A Resurgence of Bank Nationalisations

An offshoot of the global financial crisis has been the significant changes in economic policies in the developed world. The recent phenomenon relates to increasing calls from leading economists to nationalise troubled banks, particularly in the U.S. The concept of nationalisation was previously associated with the so-called ‘socialist’ economies, but is now becoming closer to reality even with proponents of the free market.

As Paul Krugman notes in his column in the New York Times, “Comrade Greenspan wants us to seize the economy’s commanding heights. O.K., not exactly. What Alan Greenspan, the former Federal Reserve chairman — and a staunch defender of free markets — actually said was, “It may be necessary to temporarily nationalize some banks in order to facilitate a swift and orderly restructuring.” I agree.”

Further, Matthew Richardson and Nouriel Roubini, professors at New York University's Stern School of Business note: “As free-market economists teaching at a business school in the heart of the world's financial capital, we feel downright blasphemous proposing an all-out government takeover of the banking system. But the U.S. financial system has reached such a dangerous tipping point that little choice remains.” Such comments arise in the context of concerns regarding the continued viability of leading U.S. banks such as Citibank and Bank of America.

Apart from the policy rhetoric, nationalisations tend to invoke certain fundamental questions. Often, there is a conflict of interest between shareholders of banks (who tend to take a ‘haircut’, as they say, in a nationalisation by having to give up their shares at low values) and that of other stakeholders (such as tax payers and the public who suffer if Governments have to continually backstop troubled banks without being taken over). There is also the question of whether governments are in a better position to run businesses such as banks as opposed to the private sector.

These issues are not novel in the Indian context with a substantial part of the Indian banking industry being populated by nationalised banks. Many of these issues have been the subject matter of intense debates in 1969 and 1980 when several Indian banks were nationalised. Some of these were even litigated all the way in the Supreme Court of India (R.C. Cooper v. Union of India, AIR 1970 SC 564). What is interesting in the current scenario is that the revival of this debate in the U.S. and other countries has thrown the spotlight on the Indian experience with reference to bank nationalisations – while the analysis in the Knowledge@Wharton suggests caution regarding adopting the Indian model of nationalisation, an interesting fact reported yesterday is that Citibank’s market capitalisation has become less than that of the State Bank of India (which is not only India’s largest bank but is also in the public sector). The key difference, however, is that the recent moves recommend nationalisation as a temporary measure, while in India it has become a permanent feature (although several nationalised banks do have public shareholders and their shares are listed and traded on stock exchanges).

Nationalisation of Large Corporations

An interesting column in the Economic Times by Swaminathan S. Anklesaria Aiyar looks at the biggest government takeovers in history:

“Socialists, like Hugo Chavez in Venezuela or Indira Gandhi in India, are famous for nationalising the biggest corporations. But the US government has taken over three of its biggest corporations within two weeks. Has the US turned socialist?

American right-wingers moan that this is indeed the case. Meanwhile, Indian leftists are stunned at nationalisation in a country they view as pitilessly capitalist.

Two of the nationalised corporations, Fannie May and Freddie Mac, are by far the biggest mortgage lenders in the world, with $5 trillion of mortgages and loans on their books. That's five times India's GDP, to put their size in perspective. The third corporation , AIG, is the biggest insurance company in the world. No nationalisation in professedly socialist countries were ever so big.
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The usual procedure in a capitalist welfare state is to let mismanaged companies go bust, penalising the shareholders and managers, and then provide safety nets to those adversely affected. But when corporations are so large that their collapse would endanger the entire financial system, it's sensible even from a capitalist viewpoint to have a government takeover before they collapse . This is a sort of pre-emptive safety net. Moreover, preventing distress wins votes (or at least doesn't lose them), and that's vital in a democracy.”

The column however concludes that this is not similar to nationalisations as they occurred in the socialist contexts:

“The US takeovers, by contrast, are temporary affairs, to be followed by re-privatisation once the crisis is resolved. The corporations will be obliged to sell chunks of their assets to pay off debts and attain stability. They will then be re-privatised. They will emerge greatly shrunken, and perhaps broken into smaller units.

Nationalisation is a misleading word for this process. It is better called forced restructuring by the government, as a pre-emptive safety net. It aims to save citizens from pain, but within a market economy framework.”

History Repeats Itself: Whither Governance?

Much has already been stated in the press about the current financial crisis that had rocked not only the U.S. economy, but also the global financial system, and indeed the magnitude of this crisis will ensure that a lot more will be said in the future. Here we focus on one aspect of the crisis, which is the perceptible failure of corporate governance involving large companies.

In a provocatively titled book The End of History and the Last Man, Francis Fukuyama argues that the advent of Western liberal democracy may signal the end point of mankind’s ideological evolution and the final form of human government. But, of immediate interest to us is a debate in corporate governance that takes a leaf out of Fukuyama’s book (or at least its title to begin with). In an article, The End of History for Corporate Law, two leading U.S. corporate law professors, Hansmann and Kraakman set the framework for the current global corporate governance debate, where their argument is twofold: (1) American corporate governance has reached an optimally efficient endpoint by adopting the shareholder primacy and dispersed shareholding corporate model, and (2) the rest of the world will inevitably follow, resulting in a convergence of corporate governance around the world on the lines of the U.S. model. Although these arguments have been subject to a fair amount of criticism, events that have occurred over the last few days severely expose chinks in the U.S. model of corporate governance, and provide at least some anecdotal evidence that such model is questionable.

The question that is being posed is: where was corporate governance when the CEOs and boards of directors of large and admired U.S. corporations such as Bear Stearns, Lehman Brothers, Freddie Mac, Fannie Mae, Merrill Lynch and AIG saw the performance of their companies plummet, which finally resulted in a massive erosion of value to their shareholders and other stakeholders? Going back into (recent) history, this is indeed not the first time that such questions have been posed. Earlier at the turn of this century, we saw the very same questions being asked when a governance crisis of a slightly different nature occurred with Enron, WorldCom, Tyco and other companies being mired in accounting scandals.

Following this, stern legislative measures were introduced in the U.S. in the form of the Sarbanes-Oxley Act of 2002 that required companies listed in the U.S. to put in place strong systems and practices to enhance corporate governance. However, those measures apparently have been insufficient to deal with the current crisis.

Nell Minow, an influential corporate governance activist and commentator has this to say in a column on the CNN website:

“Despite the post-Enron adoption of the most extensive protections since the New Deal, a survey released this week by Kroll and the Economist Intelligence Unit found that corporate fraud rose 22 percent since last year.

The option back-dating and sub-prime messes show that even the post-Enron Sarbanes-Oxley reform law and expanded enforcement and oversight cannot eliminate the severest threats to our markets and our economy.

This proves that there are limits to structural solutions. Ultimately, markets are smarter and more efficient than regulation. What the government needs to do now is insist on removing obstacles to the efficient operation of market oversight.”

That being said, it must be noted that the Enron cohort of scandals involved some element of fraudulent conduct on the part of the actors involved (that included both insiders such as the board and managers as well as outside gatekeepers such as auditors), while in the current situation there has been no such allegation or finding yet, with the situation arising mostly from misjudgments in valuing complex financial instruments and transactions that these companies either invested in or became involved with.

The Efficacy of Windfall Profits Tax

The recent spike in oil prices has rekindled the debate on the need to impose a windfall profits tax on private oil companies. The matter has even acquired political overtones in the US presidential elections, with one of the nominees, Barak Obama, supporting the imposition of such a tax.

This issue has now reared its head in India as well (perhaps for the first time, to my knowledge). Here too, it has unsurprisingly assumed political proportions. However, there is yet no clear opinion on whether such a tax would be efficient, and as to what could possibly be the implications of such a tax from an economic and legal standpoint. In a previous article, the Hindu Business Line sets out the issue (as follows):

“With global crude oil prices touching new highs, a debate has been triggered on measures to deal with the situation and partially insulate the consumers from the impact.

One such suggestion has been imposition of a windfall profits tax on private/joint venture oil-producing companies and private standalone refineries earning profits through import parity pricing policy.

The Left and other political parties such as the Samajwadi Party have been pressing for levy of such a tax citing examples of countries where the tax has been introduced.”

The article then sets out both points of view on the matter:

“A windfall profits tax is levied on oil companies because of the profits they earn as a result of the sharp increase in oil prices. Industry trackers feel that imposition of such a tax would merely mean extending the burden sharing of high crude prices on standalone refiners, and would not help much in cushioning the retail consumers. Besides, it would send a wrong signal for those who are looking at investing in oil and gas exploration in the country.
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However, the contrary argument is that with high crude oil prices, the product prices also go up, which is measured by gross refinery margins and this is where the refiners gain, thus the refiner should share the burden. Public sector players say that if the tax is levied in lieu of the subsidy burden which they have to bear then it may be acceptable, otherwise it serves no purpose.”

However, more recently, the Hindu Business Line carries a column by Raghuvir Srinivasan that launches a scathing attack on the proposal for windfall profits tax. He argues:

“A windfall profit tax on oil companies now would be illogical and an unwise economic measure; those arguing in favour should look at the experience of other countries that have imposed such a tax in the past, specifically the US, where it did more harm than good to their economy.
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So, what is all this talk of a windfall profit tax then? Such a tax is certainly not going to help bring down pump prices of petrol or diesel. What it will do though is cause immense damage to the already faltering oil companies and lead the government into complex litigation. The rationale for such a tax is completely suspect and can be challenged in the Courts. This is territory not traversed by the government before and could lead to needless complications in an election year.”

This issue is still at the early stages of evolution in the Indian context, but certainly has the potential to throw up interesting legal challenges if pressed forward.

Derivatives in Commodities: Some Issues

The issue over commodities exchanges and trading of futures and options in respect commodities has been brought to the fore with the Left parties deciding not to support the Forward Contracts (Regulation) Amendment Bill.

By way of background, commodities trading can occur in two ways. One is spot trading, where a buyer and seller of commodities enter into a contract, and settle the same by delivery of the commodities and the corresponding payment within a predefined time period (usually up to 11 days). The second is forward trading, where the delivery and/or payment occurs beyond such pre-defined period. Under the Constitution, spot trading is left to States to legislate, while forward trading is within the domain of the Parliament. It is under the latter powers that the Parliament enacted the Forward Contracts (Regulation) Act, 1952 (FCRA) that governs forward trading in commodities. Under the FCRA, while forward trading was permitted in some commodities and restricted in others, options were prohibited. To explain an option, it is a contract under which one party has the option or right (but not the obligation) to buy or to sell a commodity at a predetermined price. The administrative authority under the FCRA was the Forward Markets Commission (FMC), which was a government body.

With the development of the commodities futures markets over the last few years, the Government proposed an overhaul of the FCRA to take these recent developments into account. The principal changes relate to the allowance of options in commodities (that were earlier prohibited), the reestablishment of the FMC as an independent regulator (on similar lines as SEBI) rather than as an arm of the Government itself, and the organisation of commodities exchanges (to enable commodities futures trading) on corporate lines similar to stock exchanges. While these issues were part of the Forward Contracts (Regulation) Bill, 2006 that was pending in Parliament, the Government accelerated the reform process by ensuring the promulgation of the Forward Contracts (Regulation) Ordinance, 2008. The key features of the Ordinance are set out in a press release issued by the Government.

While there could be some questions as to the way in which the Government secured the changes through an Ordinance just two weeks before the Parliament commenced its session, there is little doubt that these changes were long overdue. Like the stock markets in India, the commodities markets too have been developing in a structured fashion over the last few years. Two large electronic exchanges in the form of the Multi Commodity Exchange of India Limited (MCX) and the National Commodities and Derivatives Exchange Limited (NCDEX) have been established and they now handle a significant portion of futures trading that occurs in commodities in India.

Economically, futures trading provides several benefits; it creates liquidity in the markets, enables price discovery by signaling the best price to the rest of the market participants, and most importantly, it provides traders with an avenue to hedge their risks. But, we must bear in mind that derivatives (such as futures and options) are complex instruments and hence are inherently risky. They are largely based on movements in commodity prices, and wrong bets on market movement can prove to be very costly, sometimes even to sophisticated players.

The Left has largely attacked the Ordinance by attributing the recent surge in commodity prices to extensive futures trading. However, that seems somewhat misdirected, as there is no correlation established between futures trading and increase in prices. Price increases could possibly arise due to myriad other factors.

I find that an important aspect that the Ordinance has failed to tackle is the issue of complexity of derivatives. It is not sufficient if the law merely provides a platform for derivatives trading in commodities. There needs to be a proper mechanism for disclosure, which requires persons that are selling futures and options in commodities to disclose all details (the risks in particular) relating to these products in a manner that the buyers of such products are able to appreciate the risks involved before they decide whether to participate in that market or not. In relation to derivatives in the stock market, the detailed rules issued by SEBI largely serve that purpose. It is also to be noted that the commodities futures market is likely to be patronised primarily by traders (some of them who may be of medium to small-scale) who may not possess sufficient sophistication to comprehend the risks involved in such complex instruments. The experience with derivatives in the financial markets (where the level of sophistication is somewhat higher) has not been good either, what with several companies now filing suits against banks (with whom they entered into derivative transactions) to renege on their commitments, including on the grounds that they did not fully understand what they were entering into. For details, see here and here on the Indian Corporate Law Blog). Therefore, a proper disclosure regime is called for in commodities trading so as to ensure informed trading in commodities derivatives, and thereby a transparent market.

The Left has also opposed foreign direct investment (FDI) in commodities exchanges. Although the press reports (referring to the Left objections) indicate that the FDI has been permitted under the Ordinance, it is not the accurate position. FDI is governed by various policies issued by the Department of Industrial Policy and Promotion (and not the Ordinance). The Press Note 2 of 2008 allows foreign investment of 49% in commodities exchanges (with 26% FDI and 23% FII investment) with the prior approval of the Government. Further, no foreign investor/entity, including persons acting in concert, will hold more than 5% equity in such companies. This appears to me to be a balanced approach towards foreign investment. While it allows major world players in this industry to participate in the Indian market and thereby introduce their expertise and business practices, it guards domestic interests as well. It is fairly restrictive as (i) investment is possible only with prior Government approval, (ii) majority shareholding still remains with domestic owners; and (iii) there is no risk of dominance by a single foreign player (or group) on an exchange as individual investments are capped at 5%.

It is likely that these issues will be the subject of heated debate in the near future, especially as the Bill comes up for discussion in Parliament.

A detailed examination of issues relating to Retail in India

Continuing the trend set by Umakanth of updating issues previously explored on the blog, those who followed the brief discussion about the debate over whether and how foreign retailers should be allowed within India, would be interested in the latest issue of Frontline. The issue dated June 30-July 13 features the issue as its cover story. The lead story provides many of the factual details that discussants on the blog had enquired about. Another story focuses on the regulatory issues involved. Other stories focus on particular cities and the challenges they face in respect of retail. In all, the stories provide a lot more factual information on the issue, which should be helpful for those interested in taking the debate forward, even if they disagree with the analysis.

The politics of economic liberalisation in India

Today's Indian Express carries an interesting column by a Mumbai based management consultant. The views expressed are a stimulating counterpoint to the conventional wisdom ( that the left parties are to blame for our current woes) that one finds repeatedly expressed in the contemporary media. Having said that, I found the columnist's claim that "the fruits of reform are now enjoyed by a broad swathe of our society, not just the middle classes" particularly difficult to swallow. The agenda that the piece marks out is ambitious. Perhaps those who are so gung-ho about market reforms in India should pay heed to the call - it certainly makes political sense.