporate Govt bodies? To ensure that Govt does not use bank loans as an off balance sheet way to finance projects which had not got budgetary approval. The rationale being that corporates(typically) even if Govt owned, are not under the Union Budget.           Banks should satisfy themselves that the project is run on commercial lines and that bank finance is not in lieu of or to substitute budgetary resources envisaged for the project
11. The FDI policy(http://dipp.nic.in/Fdi_Circular/FDI_Circular_012011_31March2011.pdf) mandates unlisted cos issuing ADR/GDR to list simultaneously/earlier in domestic market. Why? This is to avoid regulatory arbitrage, and also that companies prohibited from raising funds in India, should not be allowed to list abroad indirectly. 

I'll update this post whenever I see any such interesting points.