by Harsh Vardhan.
What would you say if someone was borrowing money at 8% and investing it to earn around 3%? “Uninformed!”, “financially illiterate!” or even outright “foolish”! And yet this is what our government has been doing with trillions of rupees over the last many years and has committed to continue to do so in the future. The process by which this is done is called capitalisation of public sector (PS) banks. Such capitalization is not only a bad idea economically as it puts enormous stress on the government resources, but also one which affects that behavior of banks and hence the robustness of the whole banking sector.
Commercial banks need capital to grow. Capital adequacy requirements ask all banks to keep a minimum amount of shareholder capital in proportion to their balance sheet size. Currently, in India this requirement is 9% of “risk weighted assets” of banks. Roughly, it means that banks are expected to have equity capital which is 9% of their commercial loans.
As banks grow their business, their risk weighted assets also grow. This means that banks has to increase their capital base in line with the growth of their loan book. Such increase in capital can come from exactly two sources – retained profits that are added to the capital base, or fresh infusion of capital from shareholders (old or new). In India, given the overall profitability of the banks (~1.1% return on assets) and the amount of dividend that they pay (~20%) of post-tax profits, banks do not have enough retained profits to support their business growth. Therefore, every now and then, they go to shareholders to raise fresh capital.
PS banks pose a peculiar challenge for the government. Being the majority owner of these banks and having committed to stay the majority owner, government has to infuse capital into these banks proportional to its ownership stake. Since the government wants to maintain its ownership at 51%, it has to supply atleast 51% of the fresh capital that PS banks need. RBI governor Dr. Subbarao, in a recent speech, said that the capital infusion by government into PS banks over the next decade will be of the order of Rs.0.9 trillion. I have read estimates of other analysts where this number is as high as Rs.2.50 trillion. These estimates depend on the assumptions one makes about a number of factors – the rate of growth of banks (which in turn depends on the growth of the overall economy), the profitability of banks, their dividend policy, their ability to raise other forms of capital (especially tier II capital), regulatory requirements on capital, etc. No matter how you estimate it, the number is very large. In other words, the government will be compelled to invest a very large amount of capital into PS banks over coming years.
Why is this a problem? Let’s look at the some simple public finance issues. India is in a deep fiscal crisis, and it is not easy to find trillions of rupees to put into PS banks. If such resources were injected into PS banks, it is not conducive to healthy public finance, since these injections are not a good deal for the government. The Indian government currently borrows long term money at over 8%. The dividend yield on PS banks shares has been between 2% and 3% over the last decade. This means that the government earns between 2% and 3% on its investments in PS banks. There is a 5% “negative carry” or loss that government bears on these investments.
A private investor also earns a low dividend yield from investing in PS banks, but can benefit from capital gains – a potential increase in the value of shares which the investor can obtain when she sells the shares. Government has never sold shares of PS banks (except when it initially listed some banks) and will not do so if it has to maintain majority ownership which is its stated policy. Hence, for the government, the financial analysis of a proposal to put money into PS banks should hinge on a comparison between the flow of dividends versus the cost of borrowing.
Capitalisation of PS banks is, thus, bad for government finances. It’s a double whammy! On the one had government has to raise vast resources to be invested into banks and then carries a loss of around ~5% on these investments year after year.
Ownership and behavior of banks
Government capitalisation of PS banks is not just a fiscal challenge. It also impacts the competitive dynamics of the banking industry. Most privately owned banks are under constant scrutiny of investors and analysts. When they go to external investors for raising capital, they have to satisfy these investors on number of critical aspects of the business – profitability and its sustainability, efficiency of capital use, quality of management team, cost efficiency, etc. In other words, private banks face a market test; they do not get capital for free. Only well run private banks get equity capital that is required for growth.
None of these questions get asked when government puts capital into a PS bank. One has never heard a senior government official commenting on the Return on Asset (RoA) or Return on Equity( RoE) of PS banks. The decision to put capital into PS banks is treated as a mechanical and administrative decision. This absence of a market test has systemic consequences. PS banks have ~70% share of the Indian market. When the majority owner is asking no or very few questions on performance, and is assuring an almost unlimited supply of capital, these banks have little incentive to improve financial metrics such RoA and RoE. This hurts the overall banking industry. For example, PS banks can underprice loans compared to their private sector peers. Such behavior would migrate the whole business to lower returns. It is hard for a private bank to be profitable when facing rivals that are not concerned about return on capital.
Misplaced obsession with majority ownership
The source of this whole capitalization issue is the government’s obsession with retaining majority (over 51%) ownership of PS banks. This is often explained in terms of the need to maintain the “public sector character” of these banks. While there may be a separate debate on whether we need to maintain public sector character for all the 25 plus PS banks, the fact is that the government does not need majority ownership to achieve this objective.
All PS banks are not companies under the Companies Act. The notion of 51% giving majority control is enshrined in the Companies Act. PS banks were created under the Nationalisation Act (SBI has its own SBI Act). The Nationalisation Act provides the government untrammeled control over these bank. While it does prescribe 51% government ownership in the PS banks, the control of government is independent of the level of its ownership. Furthermore, there is a limit of a 5% (10% with prior approval of the RBI) stake owned by any single shareholder in all banks. There is no chance, therefore, of any external shareholder acquiring control in these banks. Even relatively minor changes to the functioning of PS banks require approval of the parliament. Where is then the question of diluting the public sector character if the government ownership were to drop to, let’s say 26%, which is the threshold for “significant” minority stake in a company?
In the long run, therefore, it makes no sense for the government to commit itself to the capitalisation of PS banks. Precious government resources can be better deployed in critical areas (such as power transmission and distribution) where private capital on large scale is hard to come by. In the medium term, it can use tactical measures such as merging banks where it has significantly high ownership with those where the ownership is already down to 51%. But these tactics will not solve the issue structurally. The only long term solution is to give up the majority obsession, explain to all the stakeholders the fallacy of this obsession and the resulting pressure on public finance, build a political consensus to enact necessary legislative changes and then dilute down to a reasonable level.
by Harsh Vardhan.
On 20 June, RBI issued guidelines that permitted White Label ATMs (WLA) to be operated in India. These guidelines could make a very significant change in the banking business – one that would go a long way in improving penetration of banking. This was a move that was long overdue. We can now look forward to very rapid expansion of the ATM networks along with many new services being offered at them.
ATMs arrived in the US in the late 1970s and in India somewhere in the 1990s, when some foreign banks set up a few in Mumbai and other metros. It was not until the late 1990’s and early 2000’s that ATMs became an important channel and there was a rapid growth. This growth can be attributed to the new generation private banks who used ATM’s cleverly to expand the reach of their (then) limited branch networks to attract customers. These banks realized that it will take them a long time to match the branch reach of public sector banks, and hence adopted a model where a branch surrounded by a slew of ATM’s became the means of attracting customer. The proposition to the customer was – “Open an account in the branch which may be far away from your home or place of work but transact on an ATM which is very close to you”. A new generation of customers, more amenable to the use of this channel also helped. Slowly, most of the new generation banks managed to transfer a sizeable part (in some cases over 80%) of basic transactions — cash withdrawal, balance enquiry, etc. — to ATMs. The cost advantage was compelling. Doing transactions on ATM’s can be 50% to 80% cheaper than using branches. We also saw some small “value added services” emerge at the ATM, such as bill payments.
Despite the rapid growth of the ATM network, their density is still low compared to other countries. India has ~ 77 ATMs per million population which is much lower than even countries like Thailand and Malaysia which have ~200 ATMs per million and significantly lower than the US which has over 1200 ATMs per million people. Clearly, ATM density will have to grow which means a large number of ATM’s will have to be rolled out. For this to happen, appropriate incentives have to come into play in this field.
How do ATMs work?
It is important to first understand the mechanics of ATMs, to fully appreciate the roles played by different entities and how the new regulations change these roles and thus the incentives.
ATMs are essentially electronic contact points between a bank and its customers. The jargon of the field involves three kinds of entities:
- Issuing banks – those that issue ATM cards (or debit and credit cards) to their customers
- Acquiring banks that operate ATMs and dispense cash (similar process also is followed in case of the so called Point of Sales (PoS) terminals that are used at merchant establishments for payments)
- Payment associations (also called Network Providers) – the intermediaries that facilitate the flow of information (payment instructions) and funds between issuing and acquiring banks
The process flow of cash dispensation by ATMs (which is 95% of what they do) works like this:
- A customer approaches an ATM and inserts his card.
- The ATM “reads” his card and passes the information to the bank which has set up the ATM. This bank is conventionally called the “acquiring” bank.
- Computers of the acquiring bank read the information and determine if the customer is its own or of some other bank.
- In case of its own customers the bank invokes his account, checks if there is enough money, and if the password is correct, sends instruction to the ATM to dispense cash. Such transactions, where the acquiring bank and the card issuing bank is the same, are called “On Us” transactions.
- Sometimes the customer has a card issued by another bank (”the issuing bank”). The acquiring bank (i.e. the one which setup the ATM) sends a message to Visa, MasterCard or “NFS” the National Financial Switch (a system set up by National Payment Corporation of India) depending on the arrangements between the acquiring banks, the issuing bank and these entities. These entities are called “Payment Associations” and they perform the role of connecting card issuing banks with the acquiring banks
- Upon receiving the information from the payment association, the issuing bank checks up the availability of a balance in the bank account, and sends the payment instruction to the ATM which dispenses cash. In this situation the acquiring bank is making the cash payment to the customer on behalf of the issuing bank. Such transactions are usually referred to as “Off Us” transactions
- The payment associations keep records of all “Off Us” transactions. At the end of each day, they do clearing and settlement of funds whereby all banks pay or receive funds depending on the net Off Us transactions made through their customers and possibly their ATMs.
- The issuing bank pays some fees to the acquiring bank and to the network providers for every transaction that their customers carry out on ATMs (i.e. for all “off us” transactions). These fees are a revenue for the acquiring banks which spends money in building and running the ATM network./li>
It is useful to think that there are 2 distinct flows in this process: a flow of information (or instructions), and a flow of money. Information flow takes place on communication lines between the entities involved and funds flow is mediated by the payment association through its own clearing and settlement processes. The two flows are linked but distinct.
The new guidelines
Historically, RBI regulations prevented non bank players from competing in this space. Regulations allowed only commercial banks to own and operate ATMs. This means that each ATM, in the view of the regulator, belonged to the acquiring bank. And no entity other than a commercial bank could do the acquiring part of this process.
Building and running ATMs is more of an IT/telecom business and many banks were not keen to create these capabilities. A significant amount of outsourcing was done by banks, whereby the maintenance and in many cases even the rollout of ATM’s was done by independent companies for banks. But regulations dictated that all the crucial aspects of running the ATM network remained squarely with banks. Even the locations of ATMs – which banks needed to inform the RBI – were pegged to a bank.
The new guidelines effectively open up most of the acquiring part of the process to non bank independent players. They clearly recognize that the information and the funds flow are distinct and while there may be some logic in keeping the funds flow within the ambit of commercial banks, the information flows can be performed by non banking entities. The new guidelines make some profound changes, including allowing:
- Independent white label ATM providers to set up and operate ATM networks (without being a bank); these companies can apply for and get approvals for the locations of ATMs – the locations will be assigned to these companies and not to banks
- Independent ATM networks to connect directly with network providers such as Visa Mastercard, and NFS – thus allowing them to pass on the payment instructions emanating from the ATM without having to go through the acquiring bank, While the cash settlement will continue to be via the acquiring banks (called sponsor banks under the new guidelines), an independent ATM operator can do such settlement through multiple sponsor banks
- Allowing companies to tie up with multiple banks as acquiring (sponsor) banks; this will meant that even if the arrangement between a particular bank and an ATM operator is discontinued, the operator can tie up with another bank and continue to operate ATMs
- ATM operators the freedom to offer value added services
Effectively, these changes imply that running the ATM network has now been recognized as an independent activity, but at the same time seeing that it is a business that needs the support by banks for activities such as managing cash and for settlement. Thus the RBI has taken significant part of running ATM networks out of the ambit of commercial banking.
Why is this a good idea? Building out the ATM network is not a core activity for banks. For banks, an ATM is a transaction point for customers. Setting up and running a large number of ATMs is an activity that adds little to the profitability and performance of banks but does add a significant amount of operational burden. This is the reason why many Indian banks started outsourcing ATM rollout and management once they reached a critical mass on ATMs. This is not the business of banking. At first blush, it is an IT or telecom business. But at a deeper level, it is closer to the retail business, with issues like location, branding, efficiency, multiple services, etc.
For independent white label operators, building out a large ATM network and squeezing operational efficiencies out of it would be the core business. They are expected to focus on much faster rollout of network, strategically thinking about locations, squeezing efficiencies in the management of the network, adding value added services, etc. An analog would be the case of money-changing business – what is popularly known as “Exchange Bureaus”. For a long time only banks were allowed to run these and so we saw very few outlets even at airports and so on. This business was opened up for private independent players about a decade or so ago, which resulted in a dramatic increase in the number of outlets as well as the quality of their service.
There are several classes of players that are likely to enter this business. Large established international players (eg Star, Pulse, NYCE from the US) should be interested as they would see India as a major growth market. Local players currently providing oursourcing services for ATM rollout and management would be another class of players that are likely to enter. ATM manufacturers (eg NCR, Diebold) also could look at this as an extension of their business. Other firms in related business such as telcos that provide the network connectivity could also consider entry. Each of these different classes of players have their own strengths and weaknesses. Time will tell which is the ideal business model. The competitive dynamics between these various kinds of players will give customers in India better ATM services in all respects: more locations, better locations, more services, and superior customer experience.
Many aspects of the white label ATM business will only become clear as the story unfolds. The most critical is the long term sustainable economics of the business which will determine the capital that is deployed into the business. While the RBI guidelines prescribe overall restrictions on the fees charged by the ATM operator to the bank, they stay away from prescribing the exact charges, which is the right approach. At first, there will be a bit of a competitive frenzy; some players will set some charges to very low or very high levels. It will be some time before stable pricing structures and levels emerge. The guidelines are not absolutely clear if these companies can develop independent brands for their networks (such as Most and Cirrus in the US). Such branding will be a crucial part of making white label ATM an independent business. My interpretation is that independent branding is not explicitly prohibited but it is not explicitly permitted either and clarity on this count would be very useful.
Overall these guidelines are a move in the right direction. There is a lot in the payment space that is currently tied to commercial banking due to regulatory reasons. The evolution of technology and consumer behavior suggests that many aspects of payment business need not remain confined to banking and in fact taking them out could unleash innovation that would drive significant efficiency gain and consumer value. We can hope that the deregulation of ATMs is the first of several similar steps that the RBI takes to allow the emergence of a payments industry in India, distinct from the business of banking.
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We do not just have governments in order to rob Peter to pay Paul. We have governments because there are things they can provide that the private sector is either unable or unwilling to provide effectively – courts, police, schools, roads, other infrastructure, etc. Conservatives focus so much on redistribution that they tend to ignore this fact, but if you think about it, you’ll realize public goods are why we have government in the first place. [Emphasis added.]
I will cede that the court system is best administered by the government, given its coercive touch. However, the idea that there is no way the free market can provide policing, education, roads, and other infrastructure is simply foolish.
Regarding policing, consider that private investigators and voluntary constabularies have both played major roles in law enforcement for a decent portion of American history (with the former still in existence). Of course, there is not likely to be any free market policing of victimless crimes, like speeding and drug use, but I don’t see this as a down side, seeing as how the negative externalities of these laws as the relate to property rights are already handled by the law.
Regarding education, it is laughable to claim that the free market can’t provide schooling in light of the present existence of private schools, private universities and colleges, and home schooling. While a free market model would increase the probability that people would have to pay directly for education instead of soaking other people for the costs via taxation, this will encourage more efficiency and lower costs in the long run (and, let’s be honest, the current results of the modern public school system are simply abysmal), and will likely end the public-school-as-free-daycare model of education that currently plagues society today.
Regarding private roads, I will simply note that privatized highways currently exist, and that there have been many cases of privately funded roads. In fact, the modern road system was initially built on private financing from businesses. Furthermore, it is quite conceivable that the free market can provide lots of infrastructure. Sure, it might be more expensive, given the market tendencies of those entities known as natural monopolies, but this will likely help conserve resources and distribute them more equitably over time.
What’s also ignored in this “analysis” is the crowding effect that the government plays in competition for these services. For example, the government providing education at no cost to it recipients (or, more accurately, their parents) makes it considerably more difficult for other companies to compete since they cannot coerce people to buy their product. Really, once one accounts for the competition-distortive effects of government, it should become readily apparent that the claim that the market is unwilling to provide certain things, and thus the government must is simply wrong. Whether this claim is made in ignorance, malice, or plain stupidity is for the reader to decide.
, in response to Obama’s claim that international trade isn’t always fair:
Here we see the view, commonly held by the media and non-economists in our universities, that international trade is a competition, analogous to sports or military competition (sometimes, “trade competition” is compared to the Cold War). If the playing field is not level, then the trade is not fair. Economists, and this view is not limited to Austrians, understand that international trade is the fruit of cooperation, not competition. America and China are not trade competitors. Paul Krugman thoroughly demolishes this fallacy in “The Illusion of Conflict in International Trade” (reprinted in Krugman’s Pop Internationalism). Krugman explains that in international trade “it is the illusion of economic conflict, which bears virtually no resemblance to the reality, that poses the real threat.”
There are two main fallacies in this paragraph. The first is that of a false dichotomy. The second is the blatant ignorance of domestic economic policy as it relates to trade policy.
Regarding the former, it is wholly fallacious to say that trade is either analogous to competition or to cooperation. The truth is that there are elements of both. An automobile manufacturer, for example, must cooperate with its suppliers, distributors, and customers. It must also compete against other automotive manufacturers, as well as any company that manufactures substitute goods. Both comparisons can be correct, depending on how they’re applied, and it is thus fallacious to claim that trade is comparable to one or the other when it can be comparable to both.
Regarding the latter, it is quite fallacious to ignore reality when discussing policy. The fact of the matter is the US economy is quite hindered by regulations in ways that many foreign countries are not. It is not at all fair or free to allow foreign companies to compete with domestic companies when domestic companies have been hamstrung by the federal government. I’ve written extensively on this before, so I will not repeat myself here.<
In all, the case for free trade is often predicated on focusing on theory at the expense of reality, and building arguments on obvious fallacies. If this is the best free-traders have to offer, in the way of argumentation, perhaps they should reconsider their position.
If Beijing’s intervention into the Chinese economy justifies U.S.-government ‘retaliation’ to ‘correct’ market distortions created by those interventions, shouldn’t the still-significant lingering negative consequences of Beijing’s interventions into the Chinese economy from 1949-1978 be considered? Shouldn’t Beijing’s artificial destruction, during the middle decades of the 20th century, of production efficiencies in Chinese factories be weighed against Beijing’s artificial creation, in the early decades of the 21st century, of such efficiencies?
In short, the answer is no.
Boudreaux, in asking the question, implicitly accepts the validity of the state and of citizenship. He must also accept that the state must act in the best interest of its citizens. While the government should seek to redress the negative effects that its citizens face as a result of foreign market intervention, it has no responsibility to address the negative effects that non-citizens face as a result of foreign intervention. China is not the US, and Chinese aren’t Americans. As such, the US government has no obligation to concern itself with addressing negative economic outcomes faced by the Chinese people that arose as a result of the Chinese government’s economic policy.
Parlier earns about $13 an hour. She’d like to become one of the better-paid workers in the plant, but, in today’s factories, that requires an enormous leap in skills. It feels cruel, Davidson writes, to mention all the things Parlier would have to learn to move up. She doesn’t know the computer language that runs the machines. “She doesn’t know trigonometry or calculus, and she’s never studied the properties of cutting tools or metals. She doesn’t know how to maintain a tolerance of 0.25 microns, or what tolerance means in this context, or what a micron is.”
A good attitude and hustle have taken Parlier as far as they can. It’s hard, given her situation, to acquire the skills she needs to realize the American dream.
But skills aren’t always necessary. A dumbed-down UI can serve as a substitute for knowledge, particularly if a firm can hire a technician to know the technical aspects of the technology in use so other workers don’t have to. In fact, the trend of technology has generally been to serve as a substitute for knowledge and ability. Why learn Trig if you can run a fairly simple program on a computer?
Anyhow, this story is evidence of my claim of a technology gap. If labor were allowed to compete freely in a deregulated economy, technological growth would be slower and technological innovations implemented less frequently. This in turn ensures that labor is not stagnant or regressive, and also gives less intelligent laborers a chance to remain on the market longer as technology remains relatively expensive. In order to make technology more appealing, then, technological innovators will find it useful to dumb down the UI to make the device more readily accessible by lower-intelligence labor.
The point in all this, then, is that the government has basically set policies in place that pulls demand for technology forward, leaving less-intelligent laborers in the lurch. And since less-intelligent laborers tend to also be poor, it can be said that the government hates poor people.
Q: Who said this:
Second, the idea that U.S. economic difficulties hinge crucially on our failures in international economic competition somewhat paradoxically makes those difficulties seem easier to solve. The productivity of the average American worker is determined by a complex array of factors, most of them unreachable by any likely government policy. So if you accept the reality that our “competitive” problem is really a domestic productivity problem pure and simple, you are unlikely to be optimistic about any dramatic turnaround. But if you can convince yourself that the problem is really one of failures in international competition—that imports are pushing workers out of high-wage jobs, or subsidized foreign competition is driving the United States out of the high value-added sectors—then the answers to economic malaise may seem to you to involve simple things like subsidizing high technology and being tough on Japan. [Emphasis added.]
A: Paul Krugman (Pop Internationalism p. 16 , The MIT Press, Cambridge).
In spite of his remarkable daily stupidity, Krugman actually correctly recognizes the problem of American competitiveness in international trade. What hampers America is not foreign trade, but domestic productivity. And one of the biggest hindrances to domestic productivity is government, both at the state and municipal level, and particularly at the federal level. Thus, if one wants to know why Americans are losing manufacturing jobs, one need only look at domestic policy. The federal government has increasingly hamstrung manufacturing jobs over the past several decades.
Furthermore, instead of allowing consumers to feel the pain that domestic production policy would naturally incur, the federal government instead decided to promote increased foreign trade (under, it should be noted, the auspices of so-called “free” trade). This policy has then had the effect of subsidizing foreign production at the expense of domestic production because foreign manufacturers do not have to face the massive regulatory costs that domestic manufacturers face, giving foreign manufacturers a leg up on their competition.
As I have undoubtedly noted before, there are only two correct positions for a domestic government that presumably claims to represent the people over which it governs. Either the government can highly regulate domestic business and place tariffs on imports that approximate the costs faced by domestic producers or the government can reduce the burden of regulation on domestic business in conjunction with the decreased cost of importing. It is, however, quite foolish to do what the U.S. government is doing now: highly regulate domestic business while decreasing the cost of importing. Either a high degree of regulation is desirable or it is not. If it is, whatever regulations that exist should be applied to every person and corporation that wishes to do business in America. If it is not, the domestic market should be deregulated posthaste. There is no excuse for the current state of affairs.
The Competition Commission of India (CCI) has written an order on NSE and MCX-SX in the currency derivatives market. Even if you do not take interest in financial markets, this is an interesting episode in Indian governance. It illuminates the larger problems of
building regulatory agencies, and India’s middle income trap.
In an impressive show of strength with the media, there was a flurry of editorial and other commentary praising CCI for this order
- even before the order had been released. The files are now on the CCI website. Here is the main order and here is the dissent by two members of CCI.
Gautam Chikermane has written an excellent analysis of the order in the Hindustan Times. Unlike much of the other commentary on
this order, he has actually read the two PDF files above.
The order has breathtaking ramifications. If this works as a precedent, it would impose huge complexities upon an array of industries where some products and services are given out free. This feature is particularly prevalent in the new economy, where systems such as google search are free and have been free for the longest time, and where a blizzard of new product launches (e.g. google plus) are free. In India, regulatory organisations are still finding their feet. They have to gradually build up credibility and respect. When
a regulatory body signs on a breathtakingly large penalty which will have huge implications for the economy, they have to be absolutely sure they are right. Otherwise, the institution loses credibility. I fear that with this order, CCI is now in a soup. If the appeals process is half decent, the order will be overturned, which will make CCI look bad. If the appeals process is not half decent, CCI will be seen as a nutty source of trouble in the Indian regulatory landscape. In numerous industries, zero pricing will run into
trouble. More generally, such muggings will be a new dimension of the political risk faced by firms operating in India.
India’s crisis of governance is about the puzzle of building agencies like the Competition Commission of India or the Forward
Markets Commission, of taking these agencies closer to the competence and honesty seen at SEBI in recent years. How do we master the intricate recipe of public administration, so that such events don’t happen? Until this is done, the structure of incentives encourages a certain kind of entrepreneur.