Tag: Moral Hazard | Page 2

4 April, 2016

The Moral Hazard of Settling with Vijay Mallya

I’m gonna make him an offer he can’t refuse. Okay? I want you to leave it all to me. Go on, go back to the party. – Don Corleone in The Godfather

Vijay Mallya has made an offer to banks to settle the Rs 9,091 crore that he owes them. He has promised to pay Rs 4000 crore by September 2016. He has also promised to pay Rs 2,000 crore if wins a case against a company, which allegedly supplied defective engines to the now defunct Kingfisher Airlines.

Has Mallya made an offer which the banks should not refuse? Many analysts and experts seem to be of the opinion that banks should take on this offer and in the process limit their losses. Parag Jariwala, vice-president at Religare Capital Markets told the Mint newspaper that “Mallya’s settlement offer to banks is not too bad…The actual loss if banks accept Mallya’s proposal will be just 7% on principal.”

Over the last couple of days many people on Twitter have told me that “something is better than nothing’’ and given this banks should accept Mallya’s proposal and limit their losses. Honestly, this is a very simplistic way of looking at things. It would have perhaps made some sense if Mallya was the only or perhaps one of the few defaulters in town. But that is not the case.

Mallya owes Indian banks around Rs 9,091 crore. This is a very small amount when we look at the total amount of money owed by various corporates to Indian banks. The minister of state for finance Jayant Sinha shared some interesting data in a written reply to a question in the Lok Sabha, on March 11, 2016.

The accompanying table shows us how big the problem of banks’ lending to corporates actually is.

Rs. in Crore
Corporate Lending
Year	Gross Advances	Gross NPAs	GNPA Ratio
2012-13	31,11,761	1,00,118	3.22
2013-14	34,06,025	1,54,955	4.55
2014-15	36,15,133	1,93,123	5.34
2015-16 (till Dec. 15)	38,41,836	2,60,653	6.78

The gross non-performing ratio has more than doubled between 2012-2013 and December 15, 2015. It has jumped from 3.22% to 6.78%. The gross non-performing ratio is essentially obtained by dividing gross non-performing assets by gross advances or total loans given by the banks, in this case to corporates.
And how do we define gross non-performing assets? As the per the Reserve Bank of India: “An asset…becomes non performing when it ceases to generate income for the bank.” When the corporate borrower stops paying interest and repaying the principal on a loan (a loan is an asset for a bank), the bank typically allows for a grace period of 90 days. After this grace period is over, the bank categorises the loans as a non-performing asset and starts setting aside money (or making provisions) for it. The total sum of such loans forms the gross-non-performing assets or bad loans.

If we look at total bad loans of Rs 2,60,653 crore, Mallya’s loans of Rs 9,091 crore form only 3.5% of the total bad loans. If the banks decide to settle with Mallya, they will end up setting a precedent. Then other defaulters will also want to settle and not pay up what they owe to the banks. Do they banks really want to end up in such a situation?

While settling with Mallya may not hurt banks financially much, the same cannot be said of a scenario where they were to start settling the Rs 2,60,553 crore corporate bad loans in total.

Also, any such settlement will build in “moral hazard” into the financial system. And what is moral hazard? As Mohamed A El-Erian writes in The Only Game in Town: “[It] is the inclination to take more risk because of the perceived backing of an effective and decisive insurance mechanism.”

If the banks start settling with corporates what is the signal that they are sending to the future corporate borrowers? That it is okay to take on a lot of risk with the money that they borrow from the bank or simply siphon it off. And if things go wrong, they can always settle with the bank for a lower amount.

Hence, it is very important that such a wrong precedent is not set.

On a different note, Mallya’s offer raises several other questions. If he is in a position to pay Rs 4,000 crore to banks why did he leave the country? Or why did he not pay the salaries of the employees of Kingfisher Airlines and leave them in a lurch?

Or does all this tell us that the former king of good times is simply buying time? On that your guess is as good as mine.

The column originally appeared in the Vivek Kaul Diary on April 4, 2016

17 December, 2014

Why the govt should not be rescuing SpiceJet

SpiceJet has approached the government for financial help. The top officials of the airline met the Minister of State for Civil Aviation Mahesh Sharma, a couple of days back.
“We have given no assurance to SpiceJet. We will take a final decision keeping wider interest of passengers in mind,” Sharma told the press after the meeting. He also said that the request for financial help would be put before the petroleum and the finance ministries, as well as the prime minister’s office.
A newsreport in The Times of India suggests that the officials of SpiceJet told Sharma that the airline had an immediate cash requirement of Rs 1,400 crore and an overall requirement of Rs 2,000 crore.
The airline, like Kingfisher before it, owes money to employees, airports and oil companies. Over and above this there are statutory dues that remain unpaid. The airline has provided a guarantee that it would clear the dues worth Rs 200 crore that it owes the Airports Authority of India (AAI),
which operates most airports in the country.
Yesterday the government allowed SpiceJet to book tickets up to March 31, 2015. Earlier, the airline wasn’t allowed to book tickets beyond thirty days.
This will help the airline in two ways. First, it can honour the bookings that it had made earlier and will not have to cancel these bookings. Cancelling the bookings would have meant paying back the customers who had booked tickets, and this would mean outflow of cash for the airline. The airline is currently running short on cash.
Secondly, the airline can make fresh bookings and in the process raise some money. It will be interesting to see if the airline uses this opportunity to announce flash sales. This is how the company has been operating this year.
A report in The Hindustan Times quotes an unnamed expert as saying: ““In a bid to raise working capital, the airline started frequently coming up with flash sales. It was their desperation to raise working capital as they waited for an investor.” In a bid to shore up its working capital the airline has announced over 25 sales this year.
It will be interesting to see if consumers book seats on SpiceJet given that in the last few months the airline has used what aviation industry insiders term as the “Christmas tree” option. This essentially means that the airline is taking out spare parts from its aeroplanes and using them for other planes in its fleet. Long story short: it doesn’t even have the money to pay for spare parts. So, the question will consumers feel comfortable travelling in such an airline?
Further, the government also allowed the airline to operate for another 15 days without paying up the Rs 200 crore that it owes AAI and Rs 80 crore that it owes to other companies operating airports in the country. The company also owes Rs 14 crore to oil marketing companies.
The Times of India report quoted earlier goes on to suggest that the government may be working out a “’revival package’ for SpiceJet as it fears shut down of yet another big airline after Kingfisher — both poor companies of rich promoters — ‘will send a bad signal globally’.”
Another PTI report suggests that the government may request banks to give loans of up to Rs 600 crore to SpiceJet, so that it has enough money to keep operating.
If the government does anything like that it will be setting a bad precedent by building in moral hazard into the system. As economist Alan Blinder puts it in After the Music Stopped : “ [the]central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains (and incur costs) to avoid it.”
A very good example of this in an Indian context is Air India. Its employees know that the government will not shutdown the airline and keep pumping money into it, and given that they have very little incentive in turning it around.
While this is not the only reason for the disastrous performance of Air India, it remains one of the major reasons. Its employees know that the government will not shut-down the airline because the politicians need their free airline rides at the end of the day and that is only possible with Air India around.
The airline made a loss of Rs 5,400 crore in 2013-2014. During this year the airline will see a total capital infusion of Rs 6,000 crore from the government. Such capital infusions have become a regular feature of Air India’s survival kit. The airline also has a total debt of close to Rs 40,000 crore.
One look at these numbers tells us that SpiceJet’s requirement of Rs 2,000 crore is rather small in comparison. Nevertheless, it is important to point out here that once bailouts start they can’t be scaled back, as central banks all over the world realized in the aftermath of the financial crisis.
Further, if the government chooses to rescue SpiceJet, after this every airline in trouble will expect to be rescued by the government and so might other companies as well. And this is exactly what moral hazard is all about.
Other than encouraging the insiders to take on increased risk, it gives them the impression of the world being a safer place to do business in than it actually is. This is because the firms assume that in case of a crisis, the government will come to their rescue. And this is not good for the system as a whole.
Also, as I have often pointed out in the past, the government isn’t exactly overflowing with money. The tax collections this year have been nowhere as expected. The disinvestment programme is yet to take off. And the fiscal deficit for the first seven months(April to October 2014) of the financial year has already burgeoned to 89.6% of the annual target.
Further, as I had pointed out in a previous piece on SpiceJet, it is worth remembering that the commercial aviation business is a huge cash guzzler and has led many a capitalist to his ruin. This is not only an Indian phenomenon, it seems to be the case globally. A February 2014, article in The Economist suggests that profits margins of airlines have been less than 1% on average over the last 60 years.
In this scenario, it doesn’t make any sense for the government to rescue SpiceJet. Further if they choose to rescue SpiceJet, they will essentially be rescuing a crony capitalist, who built his main “media” business with the blessings of a political party. This will not be a good thing to project for the government.
It is important to remember here what Raghuram Rajan and Luigi Zingales write in Saving Capitalism from the Capitalists: “Since a person may be powerful because of his past accomplishments or inheritance rather than his current abilities, the powerful have a reason to fear markets…Those in power – the incumbents – prefer to stay in power.” Even if it means begging the government for a rescue.
Rajan and Zingales further elucidate on this point: “Throughout its history, the free market system has been held back, not so much by its own economic deficiencies as Marxists would have it, but because of its reliance on political goodwill for its infrastructure. The threat primarily comes from…incumbents, those who already have an established position in the marketplace…The identity of the most dangerous incumbents depends on the country and the time period, but the part has been played at various times by the landed aristocracy, the owners and managers of large corporations, their financiers, and organised labour.”
Keeping these points in mind, if the government does decide to rescue SpiceJet, it will be helping another crony capitalist survive without having to face the consequences of his actions. This can’t be good for the government which anyway gives an impression of being close to big business.
To conclude, it is important to remember what the American economist Allan Meltzer once said: “Capitalism without failure is like religion without sin. It doesn’t work.”

The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning, as on Dec 17, 2014.

10 December, 2014

What central banks can learn from the Indian cricket team

A few days back, a list of thirty probables who could make it to the Indian cricket team for the 50 over cricket World Cup scheduled in Australia early next year, was declared. Interestingly, only four out of the 15 players who had played for India in the 2011 World Cup, made the cut.
This disbanding of the Class of 2011 led to a lot of nostalgia in the media. In one such piece published on www.cricinfo.com, the writer said: “The class of 2011 has been well and truly disbanded. Only four have made it through to the 2015 list…For the rest, all we have for now are memories.”
I sincerely feel that instead of being nostalgic about the entire thing we should be happy about the situation. The selection of players is just about the only thing that is currently right about Indian cricket, which remains surrounded by a whole host of controversies.
The players who did not perform over the last few years (the likes of Virender Sehwag, Gautam Gambhir, Zaheer Khan, Harbhajan Singh, Munaf Patel and Piyush Chawla who played in the 2011 World Cup) have fallen by the wayside and have had to make way for a new set of players.
And that is how any market should operate. The non-performers need to be weeded out and not rescued. Nevertheless, that is not how the world at large operates. A great example of this are the financial firms all over the world, which had to be rescued by central banks in the aftermath of the financial crisis that started in September 2008, around the time the investment bank Lehman Brothers went bust.
As Nigel Dodd writes in The Social Life of Money: “Since the collapse of Lehman Brothers in September 2008, the world’s major central banks have been plowing vast quantities of money into the banking system. The U.S. Federal Reserve has made commitments totalling some $29 trillion, lending $7 trillion to banks during the course of one single fraught week…The U.K. government has committed a total of £1.162 trillion to bank rescues. The European Central Bank has made low-interest loans directly to banks worth at least €1.1 trillion.”
Scores of financial institutions across the United States and Europe were bailed out, nationalized, or simply merged to ensure that they continued to survive. If these financial institutions had not been rescued, the trouble would have spilled over to other financial institutions and from there to the general economy. This would have had a negative impact on the economic growth of the countries which they belonged to. Hence, it was necessary to rescue them. This was the explanation offered by central banks and governments which came to their rescue.
Soon after the central banks came to the rescue of financial institutions a quotation “supposedly” from Karl Marx’s Das Capital went viral on the internet: “Owners of capital will stimulate the working class to buy more and more of expensive goods…until their debt becomes unbearable. The unpaid debt will lead to bankruptcy of banks, which will have to be nationalized, and the State will have to take the road which will eventually lead to communism.”
As Dodd puts it: “The passage appeared on countless blogs…The quotation was a fake.” Nevertheless, whoever wrote it summarised very well how things had turned out in the aftermath of the financial crisis.
The move to rescue financial firms all over the world built in a huge amount of moral hazard into the financial system. As economist Alan Blinder puts it in After the Music Stopped : “ [the]central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains (and incur costs) to avoid it.”
Moral hazard, other than encouraging the insiders of the financial system to take on increased risk gives them the impression of the financial system being a safer place to do business in than it actually is. This is because the financial firms assume that in case of a crisis, the government(s) will come to their rescue. And this is not good for the financial system as a whole.
Interestingly, in the aftermath of the financial crisis, the American government passed the Dodd–Frank Act. The Act, prohibits government bailouts and the form of support that the Fed used to bailout AIG and other financial institutions. In fact, when he signed the bill into law, Barack Obama, the President of the United States said: “The American people will never again be asked to foot the bill for Wall Street’s mistakes.” He went on to add that in the time to come, there would be “no more taxpayer-funded bailouts.”
But former Federal Reserve Chairman, Alan Greenspan, does not buy this at all. In his book The Map and the Territory, Greenspan writes that “most of the American financial system would be guaranteed by the US government,” in the event of the next crisis. He explains his reasoning through an example.
On May 10, 2012, J.P. Morgan, the largest bank in the United States, reported a loss of $2 billion from a failed hedging operation. The loss barely reduced the bank’s net worth. And more than that, the shareholders of the bank suffered the loss and not its depositors. Nevertheless, the loss was considered to be a threat to the American taxpayers and Jamie Dimon, J.P. Morgan’s CEO, was called to testify before the Senate Banking Committee. Why did this happen?
As Greenspan writes: “The world has so changed that this…loss was implicitly considered a threat to taxpayers. Why? Because of the poorly kept secret of the marketplace that JPMorgan will not be allowed to fail any more than Fannie and Freddie have been allowed to fail. In short, JPMorgan, much to its chagrin, I am sure, has become a defacto government sponsored enterprise no different from Fannie Mae prior to its conservatorship.”
Fannie Mae and Freddie Mac were government sponsored financial firms which the United States government had to take over in early September 2008. Greenspan further points out that: “When adverse events depleted JPMorgan’s shareholder equity, it was perceived by the market that its liabilities were effectively, in the end, taxpayer liabilities. Otherwise why the political umbrage and congressional hearings following the reported loss?”
To conclude, this also explains to some extent why global financial firms have been borrowing money at rock bottom interest rates, and investing them in “risky” financial markets all over the world. They know that if things go wrong, the central banks and the governments are likely to come to a rescue.
As Anat Admati and Martin Hellwig write in The Bankers’ New Clothes: “It is very difficult for governments to convincingly commit to removing these guarantees. In a crisis it will be even more difficult to maintain this commitment and provide no support to institutions that are deemed critical for economic survival. Once a crisis is present, it may even be undesirable to do so, because letting banks fail in a crisis can be very damaging.”
Or as the Americans like to put it “You ain’t seen nothin’ yet”.

The article originally appeared on www.equitymaster.com as a part of The Daily Reckoning, on December 10, 2014

11 June, 2014

Modi's first fiscal challenge

Vivek Kaul

N Chandrababu Naidu, the chief minister of new Andhra Pradesh (what remains of the state after the creation of Telangana), wants to waive off bank loans to farmers and women’s self-help groups amounting to a whopping Rs 54,000 crore. Naidu promised this freebie during the course of the election campaign and now wants to fulfil it.
The trouble of course is that the banks which made these loans will have to be adequately compensated. And for that the newly elected state government will need money, which it does not have. It is estimated that the revenue deficit of Andhra Pradesh will amount to Rs 13,579 crore during the course of this financial year(April 1, 2014 to March 31, 2015). Revenue deficit is the difference between the revenue expenditure and the revenue income of a government.
Hence, the question is where will the government get this money from? Naidu is hoping that the Narendra Modi led government at the centre (BJP fought elections along with Naidu’s Telgu Desam Party both at the state and the national level) will help him fulfil his electoral promises.
But the central government is already stretched on the finance front. In the interim budget presented in February 2014, the fiscal deficit for this financial year was projected to be at Rs 5,28,631 crore or 4.1% of GDP. Even this projection was primarily achieved by cutting down on the asset creating planned expenditure and by not recognising’certain’expenses which in total amounted to more than Rs 1,00,000 crore. Hence, the actual fiscal deficit would have been significantly higher. Fiscal deficit is the difference between what a government spends and what it earns.
If the central government chooses to assist the new Andhra Pradesh government with the entire Rs 54,000 crore that is needed, then it will end up adding to its already high fiscal deficit. In fact, the amount that the new Andhra Pradesh government needs to waive off loans is more or less equal to the assistance that the old Andhra Pradesh received from the central government over the last 10 years(between 2004-2005 and 2013-2014). This assistance amounted to a total of Rs 54,613.4 crore. This comparison clearly tells us the astonishing amount of money that is needed to write off these loans.
One reason that the Modi government might choose to entertain Naidu is the fact that it does not have enough numbers in the Rajya Sabha. But if it entertains Naidu, then it will also have to entertain the likes of Naveen Patnaik and J Jayalalitha, who have been demanding special packages for their states, in return for their support in the Rajya Sabha. And where is all that money going to come from?
Also, it will go against the Modi’s entire electoral pitch of the government creating an enabling environment that allows people to progress, instead of giving out doles to them. It is worth remembering here that the new Andhra Pradesh has around 5% of India’s population. Given that, the question is that whether the central government should be spending such a huge amount of money in a single year on one single state? And the answer is no.
The other option for the new Andhra Pradesh government is to borrow this money by issuing bonds. The trouble is that a state cannot borrow an unlimited amount of money. The borrowing limit for old Andhra Pradesh had been set at Rs 29,000 crore, at the beginning of this financial year. Hence, the borrowing limit for the new Andhra Pradesh will clearly be less than that. Also, as pointed out earlier the state is already expected to run a revenue deficit of Rs 13,579 crore during this financial year.
The moral of the story is that the math for waiving off loans made to farmers and self help groups, does not really work out. News reports suggest that the bankers have requested the ministry of finance to try and convince the new Andhra Pradesh government, not to go ahead with this plan. Other than the math not working out, there are other reasons why the new Andhra Pradesh government shouldn’t be going ahead trying to waive off loans.
First and foremost, it is not fair on the people who have honestly repaid their loans in the past. Also, it will reward those who have defaulted on their loans.
Second, it brings the issue of moral hazard to the core. Economist Alan Blinder in his book After the Music Stopped writes that the “central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains(and incur costs) to avoid it.”
What it means in this context is that after the loans are waived off this time around, people of the state of new Andhra Pradesh, will think twice before repaying their loans, in the days to come. If the government can waive off loans once, why can’t it do it all over again, is a question that the people of Andhra Pradesh will be asking themselves?
Third, in the next election the Telgu Desam and the other parties, will compete to promise even bigger freebies.
Fourth, loans being waived off benefits those people who are in a position to take a bank loan, in the first place. Typically, farmers with large landholdings tend to fall in this category. The small farmer is not in a position to fulfil the requirements that need to fulfilled in order to take a bank loan. Hence, the question is do the large farmers really need to be subsidised?
Fifth, the government of Andhra Pradesh needs to build a new capital over the next years. It will need a lot of money in order to do that. Hence, it makes sense for it to be fiscally responsible during its initial years.
All these reasons suggest that Chandrababu Naidu should reconsider his decision of waiving loans to farmers and self help groups of the New Andhra Pradesh.

The article originally appeared in The Asian Age/Deccan Chronicle dated June 11, 2014.
(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])