Monday, February 25, 2013
Deja-vu: Nepal's liquidity crisis returns
On January 31, I wrote an opinion piece in Kathmandu Post with the title "Lessons in finance" (that is the KPost link. Link to my blog piece is here). I wrote:
...[the] number that the NRB and BFIs report as the contribution of the financial industry to our economic growth is false. The actual contribution is much less.
This misleading figure is the reason why we suffer through liquidity crises every now and then. In our recent liquidity crisis, the level of profit and savings that BFIs showed to their shareholders was distorted due to the above mentioned fudging of facts. They actually did not earn the profit that they claimed to have earned.My concern is that Nepal's financial industry is not doing as great as it projects in its balance sheets. They have been busy fudging numbers and facts to appear "healthy" so the shareholders remain "happy". I ended my article saying:
If the current trend of high risk-taking in the Nepali financial sector continues, soon there will be another liquidity crisis worse than the last one. The reason the Nepali financial market has not yet fully recovered from that crisis is that the same risk-taking behavior continues even today.And, only a month later, today, the Kathmandu Post reports that there is now a "liquidity crisis" in progress, and banks are rushing to the Nepal Rastra Bank for cash. KPost writes:
A tight liquidity situation in the banking sector has prompted a number of banks to obtain standing liquidity facility (SLF) from the central bank for the first time in a year.
.........
“The first to obtain SLF was H&B Development Bank which has been hit hard by fraud committed by its employees,” said an NRB official. “Last week, Nabil Bank and the Bank of Asia also obtained the facility.”As I mention in my opinion piece, the crisis that is now brewing is the result of poor management in our BFIs. But, do the BFIs care? No, they don't because however they screw up, the central bank is there to help them with "public" money from retirement funds, pension funds, etc. I will let the central bank's representative explain it:
“Although the government should not give the money meant for pension distribution immediately, we released the amount now to address the recent tightness in the liquidity situation,” said finance secretary Shanta Raj Subedi.I have a phrase for that: moral hazard. As long as they face no punishment for their risky behavior, and instead get rescued by the hard-earned money of the public, the CEOs in our BFIs will continue to engage in risky behavior.
Labels: BFIs, liquidity crisis, nepal, NRB
Thursday, January 31, 2013
Nepal’s financial industry needs to learn its lessons
The following article was published in The Kathmandu Post today on January 31, 2013 with the title "Lessons in finance". The unedited version is below.
Nepal’s
financial industry needs to learn its lessons
By: Mukesh Khanal
Nepali financial market took a tumble between late 2009 until late
2011. Nepal Rastra Bank (NRB) urged some banks and financial institutions
(BFIs) to merge. Some were allowed to go bankrupt, while some were rescued by
the NRB. Despite these setbacks, however, banks and finance cooperatives have
mushroomed continuously. Are these mushrooming BFIs adding any value to Nepal’s
financial market and growth? Is Nepali financial market making any
contributions to economic growth? If yes, how much is that contribution, and
how can it be measured?
BFIs pay interest to depositors, and that interest is considered the
“cost” that they incur. BFIs lend money to people and businesses, and interest
charged on these is considered their “earnings”. The difference between
earnings and cost is considered their “profit”, and this profit is considered
to be their contribution to national economic growth. This consideration is disingenuous
for a couple of reasons.
First, difference between earnings and cost is the value they have
added to our money deposited with them. It is not their profit because some
portion of this value addition is yet to be spent as “costs”. Some of this
value addition is spent to pay for various evaluations and monitoring costs
that BFIs incur while assessing, evaluating, re-evaluating and monitoring their
high-risk loans. These costs are not paid by borrowers of loans, but by the
BFIs themselves. So, BFIs end up spending a portion of their value addition on paying
such costs. Therefore, the number that NRB and BFIs report as contribution of
the financial industry to our economic growth is wrong. The actual contribution
is much less.
This misleading figure is the reason why we suffer through liquidity
crises, every now and then. In our recent liquidity crisis, the level of profit
and savings that BFIs showed to their shareholders was distorted due to the
above mentioned fudging of facts. They actually did not earn the amount of
profit that they claimed to have earned.
Second, interest rates charged on mortgages issued by BFIs have been
significantly higher than interests guaranteed on government issued long term
bonds and treasury bills. Money for providing mortgages comes from money
deposited by the accountholders. Since mortgages fetch high interests, BFIs
tend to give higher returns to their depositors as well to lure depositors into
depositing more money into their bank accounts. Therefore, entire financial
system rests on the shoulders of depositors and how confident they are with
their respective BFIs. A slight reduction in their confidence can mean a huge
reduction in available funds for BFIs. Thus, our entire financial cycle has a
very high risk associated with it. Rising instances of default—either by
depositors or by mortgage holders—takes our entire financial market on a
decline.
Many studies have disputed this general notion that risk-taking
behavior of BFIs is a “productive activity”.
In 2011, Andrew Haldane and Vasileios Madouros analyzed the worldwide
financial crisis of 2008, and discovered that investing capital in a risky
asset did not contribute to productivity. This suggests that Nepali investors
who purchase bonds from a company, or Nepali consumers who borrow from a bank
to buy houses, are taking financial risks but contributing “zero” to economic
activity. The reason for this being that nothing new is created from these
transactions in our economy. There is simply a reallocation of available
finances from one party to the other. Hence, loan portfolios have negligent
contribution—if there is one—in growing our economy.
Another chronic problem with Nepali financial system is that consequence
of risks is not borne by parties that take those risks but by others in the
society. BFIs utilize our money in issuing risky loans with much higher returns
than the interest they pay us for our deposits. If these risky loans get
repaid, they make tons of money. CEOs and shareholders of those BFIs get rich.
If these risky loans are not repaid, they go bankrupt. We lose most of our
money that we deposited with them. CEOs and shareholders of those BFIs do not
have to pay us the money that was ours but which they lost through their risky
behavior. Where’s the balance in rewards versus punishment in our BFIs?
Nepali financial system is structured in a way where CEOs get away with
their risky behavior without being held accountable for their actions. If BFIs
go bankrupt, CEOs know NRB will rescue them i.e. the public will rescue them.
If they earn ridiculous profits, CEOs know the profit will be solely their
shareholders’. So CEOs do not have to pay for their risky behavior, and so they
take more risks. Nepali financial system has created this “moral hazard”
situation where society has been paying the price for the follies of BFIs.
These criticisms do not mean that our financial system is utterly
useless and a zero contributor. Researches around the world have shown that world’s
financial industries do provide some services, and hence they provide positive
value additions. However, he also discovered that these value additions have
been overstated. Contribution of any country’s financial industry—including
Nepal’s—to its economic growth has always been overstated. Rapid growth in
contribution to Nepali GDP by our financial sector in the last few years is a mirage.
Exceptionally high returns that Nepali financial industry experienced
before the recent liquidity crisis was not a result of increasing productivity
of our financial sector but a result of illusion of growth shown by high-risk
lending and borrowing. If current trend of high risk-taking in Nepali financial
sector continues, soon there will be another liquidity crisis worse than the
one that lasted from 2009 until 2012. The reason Nepali financial market has
not yet recovered fully from that crisis is because the risk-taking behavior
continues even today.
Labels: banks, BFIs, financial institutions, financial market, liquidity crisis, NRB
Monday, May 21, 2012
Mergers: Proceed with caution
The following article on mergers was published in Republica on May 20, 2012 with the title "Tread with caution". The direct link to Republica is here.
The financial market is not going to suffer for eternity. We have seen
weak and stagnant financial activities in the last few years in Nepal due to
the recent liquidity crisis. As I have stressed in my previous articles, the
liquidity crisis in Nepal was primarily the result of our banks and financial
institutions (BFIs) providing majority of their loans to the real estate
sector. The real estate market slowed down beginning late 2008. As a result,
borrowers could not pay interests, let alone the principle amount of the loans.
So, the banks lost money, and this brought a liquidity crisis.
However, the real estate sector will eventually start improving again,
and will experience increase in its activities. Then, the borrowers—who have so
far defaulted in their payments—are going to start making their payments again.
When that happens, our BFIs are going to be flush with cash, again. So, what
will they do with that excess cash?
Since their investment and loan portfolio is not diverse, the BFIs will
have to choose between two options. First, they will have to take risk and
start providing loans to the real estate sector, again. This has a tendency to
bring another liquidity crisis if the real estate market slows down, again.
Second, to move away from the risky real estate portfolio, the BFIs could use
their cash to purchase securities which are much safer than issuing real estate
loans. However, the securities yield much lower returns compared to real estate
loans.
That would be a very confusing scenario for the BFIs. On one hand, the
BFIs would not want to go back and issue excessive loans to the real estate
sector because that was what caused them suffering in the last few years. On
the other hand, the securities option delivers them poor returns. If the BFIs
are flush with cash and do nothing with it, they will have to face intense
pressure from their shareholders. When the pressure becomes unbearable, the
past experience from around the world suggests that a third outcome is more
likely: a merger spree.
The bottom line for the BFIs is to ensure that their shareholders are
happy. The best way to make shareholders happy is to show them that their
institution is growing. The best way to grow a financial institution is to
acquire assets. And, the best asset a strong and cash flush BFI can acquire is
another BFI. So, once the real estate market in Nepal wakes up from its
hibernation, and starts making money again, our BFIs will have no logical option
to follow other than engage in mergers to grow their assets.
While the shareholders will be happy seeing their institution grow
through such mergers, the mergers do not guarantee a healthy BFI or a healthy
financial market. Today, the mergers happening in the market are not the result
of choice but compulsion in saving the institutions. In the future, the mergers
will not be the result of choice but that of compulsion—to “show” the
shareholders that the excess cash is being used in asset-building.
There are reasons why shareholders should not be too happy with mergers
and acquisitions. First, the New York Times reported during the merger surge in
2005 in the US that the shareholders’ stakes in the acquiring firm typically
declines post-merger. The structure of BFIs in the US and Nepal are not very
different. So, this decline could happen in the case of merging Nepali BFIs,
too. Second, evidences from past mergers worldwide show that the CEOs end up
pocketing around 8 percent of the merger cost as their own “compensation”. So, everyone
should ask: Was the merger done for the benefit of the institution or was it
done for the personal benefit of the CEO?
The New York Times report also mentions that there has been a strong
correlation between the size of a financial institution and the salary of its
CEO. It did not matter whether an institution was faring well or poorly in the
market. The CEOs of larger BFIs always get paid more than those in smaller
BFIs. Therefore, the shareholders need to be cautious and skeptical when their
CEO argues in favor of a merger. Who benefits the most from the merger should
be considered. Do we know how much our BFI CEOs are pocketing from their merger
deals? We need to find that out.
Labels: banks, mergers, NRB, Republica
Tuesday, March 27, 2012
Article: Costly Ignorance
My latest article in Republica today (March 27) is on the recent Nepali financial crisis. The direct Republica link is here. The unedited version of the article is below:
Recent Liquidity Crisis in
Nepal: Predictable, Avoidable and Not Over Yet
There are feelings among those involved in the Nepali financial market
that the recent liquidity crisis—that started in the late 2009 and lasted until
late 2011—is over. That is a dangerous feeling to have because the crisis is
not over, yet. It would be foolish to assume the crisis as being over simply on
the basis of a slightly buoyed confidence among the banks and financial
institutions (BFIs). Although there has been a rise in market transactions
among the BFIs, overall confidence among core financial market consumers—those
buying and selling real estate—is still very low.
The worst feeling to come out of the recent Nepali liquidity crisis is
that there were warning signs, in the early 2009, about a possible crisis in
the financial sector. However, neither the BFIs nor Nepal Rastra Bank (NRB)
seemed bothered by the impending loom. Together, the BFIs and the NRB ignored
the signs.
First, historical data from all over the world shows that liquidity
creation right before any liquidity crisis is always high. Money supply had a
decreasing trend after the Nepalese economy was liberalized after the democracy
in 1990. After 2001, however, the data shows an increasing trend. The increase
kept happening right up until the end of 2009, after which the liquidity crisis
hit the Nepalese financial system hard. So, literature review suggests that the
recent crisis was predictable. The question then becomes: Why did nobody,
especially the NRB researchers, predict it?
Second, the BFIs themselves had been forecasting net losses from their
outstanding loans. The forecasted capital levels were continually on a decline,
and the BFIs were increasingly worried about not meeting the NRB set standard
in this regard. Delinquencies were on the rise since 2007. If these internal problems
were not the signs for an impending liquidity crisis, I don’t know what were.
Unlike natural disasters, liquidity crisis does not come suddenly. It comes out
of a systemic and compounding failure of the financial market and its overseer.
The BFIs and the NRB should shoulder the responsibility for the recent crisis.
It was their own making, and the reason it lasted as long as it lasted was due
to their inability in seeing it coming in advance as well as their inefficiency
and incapability in solving it swiftly after it arrived.
Third, even if the BFIs were lying and covering up their losses, the
financial market as a whole should have known of such cover-ups. After all,
increasing charge offs and delinquencies as well as decreasing profit and
capital levels are not hidden information. These are publicly available data to
anybody and everybody who seeks them. So, those working in the financial market
as well as those monitoring the financial market (i.e. the NRB) should have
been aware that the BFIs were fudging their books. The recent liquidity crisis
was, therefore, a slap in the face to those who claim to know the Nepalese
financial market and those who claim to monitor it.
Fourth, when the crisis hit our financial market, initially, there was
no response to halt this crisis. The BFIs went about their business, crossing
their fingers, hoping that the liquidity “crunch” would not transform into a crisis.
The NRB looked the other way hoping that the market would correct itself. That
was a mistake. Eventually, after two years of crisis, the NRB decided to raise
the insured deposit amounts. Although they should have done this as soon as the
crunch hit the market, the NRB’s step should be viewed in terms of “better late
than never”.
With all these signs foretelling the severity of the crisis, the
concerned authorities did not actively seek to halt or mitigate the crisis. As
a result, the market suffered for over two years. The worst affected were those
involved in the real estate sector. As a result of the liquidity crisis, house
and land sales all over the country, especially in the Kathmandu valley, have
all but died out.
However, the past is past. Instead of ruing over the crisis, we should
think about potentially avoiding any future liquidity crisis. What can be done?
First, and foremost, the NRB should increase, improve and fulfill its duties as
a monitor of the financial market. Simply granting licenses to open up new
banks is not its sole duty. It needs to monitor, evaluate and investigate the
BFIs for any wrongdoings. Anyone found guilty needs to be punished, and not
bailed out. Bail outs should happen only if, absolutely, necessary.
While it is true that having excessive liquidity in their hands hurts
the bottom line of our BFIs, they should also realize that having too little
has a tendency to put them out of business. The NRB cannot come rescuing every
single bank that goes bankrupt. It has its own criteria and limits. Therefore,
BFIs should have enough short-term quickly liquidable assets at their disposal.
They can use such assets to ease the liquidity crunch if one presents itself in
the coming future.
Also, the proverbial “don’t put all your eggs in the same basket” saying
applies to our BFIs as well. Nepali real estate sector received as high as 70
percent of all loans made out by our banks. Therefore, the recent liquidity
crisis occurred due to our BFI’s inability to recoup their loans from this
sector. Diversifying the portfolio of investments can save them if one of our
economic sectors suffers from a crisis. The losses can always be recouped from
other stronger sectors if the portfolio is diverse. Until our BFIs learn this
lesson, there is always another liquidity crisis looming in our horizon.
Labels: banks, central bank of nepal, liquidity crisis, NRB
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