Financial Crisis 2007 - A background

Background of Financial Crisis 2007

The Banking/Financial crisis of 2007 was/is of such unparalleled ferocity that the only equivalent event that comes closer in magnitude is that of late twenties and thirties global depression in twentieth century from which world only recovered post World War of 1945. Hopefully, this time it would not require a major war to achieve complete recovery!

The epicenter for this crisis was definitely in banking/financial sector especially in USA but unlike previous crisis of 1929 depression it did not start with stock market but in financial/banking institutions. To attempt to begin to identify the cause(s) of this crisis we need to develop historical understanding of banking and financial industry which was fundamentally re-structured following thirties global depression. (This discussion will mainly concentrate on crisis effects, causes and remedies from USA perspective unless stated otherwise)

The key initiative introduced in banking/financial industry post 1933 USA to mitigate crisis effects and avoid future ones were:

• Regulatory Overhaul: Introduction of Glass-Steagall Act (Bank Act 1933) that caused for clear divide between various financial institution i.e. retail/commercial bank, investment/merchant bank, insurance, securities etc. This was a far-sighted decision which served its objective by clearly defining and distinguishing different financial business as each of them has its own distinct behaviour and risks associated with them. In addition each of these businesses would be regulated by its own specific regulator like Federal Reserve, SEC etc which would ensure a containment and also specific regulation for each industry.

• Federal Deposit Insurance (FDI): As the thrust of the crisis were felt by small bank deposit holder due to run on banks hence Govt introduce a scheme where by Fed (Central Bank) guaranteed these deposits up to a certain amount (currently $100K) which in turn ensured that trust in bank returned with public and also ensured that retail bank  wont suffer liquidity problem (from liability perspective, assets side banks have to manage).

These regulation successfully serve their purpose for next five decades as during that time USA had seen many economic expansion/recession but all of them were devoid of any financial/banking crisis and were mainly induced by Fed's monetary policy. During this period financial industry has mostly the image of staid bean-counters with regular jobs and not the glamorous millionaires that it started to resemble in 1980's.

These regulations have to be understood in wider context of changes taking place in USA (and worldwide), as post depression marked a huge change in political/economic ideology where in

the idea "Govt is good" started to flourish as oppose to laissez-faire that used to be the prevalent norm for governance. This meant that Govt. either started framing rules/regulation for industries, course followed by USA which led in terms of these regulations or Govt take over of industries itself, mostly in Europe which saw a vast public sector emerge especially in defence and health.

This pro-regulation (which sometime is also inferred as anti-business) environment continued in USA until late 1970's when with the troubles of stagflation (aggravated by oil crisis) in 1970's West began to turn towards more pro-market, deregulation philosophy whose political proponent Republicans in USA and Conservatives in UK came to occupy seat of power simultaneously.

Thus, began an era, especially in finance, which over next 25 year would turn the industry upside down and pendulum of regulation swung to other side completely. This did not happen over-night but regulations were dis-mantled slowly over a period of time, this was helped in not so small means by a secular growth in stock market which provided a tremendous increase in wealth as more and more public came to own stock (this period saw the assets of mutual funds and stocks overtake bank deposits as repository of public savings in US). The change in social attitude and almost religious belief in market forces is a far wider topic that needs to be studied separately but suffice to say that it provided a perfect platform in which post depression financial regulations were dismantled and in some cases new industries without any regulations or minimal regulations were allowed to flourish.

During this period from 1980's onward it wasn't as if there were no crises some of the prominent one in chronological order is:

• Savings and Loans USA - 1986
• Japan Banking 1991
• Asian banking crisis 1997
• Long Term Capital Bank (LTCM) USA 1998
• Enron/Accounting 2002

As each of the crisis unfolded and were resolved they were all explained away with some specific/local issues and not anything systemic that could be applicable for modern capitalist system with its pro market and deregulation gospel.  Thus, Asian banking crisis due to "crony capitalism" and nepotism of Asians (someday it would be a good topic for modern racism/white supremacy/oriental-ism discussion). LTCM was made out to be a case of a one large bet going wrong or rather one institutions risk management system not being upto the scratch.

But ignorance of Japanese banking crisis has been the worst egregious behavior for system regulators and industry especially in USA (West typically follows USA in terms of financial regulation). This was a crisis which originated in asset price bubble of 1980's led by stock market and real estate sector (at its peak total Japan real estate was valued more than that of USA!). Unfortunately as the bubble bust in 1991 it was not just case of re-adjusting quickly to demand shock for few years but instead due to presence of large non-performing assets on financial institutions which could not be written off without causing further damage to economy. Thus, this was termed "balance-sheet" recession where all economic stake-holder corporations and household spent an entire decade or more in De-leveraging i.e. reducing their overall debts and Govt has to assume fiscal deficits to prop up the economy (Public and private sector cannot run deficit simultaneously). Many economists in USA have been student of this crisis and have generally blamed Japanese Central Bank and/or Govt for being "too little too late" but looks like boot is on the other foot!.

Now with advantage of hindsight for handling of crisis during 2007-2011 it can be safely said that West had ignored the political economy part of decision making or had not properly accounted for its impact. It seriously underestimated the effort require to reach a majority consensus in democratic setup where significant and powerful section have their vested interest that are diametrically opposite to society at large.

Origin of crisis in USA Mortgage Industry

 It is common knowledge now that the first sign of asset bubble were noticed in US mortgage industry which has over the last decade seen a major change in financing due to securitization of Mortgage Assets by industry. The securitization, which was hailed initially as a risk dispersal/management mechanism by regulators, was thus encouraged wholeheartedly with minimal regulations. This provided a means of spreading the risk into other parts of global financial sector (risks never disappears it just gets transferred with loss of information, Lesson learnt!). Thus, the traditional mortgage which had only two actors i.e. customer and mortgage holder typically a bank which held the same to its maturity, now the same had been transformed where multiple actors/institutions participated in various roles:

1.      Mortgage Originator/Financier: Institution that does the original due-diligence and provides the mortgage to customer. These are primarily commercial banks  or specialize mortgage financial companies (Country wide Financial)

2.      Investment Bank: Organization responsible for converting the loan portfolio into securitized debt consisting of alphabet soups of acronyms MBS, CDO, CLO, CDO- squared etc. They were the originator and backer for all financial engineering that went into creation of these financial products.  

3.      Rating Agencies: Provide standardized and ‘independent’ rating of various securities

4.      Govt. Sponsored Enterprises (GSE): Organization with mandate to provide liquidity in specific areas like mortgage, student loan, etc.

5.      Investors: End buyers of financial security basically the organization who carry the risk on their balance sheets and could be Pension/Mutual/Hedge/Sovereign funds spread all over the globe.  

6.      Mortgage Servicer & Trust: Organization which manages the cash-flow from customer to investors and especially non-payment, default fore-closure process

7.      Debt Insurance: Organization under-writing CDS contracts on the securities,

Due to dismantling of restrictions there was trend world-wide of huge growth of all-in-one shop  “global bank” like Citi, BoA playing all the roles mentioned above thus creating a huge inter-connected networks which were not visible to regulators but would cause financial contagion at the time of financial stress.

Once the asset growth started slowing down the signs of stress started becoming visible interconnected financial system (in fact some market participant committed fraud by selling their naive clients mortgage based securities that they knew were dud, many of these are getting sorted in legal system). These stresses initially showed up in illiquid Inter Bank credit market in summer of 2007 and reached its peak with the bankruptcy of Lehman Brothers', in between causing either bankruptcy/seriously harming such global institutions as Bear Stern, Fannie Mae/Freddie Mac, AIG, RBS (UK) etc.

In the end this crisis has impacted all of financial sectors globally, each of these sectors were affected in their own way and have posed systemic risk that need to be delve in detail by its regulators. But the most prominent of all these are the Banks (Commercial and Investment) as they are fundamental to functioning of modern economy by providing the plumbing for Payment/Saving functionality to majority of population, hence need to be protected which implies an implicit Govt. subsidy in their activities. The other side of this coin would indicate since Banks cannot be allowed to fail hence they need to be regulated carefully.

FDI in Retail Industry (India)

For last week since the Govt. of India decision, which was bolt from blue, to allow 51% FDI in multi-brand retail (100% in single brand) a sort of pandemonium is going in both parliament and media but for a disinterested (OK am interested in paying less for more goods  :-) ) there is not much detail to go by especially since it was not preceded by any serious/analytical discourse in national media discussion are difficult to come by. In this space I have tried to address that lacuna without pronouncing on any judgment.

Retail Industry Landscape in India: Any mention of retail to us brings either the picture of neighborhood kirana store that we all have grown-up with or the vegetable vendors/hawkers on their carts or in a mandi. This memory accurately captures the majority of Indian retail experience untill circa 2000. Currently, Food & Beverages represents 70% of total retail trade by value and clothing forming the next segment at 10% whiles the rest being comprised of consumer durables, jewelry, personal care, footwear etc.

Except F&B all other categories have seen a strong growth of foreign owned players as these are mostly sold under single brand retail and have mushroomed substantially in last 5 years, only now new policy may allow likes of Macy’s or JC penny to open stores here but somehow that does not have emotional reaction like F&B.

The total size of retail industry is about $435 billion and accounts for about 15% of Indian GDP, and it employs about 40 million people either in retail or retail related logistics industry. In terms of comparison with others India retail labor productivity is 6% of US (thus could have huge savings but definitely with less no of jobs!) and has the world’s highest shopping density with 11 shops/person but with least space per capita (only 2 sqft/capita).Thus this is definitely fragmented and in-efficient industry which definitely needs to be turned around but would involve massive change as it touches directly/indirectly with huge population across India.

Traditional Retail: Traditional Trade is defined as all that trade that flows through outlets such as kiosks (Pan-wallahs, imagine what will ITC and Telecom service provider do without them!), Kirana shops (local mom and pop shops), open markets (Mandi), hawkers/street vendors etc. It represents all trade with the exception of that which flows through retail chains, supermarkets, or super stores a.k.a. Modern Retail.

Traditional Retail used to be the only retail channel until the last century all over India but in last decade with arrival of Modern Retail in urban India its percentage share is now about 93% of total trade.  In terms of distribution 24% of retail trade occurs in cities with more than 1 million populations i.e. the ones where foreign owned corporations will be currently allowed in to open shop.

Challenges for Indian Retail Industry:

1.       Supply Chain:  is a key area where substantial improvement needs to be achieved for Indian retailer to achieve close to Int’l norms in terms of efficiency and productivity. This is one issue where India will need to address core infrastructure if at all it wishes to benfit from retail modernization. The core issues here are:

·         Transport Infrastructure: India lags in rail, road and port development compared to its peer in BRIC countries.  This would mean Govt has to take the initiative in developing port and rail network especially rail where freight will need to be accorded higher investment as it is a profitable sector on its own.  Will require a consolidated trucking industry from the current fragmented one.

·         National Cold Chain:  No reliable cold chain network which causes huge food wastages, 40% is the wastage for highly perishable items the figures are mind boggling upwards of Rs 60,000 crores, criminal in a country with army of under-nourished children.

·         Lack of countrywide distribution network: This causes each product company to manage their own distribution with emphasis on urban areas due to high density and higher spending power.  This results in maintenance of high inventory at retailer shops which result in higher cost to end consumer.

Supply Chain issue will need to be addressed on high priority and may require common industry based solution as each retailer cannot develop this whole infrastructure on their own, for e.g. they can follow Telecom service providers who share tower infrastructure but compete on services.

2.    Infrastructure:  To develop and maintain complete retail and logistical infrastructure would require reliable Power, water, communication infrastructure to support the growth projection.

3.       Land Use/Real Estate policy:  India will need to sort out the mess that surrounds real-estate/zoning laws (look at ULCA and stamp duty). This is especially true in urban areas where large land required to support such Big-box retailing is non-existent or if available then at very high rentals which in turn means high costs to end customer. It will also need to have proper urban planning (am asking for moon!) to ensure that there is enough space to support customer transportation. If properly managed this could be a huge opportunity for construction industry (current projections have unmet demand of 500 mn sqft?? need to validate)

4.       Taxation & Govt Policy (APMC):  Tax structures need to be standardized in terms of process (states can still have different level of taxation) and octroi and entry tax needs to be abolished as they are a major source of corruption and delays in goods movement. Indian states will need to modify their APMC acts so as to enable free movement of goods and enable direct purchase from farmers without a huge chain of middle-men. This should help Govt in the long run as it will majority of transaction will be on the accounting books of retailer (modern retailers escape tax by employing highly paid CAs!)

5.       Sourcing from Producers:  This is one area where there could be huge impact, Indian farmers are fragmented lot and majority of them do subsistence farming with very small land holdings. Thus in supplier – producer relationship they will not be in a position to bargain against a deep pocketed customer , also from buyer’s perspective managing so many supplier and their relationship will be a night-mare but this could be managed by forming local co-operatives. India already have some experience in this due to now presence of food processing industry. The additional benefit is that it should result in lot of agro based industries in rural areas providing employment opportunities. Another bone of contention will be on the clause which requires them to source 30% of their supplies from SSI (Small scale Industry) in India.  This is a policy for which we can state “Road to hell is paved with good intention” as this was meant for saving indigenous handicraft and cottage industry but now is an inefficient legacy of past as it obstruct in achieving economies of scale.

6.       Misc:   Some other issues faced by industry are

·         Lack of skilled resource as India currently do not have specific courses for retail management that can meet the projected demand

·         Labour laws to allow flexible working to support 24x7x365 kind of operations

·         No customer spending patterns, country-wide or region wide

·         Large grey market

If and when these changes are implemented it is expected to raise the CAGR from current trend of 7-8% to 11-12% for long term i.e. for next 20 years which will have a significant impact on Indian GDP growth rates probably pushing it above double digit growths

Case study of China Retail Industry: China before modernization had a very similar industry structure like India i.e. it’s economy was pre-dominantly rural with very large no of small retail shops spread across multiple markets with their own distinct preferences and practices.

It started modernization of its retail industry in 1989 when it opened up Beijing and Shanghai for foreign retail corporation at that time total retail market was $100 bn.  From that moment on it has been modernizing and opening up to FDI its retail industry consistently

·         1993: FDI allowed in 11 cities through JV with maximum FDI of 26%

·         1999: Provincial capitals opened up for with FDI limit of 49%

·         2003: FDI to go over 50% i.e. majority stake

·         2005: 100% FDI with all major restrictions (like urban/rural etc) removed; Retail Sales is $500 bn even at this juncture the modern organized retail only accounted for 20% of the overall market

·         2012(E): Retail sales are expected to be around $2.1 trillion and this will be the second biggest market after US

The key feature of China markets is

·         Top 20 retailers have a market share of 8.9%

·         Majority of top retailers are Chinese; they comprise 8 of the top ten and eighty of the top 100 retailers

·         E-commerce penetration rate is 20% as oppose to approx 70% in US & Japan.

·         Online commerce CAGR of 105% from 2004 to 2010

·         Most M&A remains between domestic companies

·         Emerging Chinese retailers looking to increase overseas activities and compete in Global markets

·      Many of the western retailers have closed Chinese operations as they could not cater to Chinese needs (Mattel) or their operating model was too westernized (Best Buy)

To sum it up would like to quote AT Kearney 2011 GRDI report “While Chinese retail market will hold substantial promise for years to come, achieving profitability in the market is not easy. Success will not happen overnight, or without putting the right mechanisms in place to ensure consumer acceptance.  Also, success in China means doing business the ‘Chinese way’ – simply cutting and pasting your existing operating model won’t fly.”

The billion dollar question crucial question which I have not addressed yet is how does it impact to 40 million persons associated in retail mostly in traditional format? Do they just fold away and disappear into a black hole on appearance of modern retail? Will farmers be like slave laborers of big corporation with no power in pricing, crop or seed negotiations? What will be the fate of trading community that is involve in multiple level linking producers to retailers?

In light of our Indian experience so far it is clear that Modern Retail has not been able to change retail landscape dramatically as in our metros we continue to see the presence of both form of retail continuing to co-exist where customers have clear preference for local stores for fresh produce and small everyday item while they shop in modern stores for expensive goods such as consumer durables, watches, clothes etc. While modern outlets are preferred for better product quality, fresh stock, exclusive designs, more variety and better customer service, traditional outlets have the advantages of proximity, lower price and convenience.

Impact on various actors in Retail

Retailers: Initially, market is being opened up for in big urban areas where Indian modern retail is already present and co-existing with traditional shops. There is unlikely to be growth for traditional retail but they will definitely be around for decade or two or longer especially in fresh produce, secondly they will continue to serve low-income household due to their ability to provide short term credit which no modern retailer could provide. Do not expect too many reductions in job but growth will be flat in urban areas.

Traders (Distributors/Whole-salers/Sub-distributors): this is the group (in urban areas to begin with) that will bear most of the impact as modern retailers would not like to pay for middleman who is not providing any value add in supply chain. The niche players may survive as that relationship and produce might be difficult to replicate by Modern retailers. The biggest road-block (from retailer perspective) is the abolishing of APMC act by individual states and allowing for contract farming. This would be major impact on those households that are dependent on this as their income, it is easy to caricature them as good for nothing but most of them are from middle income group and could easily face tough times (India does not have any social welfare). In my opinion Govt will need to provide a way out where these could be provided training so they can be re-employed gainfully.

Farmers/Producers: This group is likely to gain in overall terms as in general they will receive higher prices for crops, could move into higher margin cash crops and in total sales due to lower wastage due to cold storage facilities..It should potentially see lower employment due to consolidation and higher mechanization but that should be made up due to new opportunities in value added agro-industries. This has already happened to large extent in better managed states like Punjab, Haryana and Maharashtra due to growth of agro-industries in last two decades and lesson learnt from these areas could be used elsewhere.

Conclusion: We have clear two disparate scenarios where in one India continues the existing way in retail to support its growing and demanding population with the same in-efficiencies, wastages in supply chain resulting in huge demand on producers resulting in side-effects like high inflation and huge and unmanageable demand on land. The second scenario is where we modernize each of the economic activity in this chain from production so that the gain made in this process could be shared by each actors i.e. farmers having a higher prices, retailer a bigger market share, and consumer more choices at competitive prices. 

I guess the answer is likely to be a no-brainer but we will be fooling ourselves if we do not realize that this will be major change for a lot of people and they will need support of society in different ways to cope with it. The good part is that this change is not happening over-night but spread over a period of decade.

Why FDI?

I have discussed and compared traditional v/s modern retail but someone could argue that why can’t we have wholly Indian owned modern retail and achieve the same goal that have been set before us?

It is a nice question for the argument sake but on looking in detail it is quite clear that India does not have skill and experience in building a modern retail and that includes the know-how in building and operating logistic business, merchandizing, customer insights etc. If we look at business history not nation has acquired any expertise in isolation it has always involved sharing where existing player bring business and technical know-how while the recipient provides local business processes and flavors and both needs to be fused successfully. Hence, in my post above have assumed this to be the case for above.