The Banking Business…Note Quote

Why is lending indispensable to banking? This not-so new question has garnered a lot of steam, especially in the wake of 2007-08 crisis. In India, however, this question has become quite a staple of CSOs purportedly carrying out research and analysis in what has, albeit wrongly, begun to be considered offshoots of neoliberal policies of capitalism favoring cronyism on one hand, and marginalizing priority sector focus by nationalized banks on the other. Though, it is a bit far-fetched to call this analysis mushrooming on artificially-tilled grounds, it nevertheless isn’t justified for the leaps such analyses assume don’t exist. The purpose of this piece is precisely to demystify and be a correctional to such erroneous thoughts feeding activism. 

The idea is to launch from the importance of lending practices to banking, and why if such practices weren’t the norm, banking as a business would falter. Monetary and financial systems are creations of double entry-accounting, in that, when banks lend, the process is a creation of a matrix/(ces) of new assets and new liabilities. Monetary system is a counterfactual, which is a bookkeeping mechanism for the intermediation of real economic activity giving a semblance of reality to finance capitalism in substance and form. Let us say, a bank A lends to a borrower. By this process, a new asset and a new liability is created for A, in that, there is a debit under bank assets, and a simultaneous credit on the borrower’s account. These accounting entries enhance bank’s and borrower’s  respective categories, making it operationally different from opening bank accounts marked by deposits. The bank now has an asset equal to the amount of the loan and a liability equal to the deposit. Put a bit more differently, bank A writes a cheque or draft for the borrower, thus debiting the borrower’s loan account and crediting a payment liability account. Now, this borrower decides to deposit this cheque/draft at a different bank B, which sees the balance sheet of B grow by the same amount, with a payment due asset and a deposit liability. This is what is a bit complicated and referred to as matrix/(ces) at the beginning of this paragraph. The obvious complication is due to a duplication of balance sheet across the banks A and B, which clearly stands in need of urgent resolution. This duplication is categorized under the accounting principle of ‘Float’, and is the primary requisite for resolving duplicity. Float is the amount of time it takes for money to move from one account to another. The time period is significant because it’s as if the funds are in two places at once. The money is still in the cheque writer’s account, and the cheque recipient may have deposited funds to their bank as well. The resolution is reached when the bank B clears the cheque/draft and receives a reserve balance credit in exchange, at which point the bank A sheds both reserve balances and its payment liability. Now, what has happened is that the systemic balance sheet has grown by the amount of the original loan and deposit, even if these are domiciles in two different banks A and B. In other words, B’s balance sheet has an increased deposits and reserves, while A’s balance sheet temporarily unchanged due to loan issued offset reserves decline. It needs to be noted that here a reserve requirement is created in addition to a capital requirement, the former with the creation of a deposit, while the latter with the creation of a loan, implying that loans create capital requirement, whereas deposits create reserve requirement.  Pari Passu, bank A will seek to borrow new funding from money markets and bank B could lend funds into these markets. This is a natural reaction to the fluctuating reserve distribution created at banks A and B. This course of normalization of reserve fluctuations is a basic function of commercial bank reserve management. Though, this is a typical case involving just two banks, a meshwork of different banks, their counterparties, are involved in such transactions that define present-day banking scenario, thus highlighting complexity referred to earlier. 

Now, there is something called the Cash Reserve Ratio (CRR), whereby banks in India (and elsewhere as well) are required to hold a certain proportion of their deposits in the form of cash. However, these banks don’t hold these as cash with themselves for they deposit such cash (also known as currency chests) with the Reserve Bank of India (RBI). For example, if the bank’s deposits increase by Rs. 100, and if the CRR is 4% (this is the present CRR stipulated by the RBI), then the banks will have to hold Rs. 4 with the RBI, and the bank will be able to use only Rs. 96 for investments and lending, or credit purpose. Therefore, higher the CRR, lower is the amount that banks will be able to use for lending and investment. CRR is a tool used by the RBI to control liquidity in the banking system. Now, if the bank A lends out Rs. 100, it incurs a reserve requirement of Rs. 4, or in other words, for every Rs. 100 loan, there is a simultaneous reserve requirement of Rs. 4 created in the form of reserve liability. But, there is a further ingredient to this banking complexity in the form of Tier-1 and Tier-2 capital as laid down by BASEL Accords, to which India is a signatory. Under the accord, bank’s capital consists of tier-1 and tier-2 capital, where tier-1 is bank’s core capital, while tier-2 is supplementary, and the sum of these two is bank’s total capital. This is a crucial component and is considered highly significant by regulators (like the RBI, for instance), for the capital ratio is used to determine and rank bank’s capital adequacy. tier-1 capital consists of shareholders’ equity and retained earnings, and gives a measure of when the bank must absorb losses without ceasing business operations. BASEL-3 has capped the minimum tier-1 capital ratio at 6%, which is calculated by dividing bank’s tier-1 capital by its total risk-based assets. Tier-2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss revenues, and undisclosed reserves. tier-2 capital is supplementary since it is less reliable than tier-1 capital. According to BASEL-3, the minimum total capital ratio is 8%, which indicates the minimum tier-2 capital ratio at 2%, as opposed to 6% for the tier-1 capital ratio. Going by these norms, a well capitalized bank in India must have a 8% combined tier-1 and tier-2 capital ratio, meaning that for every Rs. 100 bank loan, a simultaneous regulatory capital liability of Rs. 8 of tier-1/tier-2 is generated. Further, if a Rs. 100 loan has created a Rs. 100 deposit, it has actually created an asset of Rs. 100 for the bank, while at the same time a liability of Rs. 112, which is the sum of deposits and required reserves and capital. On the face of it, this looks like a losing deal for the bank. But, there is more than meets the eye here. 

Assume bank A lends Mr. Amit Modi Rs. 100, by crediting Mr. Modi’s deposit account held at A with Rs. 100. Two new liabilities are immediately created that need urgent addressing, viz. reserve and capital requirement. One way to raise Rs. 8 of required capital, bank A sells shares, or raise equity-like debt or retain earnings. The other way is to attach an origination fee of 10% (sorry for the excessively high figure here, but for sake of brevity, let’s keep it at 10%). This 10% origination fee helps maintain retained earnings and assist satisfying capital requirements. Now, what is happening here might look unique, but is the key to any banking business of lending, i.e. the bank A is meeting its capital requirement by discounting a deposit it created of its own loan, and thereby reducing its liability without actually reducing its asset. To put it differently, bank A extracts a 10% fee from Rs. 100 it loans, thus depositing an actual sum of only Rs. 90. With this, A’s reserve requirement decrease by Rs. 3.6 (remember 4% is the CRR). This in turn means that the loan of Rs. 100 made by A actually creates liabilities worth Rs. Rs. 108.4 (4-3.6 = 0.4 + 8). The RBI, which imposes the reserve requirement will follow up new deposit creation with a systemic injection sufficient to accommodate the requirement of bank B that has issued the deposit. And this new requirement is what is termed the targeted asset for the bank. It will fund this asset in the normal course of its asset-liability management process, just as it would any other asset. At the margin, the bank actually has to compete for funding that will draw new reserve balances into its position with the RBI. This action of course is commingled with numerous other such transactions that occur in the normal course of reserve management. The sequence includes a time lag between the creation of the deposit and the activation of the corresponding reserve requirement against that deposit. A bank in theory can temporarily be at rest in terms of balance sheet growth, and still be experiencing continuous shifting in the mix of asset and liability types, including shifting of deposits. Part of this deposit shifting is inherent in a private sector banking system that fosters competition for deposit funding. The birth of a demand deposit in particular is separate from retaining it through competition. Moreover, the fork in the road that was taken in order to construct a private sector banking system implies that the RBI is not a mere slush fund that provides unlimited funding to the banking system.  

The originating accounting entries in the above case are simple, a loan asset and a deposit liability. But this is only the start of the story. Commercial bank ‘asset-liability management’ functions oversee the comprehensive flow of funds in and out of individual banks. They control exposure to the basic banking risks of liquidity and interest rate sensitivity. Somewhat separately, but still connected within an overarching risk management framework, banks manage credit risk by linking line lending functions directly to the process of internal risk assessment and capital allocation. Banks require capital, especially equity capital, to take risk, and to take credit risk in particular. Interest rate risk and interest margin management are critical aspects of bank asset-liability management. The asset-liability management function provides pricing guidance for deposit products and related funding costs for lending operations. This function helps coordinate the operations of the left and the right hand sides of the balance sheet. For example, a central bank interest rate change becomes a cost of funds signal that transmits to commercial bank balance sheets as a marginal pricing influence. The asset-liability management function is the commercial bank coordination function for this transmission process, as the pricing signal ripples out to various balance sheet categories. Loan and deposit pricing is directly affected because the cost of funds that anchors all pricing in finance has been changed. In other cases, a change in the term structure of market interest rates requires similar coordination of commercial bank pricing implications. And this reset in pricing has implications for commercial bank approaches to strategies and targets for the compositional mix of assets and liabilities. The life of deposits is more dynamic than their birth or death. Deposits move around the banking system as banks compete to retain or attract them. Deposits also change form. Demand deposits can convert to term deposits, as banks seek a supply of longer duration funding for asset-liability matching purposes. And they can convert to new debt or equity securities issued by a particular bank, as buyers of these instruments draw down their deposits to pay for them. All of these changes happen across different banks, which can lead to temporary imbalances in the nominal matching of assets and liabilities, which in turn requires active management of the reserve account level, with appropriate liquidity management responses through money market operations in the short term, or longer term strategic adjustment in approaches to loan and deposit market share. The key idea here is that banks compete for deposits that currently exist in the system, including deposits that can be withdrawn on demand, or at maturity in the case of term deposits. And this competition extends more comprehensively to other liability forms such as debt, as well as to the asset side of the balance sheet through market share strategies for various lending categories. All of this balance sheet flux occurs across different banks, and requires that individual banks actively manage their balance sheets to ensure that assets are appropriately and efficiently funded with liabilities and equity. The ultimate purpose of reserve management is not reserve positioning per se. The end goal is balance sheets are in balance. The reserve system records the effect of this balance sheet activity. And even if loan books remain temporarily unchanged, all manner of other banking system assets and liabilities may be in motion. This includes securities portfolios, deposits, debt liabilities, and the status of the common equity and retained earnings account. And of course, loan books don’t remain unchanged for very long, in which case the loan/deposit growth dynamic comes directly into play on a recurring basis. 

Commercial banks’ ability to create money is constrained by capital. When a bank creates a new loan, with an associated new deposit, the bank’s balance sheet size increases, and the proportion of the balance sheet that is made up of equity (shareholders’ funds, as opposed to customer deposits, which are debt, not equity) decreases. If the bank lends so much that its equity slice approaches zero, as happened in some banks prior to the financial crisis, even a very small fall in asset prices is enough to render it insolvent. Regulatory capital requirements are intended to ensure that banks never reach such a fragile position. In contrast, central banks’ ability to create money is constrained by the willingness of their government to back them, and the ability of that government to tax the population. In practice, most central bank money these days is asset-backed, since central banks create new money when they buy assets in open market operations or Quantitative Easing, and when they lend to banks. However, in theory a central bank could literally spirit money from thin air without asset purchases or lending to banks. This is Milton Friedman’s famous helicopter drop. The central bank would become technically insolvent as a result, but provided the government is able to tax the population, that wouldn’t matter. The ability of the government to tax the population depends on the credibility of the government and the productive capacity of the economy. Hyperinflation can occur when the supply side of the economy collapses, rendering the population unable and/or unwilling to pay taxes. It can also occur when people distrust a government and its central bank so much that they refuse to use the currency that the central bank creates. Distrust can come about because people think the government is corrupt and/or irresponsible, or because they think that the government is going to fall and the money it creates will become worthless. But nowhere in the genesis of hyperinflation does central bank insolvency feature….

 

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Global Significance of Chinese Investments. My Deliberations in Mumbai (04/03/2018)

Legends:

What are fitted values in statistics?

The values for an output variable that have been predicted by a model fitted to a set of data. a statistical is generally an equation, the graph of which includes or approximates a majority of data points in a given data set. Fitted values are generated by extending the model of past known data points in order to predict unknown values. These are also called predicted values.

What are outliers in statistics?

These are observation points that are distant from other observations and may arise due to variability in the measurement  or it may indicate experimental errors. These may also arise due to heavy tailed distribution.

What is LBS (Locational Banking statistics)?

The locational banking statistics gather quarterly data on international financial claims and liabilities of bank offices in the reporting countries. Total positions are broken down by currency, by sector (bank and non-bank), by country of residence of the counterparty, and by nationality of reporting banks. Both domestically-owned and foreign-owned banking offices in the reporting countries record their positions on a gross (unconsolidated) basis, including those vis-à-vis own affiliates in other countries. This is consistent with the residency principle of national accounts, balance of payments and external debt statistics.

What is CEIC?

Census and Economic Information Centre

What are spillover effects?

These refer to the impact that seemingly unrelated events in one nation can have on the economies of other nations. since 2009, China has emerged a major source of spillover effects. This is because Chinese manufacturers have driven much of the global commodity demand growth since 2000. With China now being the second largest economy in the world, the number of countries that experience spillover effects from a Chinese slowdown is significant. China slowing down has a palpable impact on worldwide trade in metals, energy, grains and other commodities.

How does China deal with its Non-Performing Assets?

China adopted a four-point strategy to address the problems. The first was to reduce risks by strengthening banks and spearheading reforms of the state-owned enterprises (SOEs) by reducing their level of debt. The Chinese ensured that the nationalized banks were strengthened by raising disclosure standards across the board.

The second important measure was enacting laws that allowed the creation of asset management companies, equity participation and most importantly, asset-based securitization. The “securitization” approach is being taken by the Chinese to handle even their current NPA issue and is reportedly being piloted by a handful of large banks with specific emphasis on domestic investors. According to the International Monetary Fund (IMF), this is a prudent and preferred strategy since it gets assets off the balance sheets quickly and allows banks to receive cash which could be used for lending.

The third key measure that the Chinese took was to ensure that the government had the financial loss of debt “discounted” and debt equity swaps were allowed in case a growth opportunity existed. The term “debt-equity swap” (or “debt-equity conversion”) means the conversion of a heavily indebted or financially distressed company’s debt into equity or the acquisition by a company’s creditors of shares in that company paid for by the value of their loans to the company. Or, to put it more simply, debt-equity swaps transfer bank loans from the liabilities section of company balance sheets to common stock or additional paid-in capital in the shareholders’ equity section.

Let us imagine a company, as on the left-hand side of the below figure, with assets of 500, bank loans of 300, miscellaneous debt of 200, common stock of 50 and a carry-forward loss of 50. By converting 100 of its debt into equity (transferring 50 to common stock and 50 to additional paid-in capital), thereby improving the balance sheet position and depleting additional paid-in capital (or using the net income from the following year), as on the right-hand side of the figure, the company escapes insolvency. The former creditors become shareholders, suddenly acquiring 50% of the voting shares and control of the company.

The first benefit that results from this is the improvement in the company’s finances produced by the reduction in debt. The second benefit (from the change in control) is that the creditors become committed to reorganizing the company, and the scope for moral hazard by the management is limited. Another benefit is one peculiar to equity: a return (i.e., repayment) in the form of an increase in enterprise value in the future. In other words, the fact that the creditors stand to make a return on their original investment if the reorganization is successful and the value of the business rises means that, like the debtor company, they have more to gain from this than from simply writing off their loans. If the reorganization is not successful, the equity may, of course, prove worthless.

The fourth measure they took was producing incentives like tax breaks, exemption from administrative fees and transparent evaluations norms. These strategic measures ensured the Chinese were on top of the NPA issue in the early 2000s, when it was far larger than it is today. The noteworthy thing is that they were indeed successful in reducing NPAs. How is this relevant to India and how can we address the NPA issue more effectively?

For now, capital controls and the paying down of foreign currency loans imply that there are few channels through which a foreign-induced debt sell-off could trigger a collapse in asset prices. Despite concerns in 2016 over capital outflow, China’s foreign exchange reserves have stabilised.

But there is a long-term cost. China is now more vulnerable to capital outflow. Errors and omissions on its national accounts remain large, suggesting persistent unrecorded capital outflows. This loss of capital should act as a salutary reminder to those who believe that China can take the lead on globalisation or provide the investment or currency business to fuel things like a post-Brexit economy.

The Chinese government’s focus on debt management will mean tighter controls on speculative international investments. It will also provide a stern test of China’s centrally planned financial system for the foreseeable future.

Global Significance of Chinese investments

Private Equity and Corporate Governance. Thought of the Day 109.0

The two historical models of corporate ownership are (1) dispersed public ownership across many shareholders and (2) family-owned or closely held. Private equity ownership is a hybrid between these two models.

The main advantages of public ownership include giving a company the widest possible access to capital and, for start-up companies, more credibility with suppliers and customers. The key disadvantages are that a public listing of stock brings constant scrutiny by regulators and the media, incurs significant costs (listing, legal and other regulatory compliance costs), and creates a significant focus on short-term financial results from a dispersed base of shareholders (many of whom are not well informed). Most investors in public companies have limited ability to influence a company’s decision making because ownership is so dispersed. As a result, if a company performs poorly, these investors are inclined to sell shares instead of attempting to engage with management through the infrequent opportunities to vote on important corporate decisions. This unengaged oversight opens the possibility of managers potentially acting in ways that are contrary to the interests of shareholders.

Family-owned or closely held companies avoid regulatory and public scrutiny. The owners also have a direct say in the governance of the company, minimizing potential conflicts of interest between owners and managers. However, the funding options for these private companies are mainly limited to bank loans and other private debt financing. Raising equity capital through the private placement market is a cumbersome process that often results in a poor outcome.

Private equity firms offer a hybrid model that is sometimes more advantageous for companies that are uncomfortable with both the family-owned/closely held and public ownership models. Changes in corporate governance are generally a key driver of success for private equity investments. Private equity firms usually bring a fresh culture into corporate boards and often incentivize executives in a way that would usually not be possible in a public company. A private equity fund has a vital self-interest to improve management quality and firm performance because its investment track record is the key to raising new funds in the future. In large public companies there is often the possibility of “cross-subsidization” of less successful parts of a corporation, but this suboptimal behavior is usually not found in companies owned by private equity firms. As a result, private equity-owned companies are more likely to expose and reconfigure or sell suboptimal business segments, compared to large public companies. Companies owned by private equity firms avoid public scrutiny and quarterly earnings pressures. Because private equity funds typically have an investment horizon that is longer than the typical mutual fund or other public investor, portfolio companies can focus on longer-term restructuring and investments.

Private equity owners are fully enfranchised in all key management decisions because they appoint their partners as nonexecutive directors to the company’s board, and some- times bring in their own managers to run the company. As a result, they have strong financial incentives to maximize shareholder value. Since the managers of the company are also required to invest in the company’s equity alongside the private equity firm, they have similarly strong incentives to create long-term shareholder value. However, the significant leverage that is brought into a private equity portfolio company’s capital structure puts pressure on management to operate virtually error free. As a result, if major, unanticipated dislocations occur in the market, there is a higher probability of bankruptcy compared to either the family-owned/closely held or public company model, which includes less leverage. The high level of leverage that is often connected with private equity acquisition is not free from controversy. While it is generally agreed that debt has a disciplining effect on management and keeps them from “empire building,” it does not improve the competitive position of a firm and is often not sustainable. Limited partners demand more from private equity managers than merely buying companies based on the use of leverage. In particular, investors expect private equity managers to take an active role in corporate governance to create incremental value.

Private equity funds create competitive pressures on companies that want to avoid being acquired. CEOs and boards of public companies have been forced to review their performance and take steps to improve. In addition, they have focused more on antitakeover strategies. Many companies have initiated large share repurchase programs as a vehicle for increasing earnings per share (sometimes using new debt to finance repurchases). This effort is designed, in part, to make a potential takeover more expensive and therefore less likely. Companies consider adding debt to their balance sheet in order to reduce the overall cost of capital and achieve higher returns on equity. This strategy is sometimes pursued as a direct response to the potential for a private equity takeover. However, increasing leverage runs the risk of lower credit ratings on debt, which increases the cost of debt capital and reduces the margin for error. Although some managers are able to manage a more leveraged balance sheet, others are ill equipped, which can result in a reduction in shareholder value through mismanagement.