Thoughts & Ideas

Thursday, December 29, 2005

On Strikes & Striking

Of and on there has been a substantial amount of debate on whether going on strike generally justified in relation to the issues involved and whether going on strike is a justified form of protest for most issues.

On both these issues I have reservations. Though it is desirable to be socially aware and to stand up for ones rights, the extent to which the action is to be carried out is a somewhat subjective matter. One basic thumb-rule in a democratic society which one can follow is that direct action should be taken only on issues concerning one’s immediate social environment. This would imply that direct action can take various forms and going on strike is just one of them. Moreover, direct action should be prompted, planned and carried out by and through the people involved without interference and / or any type of extra-constitutional control from outside parties.

While it is true that there are issues on which it is justified to take direct political action, I strongly feel that going on strike is not a valid form of protest for all and sundry issues, specially in a country like India where finding employment in any form is very difficult and the opportunity of having work to do is a great privilege. Striking work should be considered an extreme form of protest to be utilised only in the rarest of the rare case. Furthermore, where this form of protest is carried out, there should be a high level of discipline. What is observed in most strikes is that the hartal days are utilized by a large majority of members as a unpaid holiday and very few people even bother to turn-up at the place of work, let alone spend time outside the premises in protest. The gaggle of picketers are just a handful of the total work-force who are supposed to be on strike. Maybe some market research agency could do a study as to what percentage of the picketers are actually part of the striking work-force and what percentage are hired musclemen.

Strikes as a form of protest was devised to be kind to battle to be carried out against the adversary counter-party. In most cases, specially in Public Sector Undertaking and the Government Departments, there is very little to differentiate between the management and the workers. In such cases striking work is hurting oneself and patently counter-productive. In our country strikes were designed to be a moral high-ground against a foreign agent and such is hardly the case in most situations in India today. Another related issue is that going on strike without thinking out any other form of making an arrangement work (which should be the slated end result) shows the utter bankruptcy of ideas of the political class in providing leadership suited to the times.

5th July 2008: I just came across a quote from Dr. B R Ambedkar which supports my line of thinking. I am giving it below:

"We must abandon the method of civil-disobediance, non-cooperation, and satyagraha. Under an autocratic regime, there might be some justification for them, but not now, when constiutional methods of redress were available".

On Blood Donation

I once attended a meeting of voluntary blood donors called by an organisation which co-ordinates such activities. Life & Blood are emotional issues. The occasion gave an opportunity to voluntary donors and recipients to voice their feelings. The meeting was also addressed by a medical doctor who gave an impressive speech on the pros, cons and importance of blood donation.

One fact that stood out in course of the deliberations was that virtually all the speakers (donors / recipients / organisers) had initially been attracted to this activity due to crises in their personal life. It gave me an opportunity to reflect as to how I became a regular voluntary blood donor for over 20 years.

As an undergraduate student one of the recommended texts was a book called “Readings in Economics”. This book contained an article by Prof. Paul Samuelson titled “Free Blood in England, Bought Blood in the United States”. Prof. Samuelson is a Nobel Prize winner in Economics and is renowned in his field. In this article originally published in “Newsweek”, Prof. Samuelson gives his views on a book titled “The Gift Relationship : From Human Blood to Social Policy” by Prof. Richard Titmuss a sociologist with the London School of Economics.

Prof. Samuelson argues that there are issues in Society beyond the realm of money - that there is something called a free lunch. In his words, “No Englishman pays even a shilling for all the blood his doctors prescribe for him. ... Where is the catch ? ...medicine is socialised in Great Britain; so although the patient does not pay directly .. surely the long suffering middle classes are bled white by the tax system so that paupers can live parasitically on the red cells and energies of their betters ? Wrong.” He goes on to explain the phenomenon, “No one pays for blood in England because no donor receives anything for his gift. That is, nothing except the mere satisfaction from giving. When I give blood in England that does not give me a surer claim on blood at a future date when I may need it. it does not give my child a preferred place in the queue for blood. All I get is the anonymous pleasure of knowing that I have helped my fellow man.”

Many of the underlying assumptions on which the article is based may not be now relevant. However, one thing which is relevant, remains so and would in all probability would remain relevant is the idea that how we structure our society is of paramount importance. In UK there is a culture of voluntary blood donation. Only 6% of the population is actively involved in this philantrophic activity. However, this in turns ensures that the public health system is never short of blood. Any needy person gets all the blood he requires without paying for it. Moreover, since the blood is donated freely, the cost to society is less. A voluntary donor is more likely to desist from giving blood in case he has suffered from infectious diseases which makes his blood unfit for transfusion, unlike the case of a professional donor. (Prof. Titmuss has given extensive statistics from various countries to conclusively prove this point). This also ensures a regular supply of blood, as blood is not collected by way of donation camps but individuals either make it a point to donate blood on any anniversary of their choice or they register themselves and make themselves available for bleeding in case of need.

The question on how we structure our society involves all of us in the ordinary course of our life. It does not call for any great investment in time, effort or money. All it calls for is greater participation in one’s immediate social environment. Donating blood is just one of them.

On Luxuries in Life

A few days ago, there was an article by Malavika Sangghvi’s in DNA on life’s luxuries. It was a typical ode to the Mammon, hotels, cars, watches and a whole lot of yuk. Pity that she never heard Beatles – Money Can’t Buy Me Love. All in all I found the article it (to say the least) myopic, hackneyed, frivolous, superficial, shallow …. She just does not have enough sense to realise or understand what is luxury, leave alone write a stupid article on it. But like every dark cloud it had a silver lining. It set me thinking on what is my perspective on luxuries in life. Listing some of them below:

  • Getting up in the morning, lying in bed with the sun filtering in and knowing that there is no need to jump out of bed and shave, and dress and catch the 7.57 monster called the local since it is a holiday is - luxury.
  • Having water flow out of a tap when you turn the knob or getting the hot stale air to be stirred when you put on the switch is - luxury.
  • For the woman taking care of three small children and an unemployed husband by working as a domestic servant in 5 households, the small glass of hot, sugary tea brewed out of recycled tea leaves, but which will help her carry on for the next 3 households is - luxury.
  • Having the time to participate in your children’s fantasies or take your Mother for her long cherished trip to Vivekanand Rock is – luxury.
  • The warmth of the Rs.5 coin in the pocket which makes the difference between walking 8 km or taking a bus is - luxury.
  • The street light which enables reading for the exam next day is - luxury.
  • The second hand coat which keeps off the bitter North Indian winter is the height of - luxury.
  • Having the entire family sitting around and having lunch together is - luxury.
  • Getting the wife to see your point of view is – luxury.
  • A large cool “kulhad” of lassi on a hot summer afternoon – is luxury.
  • An afternoon nap is a luxury.

Wednesday, December 07, 2005

A Joke Called Current Ratio

This (Current Ratio) appears to have been developed by bankers towards the end of the 19th century as one of their first and, as it proved, one of their last contributions to financial analysis.

Bob Vause (Guide to Analysing Companies - Published by The Economist)

In any lending situation a person (or bank which acts on behalf of a group of persons) having excess funds feels that he would be better of if he made it available to someone who is in a position to use it productively. That is, the lender expects the borrower to use the funds and generate a return, which the lender himself is not in a position to do. This would enable the borrower to return the borrowed funds with interest (cost of use of funds) and the surplus would be profit for the borrower. This is a classical win-win position, which keeps any market functioning.

One of the prime due diligences that any lender has to do before actually parting with funds is to ensure that the borrower can actually use the funds productively so as to enable him return the funds along with interest on it. He tries to protect himself from failure of the borrower to productively use the funds and return it by having a loan agreement, which seeks to ensure that the borrower uses the funds in the manner intended. The second line of defence for the lender is to have collateral security which can be disposed in case of failure of the venture for which the funds were borrowed.

Relying on the sale value of collateral is the second line of defence for the lender and that too, not a sound one in view of the various infirmities of the Indian legal system. Therefore, the prudent first step, is to take a view on the ability of the borrower to use the funds productively. This analysis is difficult due to asymmetry in information between the lender and the borrower. That is, the lender does not (and cannot know) all the risks involved in running the business of the borrower.

Asymmetrical information exposes the lender to two kinds of risks. First the risk of ‘Adverse Selection’, and second the risk of ‘Moral Hazard’. Adverse selection, is the risk that the lender takes prior to committing or lending the funds. This happens due to the lender not being in a position to fully appreciate or understand the risks involved in the business. Borrowers, by nature, are inclined to take an optimistic view of their businesses. In case the lender believes the optimistic view and lends money, when actually the business does not have as rosy prospects as depicted by the borrower, the lender is said to have made an “Adverse Selection”.

The risk of Moral Hazard, arises after the funds are lent, i.e. after use of the funds is at the discretion of the borrower. Once the utilisation of funds is at the discretion of the borrower, he may be tempted to utilise it for a venture with very high risks (not the original venture for which the funds were made available – say speculating in the stock market or betting on horses) since the entire benefits of the risky venture would go to the borrower. The lender being only entitled to the contracted rate of interest, takes the full brunt of the downside risk, since in case the risky venture fails (as it is most likely to), the poor and anachronistic shape of the Indian legal system would prevent the lender to make out a case for refund of his funds. Anyway, the borrowed funds have been frittered away and there is nothing to collect!

The framework for bank lending in India developed out of lending to trade in commodities. Under the traditional system, asymmetrical information was covered in its entirety by the Current Ratio. Moral hazard being eliminated by having goods under lock and key of the banker, and by inspecting stocks to ensure that they confirmed in terms of specified quantity and quality. Adverse selection was eliminated by keeping a margin over market value of security. Margins varied depending on the volatility in the price of the commodity financed. That is, the risk of diminution in value of stocks (primary security) against which money had been lent was covered by a suitable margin in calculating permissible Drawing Power.

Over time, the conceptual framework developed for bank funding for trading in commodities has been extended for extending working capital funds to industry. The whole gamut of stock statements, stock inspections, maximum permissible bank finance, and the elusive optimum level of Current Ratio is extension of the original line of thinking. And it has kept Indian bankers, right from RBI, to Tandon and Chore committees, to commercial banks occupied. For example, Tandon Committee speaks of methods of lending and permissible bank finance. But in any lending situation, two related decisions are involved. First, does one lend money or not. If the answer to the first question is in the affirmative, then one comes to the second question. How much?

However, asking the first question is conspicuous by its absence. As such, we have reams written on permissible levels bank finance and by corollary the most appropriate level of Current Ratio which would enable the borrower to seek (or be eligible for bank funding). We have borrowers who insist on having a right to a certain quantum of bank finance based on estimation of projected levels of current assets. No questions asked on the basic viability of the entity. We have a legions of consultants who are adept at constructing projections which enable corporates get the working capital limits they desire. This makes the current ratio an extremely holy concept, with countless man-hours spent discussing it. The out come is detailed instructions as to how to calculate the current ratio and as to what all items in the B/S would or would not go into classification of Current Assets and Current Liabilities.

The net result is that for bankers the Current Ratio of 1.33 has become as sacrosanct as Chandrashekar’s constant (1.44 Solar Mass) is for astrophysicists. Chandrashekar’s constant, named after Nobel Laureate S Chandrashekhar, specifies, based on size, as to which stars would explode into a supernova in course of its lifetime. Similarly, a current ratio of 1.33 or more for the typical Indian banker differentiates a bankable proposition from one, which is not. If the current ratio is more than 1.33 it is becomes advisable to lend, otherwise not and the entire credit appraisal system has become a joke (which is fast turning into a fraud).

The basic idea that bankers should treat any lending to a going concern and its ability to keep generating surpluses is lost in the discussion on optimality of the Current Ratio. They fail to realise that no banker can run his business by depending solely on recourse to collateral security.

Lending to SMEs

The conceptual framework under which most bank lending takes place in India, including lending to the SME segment with its stress on the current ratio and insistence on collateral security is flawed. First, this approach considers the borrower as a “gone concern” rather than a “going concern” a transgression of a fundamental accounting principle. Second, it does not take into account that due to the weak foreclosure laws and a time consuming legal system, virtually the only security the banker has is a “going concern” and the key skill is ability to entrap cash flows. Third, project finance through debt for start-ups confuses venture capital funding from debt with consequent mismatch in pricing.

The fact that banks can make money in the lending business only by lending to the so called perceived higher risk category borrowers was initially suggested by George Ackerlof in his essay “The Market for Lemons” way back in 1971 (which also gave him a Noble 30 years later). Subsequent research and experience has only added to reinforce this understanding. As such, since the perceived risk in lending to the SME market segment is higher than in lending to the large corporate segment, this should be seen as an opportunity by the Indian banking sector.

Credit risk, i.e., the risk that a borrower will not repay principal and interest arises due to information asymmetry between the borrower and the lender. In other words, there always is and would be a gap between the true worth of the borrower (in terms of his intentions and capability to repay the loan) and what is apparent to the lender.

Asymmetric Information leads to 2 kinds of risks, (a) Risk of Adverse Selection and (b) Risk of Moral Hazard. Adverse Selection is an asymmetric information problem that occurs before the transaction occurs. Potential bad credit risks are the one who most actively seek out loans. Thus the borrowers who are the most likely to produce an undesirable outcome are most likely to want to borrow money.

The larger and more well known a borrower is, the more sources of information (not just financial statements, but also customers, suppliers, equity analysts, employees etc) is available and tracked by all stakeholders, and consequently information asymmetry is lower. As such, the more well-known a borrower is, the more number of banks chasing him so as to lend money. Conversely those entities on whom information is not available readily, have difficulty in raising institutional credit. A direct result of this in the Indian markets is that since banks are not able to readily distinguish good borrowers from bad, large amounts of funds have been invested in low yielding government securities. (And we always thought that the primary purpose of banks was to channelise savings towards loans and advances for productive purposes to enable the economy to grow and create employment and not to put the funds in low yielding government securities.) At the same time there are vast swathes of unorganised industry and agriculture where availability of credit is much more critical than cost and interest rates from 3% to 5% per month are the norm.

The solution to adverse selection problem in financial markets is to eliminate asymmetric information by furnishing people supplying funds with full details about the individuals or firms seeking to finance their investment activities. However, the system of private production and sale of information does not completely solve the adverse selection problem because of the free-rider problem. The free rider problem occurs when people who do not pay for information take advantage of the information that others have paid for. As such, the recent trend of having a credit rating system for SMEs is expected to have limited impact in either differentiating good borrowers from bad or in increasing the flow of bank credit to this sector.

One solution to the free rider problem is the existence of market intermediaries whose functioning is such that they are able to overcome the free rider problem. For example, a bank which becomes an expert in the production of information about firms so that it can sort out good credit risks from bad ones, can acquire funds from depositors and lend them to the good firms. Because the bank is able to lend mostly to good firms, it is able to earn a higher return on its loans than the interest it has to pay to its depositors. As a result, the Bank earns a profit, which allows it to engage in this information production activity.

An important element in the ability of banks to profit from the information it produces is that it avoids the free-rider problem by primarily making private loans rather than by purchasing securities that are traded in the open market. Because a private loan is not traded, other investors cannot watch what the bank is doing and offer lower interest rates to the point where the Bank receives no compensation for the information it has produced. The bank's role as an intermediary that holds mostly non-traded loans is the key to its success in reducing asymmetric information in financial markets.

Moral Hazard arises after the transaction occurs. The lender runs the risk that the borrower will engage in activities that are undesirable from the lender's point of view because they will make it less likely that the loan will be paid back. For example, once borrowers have obtained a loan, they may take on big risks (which have possible high returns but also run a greater risk of default) because they are playing with someone else's money.

The solution to the Moral Hazard Problem is to write out debt contracts with restrictive covenants, and monitoring and enforcement of these covenants. Restrictive covenants are directed at reducing moral hazard either by ruling out undesirable behavior or by encouraging desirable behavior.

Although restrictive covenants help reduce the moral hazard problem, they do not eliminate it completely. It is almost impossible to write covenants that rule out every risky activity. Furthermore, borrowers may be clever enough to find out loopholes in restrictive covenants that make them ineffective.

Another problem with restrictive covenants is that they must be monitored and enforced. A restrictive covenant is meaningless if the borrower can violate it knowing that the lender won't check up or is unwilling to pay for legal recourse. Because monitoring and enforcement of restrictive covenants are costly, the free-rider problem arises in the debt securities (bond) market just as it does in the stock market. If one knows that the bondholders are monitoring and enforcing the restrictive covenants, others can free-ride on their monitoring and enforcement, so the likely outcome is that not enough resources are devoted to monitoring and enforcing the restrictive covenants. Moral hazard therefore continues to be a severe problem for marketable debt.

Banks have the ability to avoid the free rider problem as long as they primarily make private loans. Private loans are not traded, so no one else can free-ride on the bank’s monitoring and enforcement of restrictive covenants. The bank therefore receives the benefits of monitoring and enforcement and will work to shrink the moral hazard problem inherent in debt contracts. The existence of moral hazard is an important reason why banks play an important role in channeling funds from savers to borrowers.

In lending to the SME sector, the key issue is that banks need to make a paradigm shift in what constitutes credit risk, similar to the paradigm shift made in micro finance lending. However, since the SME structure is different from the micro finance segment, similar parameters would not be relevant.

Therefore, if banks in India have to remain profitable in their lending business, they have to develop expertise in lending to the SME sector. And the lending expertise should encompass proactive search for lend able entities, appraisal, structuring, monitoring and exiting. This sector is not only large in size but also provides ample opportunities for profitable and safe lending provided the risks involved in their appraisal and monitoring are thought through and appropriate processes are devised to handle them. It is ironic that the older less tech savvy public sector banks with poor conceptual skills have intuitively developed various mechanisms over time to handle information asymmetry and as such are better placed in lending to the SME sector. While the foreign and new generation private sector banks have so far restricted themselves to peripheral SME lending, such as, financing of supply chain of established corporates or the immediate personal requirements of the promoters of the SME sector etc.

In the process both industry and the banking sectors are losers with banks losing great opportunities for profitable lending and industry (including agriculture) being starved for funds. And in the end society (that is all of us) looses with lower levels of growth, income and employment because of lower levels of transfer of savings for productive investment.

TV News Channels

There was a time when I though that 24 hour TV news channels were great ideas. After enduring them over the past few years I am not so sure. What has really got my goat is the presentation carried out by nearly all channels of the Lucknow based IPS officer Mr. D K Panda.

I just cant understand the reason or newsiness of this particular feature. It is obvious that the person is very ill mentally and requires immediate expert psychiatric treatment. This simple fact is not only lost to the Govt. of India and the Govt of Uttar Pradesh but to all the news channels.

I would like to ask the person who was anchoring this programme as to how much would he appreciate it is one was to ampute his arms and legs, gouge out his eyes and make him a beggar and then make a TV news feature on him.

Similarly was the case of a girl child who was being mistreated by her parents particularly the father. Do the channels asking all those questions on camera realise that they are making life even more miserable for the child. The action to my mind was clear. First - counsel the parents to take care of the child and monitor if there is improvement. In case that is not feasible, seek and put the child in a foster home.

It is really shameful the way TV news channels create news.