General stuff, Politics, Uncategorized

Crackers and the judiciary

I rarely write on judicial orders, but N is tired of me ranting to her, so am indulging myself on the web.

The supreme court in its wisdom has decided to ban the sale of firecrackers in Delhi due to the (quite justifiable) fear that the pollution caused will result in health issues. Given Delhi’s quite abominable air quality, the fact that adding a bunch of Sulphur di-oxide is going to be quite deleterious is indisputable.

What is disputable however, is the fact that while sale is now illegal, it is less certain that actually bursting fire crackers is illegal. I am almost certain that it is not illegal in most of the rest of the country. And by making sale of firecrackers (otherwise legal in most of India) is the court not infringing on the rights of all those otherwise upstanding businessman to conduct their trade?

Now, I have no skin in this game. I neither live in Delhi, nor am involved in the cracker supply chain in any form or fashion; being an LED diya person. But the trend of judicial activism into areas which traditionally belonged to government and legislative action is something that is increasingly visible in India. It may have had benign intentions and may have been widely lauded, as when the court ruled that buses in Delhi should only run on CNG and not diesel. But this has emboldened the courts to bravely venture forth where no judge has gone before.

From crackers to alcohol shops, from coal licences to telecom spectrum, the reach of the legislature has shrunk, with the judicial arm of the state taking its place. We may not like our politicians, and we may disagree strongly with their actions. But I think its worth asking if the courts taking their place is a good solution.

Banking, Economics, Uncategorized

Public Sector Banks – status report

Over the last few months, the Indian banking system has shown its true colours. And unlike the Phil Collins song, they aren’t beautiful at all. With gross bad loan numbers ranging from 7% (Indian Bank) to 24% (IDBI Bank), the best of them need significant capital infusion to grow, and the worst are on the verge of insolvency.

To paint over the true colours, the government had announced Indradhanush (Hindi for Rainbow), a recapitalization of banks which would total INR 700 trillion. This amount was frontloaded with INR 300 Trillion being infused into the banks in 2015-16. The remaining 250 trillion was disbursed in 2016-17. Now there is only 100 trillion every year to provide for the next 2 years. Sadly for the banks, this  is not even remotely going to be sufficient. Let us examine why?


Non Performing Asset – Types and Introduction


There are two types of  Non Performing Assets (NPA). The first, called gross NPA is made up of all the loans of a bank where the interest is not paid for over 90 days. The second, called net NPA, reduces the gross NPA level by the amount of money the bank has set aside to cover for these non-paying loans. This money is called provisions. There are also some minor adjustments, which we will leave out for purpose of simplicity. So why do we have 2 types of NPA’s? Why can’t one do?

Gross NPA

The gross NPA number is a good indicator of current earnings of the bank. A banks business depends on people paying interest. So, the percentage of loans that don’t pay interest is useful when people want to look at future earnings.


The net NPA number is a good indicator of the solvency of the bank. Banks are quite odd creatures. They take in deposits and lend those deposits out to other people as loans. Banks must pay back those deposits, even if the loans aren’t paid back. They can do this either from earlier years profits, or from the capital that the bank has taken from its shareholders.


The NPA problem for PSU Banks

Now that we know some of the jargon that bankers use, let us look at some numbers. The total Gross NPA of the PSU banks stands at 7.29 trillion rupees. An estimate of their total loans is approximately 57.17 trillion rupees. So effectively one eighth of the loans a bank gives out is no longer paying any interest.

The net NPA number is a little more complicated as there are some adjustments made by each bank, but the aggregate number is approximately 4.42 trillion rupees. This number needs to be adjusted against the shareholder capital and any reserves and surplus that the banks may have. The total shareholder funds of all the PSU banks is about 5.817 trillion rupees. This means that if all the PSU banks were considered as one megabank, they would have additional shareholder capital of about 1.4 trillion rupees.

Do note that in this discussion, there is no mention of the regulatory capital requirements that are mandatorily needed. The current total loans is approximately 50 trillion Rupees (after subtracting the bad loans). The percentage of equity remaining to total loans is approximately 2%. The regulatory requirement I have seen for Tier 1 capital is 5%. Effectively, the PSU banks in aggregate have to raise at least 2.5 times their existing shareholder funds in order to meet the minimum requirement to be called solvent.


A large number of trees have been killed and whole reams of newsprint been used to discuss the NPA problem in PSU Banks. This article adds to that discussion, without proposing a solution. This is deliberate. I believe that defining the problem accurately is the first step to actually solving it. In further articles, we will take a look at the possible alternatives available to the regulator and the principal shareholder, the Indian government.


Economics Post — Information asymmetry in free markets

Over the last several months I have been thinking about several factors that seem to affect the behavior of prices of goods and financial instruments, and realised that they all seem to revolve around the concept of information asymmetry.

There are a lot of points to be covered, so this may be part of a multi post series.

Information Asymmetry — What is it and why is it important?

In any marketplace, the following conditions need to be met for a perfect market.

  1. No individual market participant can control pricing (practically infinite market participants)
  2. No barriers to entry or exit (No significant capital costs or bankruptcy coss)
  3. Non-intervention by external forces (eg: No government intervention or weird taxes on products/services)
  4. Profit maximisation (parties behave rationally and the measure of rationality is profit)
  5. Perfect market information (every market participation has all information available about the product/service)

A liquid stock market satisfies requirement 1 and 2. Item 3 is a bit more problematic, but we can assume it to be irrelevant for the purpose of this discussion. 4 is definitely a problem area as human beings are rarely rational, but will have to be tackled at a different point in time.

Perfect market information is an interesting one though. This is one that should be easy to establish. If there is any information asymmetry about a stock, those who possess the information should be able to exploit this asymmetry and thereby move the price. Hence the phrase, ‘the news is in the price.’

However, this is not true. In fact if it were perfectly true, then everyone would agree on the price of a stock. And once they agree on the price, what is the incentive to buy or sell it? Warren Buffet thinks that Wells Fargo is a good company that motivates its employees to cross sell products, so he would like to buy it. And Elizabeth Warren thinks it is a fraudulent company that is built on exploiting poor people and forcing them to cross sell useless products to customers. So she would gladly dump the stock (assuming she owned it). The news in this case is identical. But the interpretation is very different.

There are other instances which are less simple. Lets take the example of a retail investor who sees that Walmart is up 10% for the year. He is pretty happy with this gain and wants to sell his shares. A hedge fund owner on the other side has invested 10 million dollars to buy time on a satellite camera to look at all the parking lots at all the Walmarts in the United States on Thanksgiving weekend. He sees that the car parks are all full. His camera even spots that the boots of the cars hold huge flatscreen TV’s. So the hedge fund guy (and its almost always a guy) will be happy to buy Walmart stock from the retail investor because he knows that Walmart quarterly numbers next month will look great.

Is using a satellite to get an edge unfair? Sure it is! But nobody said the market had to be fair. It only has to work.

To summarise, information asymmetry is a key part of what makes free markets work. However, the very thing that makes the market work also makes it deeply weighed in favour of those with the resources to get the edge that makes them profitable.

Future posts will take this thought forward a bit more.

Economics, Freakonomics, free trade

Productivity measured through cost alone

Productivity improvements are almost always considered to be an unmitigated good. They help the overall economy grow by making more output out of a finite input. As an example, the move to computers from typewriters was quite a good productivity improvement. (Most) People could type documents faster with a computer than they could with a typewriter.

However, it is interesting to see how productivity is measured and managed today in the globalized single market. As an example, let us take software development. In the world pre-globalization and outsourcing, the cost to develop and maintain software in the US was a function of the price you had to pay a programmer in the US.

Today, you can hire a programmer from India to do the same thing at a third of the cost. And simple exchange rate and cost of living arbitrage means that the Indian programmer would be able to have a better standard of living even at this spectacular lower cost.

This seems like a no-brainer to most companies today, and lots of jobs are being shunted around to low cost locations around the world leading to improved margins or dramatically lower prices. However, this spectacular improvement in productivity for the global economy as a whole has some very pertinent local impacts.

Developed markets which have relatively high labour costs tend to have their jobs threatened by these low cost interlopers. In the 1980’s and 90’s this was the skilled manufacturing jobs that moved to China and South East Asia. In the 2000’s and this decade, the shift has been less labour intensive, but no less profound as low value IT jobs and back office processing moved to India and the Philippines.

The next steps will be a shift when relatively high value jobs, like management consulting and legal and financial advice get shifted to the lower cost countries.

A careful observer will state that these shifts are actually a good thing. Today, Apple is the most valuable company in the world. And while its products may be made in China, they are designed in the United States and the maximum value (30% margins) that is generated is reaped within the United States, with China getting the crumbs in the form of manufacturing margins of 3-4%.

However, this means that the developed world labour markets are in constant flux, with the employees in this world needing to constantly upgrade their skills or to perish in the low margin world of the outsourced.

Is this sustainable as a long term trend? And would this not be replicated when cheap Chinese labour is replaced by cheaper automated robots? I don’t have the answers, but I think its time people start thinking about them.


The impact of rates on banks

This post is from a mobile phone while I am getting ready to sleep, so may not make much sense. With this warning I shall dive right to my topic

Indian banks tend to have their stock price go up when the central bank lowers rates. For the longest time, I had never questioned this ‘fact’ and never stopped to wonder why.

When I did, at first the answer seemed obvious. Of course Indian banks prices would go up. After all the cost of funds is driven by the risk free rate and when the RBI drops it, the cost incurred by the banks comes down. What’s to question?

Then I thought about it some more. And this time, I put on my central bank hat. RBI (or any central bank) does not drop rates in order to help banks make more money. They do so in order to have more people take loans to grow the economy. The thing that banks should therefore do is to lower the rate at which they lend money and thereby keep their margins stable.

However, banks also have costs other than interest. They have to pay their CEO’s and CFO’s; their risk managers and their Vice Presidents who are responsible for sales. They need to pay for branch leases and ATM machines. Operational costs that are not interest. So they should actually make less money when rates go down.

Luckily there exists another driver. When rates go down more people start taking loans. This means that increased loan volumes make our CEO’s and VP’s work harder and therefore they get more productive. This leads to more profits and happy shareholders.

So the Indian example is now explained. What about places like the US or theEurozone? There the cost of money is very close to zero and any lowering of interest rates may not be of use in increasing lending.

In these cases, I suspect stock prices of these banks will go up when interest rates rise. We can wait and watch as the Fed is likely to raise rates over the next year and see if what I said turns out to be true.

Some bonus points for any readers who can identify the assumptions behind this post.


Derived Value — An alternative story of money


I was advised by A, the software coding capitalist socialist to pen my last conversation with him into a blog post failing which he promised to give me a kick in various sensitive parts of my rather large economy size posterior. This is of course, a fate best avoided, so I will get cracking!

The post describes one of the ways I think about economic markets. It should not be taken too literally, and a careful and pedantic reader will find several holes in the story that I am going to tell, but this will serve as a very basic guide to the way our market based system has evolved.

The Beginning — The barter system

The barter system was the original way men could trade. one item of value was traded for another item (or service) for equivalent value.

However, it faced a whole bunch of problems, largely because barter depended on the co-incidental needs of two counterparts who just happened to need what the other person had. Such co-incidence may make for good stories, but very rarely does it make a good marketplace.

Thus was born money, which became a proxy for value

The first derivative — money

There is the standard definition of money. If you want that you can read an economics or commerce textbook. For this post though, lets think of money as a proxy for value. Money’s own value is only in the fact that other people exchange it for items of value. So we can think of money as a first derivative of value.

Any derivative of a product imposes costs. So trading with money imposed costs like keeping track of money, worrying about money losing its value, people stealing your money, or a hundred other things. But the benefits of money far outweighed the small costs of adopting it, and thus was born the story of money

For many thousands of years, that was enough. Money, in some form or another was good enough to make market places work, and kingdoms and empires run. Then came the spice rush!

The second derivative of value — the Joint stock company

When people wanted to sail thousands of miles in order to get spices from the East Indies (actually Sumatra, Java and Indonesia), they needed to get enough money to build fleets of ships, hire hundreds of sailors, buy thousands of beads to sell to the natives, and muskets and swords to take from the natives what they could not buy, and…well you get the point. The people who wanted to buy spices needed a lot of money. It was so much money that even rich merchants did not have enough.

Thus was born the first stock issuance, where people raised money by selling shares in a shipping enterprise. One of the first of these entities was the Dutch East India Company.

The purchasers of stock in a company got the rights to receive a portion of the money that was generated by the sale of spice. So the value that was generated was the spice, which in turn yielded a derivative of value, which was money, and the buyers and sellers of the stock of the Dutch East India Company could said to be trading in the first derivative of money, or the second derivative of value.

Now this imposed more costs. Shares and stocks of a company needed to be tracked. Legal systems needed to be made to account for this new thing called a company. Books of accounts needed to be maintained. Armies of clerks were suddenly needed to write these accounts.

But the benefits of pooling capital were undeniable….and the second derivative of value was here to stay

This was good enough for the capital market-place for the next 300 years or so. Then sometime in the 1950’s and 60’s a bunch of people started wondering if the stock of companies being exchanged really correctly reflected the “value” of a company.

And they noticed something odd. The more stock of a company changed hands everyday, the better its “value” seemed to be. This seemed to be because a larger number of buyers and sellers seemed to somehow correlate to more information about a company feeding into the market place. The reasons are too complex for this post and will need a separate set of posts altogether, but suffice to say, greater liquidity seemed to encourage better pricing.

The Third derivative of value —- Future and Options

So someone came up with an idea. How about we create a product called a derivative, which will be separate from the stock of a company, but will be based on the “Value” of the stock of the company. A whole gaggle of products, futures, options, calls and puts, and Interest Rate Swaps suddenly came into existence, and the world of markets was changed yet again.

The futures and options market imposed still more costs on the now vast financial market-place. A whole new breed of speculators came into being. A brand new vocabulary needed to be invented. Whole hordes of lawyers were sacrificed in the drafting of the first derivative contracts, before an industry was formed that specialised in trading these new and exotic creatures. Words like all-inclusive finance cost and cost of hedging came to bedevil CFO’s of otherwise normal companies.

In fact the derivatives markets in most stock markets now are 5-10 times larger than the underlying stock markets.

But even so, the benefits still seem to overcome these costs. Stocks can be traded quicker, pricing is quicker, and the wheels of finance needed to be greased generously with the lubricant of derivatives for them to function correctly.

The beginning of the next wave — Credit Risk

Now the tale starts getting a bit murkier. A mere dozen years after the first derivative contract was born, derivatives of derivatives start getting traded. However, they still track (in some form) the underlying value that companies generate, and therefore still were related to the core of the barter system, which was the exchange of value.

Now, some extremely intelligent people asked the next question….is there some way to get rid of the risk that is generated by the process of generating value?

Now a step back to explain. Value is generated by people making goods and services that they hope other people will have a use for. But there is always some risk that is generated when people engage in this process. Maybe unseasonal rains will harm a wheat farmers harvest. Or a fire at a factory could ruin a company that produced widgets.

With so many people now trading so many products that only derived value from the underlying company people started to worry that perhaps the risks involved in running a company were not being appropriately priced. Thus was born the concept of the Credit Default Swap.

The wheels start coming off the wagon — the fourth derivative of value

The idea of Credit Default Swap (CDS) is deceptively simple. In case someone fails to make a payment of debt, the Swap will act as insurance for the holder of that debt. The buyer of a CDS buys insurance, and the seller of the CDS takes on the credit risk.

The idea now is that the seller of CDS now takes the final step of evaluating the credit risk that may face an entity, and by pricing the CDS appropriately, the cost of money (first derivative of value)  for a company (Second derivative of value) would drop, which in turn would make the product more fairly priced (generating more value).

Everyone wins! The CDS will never need to lose money because the insurance that is sold is always sold only after the credit risk is clearly mapped out, and the company gets to lower its funding cost because of increased certainty. What could go wrong?

As it turns out….lots can go wrong now. The additional complexity now involved is now so high that it is extremely difficult for the system as a whole to now generate more value than the added complexity. Sure, and individual CDS seller may be very good at pricing risk, and therefore could probably make money. But the various components that make up credit risk are too many to know with certainty, and now the structure starts to wobble.

Collapse and the destruction of Value 

Any mistake in pricing risk will either increase funding costs of a company (thereby making its product unviable) or will hide the risks involved in the company (which will lead to a sudden catastrophic failure at some point in the future). Both of these things will tend to destroy an otherwise value generating entity.

More seriously, because of the large costs imposed in the entire value creating process, the failure will tend to affect not only the producers and customers of the goods being produced, but investors, traders and buyers of every derivative product the entity has linked to.

This is bad enough if the company is a large conglomerate like a GE. But what if the entity that is being affected is an entity that actually creates money; ie: the banks who create money by lending money and accepting deposits (another extremely long blog post required to explain the mechanism).

When banks get the price of their risk wrong, the chain of events that occurs can appear to be a reinforcing feedback loop which will eventually lead to the entire system of money that the bank depends on to shut down (at least temporarily)


This view of the market-place is one that I find useful to try to understand how individual items in financial markets move. By no means is this the only way to try to understand financial markets. In fact, its very likely this is not even the correct way. After all, CDS being a fourth derivative of value sounds like quite a stretch!

But the underlying point that each strand in the web of financial complexity adds costs, while delivering some benefits. it is when we weave too many strands that the costs can bring down the economic system.

Does this mean that complex financial products should be prohibited? I honestly do not know. My own thoughts are that rule based systems tend to be too inflexible to work in a changing world. But I have been wrong before, and could be wrong again.


The Internet

This is a short one. Over the last few days, I have started using my internet connection to do more than watch rhymes on Youtube.

I have been downloading several Gb of games from Steam, and while doing so, I could not help but compare the world today with the world of 1999.

15 years ago, I was younger, and took 3 months to download a 75 Mb game demo.

One reason was my dialup connection that gave me 33.6 kbps (that is kilobits per second) at best, and was usually about 16-17kbps.

The second was the fact that we were billed for the internet both for the hours we put in, as well as for the phone call it took. And my dad would have several things to say if he saw a 70% rise in the phone bill!

Today, I downloaded a 10Gb game in about 45 minutes. While updating my drivers and browsing various news sites. That is quite a change from the world of 15 years ago.

its worth thinking about!