The threat posed by banks of another kind

Apr 10, 2012

In this issue:
» Is the US job market really recovering?
» Minority investors are becoming more aware
» Government is causing a liquidity crunch
» Coal imports could see a rise
» ...and more!

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Modern finance, over the years, has evolved a lot. And with globalization gaining pace, financial markets the world over have become increasingly interconnected. While the advantages have been many, the pitfalls have been numerous too. And it is these pitfalls that will be remembered for a long time to come culminating as it did in the financial crisis. This was not only a result of the excesses of Wall Street but also because of how complex finance has become. Interestingly, the aftermath of the crisis has seen regulators scrambling to impose stricter regulations on banks. But what about other finance institutions; in other words also known as shadow banks?

Indeed, traditional banks have been wary of lending on account of the destabilization of Europe, the 2008 crisis and the requirements thereafter to have higher amount of capital. But the shadow banking system still appears to flourish. Shadow banking is a phrase used to include a broad range of institutions and mechanisms, from hedge funds to mortgage lenders to money market funds and the like. These have recovered more rapidly and are poised to usurp banks in a variety of ways. Thus, it is all very well to strictly scrutinize banking activities. But regulators have now a much bigger problem of dealing with a vast sector that has little or no supervision.

Paradoxically, the global financial crisis does not seem to have weakened these shadow institutions in the same manner as banks. Far from it. Infact, they have mushroomed all over the place as banks grapple to meet the regulations imposed on them. So much so that there seems to be a greater incentive to become a shadow bank rather than a traditional bank. Readers would do well to recall that although global banks were involved in the crisis, other financial institutions also played an equal and damaging role in fuelling this crisis. Thus, it goes without saying that if the activities of these institutions go unchecked, it could only sow the seeds for the next financial fiasco.

Thus, it becomes imperative for governments across countries to have a broader understanding of how the financial markets work and devise regulations accordingly. The UK and Europe have begun to consider and draft legislations in this regard. With the developed world still struggling to recover completely from the financial crisis, another one of the same scale and scope is the last thing that the global economy needs.

Do you think that shadow banks pose a greater threat to the global economy than traditional banks? Share your comments with us or post your views on Facebook page / Google+ page.

 Chart of the day
Today's chart of the day shows the trend of sales volume growth across segments in the auto industry over the years. Given that the Indian auto sector largely mirrors GDP growth, segments such as passenger vehicles, commercial vehicles and two wheelers have also broadly stayed true to this trend. However, some differences exist and this was all the more apparent in FY09. For instance, within segments, commercial vehicles are much more cyclical in nature than two wheelers as the former is more closely linked to economic growth. Thus, in FY09, when Indian GDP growth slowed down, commercial vehicles growth was the worst hit, while two wheelers saw some growth.

Data Source: SIAM

Have you ever tried thinking what happened to the manufacturers of buggy whips after automobiles were invented? Or to take a more recent example, what happened to people employed at typewriter manufacturing companies since the advent of the computers? Well, it goes without saying that all these jobs were permanently lost as the products behind them went completely out of fashion. Thus, people employed at these firms either opted to go to some other industry or took themselves permanently away from the job market.

The US economy is also staring at something quite similar. It has been established beyond doubt that the economic boom preceding the subprime bubble was just a mirage. And so were the jobs created during that period. Thus, all reports that the US job market is returning to normalcy of the boom years of 2006-07 should be taken with a pinch of salt. Excesses created this way can't be just wished away in a matter of 3-4 years. It will take much longer than that we believe. Thus, let the US economists keep crunching numbers on employment scenario in the US. But we know for a fact that the country's job market is far from what it looked during the boom. There is surely a lot of catching up to do.

Monopoly may allow you to be callous about growth and profitability. But inefficiency comes to haunt you at some point or the other. In other words, some stake holder or the other needs to pay for an entity's inefficiency. Unfortunately for government owned entities in India, it is usually the shareholders. Coal India (CIL) is a classic example of such monopolistic arrogance. The company had no incentive for efficiency. All the employees had to do to garner better pay was to go on strike. CIL had a poor track record in meeting production targets over the past two to three years. Despite that, the company did manage to get wage enhancement bills passed. With little competition and hold over majority of mining blocks, CIL boasted of pricing power. However, all that came to a standstill once the government realized the implications of CIL's inefficiency.

Thanks to insufficient coal supplies to power producers, the country's incremental power generation capacity has barely crawled up. The 11th plan period has been testimony to the pitiable progress in power generation. So desperate is the government to get things in order that it brought in the highest authority to bring CIL to book. Despite the Presidential mandate, the target for incremental production in FY13 is ambitious to say the least. At 64 m tonnes it is nearly three times the incremental production in the past fiscal. That said, penalties are in order if CIL is unable to meet the fuel supply targets. Hence import of expensive coal seems to be the most likely interim solution. Passing on the cost to power producers is most unlikely for that will undo the objective of fuel supply agreements. Either ways, it the shareholders of CIL who stand to lose the most.

Growing awareness has started to work in the favour of investors. Particularly in the favour of minority investors. There have been recent cases of minority shareholders rebelling against the presidential directive to Coal India Ltd. The minority investors gained victory in the case of Akzo Nobel India where they managed to upturn the management's decision to pay a higher royalty to the parent company. With growing awareness and improving corporate governance, majority shareholders can no longer take random decisions. If the decisions hurt the shareholder interest, they would end up facing resistance. Obviously this is not the case in each and every company. But with each success of cases like the ones cited above, minority shareholders will get more and more confidence. And eventually this would lead to better corporate governance standards.

Two Cash Reserve Ratio (CRR) cuts later, and the liquidity situation is still far from being resolved. The Reserve Bank Of India (RBI) has a tough task ahead of it to try and manage the current scenario. In order to fund a fiscal deficit of 5.9% of GDP in FY12, and a forecast of 5.1% of GDP in FY13, the government has been increasing its borrowings. According to indicative data from the RBI, the Center plans to borrow an average of Rs 150 bn every week in the first half of financial 2012-13. This will soak up the liquidity in the system like a sponge. Slowing foreign investments, high crude prices and excess borrowings leave little room for the central bank to cut rates. But does the RBI have any other ace up its sleeve to help stimulate the economy? We think not.

The Indian stock markets were quite volatile in today's trade and remained mostly in the negative zone. At the time of writing, the BSE Sensex was down by 60 points (0.3%). Among sectoral indices, all were on the losing side except FMCG and automobile stocks. Asian stock markets were a mixed bag with China as the top gainer while Hong Kong registered maximum fall. Europe opened trade in the red.

 Investing mantra
"A market downturn doesn't bother us. For us and our long term investors, it is an opportunity to increase our ownership of great companies with great management at good prices. Only for short term investors and market timers, it is a correction not an opportunity." - Warren Buffett

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    2 Responses to "The threat posed by banks of another kind"


    Apr 10, 2012

    The basic problem is the whole world is completely in dearth of leaders and personalities both in politics and economics who can command respect thro' intellectual and wise thoughts and actions. The modern economists and politicians passing out from the world's best universities have absolutely no interest or idea to frame economic and political reforms or policies or systems which can be universal with simple & easy to use techniques so that monitoring them becomes just a fool proof mechanism.

    My simple common sense says that let us assume the whole world as a business enterprise which has got to be managed efficiently having a long term view. Anybody who starts a business would keep the price of a product high expecting a very low volume initially so that the high margin of profit could balance the expenses and as the business grows the price decreases but the volume increases multifold and the margin of profit for the same product is reduced to the minimum possible without compromising on the quality of the final product.

    Now let us substitute the business as world and the volume as population, the price as economics and the product quality as the quality of people's well being and manage the world similar to how the business is run. Instead today's politicians and economists keep on increasing the price multiplied by volume with more complex theories and fundamentals to manage thereby completely ignoring the quality of end product.

    In fact i would conclude that the high, rich and powerful are becoming more and more cowherds and selfish that on a fine day if all the central governments decide to attach atleast 50% of all the movable and immovable assets of individuals then more than 75% of them would die of an immediate cardiac arrest or a heart attack.



    Apr 10, 2012

    I am sick of articles blaming regulators and lack of regulations for the blunders the investors commit. Sane people who spend several minutes before bargaining with the street vendors for a kilo of tomatoes, decide to buy financial instruments worth thousands of rupees without proper diligence. Such people should learn by their mistakes. It is myopic to punish other investors with the buden of regulations for the foolishness of the general public!

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