Re-visiting Modern Accounting Standards

Should acquisition cost of an asset depend on how it is financed?

To my mind, and to most non-accountants, the simple answer seems to be No. But that is not how modern accountants see it. Costs incurred (including interest) till the time an asset is ready for use is treated as part of the cost of the asset. Whatever compulsions may have been behind adoption of such a treatment as standard, it tends to militate against simplicity, and creates needless (in my view) complexity.

Can a company have Net Profit After Tax equal to double its turnover for a quarter?

Common sense tells us that this is impossible. How can profits exceed turnover, that too profits after tax? However, modern accounting is not all common sense. Or maybe, it is such highly developed common sense that it takes truly uncommon levels of sense to understand why this can happen. As it happens, there are several reasons why this can happen. Deferred Taxation Accounting (DTA) is one of the reasons. DTA is one more area where accounting has been made dreadfully complex. So much so that it creates situations occasionally as the one described in the question above, where quarterly Net Profits After Tax of some companies exceed even quarterly revenues! How can accountants explain to laymen this paradox – where, say, the quarterly turnover of a manufacturing company is Rs.50 crores and its NPAT is Rs.90+ crores? Most accountants trying to explain this situation will end up tying themselves and their listeners in knots. This happens in the relatively rare instance when a company has just turned the corner after several years of losses. One argument in favour of the currently favoured treatment of deferred taxes is that it makes clear the differences in expected tax provision on reported profits, and the actual tax provision. However, we lose sight of the fact that the net result of the income statement becomes almost impossible to understand, even to reasonably financially literate individuals. Surely, this could not have been the intent of introducing such accounting treatment!

Is it a bad thing to allow retired employees medical treatment for life in hospitals run by the company?

Certainly, one cannot fault managers in Tata Steel if they begin to think like this. Accounting for Employee Benefits is another area where accounting complexity has reached ridiculous levels (in my view). Tata Steel used to routinely allow their retired employees and their families to be treated in the wonderful hospital they have built in Jamshedpur; and absorb and meet the net losses or cash shortfalls of that hospital quite routinely, as part of its employee-friendly initiatives. Let us say their costs were Rs.30 crores per annum, give or take a few crores. When AS 15 was made mandatory, suddenly they realized that because they allowed their retired employees and their families to enjoy these facilities for life, they suddenly had to recognize the present value of all the costs they expected to incur over the next several years, as a cost in a single year. This resulted in a hit to their Income Statement to the tune of hundreds of crores in the year in which the new Standard was made mandatory (if I remember it right, it was over Rs.250 crores). Why? Could not well enough be left alone? Now, it has accountants and managers thinking closely about the impact of such facilities to its past employees on its current profits, way beyond the actual cash expenses of offering such facilities. Simplicity flies out of the door, to be replaced by dreadful complexity. What I wonder is, what purpose is served by such complexity?

Why did Warren Buffett call derivatives "weapons of financial mass destruction'?

Buffett should have included "securitised, structured products" which are a class of "innovative" derivatives, by the same appellation. We know now that derivatives and securitisation have made financial life, and accounting for the new-fangled "innovations" they spawned infinitely more complex. Banks in the developed world are still facing the consequences of the complex accounting legacy of the millions of securitised structured note transactions it entered into almost without thinking in better times. They are now realising the impact of all that complex accounting – it only passed the parcel of risk onto others. It did not eliminate risk. Ultimately, every bank in the developed world was left holding such risk parcels to varying degrees. But they did not simply pass on risk to others. Some structured products passed on risks to a distant tomorrow.

We have yet to see the complete impact of such contracts that, in addition to passing the risk around to different people, also passed the risk to a future date. There are several apparently innocuous deals and assets sitting on the books of several companies (not just banks) which represent accounting legerdemain of pushing losses off to a point of time in the distant future, so that the current management came out smelling like roses though their results should have had the faecal matter hitting the overhead rotating cooling device. They are the financial equivalent of mines in modern warfare. They will go off and claim the lives of innocents at any time in future, without warning. This is because several best-selling "structured products" designed by mathematical geniueses sitting at investment banks the world over, were designed to hide losses from shareholders, future management and regulators alike. We have yet to see the full impact of such deals. Liabilities under such contracts will crawl out of nowhere, as it were, and trouble future managers and bankers alike. This is the long-term legacy of allowing untramelled financial innovation. AS 30, 31 and 32 (collectively dealing with accounting and reporting of derivatives) is something that almost 90% of practising Chartered Accountants – those charged with implementing them and checking their implementation incompanies, will privately admit to not being comfortable with. I think these Accounting Standards is a gigantic case of GroupThink – the management phenomenon where even a unanimous decision taken by a Group is completely at variance with what almost all of those participating in taking the decision privately think and opine. We need the small boy who points out shrilly that the Empe3ror is not really wearing clothes!

Why should we bother about all these complexities?

Almost all the modern accounting standards that have contributed their bit to making accounting more complex and less understandable have behind them the objective of making a company's Balance Sheet more "realistic". What they have actually succeeded in doing is to make the Income Statement almost impossible to understand or predict. Why should one prefer Balance Sheet accuracy to Income Statement accuracy? I think that the Balance Sheet showing assets at unrealistic low values based on historical cost is a form of desirable conservatism in accounting. We have succeeded in making the Income Statement, which is a good indicator of how well a company is being run, almost too volatile to be of any use – whether to compare results with past years, or to compare results with those of peers. Therefore, what I make above is a case for a complete re-thinking of the basis of modern, fair-value based accounting, and slowly going back to the traditional historical cost based accounting.

Algorithmic Trading - Why Indian Stock Markets are Endangered

A few months ago, I had blogged about tight coupling in financial markets. In that entry,I had explained at a micro-level the impact of algorithmic trading. Given below is a "macro" story about how high-frequency trading in securities using computer programs played a big role in (though I would stop short of saying that they caused) a violent fluctuation in shares' and securities' prices on Wall Street last year. In less than 15 minutes, the Dow Jones Industrial Average Index plummetted and lost almost 6% of the opening value - and then recovered almost all of it in the next 15 minutes.

What happened on May 6, 2010 on Wall Street?

Major equity indices in futures as well as securities markets, already down 4% from the earlier day's close, suddenly plummetted a further 5-6% before recovering equally quickly, all in minutes. This affected almost all the 8,000 securities and ETFs in similar manner. Over 20,000 trades were reported to have been transacted at prices 60% from their prices just a few moments earlier.

Why did this happen?

At 2:32 pm, on an already volatile day, Waddell and Reed Financial Inc (not named by the joint CTFC-SEC report dated Sept 30, 2010, but named by many news reports) started a computer program to sell 75,000 E-Mini futures contracts worth close to $4.1 Bn. This was programmed to sell at any price and time, so instead of an orderly sale over a few hours, it sold this huge quantity of contracts within the space of 20 minutes, accelerating the sales as prices fell.

What actually happened during the crash?

The contagion spread to the equities market when arbitrageurs noticed the growing gap between the equities and futures prices. A significant finding is that 6 HFT (High Frequency Trading) firms (i.e., firms that extensively used algorithmic trading) remained active in the market even during the crash period of a few minutes. A blow-by-blow account follows:

• Five minutes into the crash, at 2:37 pm, data feeds from computers groaning under the huge numbers of contracts, started slowing down, leaving both, exchanges and investors uncertain about where share prices stood.
• The NASDAQ went into “self-help mode” at 2:37 pm where the transactions were not routed through NYSE's Arca electronic trading platform. CBoT and BATS exchanges (BATS at 2:49 pm) followed and also went into “self-help mode” which means that trades on NASDAQ, CBoT and BATS did not need to honour an Arca quote from NYSE.
• By 2:40, some trading and market-making firms started pulling out, due to algorithms that pause when they sense large price movements that could be due to questionable data feed. This left the market short of ready buyers and sellers. Apple, for example fell by $23 in 2 minutes, with the buy-sell spread going up to $5 instead of a few cents.
• Volumes of E-Mini contracts that normally mimic the S&P 500 surged but liquidity dried up. As a result, at 2:45:17 pm, E-Mini prices plunged 12.75 cents in half a second. This set off a circuit breaker that halted trading for 5 seconds.
• As individual stocks declined as much as 10%, ETF traders started withdrawing from the market.
• Then, at 2:46, even more strange things started happening because of the sheer speed difference between trades being put through and displayed – P&G shares were offered for purchase at prices higher than offered for sale! This is never supposed to happen in an electronic exchange.
• At 2:47, Dow reaches its nadir for the day, down 998 points or 9.2% from the opening level. Accenture, trading minutes earlier at $40, was offered at 1 cent.
• Then, at 2:49, the Dow rebounded by 300 points in 1 minute.

• There were no takers for ETF shares – iShares S&P500 Value Index Fund traded for 11 cents. But the broad recovery continued. By 2:58, indices reached the level they were at 2:30 pm.
• At 3:01, almost a half-hour to the minute since the crisis began, NASDAQ snapped out of its self-help mode and resumed routing orders to the Arca trading platform.
• At 4 pm, the DJIA closed 340 points below its previous close.

The Joint CFTC-SEC investigating committee reported that several HFT firms they interviewed had algorithms that took trading decisions based on direct proprietary data feed from the exchange directly rather than on consolidated market data, to reduce “latency” or delays measured in milliseconds. These algorithms went awry when the data feed from the exchange slowed down. Those HFT firms that did not depend on direct feeds for trading decisions got contradictory feeds that led to unease in taking decisions. Yet others that were not concerned with data latency in milliseconds simply withdrew from the markets.

The HFT firms that depended on their algorithms for trading decisions were not affected by the “self-help” declarations of NASDAQ, CBoT and BATS, and continued to rout orders to these exchanges. Therefore, the “self-help” declarations were ruled out as a cause of the volatility.

While no clear single cause was pointed out, HFTs using algorithms to trade rapidly (in one documented case, 200 trades exchanged hands 27,000 times in 14 seconds) were commonly thought of as the villains. It must be said, though, that there have been spirited defences by algorithmic trading experts, who point (among other factors) to volatility when markets are closed (ie difference between closing prices and opening prices on next day) as the real villain of the piece – on the logic that overnight differences can only be caused by humans, who are prone to panic unlike computers.

Even so, the SEC has since instituted a system of circuit breakers to arrest rollercoaster falls like the one experienced on Wall Street on May 6, 2010. This is another lesson that they have learnt by experience – instead of simply looking eastwards and learning from Indian bourses.

What can we learn from this?

But now, the stage has come to re-learn from our own wisdom. Algorithmic trading is now allowed on Indian bourses. Reports have suggested that over 40% of all trades are done by computers on NSE and BSE. Add to it the other dangerous fact - that FIIs that invest "hot money" that can fly out of the country in seconds account for over 70% of all floating stock (ie, stock that gets traded on the bourses).  See this in juxtaposition with the often displayed behaviour of FII fund managers who, like a herd of sheep, make a beeline for the two exits (NSE and BSE) for their investments at the merest sniff of danger anywhere in the world (even if it does not endanger their holdings in India), and it becomes clear that we have set up our bourses for spectacular volatility where securities' prices falling off a cliff in minutes will become sickeningly regular occurrences.

Ratings are rotten - proof from an insider

Earlier, I had written about the fact that rating agencies' methodologies were suspect - "Rating agencies will have to revisit their sovereign rating norms. Currently, it is unthinkable in their models to question the rating of AAA to the US".
Now, there is proof from an insider that the rating agency Moody's was utterly compromised and conflicted.  This 78-page Comment on SEC Proposed Rules for Nationally Recognized Statistical Rating Organizations makes for shocking reading, though it confirms what we had always suspected - that conflict of interest permeated all levels of this "Nationally Recognized" rating organization. It is a must-read for those trying to understand how the crisis of 2008 could have happened, and the role of rating organizations in this crisis.

Putting the Bank of America situation in perspective

What would you think of the state of the Indian economy, if what I said of BofA and Citibank was said of State Bank of India and ICICI Bank in India by some economist of repute? 

The situation is that serious for the US and for many countries in Europe, where the nation's top banks have dug themselves into deep holes that not even the EU or their respective Governments can afford. All these economies have their underbellies exposed.

On both continents, banks are hiding behind accounting gobbledygook called Impairment and Fair Value Accounting. But the understanding is filtering through. Tonight (in India) brought news of a blood bath on bourses in the US and Europe. So tomorrow (19th August) will almost certainly see a bloodbath on Indian stock exchanges - as FII Fund Managers make a beeline to the nearest exit. Expect a fall of at least 400 points in the Sensex on 19th August, 2011 before short covering enables a partial recovery.

I believe that this is the beginning of the unravelling of several economies in Europe and of the US economy as well, with them slipping into R-2, needing QE-3 and possibly QE-4.

I shall write again tomorrow to report whether what I said about the bloodbath on Indian stock markets was accurate. I feel comfortable making these gloomy predictions because I currently am sitting on cash, having (fortunately) believed in my own predictions and taken my own advice!

The Death Spiral beckons ...

Bloomberg reported that as of August 10, 2011, 186 US-based financial services companies traded for less than 60 percent of their book value, or common shareholder equity, including Bank of America, Citigroup Inc., Morgan Stanley, AIG and SunTrust Banks Inc. Together, they had a market capitalization of $300.5 billion, compared with $686.4 billion of book value. This means that a fall in their share prices to this extent (40%) is well nigh inevitable. 

How likely? These banks are very, very vulnerable. For example, earlier this week, AIG filed a suit accusing Bank of America of securities fraud; demanding damages of $10Bn. This sent the BofA stock down 20%, in addition to the bloodbath that the Dow Jones has experienced in the week after August 2, and the S&P downgrade. Its market cap stood reduced to $68.6Bn. Compare this with just one year-end intangible item on its 2010 Balance Sheet: Goodwill is shown at $73.8Bn (see p.130, Table XIII. See also Footnote 1 below)  – forget the rest of its balance sheet, BofA would have the world believe that this intangible item alone, built up from excess over book value paid for its past acquisitions, is worth more than the entire BofA is worth on Wall Street. How many will believe this, and for how long? There will always be the small boy who shouts, “The Emperor is not wearing any clothes!”. After reading Page 114-115 of its 2010 Annual Report, any accountant will understand that BofA will have to write down goodwill significantly (it wrote down $12.4Bn in 2010) - and to keep the shareholders' equity intact after this write-down, it would need to raise more equity. The dilution this would almost certainly drag the share price lower. Which will require them to raise more equity at even lower prices ... leading to a death spiral.

What about the demand for financial sector shares? All but non-existent. Retail interest was never very visible in the US in equities; now it has disappeared. Institutional investors are worried about what write-down of such intangibles would do to the Balance Sheet – and will stay away from any further issues in sufficient number as to make a public issue a very big gamble that could very easily fail. So the only solution – a government bailout wherein the financial institutions that still bear the TBTF tag (Too Big To Fail) are partly nationalized. Expect this to happen in the not too distant future, when the pressure of reporting numbers that have no relation to stock market prices forces them to look for ways of raising their net worth to blunt the edge of the writedowns that are inevitable already. 
What if the US Government finds it politically unpalatable or impossible to rescue these firms with a QE3? Refer to the title of this post! 




Footnote 1 referred to above: 
Table XIII on p.130, and Table XII and Table XIV before and after it, were the result of BofA's attempt to dress up their Income Statement and Balance Sheet, and the justifications for using these were on page 40. If they had followed GAAP alone, the Tables and the explanation on p.40 would be unnecessary. They used "non-GAAP measures" - euphemism for accounting legerdemain to make accounts smell sweeter, euphemism for which is "additional clarity". The footnote to Table XIII reads: Presents reconciliations of non-GAAP measures to GAAP financial measures. We believe the use of these non-GAAP measures provides additional clarity in assessing the results of the Corporation. Other companies may define or calculate non-GAAP measures differently.

Not a good time for any stock market

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Airline and automobile industry have always been GDP multipliers. That is because of the huge direct and indirect employment they generate, both upstream (component and ancillaries manufacture, assembly, services) and downstream (sales, service/ maintenance, spares, travel and tourism) besides the airline manufacturers and operators themselves. When any of these industries get hit, the economy gets multiple hits.

Of the two, the airline industry is more vulnerable to random hits, because of the global nature of their operations. Not only are they buffeted by almost every risk there is, including terrorism, hijacking, fuel price and availability risk, currency fluctuation/market volatility risks, political and taxation-related risks, etc., but they are also vulnerable to Mother Nature – sudden “clear air turbulence”, volcanic ash, storms, lightning and bird strikes, storms, besides risks arising out of mechanical, electrical, hydraulic and electronic failures, Air Traffic Controllers' errors, pilot error, irate governments who impound planes to score political points, militant cabin crew and pilot unions, irate customers demanding refunds and free accommodation, careless loaders, .... the list is endless. There is no other industry I can think of, that has such a profusion of risks to contend with every single day. Of course, the insurance industry is a close second.

The automobile industry is already doing very badly in all countries save China and India, thanks to the 2008-9 meltdown and recession, and these two markets are becoming hyper-competitive, thinning the margins and making the business environment even more difficult for all players.

When both these industries are doing badly, it is well nigh impossible for any economy to grow, especially in developed countries where markets are already very developed, saturated and competitive. Add to this fiscal profligacy of successive governments and you have a great recipe for financial disaster. This is what Europe and the Euro area is facing today.

With growth rates of all these economies being in the low single digits where positive, and negative in most places, it does not take much to knock an economy, and by extension, due to globalization, an entire region, off-balance. The recent volcanic ash episodes have paralyzed much of Europe, especially the UK for upto a week. Given that a week is almost 2% of a year, loss of such a level of business more than once in a year is a luxury that any European country can ill-afford. We are already into the second bout of airport and airspace closures, and Katla, the bigger next-door volcano, has yet to erupt! Add to it the cost and turmoil of elections (in the UK), fiscal profligacy (Greece, Spain and Portugal) and strikes and unrest (Greece) and it would be a very credulous person who would bet on the European economy growing over the next two years.

Because of the very interconnected nature of markets, it takes seconds, not years, for any contagion, whether of optimism or pessimism, to travel across the globe. So brace yourself for stock market failures. This contagion will definitely travel to India, for no mistake of it own, except Indian markets' connectedness with world markets and contagiousness of investor sentiment. 

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More on ULIPs - esp NAV Guarantee

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In this entry, I had done a round-up on the ULIP SBI vs IRDA controversy, quoting a few experts. One of those experts, Jayant Thakur, commented on one aspect of my entry on which entity takes up the downside of the NAV guarantee, and what is its capital adequacy. He pointed out this article to me.  Inter alia, this article points out that the way the guarantee is managed is that if the NAV spikes on any day, enough of the portfolio is transferred to debt to cover the guaranteed NAV on maturity. This struck me as very unfair to the investor.

 Most ULIP brochures (here is an example) include words to this effect:

There will be an additional charge for the cost of investment guarantee of 0.10% per annum. These will be made by adjustment to the NAV.

This actually is the opposite of what advertisements make out implicitly -- that the risk and cost of the guarantee is being borne by the insurance company, whereas they are charging the investor every year. This sentence was what made me think in the first place that perhaps there would be a third party backing up or taking the downside for the guarantee, in return for a fixed charge, similar to bond insurance premia charged by monoline insurers in the US. Till I saw this sentence in the above-referred example ULIP brochure:

If the NAV of Pinnacle Fund falls below allowable limits, assets will be completely reallocated to debt.

If the guarantee is to be implemented by shifting from equity to debt as the article suggests, (and also what the above example brochure suggests) then it is insult added to injury added to dishonesty. Why so?
(a) It means they are charging the investor for what the fund managers already have the right to do, viz. invest any part of the portfolio in debt. That is Insult.
(b) It means that when the going gets tough, switching to debt to contain the fallout of the guarantee is a "poison pill" that the fund manager forcibly makes the investor swallow, because it lowers the expected rate of return dramatically and reduces NAV fluctuation dramatically too. It also means that the fund managers have virtually abdicated their fund management function. That is Injury.
(c) Switching to debt predominantly to de-risk and cap NAV guarantee liability means hardly any equity exposure left. Why should the investor pay a higher fund management charge on the now specious argument that investing in equity being riskier justifies a higher risk management charge? Worse, the fund reserves the right to increase the fund management charge to 2.5% per annum [being almost double of what they are charging today (1.35% in the example)]. All this when the investment risk is borne by the investor! That is Dishonesty. It is also Unfairness.
If, on the other hand, the guarantee is being implemented by passing on most or all of the guarantee cost to a third party, then the questions raised in my earlier blog entry remain relevant.
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Regulatory Turf Wars: SEBI v IRDA

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Generally, turf wars are a bad thing. However, in this case, I am totally on SEBI's side. 

See the SEBI order here.

I have examined ULIP scheme after ULIP scheme, only to find in the fine print that the fees and charges levied by the insurance companies are so high as to be unconscionable. For example, at the end of a three-year lock-in period, even if I assume an average return of 20% per annum on money invested, I find that the NAV of the units the investor is entitled to will be barely equal to what the investor has paid in. In other words, for 3 years, the insurance company effectively confiscates all returns on investments to the extent of the first 20% per annum at least. If the return is lower than that, the investor swallows the loss, even though he has parted with a fat fund management charge every year.  

I was also sure that the commissions paid on these schemes must be very high, because none of the agents I contacted offered me a tax-saving MF scheme (ELSS) instead (mostly, insurance agents also double up as agents for MF schemes) when I expressed my dissatisfaction. Hence, I eventually preferred a bank deposit with a 5-year lock-in at 7.25% per annum compounded assured return, that also gave me the tax benefit I sought. The hook in the ULIPs is that the highest NAV over 7 years is guaranteed. The fine print here is that you have to be locked in for that whole period (at least 7 years) and the premium paid every year to insure the risk of paying out amounts exceeding the NAV on the redemption date are paid for by the investor. No skin off the fund manager's or insurance company's nose! I would like to be enlightened on which entity insures this risk., and what their capital adequacy to cover this risk is.

If MFs can make do with much lower asset management fees, with a better governed (chinese walls between AMC and Trust, separate Boards for both, etc) investment management structure, with more sensible incentive structures (no front-end commission, agency commission paid over the life of the MF deposit) I cannot see why insurance companies should be an exception to this. Especially because the insurance risk is kept to a very low figure -- for example, the insured sum does not exceed, in single payment schemes, twice the premium. In other schemes where premia are paid over several years, the insured sum cannot exceed 5 times the annual premium. In any case, linking it to the premium paid is mere semantics -- because what is being paid is nothing but an instalment of an SIP, with a minuscule proportion of the payment being diverted for insurance cost, the fig-leaf that enabled insurance companies to market ULIPs on flagrantly different terms than an MF is allowed to do. 

The biggest factor helping the insurance companies is the huge size of the market, and the sheer number of investors who would lose money if the ULIPs were banned with immediate effect -- a lot of what they have paid would just disappear, having been paid to cover sales and marketing costs, various upfront and recurring fees and charges, and the costs of unwinding if it becomes necessary. The unfairness of this would have to be balanced against allowing continuance of such hopelessly one-sided schemes. Fait accompli should not be allowed to be a defence or a consideration in the decision arrived at.

Several experts have lauded this order from SEBI. 

• Jayant Thakur, for example, asks why the ban should not be extended to endowment schemes too, because obviously nearly 90% of the premium paid goes towards the investment corpus, if we compare it with term insurance schemes.  
• Sandeep Parekh expresses a similar sentiment as I have expressed in an earlier paragraph.  
• Ajay Shah has acclaimed SEBI's order for breaking the silo-like thinking of regulatory verticals -- where the IRDA regulates insurance companies, though ULIPs are predominantly investment products, and not insurance products. He also writes in today's Financial Express, exposing 3 common fallacious arguments against SEBI's intervention.
• Vivek Kaul writing in DNA, exposes how less the proportion of insurance really is in different ULIP schemes -- approximately 1.1% of multiple premium schemes, and 0.6% of single premium schemes, if equivalent term insurance policy rates were applied to the amount of insurance cover extended.
• Suniti Ahuja Kohli, writing in the Indian Express, points out that whatever the decision maybe, at the end of the day, it is the policyholder who stands to gain the most. She also goes on to trace the chequered history of ULIPs.

Keep your eyes peeled on this turf war. While we should regret regulatory turf wars, this kind of a war is far preferable to the kind of war seen a few years back in the US -- where both, the SEC and the CFTC eagerly disowned jurisdiction over derivative instruments like CMOs and CDOs, and the nvestment bankers made merry till the economy and the risk bubble they built up imploded.

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Is SBI's foray into general Insurance wise?

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A few days back, I criticised LIC's intention to get into banking.

Now comes a report that, to top its foray into Life Insurance, SBI intends to enter General Insurance business before end of April, 2010. They have already been recruiting managers for this venture for the last 10 months, and are almost ready to launch.

The same logic and criticism applies to SBI's joint venture with Insurance Australia Group too. It is bad enough that they have ventured into Life Insurance. This makes it worse, in my view. Why?

Banking and Insurance are the two most risky businesses worldwide, and involve two completely different challenges. Insurance companies have to deal wisely with a surfeit of liquidity (usually) and banks have to constantly manage threat of liquidity shortfalls. Combining both reduces the strength of the combination to overcome threats and severe demands on liquidity that affect both industries. The recent global recession is an example of a threat to both industries simultaneously. Enough financial pundits (Nouriel Roubini, Nassim Taleb, et al) have predicted that this could happen again, and in our lifetimes.

We in India escaped the impact of the global crash because of three major factors: 

1. Our financial institutions were just not allowed to invest in derivative securities and there was consequently hardly any significant secondary market trading in debt securities;
2. Our banks had a very significant liquidity padding (SLR/CRR) that was nearly absent in the first world; and 
3. Our banks were not major players in any part of the banking business, and our insurance players were similarly almost absent in the banking sector.

Now the situation is set to change -- in the name of development and liberalisation. 

Banks are getting into insurance, and insurance companies are getting into banking. This in my view magnifies the riskiness of both businesses, and does not diminish it. I am not even talking of conflict of interest here, which can also rise considerably.

There is constant clamour for reduction in SLR/CRR, which, in my view is nothing but an operating profit cushion against the banking industry's inability to extract risk-adjusted returns on their lending and assurance intermediation (L/Cs, Bank Guarantees, etc) businesses, which the RBI has, in its wisdom, resolutely resisted, and I really hope they continue to do so..

In addition, our stock exchange margining system and transaction settlement system worked even better than in the US in containing huge negative exposures of individual players, mainly because algorithmic trading (which can very rapidly put through transactions involving mind-boggling amounts) was not permitted in India. Now algorithmic trading is permitted, and probably accounts for about 20% of all trades today. This percentage is set to zoom, giving traders with access to this technology a huge edge, and reducing retail investors to mere peripheral price takers. Given that our markets still do not have depth comparable to the first world exchanges, a runaway rogue trading program has the potential of putting almost the entire exchange settlement and margining system at risk, leading to a possible rapid stock market crash or boom. 

I hope I am wrong.  

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Banks -- Their importance to financial markets

With the Sensex at an all-time high of 12900, I do not know what to think about investing in the stock market. Idly, my hands went to a book which I had written in September, 1991 (it was published in November '91 by Bharat Law House, Delhi). One small extract from it struck me as relevant even today as a sobering thought and influence.

"Our stock markets are still not so large that they cannot be affected except marginally by the actions of a few large operators acting in concert. This has happened today ... Already the BSE Sensex (Sensitive Index) has risen over 65% over only one year -- from around 1200 to nearly 2000 today. This is the tell-tale evidence of too much money chasing too few shares."

And another one:
"... there is a logical limit beyond which share prices cannot be leveraged. This limit is linked to the amount of real assets which all shares represent in totality. As long as there is some relation of the amount of shares available in the markets and the amount of real assets represented by this share capital, share prices can be maintained.
But what happens when, for every rupee of real asset, there are Rs.10,000 or more worth of shares? There will be many companies and funds which have no real assets barring a table and a chair, and yet, they will be capitalised in the millions on the stock market.
When too many such companies come to exist, sober reality will begin to assert itself and the stage will be reached when the people will realise that the Emperor is not really wearing clothes at all. Then will come the massive denouement: prices will begin to plummet in the stock market and people will lose confidence in all shares. This is exactly what happened in the United States" (in the late 1920s)
... What we are seeing is the beginning of an investors' bubble: the task before the Establishment is to puncture the bubble before it gets too big, and puncture it without it bursting, but so that it subsides gradually. By all standards, this is a delicate task."

This proved very prophetic --- and very soon too. In May 1992, a scarce 5 months after this was published, came the first denouement. Then we had the Ketan Parekh lesson of the mid-1990s. Each of these saw two banks go belly-up. In the first, it was the Bank of Karad and Metropolitan Co-operative Bank. In the next, it was Global Trust Bank and the Madhavpura Co-operative Bank. The lesson I saw in these experiences was that banks are the soft underbelly of the financial marketplace. If you have strong banks with robust processes and people, that is the best insurance against major shocks in the marketplace.