M&A’s IN THE INDIAN BANKING SECTOR

By:

Somnath Das Bakshi

IIM Lucknow

Introduction

In mathematics we know that points make up lines and lines make up planes and planes make up space or in common parlance small makes big. In the paradigm of corporate world it is not always bottom up and get big approach. Companies grow, shrink, merge, and acquire in order to gain long term strategic advantages. In this paper we will concentrate on merger and acquisition in banking sector in Indian. First we discuss possible benefits from merger. Next present scenario is discussed along with potential problems due to merger followed by key drivers of merger. The paper is concluded with future merger direction in the country.

Benefits of Merger

The question is why merger? Merger takes place in search of synergywhich takes three forms of operational, financial, and managerial. In case of banking such possible synergies can be classified as below

Operational synergy- Operational synergy can be achieved in four ways. Firstly due to economies of scale; as the fixed cost spreads over larger revenue base. Second in terms of scope economies as the opportunity arises in cross selling different products. Third is bank’s ability to serve larger and complex client base. Fourthly existence of bigger bank can help in resolution of smaller banks in time of crisis

Financial synergy- Financial synergy can be realized in access to lower cost of capital. Bigger banks will have access to wider capital base and diversified operation into various services reduces probability of bank failure. Other benefit is the access of smaller banks to better risk management and control system of larger banks, and tax relief that comes with merging with distressed banks.

Managerial synergy-One of the main benefit in merger is knowledge transfer resulting in superior planning and monitoring ability of the combined entity as a whole. Both Smaller and bigger banks can benefit from each other in term of efficient handling of resources.

Other controversial advantage in banking is the status of “too big to fall”. The idea is fall of big bank will lead to loss of confidence in the sector and widespread panic. So a government is expected to bailout larger banks. This has indeed been the case during crisis in USA and more recently in Ireland. We discuss more about it later.

Success of merger can be attributed to realizing all synergies and should be reflected in performance of banks post-merger in two fronts. One in improves bottom line and second is improved performance in stock market. Academic studies related to post-merger benefit analysis in foreign banks do not find significant benefit from either of two(Jayadev & Sensarma, 2007). Though there has been increased scale efficiency due to technological progress, regulatory change and beneficial effect of lower interest rate.

Merger in Indian Banking Sector

Banking in India has come a long way since the establishment of General bank of India in 1786, first of its kind in India. Important milestone in Indian banking were nationalization of banks, 14 in 1969 and 6 in 1980, and liberalization of Indian economy during early 1990 and subsequent entry of private players in banking sector. As of March 31, 2009, the Indian banking system comprised 27 public sector banks, 7 new private sector banks, 15 old private sector banks, 31 foreign banks, 86 Regional Rural Banks (RRBs), 4 Local Area Banks (LABs), 1,721 urban cooperative banks, 31 state co-operative banks and 371 district central co-operative banks(RBI, 2010).

Narasimham committee report in 1998 suggests merger in banking and creation of stronger banks to support current account convertibility related issues like domestic liquidity and interest rate movement. The committee further suggested existence of two or three banks with international orientation, eight to ten large banks catering to corporate needs and many smaller banks serving local trade.

While merger of domestic companies are guided by company’s law acquisition comes under takeover code of SEBI. In case of foreign companies acquisition requires approval of Foreign Investment Promotion Board (FIPB). Merger requires approval of both FIPB and Reserve Bank of India (RBI). Bank merger needs to take permission from RBI to be effective. Before 1960 only voluntary amalgamation was permitted by section 44A of Banking Regulation Act. Later section 45 was added to prevent weak banks from falling. Under this section RBI has power to reconstruct a weak bank and direct it to merge with other banks. RBI directed Bank of Baroda to merge with South Gujarat Local Area Bank Limited though the former was not keen on merger.

So far Indian banking sector has not seen mega mergers. Most of the past mergers have been driven by dictate of central bank in order to rescue unhealthy banks. The purpose has been to save sick bank’s customers. Post Narasimham committee report discouraging sick merger the trend has so far subdued though not stopped. Very recently Bank of Baroda has acquired Memon cooperative bank which had been non-functional since 2009. A list of recent mergersinvolving Indian commercial and investment banks can be found in appendix.

In Indian scenario four types of merger have taken place so far. First is public sector bank merging with other public sector banks; for example State Bank of Indore was merged with State Bank of India in 2009. Second is merger of private sector bank with public sector bank, this happened in 2004 when distressed Global Trust Bank was taken over by Oriental Bank of Commerce. Third one is merger of two private sector banks which has taken place in regular intervals post entry of private player with HDFC taking over Times Bank (2000), ICICI bank merging with Madura Bank (2001) and recent merger of HDFC bank with Centurion Bank of Punjab (2008) and ICICI taking over Bank of Rajasthan (2010). Fourth type of merger is foreign banks taking over foreign bank which happened in 2000 when Standard Chartered Bank acquired ANZ Grindlays bank. Other type of merger approved by central bank is merger of development financial institute with banks. ICICI limited merged with ICICI bank and IFCI Limited merged with Punjab National Bank.

So far Indian banks have remained focused on domestic market and have not ventured abroad. Two reasons are attributed for that. One is mature western banking market has not attracted Indian bankers and they instead concentrated on high growth domestic market. Second reason is that Indian banks are minuscule in size with respect to its global peers.

Drivers for Consolidation

There have been several drivers for growth in bank consolidation in US and western countries. The same factors are playing role in India as well

· Increases in global trade- Indian business houses have become big in last decade thanks to global big ticket acquisition by domestic businesses. Coupled with that increased domestic demand has led to more import. Growth in Indian business has led to growth in banking business also as seen from figure 1 which shows growth in NSE 100 index versus bank index since the latter’s inception in 2003.

• Increase in corporate risk management activities in foreign exchange and interest rate market is a direct consequence of increase in both global trade and farm balance sheet. As exposure to foreign exchange and interest rate increases so does need for hedging.
• Increase use of off balance sheet activities- Though RBI limits various off balance sheet activities still private banks have started use it.
• Increase in customer credit through mortgages, home equity financing and credit card debt- Customer credit is linked with consumption. Boom in service sector resulted in Indian middle class people having more disposable income. Consequently demand in credit card and debt has gone up.

Too big to fall

An argument that has been referred against bank merger is that big banks become “too big to fall”. Fall of big banks have been problematic because of four reasons. First is deposits are insured by agencies, in India they are insured by Deposit Insurance and Credit Guarantee Corporation (DICGC) for a value up to `1 lakh , so any fall of big bank means big outlay by insurance agency and further crisis. Second is that most banks are interconnected with balance sheet exposure to other banks. So any fall may trigger a series of crisis. Third is the panic effect. Any big bank fall will result in panic and widespread withdrawal creating systematic bank crisis. Fourth if banks are big enough any trouble in bank may result in sovereign crisis which have been the case in Ireland recently.

Now in India no banks are big enough to trigger sovereign crisis. An indicator measuring bank asset to country GDP shows largest Indian bank has asset close to 24% of Indian GDP far below of what biggest Irish bank had(close to 100%).

Public sector Banks			Private Sector bank
	Asset(`crore)	Asset/GDP		Asset(`crore)	Asset/GDP
St Bk of India	1451219.84	0.260334	ICICI Bank	489827.2	0.0878701
PNB	303594.72	0.054462	HDFC Bank	223045.73	0.0400122
Bank of Baroda	284272.58	0.050996	Axis Bank	180619.29	0.0324013
Canara Bank	266841.6	0.047869	Kotak Bank	55114.81	0.009887
Bank of India	277204.01	0.049728
UBI	195509.44	0.035072

Table 1 Asset and asset to GDP ratio for big Indian banks (source Capitaline)

Challenges & Road Ahead

When compared on size globally Indian banks lack their peers in other emerging countries like China, Brazil according to BCG report on banking(BCG). The same report ranks banks on the basis of total shareholder return (TSR), consisting of capital gain and free cash-flow yield. Relative TSR (RTSR) is used as an indicator and on the basis of that among large cap banks SBI ranks 34^th in 2009 but when compared for the duration 2004-09 SBI climbs to 8^th spot. This proves higher performance of Indian banks during global crisis. Along midcap banks HDFC and HDFC bank takes 6^th and 8^th spot while ICICI bank grabs 22^nd spot on the basis of RTSR during 2004-09. The solid performance of Indian banks it is time to scale up to global peer and merge Indian business conservatism to western world’s best banking practices. Something that Indian companies in other sector like Tata Steel, Hindalco already doing.

Mergers have hit many roadblocks. Trade unions have acted against any kind of merger among PSBs in the past and they have been very strong in banking sector. Also heavy government holding in PSBs rules out any merger between PSB with private and foreign banks in near future. So major merger drives are expected to take place in private sector; which has indeed been the case as seen from appendix. PSB mergers have been driven by RBI dictate rather than being market driven.

Going forward there is little scope of big ticket mergers in Indian scenario happening in short run. But as the restriction on foreign banks are relaxed and Indian market evolves more, and regulatory requirement becomes stringent natural push will be toward consolidation. What needs to be kept in mind that consolidation will happen in Indian way and not necessarily following western models.

Bibliography

BCG. (n.d.). Creating Value in Banking 2010. Retrieved December 01, 2010, from http://www.bcg.com/documents/file39719.pdf

Jayadev, M., & Sensarma, R. (2007, October). Mergers in Indian Banking-An Analysis. South Asian Journal of Management, XIV(4), 20-49.

RBI. (2010). Discussion Paper on Entry of New Banks in Private Sector.

New Banks on the cards: The road ahead

By AJIT KUMAR MISHRA

INDIAN INSTITUTE OF MANAGEMENT INDORE

Shares of non-banking financial companies (NBFCs) such as Religare, IFCI, Mahindra & Mahindra Financial, Shriram Transport Finance, and Reliance Capital rallied aggressively after this release only to cool-off by the end of the day.These stocks went up hoping that the profitability of these NBFCs would improve if they were converted into banks. However, the road to bank conversion is more challenging than it appears. The issue of conversion of NBFCs into banks got a fillip after the Reserve Bank of India gave Kotak Mahindra the licence to convert into a bank last year.

Now, other large profitable NBFCs such as Sundaram Finance, Ashok Leyland Finance and Cholamandalam Finance have this option.Not that the RBI will be in a hurry to give these NBFCs a banking licence. But it is certainly an option for them considering that one of their competitors has opted for it.Importantly, with total assets of more than Rs 2,000 crore in the case of Ashok Leyland Finance and Sundaram Finance, they are even larger than some of the old private sector banks.

Uniformly, however, all the three NBFCs mentioned are not enthusiastic about converting into banks. Ashok Leyland Finance is sure that conversion into a bank may not even prove advantageous; that there is already a bank in the group — IndusInd Bank — may also be a reason for its lack of enthusiasm.However, even the other two look at the conversion option as a question that needs to be answered over the long-term.

A non-banking financial company (NBFC) is a company registered under the Companies Act, 1956 and is engaged in the business of loans and advances, acquisition of shares/stock/bonds/debentures/securities issued by government or local authority or other securities of like marketable nature, leasing, hire-purchase, insurance business, chit business, but does not include any institution whose principal business is that of agriculture activity, industrial activity, sale/purchase/construction of immovable property.A non-banking institution which is a company and which has its principal business of receiving deposits under any scheme or arrangement or any other manner, or lending in any manner is also a non-banking financial company (residuary non-banking company).

Differences between the NBFCs and Banks:

• (i) a NBFC cannot accept demand deposits (demand deposits are funds deposited at a depository institution that are payable on demand -- immediately or within a very short period -- like your current or savings accounts.)
• (ii) it is not a part of the payment and settlement system and as such cannot issue cheques to its customers; and
• (iii) deposit insurance facility of DICGC is not available for NBFC depositors unlike in case of banks.

However, to obviate dual regulation, certain category of NBFCs which are regulated by other regulators are exempted from the requirement of registration with RBI viz. venture capital fund/merchant banking companies/stock broking companies registered with Sebi, insurance company holding a valid certificate of registration issued by IRDA, Nidhi companies as notified under Section 620A of the Companies Act, 1956, chit companies as defined in clause (b) of Section 2 of the Chit Funds Act, 1982 or housing finance companies regulated by National Housing Bank.

The NBFCs that are registered with RBI are:

• (i) equipment leasing company;
• (ii) hire-purchase company;
• (iii) loan company;
• (iv) investment company.

With effect from December 6, 2006 the above NBFCs registered with RBI have been reclassified as

• (i) Asset Finance Company (AFC)
• (ii) Investment Company (IC)
• (iii) Loan Company (LC)

AFC would be defined as any company which is a financial institution carrying on as its principal business the financing of physical assets supporting productive / economic activity, such as automobiles, tractors, lathe machines, generator sets, earth moving and material handling equipments, moving on own power and general purpose industrial machines.

Principal business for this purpose is defined as aggregate of financing real/physical assets supporting economic activity and income arising therefrom is not less than 60% of its total assets and total income respectively.The above type of companies may be further classified into those accepting deposits or those not accepting deposits.

Besides the above class of NBFCs the Residuary Non-Banking Companies are also registered as NBFC with the Bank.

The NBFCs that are registered with RBI are:

• (i) equipment leasing company;
• (ii) hire-purchase company;
• (iii) loan company;
• (iv) investment company.

With effect from December 6, 2006 the above NBFCs registered with RBI have been reclassified as

• (i) Asset Finance Company (AFC)
• (ii) Investment Company (IC)
• (iii) Loan Company (LC)

AFC would be defined as any company which is a financial institution carrying on as its principal business the financing of physical assets supporting productive / economic activity, such as automobiles, tractors, lathe machines, generator sets, earth moving and material handling equipments, moving on own power and general purpose industrial machines.

Principal business for this purpose is defined as aggregate of financing real/physical assets supporting economic activity and income arising therefrom is not less than 60% of its total assets and total income respectively.

The above type of companies may be further classified into those accepting deposits or those not accepting deposits.Besides the above class of NBFCs the Residuary Non-Banking Companies are also registered as NBFC with the Bank.

The main reason for NBFCs being so keen on this change is access to low cost funds. Currently NBFCs cost of funds is around 15%, banks due to their float funds, current and savings account have a cost of funds of around 7%-8%. Also banks are part of the payment and settlement system while NBFCs do not have access to this. However this move would require NBFCs to ensure that the interests of the company and the depositors are not hurt in the bargain. Some NBFCs have hired consultants to give them recommendations on this.

In the long term this move will be good for NBFCs as they will have access to cheaper cost of funds. Also as many NBFCs are not very viable this provides an option to merge with stronger banks. For the banks they would benefit from a larger branch network and the strong brand equity of the leading NBFCs in the retail sector. Banks would also benefit from merging with some strong NBFCs who have high localised business presence and the banks will be able to encash on this and build it up further. From the depositors viewpoint they would suffer as they will have to put their deposits into banks which pay lower interest rates. However the stronger regulations for banks will make them safer for depositors.

The costs of conversion appear primarily to be dissuading factor. Though NBFCs can get low-cost savings and current account deposits, as also tax advantages, when they convert into a bank, they would also have to park a higher proportion in government securities.The statutory liquidity ratio is 25 per cent for banks while it is 15 per cent for NBFCs. Conditions such as mandatory priority sector lending are also viewed as imposing additional costs.

Overall, there is the feeling that the advantage of low-cost deposits is neutralised by the conditionalities of a banking licence. This has certainly made the NBFCs wary of conversion.

NBFCs are also not sure of transforming themselves into a bank, which involves more than lending to customers and managing assets.Skills relating to offering of products such as savings bank account, cash management services, forex management and so on need to be learnt. NBFCs are not certain if such skills can be acquired without making large capital investments.

As it is, the capital needs of their business are quite high. Being one among many in the banking industry compared to being among the top of the NBFC industry does not also sound such a great idea.The NBFCs may view the conversion into a bank as an opportunity to grow. Over the long-term, growth opportunities in the retail financing space may get constrained because of spread compression and single-digit volume growth. Conversion into a bank may be seen as an option to grow in size.That, however, seems a long way off. The prospect for growth in the next couple of years appears encouraging and these NBFCs seem to have the wherewithal to succeed in the market place.The experience of Kotak may also be keenly watched before a decision is taken. Kotak has taken the plunge and if it succeeds then the probability of Sundaram Finance or Cholamandalam exploring the conversion option seriously will increase.

However, of the various issues touched upon, the possibility of NBFCs converting into banks appears high, as these institutions are already regulated by the RBI and follow some of the prudential norms such as capital adequacy, provisioning norms applicable to banks.

In addition, historically RBI has given NBFCs with a good track record and low-NPAs an option to enter the banking sector. Only one NBFC, Kotak Mahindra Finance, availed itself of this option.Today NBFCs are also in a position to bring in the capital requirement, which maybe anywhere between Rs 300 crore and Rs 1,000 crore.

The advantages NBFCs would enjoy once they get converted into banks, is access to lower-cost deposits and improved leverage. Currently only a few NBFCs are allowed to access public deposits. As of March 2009, NBFCs had only Rs 21,548 crore as deposits outstanding against Rs 37,00,000 crore with the scheduled commercial banks.

The prudential norms prescribed by RBI for NBFCs and lack of access to low cost funds have suppressed their return on equity (RoE) as compared to banks. Profitability will go up with access to low-cost deposits and lower capital requirements.

However, the transition to a bank will not be easy for a NBFC.

Access to low-cost deposits would depend on the branch network and currently branch licences are scarce in metro and urban areas. Banks, with their first mover advantage, have already charted out huge branch expansion programmes which would increase the competition for low-cost deposits.

Once they convert to banks, NBFCs will also have to comply with Cash Reserve Ratio and Statutory Liquidity Ratio norms as well as the mandatory priority sector lending norms.

The concentrated loan-books which now allow some NBFCs to focus on lucrative niches and earn exceptional spreads may no longer be possible. Lending would need to become broadbased.

In addition, the conversion may entail a rejig in the branch networks of NBFCs and not all their existing branches may continue to be operational. While this move to open up entry into banking sector is positive for NBFCs it is not negative for the existing banks.

Despite the threat of increased competition, the impact will be low.In 2008-09, NBFCs accounted for 9 per cent of the total financial system assets, while commercial banks held a dominant 70 per cent of the assets. Therefore NBFCs are currently not of a scale to threaten existing banks.In addition, NBFCs will also forego the advantages of operating in an unregulated turf with concentrated exposures. Banks on the other hand, will get to enter the markets serviced by the .NBFCs

References: www.rbi.org.in

www.wikipedia.org

www.thehindubusinessline.com

How Do You Think 3 G Services Will Change India

After Sachin Tendulkar’s double century what is probably heard the most in India is 3G services. Department of telecom have planned to issue 3G licences in phased manner according to circles in which DoT has divided entire Indian telecom operations. What 3G is offering is basically high capacity data transmission and other value added services. With high competitive environment there is a tough race amongst all the telecom operators to get the licence to tap larger market share. With so much hoopla around 3G services more or less everyone is aware the potential benefit it will render to consumers at but in this article lets go a little behind the scene and find out how it will impact on telecom infrastructure which has gained altogether a separate industry status in past few years. Telecom infrastructure industry in India stands at nearly $28 billion. There are three main constituents of this industry Passive (steel tower), backhaul and active(BTS & microwave). Passive infrastructure being one of the most important components of a mobile network, the same has been a critical area of operations for telecom companies in the past. However, with increasing competition posing an urgent need for telecom companies to expand their coverage and sharpen their focus on core operations so that they can sustain and improve their market position, passive infrastructure has assumed the status of an independent industry during the past few years.

With the competition in Indian telecom industry set to intensify further for 3G services the key factor that would earn competitive advantage to the operators is faster rollout. Faster rollout necessitates the need for sharing of passive infrastructure. By sharing of passive infrastructure means that on a single tower more than one operator can install their active communication devices which was not the case earlier. This will change the entire working model of this industry. Not only will it bring down the operating expense of telecom operators but also at the same time will increase the revenue of ITICs(Independent Tower Infrastructure Company). According to ICRA’s estimate the improvement in a tower company’s profitability with increase in tower-sharing ratio to 49% (approx.). Analysis indicates that capital expenditure savings could reach US$4 billion if operators achieve double tenancy on deployed sites by 2010.Apart from faster rollout in race of providing affordable 3G service the only way Telecom Company could improve their ARPUs(average revenue per user) is to reduce their operating expense which is possible through tower sharing.

Initially larger telecom companies in order to focus on their core operation hived off their tower portfolios but with the increasing scope of tower sharing comes increase in revenue generation several large telecom companies are entering in to infrastructure business.

So in near future with the advent of new technologies like 3G not only will we see the change in the revenue generation model of tower infrastructure industry but also the telecom infrastructure industry will see the path of consolidation like formation of consortium of leading GSM players as Indus tower.

References:

Booz & Company report, ICRA’s report

Written By:

LEENA CHAND

MBA-IB

2009-11

IIFT Kolkata

RBI’s Proposed Rules For Granting New Private Bank Licenses

Financial inclusion has been the priority of the government since quite some time. In order to achieve its target of total financial inclusion in the country by March 2011, the government has been adopting several steps. Amongst them was the proposal given by Finance Minister, Pranab Mukherjee during Budget 2010-11 that new banking licenses be granted to eligible corporates and non banking financial companies (NBFCs). Banking regulator, Reserve Bank of India has been working on the issue for some time and has come up with draft guidelines for issuing fresh banking licenses. The fact that the level of regulation is quite less for NBFCs than banks might pose an issue for these companies in getting a bank license.

Adequate capital requirement is likely to be an important criterion to be eligible for obtaining a banking license. This is because an entity with strong capital base can aid better to the goal of financial inclusion. If that be the case, then corporate houses stand a fair chance of getting selected in the race. But a key disadvantage associated with handing a license to Corporates lies in the fact that they might get biased towards their respective associate companies and subsidiary units and gives lesser priority to other clients and in times of crisis it can quickly increase the amount of bad loans. This disadvantage cannot be seriously overstated enough as it is believed that the presence of large Corporate-owned banks was one of the key reasons for the Asian Financial Crisis of 1997. Indeed the RBI has long been opposed to the idea of corporate owning banks, a policy it has completely reversed this year as a result of the Finance Minister’s announcement. It is believed that, as a result, the biggest corporate houses in the country like Reliance, Tata Group and AV Birla Group are all eying the lucrative possibility of starting their own banks.

So is the RBI undertaking sufficient precautions after taking cues from the experiences of other countries while drafting the policies for new private bank licenses? The draft discussion paper released in August this year suggests that RBI is indeed undertaking an extensive study of all the different issues involved. It has justified the rationale for simplifying the issue of bank licenses by stating that, “a larger number of banks would foster greater competition, and thereby reduce costs, and improve the quality of service.” On the other hand it has also suggested, quite rightly, that if corporate houses are to be given licences, there has to be amendments to various statutes and acts. There are several deep rooted fears in allowing industrial and business houses to own banks, the paper said. Conflict of interest, concentration of economic power, likely political affiliations and potential for regulatory capture were some of the concerns listed by the RBI. “When banks are flush with liquidity, there is a great risk of diverting the funds to liquidity constrained operations of the group,” the paper said. Further, the paper has said that companies and even non-banking financial entities directly or indirectly involved in real estate should not be allowed to promote banks. As an intermediate step, however the paper suggested that, industrial and business houses could be allowed to take over regional rural banks.

The RBI has invited suggestions from banks, non-banking financial institutions, industrial houses, other institutions and the public at large on six aspects.These are: minimum capital requirements for new banks and promoters contribution (net worth of Rs 500 crore or Rs 1,000 crore), minimum and maximum caps on promoter shareholding and other shareholders, foreign shareholding in the new banks (50%), whether industrial and business houses could be allowed to promote banks, should non-banking financial companies be allowed conversion into banks or to promote a bank and business model for the new banks.RBI listed three options, namely having a low minimum capital requirement but above Rs 300 crore, a minimum requirement of Rs 1,000 crores, and that of Rs 500 croreswith a condition to raise the amount to Rs 1,000 crores within five years. Suggestions were accepted till September 30 and now the Central Bank is working on the Final Guidelines after going through the feedback.

There is one aspect that the paper is however clear on- that companies with real-estate linkages should not be allowed to set up banks. The RBI has said that it fears for financial stability if an industrial house that is involved in real-estate also establishes a bank. The regulator stated that given the sensitivity of the real-estate sector, any sub-version of the Chinese wall between the bank and rest of the group could have extremely negative consequences for financial stability. Individual promoters are also unlikely to get another shot at what’s a lucrative business since their past performances have been far from satisfactory as seen from the failures of banks like Global Trust Bank.

While this is expected to be a long drawn-out process, it is expected that the tight licensing regime is now irrevocably changing for the better and the customers- i.e. the people of India will be hugely benefited if the process is carried out right.

Written By:

Arka Khasnabis

MBA (IB) 2009-11

IIFT Kolkata

Microfinance from an Indian Perspective

The term microfinance has been a part of the common man’s dictionary for quite some time now. Considering the exponential growth that the entire microfinance sector has shown in the past few years, I guess it’s time to take a good long look at this newest animal in the zoo after witnessing the innovative financial instruments of the financial institutions of the U.S. and the common currency economic model of Europe.
The concept of microfinance, contrary to the popular belief, is not new and it has captured the minds of many social reformers over the past few centuries. However, its first successful implementation was during the microcredit movement of the 1970s which was spearheaded by Muhammad Yunus and his Grameen Bank. This bank now serves over 7 million Bangladeshi women. Since then, the microcredit movement has gained huge momentum in S-E Asia and many other developing countries of the world. India is no exception.
In India, SKS Microfinance is the top institution in terms of loan amount outstanding. It has disbursed over Rs 10 billion till date and it raised Rs 1,654-crore through its IPO launched on 28th July. It has already roped in high profile investors like Narayan Murthy and the Quantum Hedge Fund founded by the billionaire investor George Soros. This is surely going to rev up the microfinance market. Another positive indicator for the microfinance in India is the Forbes Top 50 list of microfinance institutions. There are 7 Indian institutions in this list with Bandhan Society coming in at number two. If it looks all too well for the future of microfinance, then it must be noted that presently, a microfinance bubble is feared in South India as most of the MFIs are located in this region. In fact, a repayment crisis in Southern Karnataka has significantly dented some MFI portfolios in the region.
Though microfinance was once being hailed by many economists as the single handed solution to the problem of poverty, there are many issues when you take a broader perspective. Firstly, microfinance is looking increasingly unprofitable in regions with low population density. This is because of the fixed costs associated with maintaining a regional branch. Here, it’s worth mentioning that the main reason why traditional banks don’t provide loans to the poor is because of the fixed costs associated with maintaining an account. The revenues from a loan and the associated fixed cost incurred by banks match at one point and banks refuse to lend where the revenues are below that point. Similar problems are faced by MFIs operating in regions with low population density.
Secondly, microfinance is necessary but not sufficient to solve the problems of the poor. Poor needs micro-insurance and money transfer facilities as well. And then, in some situations, private moneylenders appear as a better option over the MFIs. The reason is that private moneylenders provide flexible repayment schedules and they almost never ask why the borrower needs that loan. On the other hand, MFI loans are mostly restricted to starting up small enterprises. So, people do shore up to moneylenders in spite of the fact that they charge considerably high interest rates.
So, though the future of microfinance looks bright, there are some issues that must be addressed along the way. However, if we can achieve a sustainable model for microfinance, then we will have a scheme through which the rich can alleviate poverty profitably. Combine that with other social policies like NREGA and what you get is growth for every section of the society.

Could Glass-Steagall Act have saved us from Recession?

Contributed By:
Kushal Masand, IIFT Batch of 2012

The economic recession from which we are still recovering from, has brought with it a number of questions. Some of these questions will remain unanswered,not because we don’t have enough statistical data to prove it, but it will be impossible to expect economists from around the world to agree upon a single reason.
Moreover, in today’s complex economic world, there is only one thing on which economist can agree upon, and that is, a number of reasons joined force together to bring the recession of this level seen only during Great Depression. Some of these factors are sub-prime mortgage crisis, over-complicated financial instruments, bubble in commodity prices and real estate, unbalanced economic trade, easy credit conditions, regulations not able to keep pace with financial innovation, increased importance of shadow banking. These are some of the many reasons which contributed in recession.
One of the factors which lead to the economic recession has been the havoc the investment banking business, seen by many as risky,on to the commercial banking business, seen as traditional and not risky. To an idea how the securities played an important role in the recession can be understood by the fact that how mortgages were converted into AAA ranked debt securities under names as collateral debt obligation (CDO), Mortgage based securities (MBS), assets bases securities (ABS). But when another fact is added to this scenario that these securities were created not only from the good quality mortgages but also consisted of poor quality securities. By converting the mortgages to securities the banks havee removed the risk from their balance sheets and at the same time have created more liquidity to give more sub-prime mortgages, thus further increasing the risks for the people buying these securities. This all went well till the real estate prices were increasing and once the bubble burst all these securities turned into toxic assets which had to be pruned at the cost of tax-payers money.
Now let us see what were the changes brought by the Banking Act of 1933 popularly known as the Glass-Steagall Act.
Glass-Steagall act was introduced in 1933 by Senator Carter Glass and Congressman Henry Steagall. This act came after the Great Crash of 1929, during which one of every 5 American banks failed. Many people thought that the market speculation created by banks as the cause of this crash. This act was created to separate the investment banking business of the traditional commercial banks. It prohibited bank sales of securities and created Federal Deposit Insurance Corporation (FDIC), which insures deposits which guarantees the safety of deposits in member banks. In the early 1900’s, many commercial banks created there investment banking arms which corporate stock issues. This continued till great crash of 1929, after which a number f banks failed and the people confidence in US financial structure was low. To restore the public confidence, the Glass-Steagall Act was enacted. It prohibited the banks from using their own assets to invest in various securities. In 1920’s , a number of commercial banks were found guilty of misusing the depositors fund to acquire and trade into stocks and bonds.
So what Glass-Steagall act did was to strengthen the Federal Reserve. Member banks of Federal Reserve have to report all investment transactions and loans. Also it was mandatory for banks belonging to federal reserve to join FDIC and in order to join FDIC the had to be in sound financial position. Thus in the hindsight the act brought Darwin’s law of “ Survival of the fittest “ in the financial world of US banks where only the strong banks were able to survive. Thus by 1934, the failures of banks stopped and many banks reopened after joining the FDIC.
Now let us see how the Glass-Steagall Act was repealed layer by layer. The first effort started when some brokerage firms began encroaching in the banks territory by offering accounts that pay interest and offer credit and debit cards. Then in 1986, the Federal Reserve, under the pressure from Wall Street and intense lobbying, reinterpreted the section 20 of the Glass-Stegall Act, which bars commercial banks from engaging in the security business. It decided that banks can have 5 percent of their gross revenues from investment banking business.
Then in 1987, the fed board hears a proposal from the Citicorp, J.P. Morgan and Bankers Trust to allow banks to underwrite several securities like MBS and commercial paper. In the same year the Fed allows Chase Manhattan to underwrite the commercial paper. And at the same time it indicated that it may increase the limit that investment banking business can contribute in the gross revenues of the banks to the order of 10 percent.
In 1989, the Fed board approves the application from a number of banks to deal not only in commercial paper and municipal securities but also in debt and equity based securities.



In 1996, the Federal Reserve Board, under the Chairmanship of Alex Greenspan, a former director of J.P. Morgan, comes out with the rule that the investment banking business can contribute a hefty 25% to the gross revenues of the banks. Without considering that any bank holding company can remain under stipulated 25% norm.
Finally on 22nd October 1999, after 12 attempts iin 25 years, Congress repealed the Glass-Steagll Effect. A number of reasons were given to repeal the act. Some of them were that the investors are more knowledgeable today, and the existence of the sophisticated agencies, and the fact that banks of other countries doesn’t have to work under any regulations of such kind.
Now we come to question, had the Glass-Steagall Act had not been repealed, could we have saved ourselves from the economic downturn we are suffering from?
Some people say that it is most obvious to reinstate the Act, and the fact if it had not been repealed, the we couldn’t have seen the banks engaging themselves in so much of business relating to securities and creating toxic assets not only for themselves but also for the investors worldwide. And we didn’t had to save the so-called “ too big to fail “ banks which cost taxpayers their dearer money and could have been used to strengthen the public system, during the turnmoil.
Others advocate that the shadow banking system i.e. is nonblank lenders like Bear Stearns, Lehman Brothers, Goldman Sachs and Morgan Stanley sits at the epicenter of this turnmoil and that the fact these resides outside thee jurisdiction of Glass-Steagall Act. Also that banks like Washington Mutual, which collapsed even without the investment banking arm.
Economist can support either of the cause, but it is hard to remember any big banks which have failed during the time period of the Glass-Steagall Act. So it is to be decided by the conscience of the bankers and the tougher regulations from the governments that the world doesn’t have to suffer from a recession of such scale.

Why Goldman Sachs made money & UBS lost during recession?

Contributed By: Shashank Kyatanavar
IIFT MBA (IB) 2010-12 Batch, Kolkata

The belief is investment banks more than any other institutions created the culture of excessive leverage, excessive risk and excessive bonuses that led to the downfall of the financial system, hence consequently should be the first ones to go under. But big daddy of investment banking, Goldman Sachs, debunking this theory earned a handsome profit & gave bonus; a bonus which infact is the largest bonus payouts in the company’s 140 year history.
On other hand we have one the safest destination where wealthiest people park their money , the Swiss Bank and the largest among them, Union Bank of Swizerland(UBS) suffering huge loss, an amount that is more than the sum needed to rescue Greece! Let’s try to understand this which seem to turn logic on its head.
Starting with UBS, it has lost about SwFr60 billion since the start of the credit crunch, partly because it was one of those deepest into the subprime, but also because it has fallen foul in a big way of the most countries tax authorities, especially US, who discovered by various means that the bank had been encouraging its residents to bank with it and engage in schemes which would avoid tax. This eventually led to a punitive settlement the fallout of which has been too much for a lot of clients and effect that they have took their business elsewhere. As a result the net money outflow for the division known as “Wealth management and Swiss Bank” was Swfr 33 billion, the division known as Wealth Management Americas lost Swfr12 billion and the Global Asset Management division had an outflow of Swfr11 billion
Goldman Sachs on other hand has reduced its overall leverage from a year ago with its fixed-income business, a less-risky arena than the illiquid derivatives and others products it loaded up on amid the credit bubble. It not only managed risk better, but it dramatically reduced is exposure to sub-prime mortgages. It also saw an opportunity in recession where it created a financial product that allowed one hedge fund, to bet against the value of housing. Also, the company has benefited because competitors like Lehman Brothers went bankrupt.
So is Goldman Sachs merely being punished for being a better bank than its peers? The answer is probably yes. And the reason for Goldman's profits - the source of the bonuses - are not from lending but from trading, using its own capital to buy stocks and bonds, and selling stocks and bonds short. And the reason Goldman Sachs thrived is just that it learned to play better than anyone else.