ARTHAARTH ISSUE IVEDITORIAL - IIM...

INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR FINOMINA

Editorial Team: Rahul Agarwal, Prateek Shukla and Ankur Agarwal

Design Team: Ankur Agarwal

Cover Design: Rajesh Kumar

Publishing & Distribution: Ashvini Kumar

Coordinators: Ankur Agarwal , Gopi Ramachandran

Contents

Bitcoin– Will it be able to kill fiat currencies ?

Page 1

Regional Rural Banks in India Page 4

Consolidation of PSB’s -

Need of the hour ?

Page 7

Does Gold have an intrinsic value? Page 11

Private equity

Page 14

Restructuring of European Banks post Eurozone crisis

Page 18

Visit us at finomina.iimu.ac.in

ARTHAARTH ISSUE IV CONTENTS


From the Editor’s Desk, Finomina is proud to present yet another brand new issue of Arthaarth. Finomina, the Finance Club of IIM Udaipur, strives towards nurturing interest and creating aware-ness among students regarding the different domains of the financial services indus-try and finance profiles in other industries. Arthaarth goes a long way in helping Fi-nomina achieve these objectives. The current issue of Arthaarth is quite unique in itself and very different from the

previous issues. There are articles focusing on issues ranging from Bitcoin to revival of European banks from euro-crisis. Arth-Samvaad is the flagship event organized by Finomina – the Finance Club of IIM Udaipur. This year we look at “Financial Management – Cues for the future” where we try to understand the application of Corporate Finance theory and the nature of Capital Markets in India. IIM Udaipur has been able to put in place, along with the traditional and necessary disciplines, subjects and issues that are most relevant to the current times that will help shape future trends. It is imperative that future managers get to know of the current trends in the industry and how the various macro and micro-economic factors interact to affect the way business is done all over the world. Arth-Samvaad is a platform to deliberate on developments in the world of finance. Apart from having the privilege of being launched at the prestigious flagship event of IIM Udaipur, Arth-Samvaad 2014, the issue has an impressive assortment of articles which explore the depths of finance. The cover story of this issue, “BitCoin – Will it able to kill the fiat currencies” is an academician’s galore. It is a winning article of Article writing competition, Vitt-Sangram in which the future aspect, pros and cons of Bitcoin are discussed. I dare say. “Regional Rural Banks in India” looks at the issues being faced in India and compares it with the recent reforms. The article on “Consolidation of the PSB’s” discusses the merging of two or more and its recent trends. “Does Gold have an intrinsic value?” takes a look at the dif-ferent aspects of the gold as investment. Speaking of the financial crisis, we have another article “Private Equity” which talks about the struggle of private equity in 2013 and compares with other firms in global market. Last but not the least we have an article on ”Restructuring of European Banks post Eurozone cri-sis” discusses on the revival of banks post European crisis since 2008. We wish your reading would be as pleasurable as it has been for us authoring the articles to perfection.

Yours Sincerely, Ankur Agarwal

ARTHAARTH ISSUE IV EDITORIAL

Bitcoin - Will it able to kill the fiat currencies? Working of bitcoin network: Bitcoins are used for electronic purchases and online transfers for services. A central server called ‘blockchain’ creates a log of every transac-tion ever performed using a bitcoin along with the time of purchase (a timestamp) and information about number of bitcoins involved. This is proper-ly encrypted to maintain its integrity. This is simi-lar to maintaining an audit trail, except instead of maintaining for a company, this is maintained for bitcoins transacted all over the world. It is called a blockchain because it is essentially a chain of blocks which record transaction details. These transactions are confirmed and verified by people called as ‘miners’. Ownership details of bitcoins are maintained by these miners whose job is to ensure the transaction done is secure and safe. They are rewarded for this by commission fees by vendors/merchants otherwise involved in the transaction. Miners are also awarded a ‘subsidy’ of newly cre-ated coins in the process. Mining process is made difficult such that a mathematical problem must be solved to find a block. When such a block is discovered, the discoverer gets a reward of few bitcoins which is agreed upon by other miners in the network. Currently this is 25 bitcoins/block. This value will halve every 210,000 blocks to control the coin supply and control inflation. This ensures that the total number of bitcoins won’t ever exceed 21 million. Currently blocks are mined every 10 minutes.

B itcoin first came into operation in 2009, in-troduced by a programmer or group of pro-

grammers who went under the pseudonym Satoshi Nakamoto. It started as an obscure project that a set of geeks and genius computer enthusi-asts experimented with. It is just like US dollar or Euro – a form of currency, except bitcoins are not controlled by any government or bank. It is not a physical entity to be handed over, it exists in digi-tal world only and they live in online wallets much like the Google wallet used to purchase An-droid apps. Although some physical proxies are introduced for bitcoins, digital format is most trusted and used. It can be exchanged for other currencies, goods or services. It is basically virtual currency which is completely decentralized and limited in number – target set to be 21 million by 2014. Bitcoins have a market value of approximately $9.8 billion based on supply and exchange rates. They are highly volatile. Bitcoin values have fluc-tuated from $266 to 84$ in a week. They are not backed up by gold or reserves like other normal currencies.

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ARTHAARTH ISSUE IV BITCOIN

FINOMINA INDIAN INSTITUTE OF MANAGEMENT - UDAIPUR

Bitcoins – The bright side: Inflation problem is low: The control of currency supply to 21 million is a big factor in controlling the inflation. Traditional fiat currencies. Since governments keep printing money every year, every currency denomination in the world will lose its value over years. The number of bitcoins are finite, the release of new bitcoins are being halved every few years and will stop com-pletely in a few decades. Around 2050 it is project-ed that there will be approximately 1 bitcoin every 500 people. Because of this bitcoin inflation prob-lem is essentially low. It also suggests a better pro-spect of investing in bitcoin currency due to its fi-nite nature, rather than stocking up on fiat curren-cy which is devaluing every year. Governments and currencies: Since bitcoin is not printed by any government as such, it does not depend on the welfare of any sin-gle country. Countries like Somalia which had their shillings thrashed to very low exchange rate (1USD = 35,000 shillings) due to the civil wars in the na-tion. This will never be the case with bitcoins. Since it is a virtual global currency collapse of this cur-rency will never be a risk. Safe and Simple: The entire transaction is highly encrypted with public key-private key SHA encryption. Since there is no banking authority involved in the transaction it is fast as well. Usually currency is transferred and becomes usable for the other party in a matter of minutes. There is usually a 2-3% credit card trans-action fee that the seller needs to pay. With bitcoins there is little to no fees involved. So the seller has a very huge advantage when using bitcoin for large

transactions. All necessary information is public and transparent. Entire bitcoin network is aware of each and every transaction. It is a big problem to online merchants who ship their products only to find a note from bank of the buyer’s that the transaction has been reversed / cancelled. In bitcoins transactions are 100% irre-versible working for seller’s benefit. Buyers must verify the credibility of vendor before transfer-ring. High liquidity and portable: Physical currency, Gold and other valuables al-ways run under the risk of getting robbed during transportation. Bitcoins are highly liquid in the sense it is same as cash maintained online and it can be sliced up into smaller pieces. It could be chopped up to 12 decimal points, with a currency exchange rate of $500 it gets down to as low as $5.5. Since it is a virtual currency it lives in online wallet. Thus these funds can be accessed from anywhere in the world with an internet connec-tion, or it can be downloaded to a USB thumb drive making it easy to carry billions in a flash drive. Bitcoins – The flip side: Untraceable: Since bitcoin transactions are virtually untracea-ble, it attracts a lot of illegal activities like betting and selling and buying drugs online. The payment system which is arguably the best in online ex-change currently, accepts only bitcoins and does not ask for any private information, passport info, or other details and hence complete anonymity is maintained making it a problem for governments to prevent trafficking activities.


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Prone to security attacks: With cash or credit card, money once lost can be regained on fast action and since bank maintains a record of the bank balance and is cov-ered by insurance in case of bank theft. Bitcoins have no such mechanism. If online wallet is hacked and bitcoins looted there is no method to regain it. Safest way is to store bitcoins in a disk disconnected from net. Volatility: Bitcoins, as already mentioned are highly volatile making them difficult for accepting in shops. Fluc-tuations are much, that a web shop need to main-tain the prices on daily basis to accept them and hence is difficult for transaction presently but this is expected to change in few years when the rate stabilizes. Of all this the biggest threat will be the threat of security of bitcoin algorithm. Since everything is done online and by an anonymous party with no means of regularization or a saving authority, one should always live in the fear of bitcoins being looted by a hacker in the future. It has no trace and hence this can’t be found and reclaimed too. This puts a big dent in the whole prospect of moving towards a bitcoin based world. Future of bitcoin: Bitcoins came in a world ruled by governments, to remove corruption in issuance of currency and its exchange. In Nakamoto’s words,

“We have to trust them (government) with our privacy, trust them not to let identity thieves drain our accounts… With e-currency based on

cryptographic proof, without the need to trust a third party middleman, money can be secure and transactions effortless”The idea is to have a flaw-less exchange of currency based on mathematics rather than trust on government. This was experi-mented in 1920s by a similar system of currency valuation - Gold Standard. Having the paper cur-rency to match to a fixed amount of gold will es-sentially inhibit capitalism which bitcoin will bring about if adopted by economy. Bitcoin de-nominated securities which would lead to the as-set bubbles similar to that of 1929. Good old fiat currency backed up by government security is trustable in that it has an intrinsic value associat-ed with it. In times of crisis such as the ones world has witnessed before in the past few decades, bitcoins will not be backed up by any authority and has no security for its value to remain stable. Even though bitcoin is compared to gold on the basis of limited quantity issued, and that it is in-ternationally acceptable, gold has a strong history for being a valid exchange medium of intrinsic value. Due to these reasons bitcoin won’t be able to compete with fiat currencies head-on in the near future. Bitcoins simple cannot kill currencies altogether. With improving security mechanisms, solving of hacks of online wallets, and more well-known companies (Wordpress, Reddit, Zynga etc.) join the wagon of accepting bitcoins, it is well on the right track to be an alternative decentralized service and one of the many to come in future. R.Sathyanarayanan, IIM Bangalore

Winning article of Vitt-Sangram’s article writing com-petition

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R egional Rural Banks were setup in India as a result of the RRB Act, 1976. The need for RRBs

was felt because the then existing commercial banks were not deemed sufficient for the rural area demands. The high cost structure of commercial bank which primarily catered to the urban popula-tion could not support disbursement of credit at low interest rates to the poor. RRBs were aimed at providing savings and credit opportunity to the large and growing rural population. The Reserve Bank of India categorized the perfor-mance of RRBs in 3 phases: Expansion, Declining and Turn Around phases. The expansion phase was marked by rapid opening up of RRBs and their branches. By December 1987, 196 RRBs with 13353 branches had already come into existence. The deposits amounted to ₹ 2305.82 crore and the loans of ₹ 2232.26 crore. However, this expansion although rapid had its share of difficulties. A very limited area of opera-

tion and high risks due the target segment were the major problems faced by RRBs. As the location of banks was not appeasing for people with bank-ing sector background, the RRBs faced severe shortage of skilled workforce. The focus on branch expansion and credit expansion neglect-ing the profitability and efficiency part led to problems like high NPAs, low profitability and low service quality. The losses kept on mounting due to tough operational conditions as most of the branches were located in resource-poor areas. A report by RBI states that there were only 23 RRBs in profit at the end of FY 1993-94. The banking sector reforms by Government of In-dia brought rehabilitation packages consisting of financial as well as non-financial components. Apart from the refinancing packages by the stake-holders, the RRBs underwent a host of policy changes like they were allowed to extend credit to non-target groups (target groups comprised of small and marginal farmers, landless laborers, ru-ral artisans and other weaker sections of society), they were permitted to subscribe to tier II bonds of the sponsor banks or other institutions up to 10% of funds owned by them, they were permitted to open and maintain non-resident rupee accounts, etc. RRBs were also allowed to finance both hous-ing and education loans. NABARD was directed to conduct training programmes for human resource development which was complemented by visits to institution in country and abroad for exposure. Impact of reforms The reforms had a significant improvement over

Regional Rural Banks in India

ARTHAARTH ISSUE IV RURAL BANKS

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Source: http://www.thehindubusinessline.com/industry-and-economy/banking/regional-rural-banks-may-be-allowed-to-tap-private-capital/article4644310.ece

The RRB Gross Bank Credit Growth and over the last decade has been fluctuating. Post the slow-down period, the Bank Credit growth have gone hand in hand. RRBs are controlled by different stakeholder and their joint ownership is limited to the issued capi-tal contributed by them. There are three stake-holders in RRBs i.e. Government of India (50%), the state government concerned (15%) and spon-sor banks (35%). If the proposed RRB (Amendment) bill gets sanc-tioned by the parliament then it will amend the Regional Rural Banks Act, 1976 and listing of re-gional rural banks on stock exchange could be allowed. The idea behind this is to make require-ments for raising capital by RRBs not just limited to the central, state government concerned and sponsor bank but also open to other sources. But in no condition, the total shareholding of the cen-tral and sponsor bank will go beneath 51%. The capital authorized for each RRBs is Rs.5 crore

the performance of RRBs. Spectacular results were seen in loan recovery performance, NPA manage-ment and branch and staff productivity. Statistics available with RBI show loan recovery at 80% in 2006 up from 51% in 1995 and Gross NPA at 7.28% in 2006 down from 43% in 1995. Looking at the data from 2010 to 2011, RRBs gen-erate its funds from various sources i.e. NABARD, sponsor banks, SIDBI etc. RRB owned funds consist of share capital and deposits of share capital con-tributed by the shareholders increased to Rs.13839 crore as on Mar 31st 2011 with a rise of 13% over the previous year. This increase was mainly possible due to the contribution of profita-ble RRBs. The deposits and borrowings of RRBs have also increased in 2011. RRBs deposits im-proved to Rs.166232 crore in 2011 with an in-crease of 14.6% as compared to 2010. Out of the 82 RRBs sixteen of them have Rs.3000 crore or more of deposits individually. Similarly RRBs bor-rowing also improved to Rs.26491 crore in 2011 with an increase of 41.1% as compared to 2010. RRBs have different uses of its funds i.e. issuing loans and investments. RRBs investments have in-creased to Rs.86510 crore as on Mar 31st 2011 with an appreciation of 9%. The share of invest-ments for SLR and non-SLR stands at 53.05% and 47.95% respectively. The total loans RRBs issued during 2011 was Rs.71724 crore increased by 27.9% as compared to the last year whereas the total loans outstanding during the year increased to Rs.98917 crore in 2011 with an increase of 19.4% as per 2010. The profitability of RRBs has also increased over the years.


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Capital require-ment*

2010-2011

2011-2012

Number of branches 16001 16909

Number of districts 620 638

Number of staff 70153 74291

Overall business (Rs. Cr) 265150 302721

PBT (Rs. Cr) 2421 2549

*82 RRBs (75 in profit)

http://www.thehindubusinessline.com/industry-and-economy/banking/regional-rural-banks-may-be-allowed-to-tap-private-capital/article4644310.ece

http://www.thehindubusinessline.com/industry-and-economy/banking/regional-rural-banks-may-be-allowed-to-tap-private-capital/article4644310.ece


and the maximum issued capital could be Rs.1 crore as per the Regional Rural Banks Act, 1976. In the new proposed bill this limit has been asked to increase for each RRBs authorized capital to Rs.500 crore and shared capital to a minimum of Rs.1 crore. This is expected to expand the role of RRBs in extending the banking services in rural areas by strengthening their capital base. However, some are of the opinion that this would jeopardize the rural credit system and benefit private monopolies and corporates. RRBs have a key role to play in the RBI’s policy of priority sector lending. Some of the priority sector categories include agriculture, micro and small en-terprises, education, housing, etc. Like domestic and foreign banks with at least 20 branches in India, earlier RRBs were also required to lend 40% of their net credit to the priority sector. However, go-ing by the motive of providing more credit to pri-ority sector segments, the limit was raised to 60% for RRBs in 2002. The commercial banks have largely failed to meet the mandated requirements in this effect. To avoid penalty, the commercial banks look for some contribution towards the man-dated priority sector lending. The RBI guidelines allow for the RRBs to sell their loan assets under priority sector lending categories in excess of the prescribed priority sector lending target of 60 per

cent. This gives RRBs a twofold purpose of work-ing towards priority sector lending. The excess loan sold help in strengthening the financial posi-tion of the RRBs. The operations of RRBs have to be incentivized

and the expansion has to be executed in a planned manner such that the productivity and efficiency of the branches are not compromised. Going for-ward, there is a need to make the RRBs economi-cally viable for them to fulfill the purpose of fi-nancial inclusion so that they reach the rural, less developed region and weaker section people.

Ashvini Kumar & Mohit Mathur, PGP1


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Consolidation of PSB’s - Need of hour ? zation, investment and rendering of financial ser-vices. Today, for a loan size of say Rs.10, 000 crore, not a single bank in the country can take the portfolio on the book. This makes funding for the infrastructure projects (which is a backbone of an economy) very difficult. Hence consolidation of Public Sector Banks (PSBs) is more important than issuing new banking licenses in India.

Consolidation in banking industry means merging two or more banks to create a large sized bank. It is time to create a global sized bank in the Indian banking space to compete with their international peers. One of the rationale behind the consolida-tion of banks is it provides faster growth in scale and increasing the market reach.

Consolidation in banking industry is not uncom-mon in countries like UK, USA. Around 25 to 30 percent of the banks in USA have been merged or closed in the last 20 years. Europe also saw more number of mergers in banking space. Around 730 mergers in the banking space took place during 1990-1999. Countries like Singapore, Taiwan, South Korea and Malaysia also supported consoli-dation in the banking industry.

If State bank of India merges with its associate banks, it will be a global sized bank and it can compete with the top ten banks in the world. Though these banks are called the associate banks of state bank India, SBI is neither the promoter nor the owner of these banks. Out of the net owned fund of Rs.26436 crore of associate banks, SBI’s total investment is only Rs.430 crore. SBI had al-ready merged with two of its associates State Bank

The banker magazine recently published the List of top 1000 banks in the

world. None of the Indian banks could occupy a position in the Top 50. Industrial and Commercial Bank of China (ICBC) ranked first in the list. China has 4 banks in the Top 10 and 96 banks in the top 1000 of the world. India’s largest public sector bank State Bank of India occupied 60th position in this list based on Tier-I capital or equity and re-serves. In terms of assets, State Bank of India holds 70th position in the world. India’s leading private sector bank, ICICI bank Ltd, holds 148th position in the world. The combined assets of 5 largest banks in India- SBI, ICICI, Punjab National Bank, Canara Bank and Bank of Baroda are just half the asset size of China’s largest bank, Bank of China.

We have State Bank of India, 5 Associate banks of SBI, 21nationalised banks, 24 private sector banks and 80 regional rural banks. Apart from this we also have cooperative banks and foreign banks. So in total we have more than 150 banks but we don’t have even one bank that could compete globally in terms of credit disbursal, fund mobili-

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ARTHAARTH ISSUE IV PUBLIC SECTOR BANKS


of Indore and State Bank of Saurashtra. The associ-ate banks have total network of 5200 branches which is 8% of the total number of branches of public sector banks. SBI absorbing the associate banks would be comparatively easy considering the technology and human resource management. Cost of operation of opening new branches can be re-duced considering that more than 5 lakh villages in the country don’t have a bank branch.

Due to the intensifying competition, getting low cost deposits is important for the growth of the bank. Hence to sustain in the market and to make profit, banks need to improve their CASA ratio (The ratio of current and savings deposits to total depos-its). If a bank has sufficient CASA deposits its cost of capital is reduced and the profitability of the bank can be improved. This may also reduce the lending rate of these banks thereby boosting the economy. Now every bank is trying to grab some portion of the total CASA deposits in the country. As a result most of the public sector banks are not getting enough CASA deposits to minimize the cost of capi-tal. In this stiff competition, private sector banks like ICICI, HDFC, and AXIS bank lure the customers in terms of their service. This is one of the chal-lenges that the public sector banks are facing now. Size and customer service are among the challeng-es they are facing. As a result the lending rate of these banks increases. Consolidation may help the PSBs to grab sufficient portion of CASA so that the banks can reduce the lending rate. Banks with strong retail deposit base can acquire the bank with weak deposit base. The table shows the CASA ratio of some of the PSBs in India

The main rationale behind the consolidation of PSBs is economies of scale and scope. In India nearly 60 crore people don’t have a bank account. Around 5 lakh villages in the country don’t have even a single bank branch. There is a need for in-creasing the reach of banking services to these corners of the country. But operating a bank branch in the rural area does not always profit for the bank. Priority sector lending leads to rising NPA in the loan books of the PSBs. Banks are re-luctant to open a branch in the rural area for the same reason. Consolidation of banks leads to stronger banks acquiring weaker banks thus cre-ating a structure which can absorb the losses. This also reduces the cost of opening a new branch as the bank which is dominant in a particular area can acquire a bank which is dominant in other parts of the country. Mergers can also be between two strong banks leading to a global sized bank.

CASA Ratios

Andhra Bank 25.7%

Oriental Bank of Commerce 23.7%

Bank Of India 32.7%

UCO Bank 35.4%

Syndicate Bank 28.0%

Vijaya Bank 20.0%

Indian Overseas Bank 25.6%

Dena Bank 29.0%

Allahabad Bank 31.0%

IDBI Bank 26.0%

Corporation Bank 21.0%

Central Bank 32.0%

Punjab & Sind Bank 25.0%


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The acquisition of Centurion bank of Punjab by HDFC bank is a perfect example. This is so far the biggest merger in the Indian banking industry.

Bank of Baroda has a dominant presence in the western parts of the country. IDBI and UCO bank has branches mainly in northern and eastern parts of the country. The merger can lead to large sized bank which has presence in all parts of the coun-try. Same is the case for Bank of India which has more branches in the western region. It can merge with Oriental bank of commerce which has domi-nant presence in Northern region and Andhra Bank which has dominant presence in the south India.

The ministry of finance divided the PSBs into sev-en pools last year based on the size and geograph-ical presence. Each pool consists of a large bank in terms of balance sheet size, number of branches etc. The functioning of banks will improve if the amalgamation happens within banks in these pools.

Another challenge facing the Indian Banking In-dustry is the capacity to fund huge projects par-ticularly in infrastructure. Countries like USA, UK and China have global sized banks so that the funding for the large projects can be borne by a single bank. In India a high budget project is funded by two or three banks together. Also larger

State Bank of India Canara Bank

State Bank of Mysore Indian Overseas Bank

State Bank of Hyderabad Syndicate Bank

State Bank of Bikaner & Jaipur Corporation Bank

State Bank of Patiala

State Bank of Travancore Bank of Baroda

IDBI Bank

Central Bank of India UCO Bank

Indian Bank

Allahabad Bank Bank of India

Bank of Maharashtra Oriental Bank of Commerce

Andhra Bank

Union Bank of India

United Bank of India

Punjab & Sind Bank

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the size of the Bank, higher is the risk bearing ca-pacity of the bank. Consolidation may help in im-proving the risk absorption ability of the bank and strengthening its balance sheet.

Banks are in the process of implementing Basel III norms. According to these guidelines, banks are required to maintain tier-I capital of 9%. As banks go on increasing the risk weighted asset portfolio to meet the growing economy's credit requirements, they would need additional capital funds under Ba-sel III. With respect to public sector banks, the ad-ditional equity capital requirements for public sec-tor banks are Rs. 1400-1500 billion. Out of this amount the Government will have to infuse Rs. 880–910 billion as per the current shareholding pat-tern. Consolidation of mid-sized Public Sector Banks will increase their tier-I capital to more than 10% and hence can help reduce the Government share in these banks to a mini mum of 51% and in this case the Government will only need to infuse Rs.660–690 billion.

But consolidation of banks has its own challenges. The foremost challenge is with respect to the “too big to fail” theory which states that larger financial institutions receive support from state and benefit from policies since the government cannot afford these big institutions to fail. We have also seen in-stances wherein the banks have exploited this pro-vision by taking high risk positions since they are able to leverage on these risks based on the prefer-ences they receive. The six biggest banks of USA Bank of America Corp. (BAC), Citigroup (C)Inc., Goldman Sachs Group Inc., (GS) JPMorgan (JPM) Chase & Co., Morgan Stanley (MS) and Wells Fargo & Co. (WFC) have been the biggest benefi-

ciaries of this “too big to fail” phenomenon since the end of 2008 when they benefited from tax breaks and Federal Reserve largesse.

Other challenges include technology and work-force. The core banking solution (CBS) have made it less difficult than how banks perform during the nineties. The banks operate on different plat-forms like Flexcube, Finnacle etc. and IT enabled synergies like payroll, customer service, risk man-agement etc. may pose stiff challenges for the banks desiring to merge. Integration of workforce is another challenge. Trade unions in the PSBs are already against the government on this consolida-tion move. It is a belief among the employees that the consolidation may result in job cuts as the bank may close some of the branches after the merger. Consolidation requires co-ordination be-tween the political leaders, regulators, industry officials and employees and their trade unions. During 1950, around 243 private insurance com-panies have been merged to create a single Life Insurance Corporation of India (LIC) in just four years. This is an example of how all of those chal-lenges can be overcome by excellent coordination. With RBI gearing up for banking licenses to the corporate houses, the competition will get stiffer and consolidation is the only way to win the race.

Mohan Ram and Madhvi Patil , PGP 1


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http://www.bloomberg.com/quote/BAC:US

http://www.bloomberg.com/quote/C:US

http://www.bloomberg.com/quote/C:US

http://www.bloomberg.com/quote/GS:US

http://www.bloomberg.com/quote/JPM:US

http://www.bloomberg.com/quote/JPM:US

http://www.bloomberg.com/quote/MS:US

http://www.bloomberg.com/quote/WFC:US

http://www.bloomberg.com/quote/WFC:US

Does Gold have an Intrinsic value ? in a very short span of time. Not a thumb rule ar-rived at with substantial basis. Nonetheless, I was lucky and it worked for me with gold prices close to USD 1,750 in 2011. My exercise to attempt valuation of gold remained unfinished.

Ever since that close to 9% drop in gold prices in a single day in April 2013, I wanted to dig deeper into what’s driving these prices. Before attempting to determine the intrinsic or fundamental value of gold, I wanted to know its determinants. To arrive at the intrinsic or fundamental value of any asset, we need to know cash flows it can generate, its growth potential and risks. It would be coupons for bonds, dividends for stocks, rental income for real estate. With this definition in mind, gold as an investment is non-cash generating. Once bought, it will just be locked inside the door of my almi-rah. It generates no cash flow; and quantity of gold bought today will remain the same ten years hence. Investment in gold does not grow but for appreciation. However, dividends earned can be reinvested, businesses can grow in scale over the years, but gold is a non-yielding asset. From an economic point of view, it even takes money out of the system (money supply). However, with NBFCs like Manappuram, and Muthoot offering loans against gold, the money supply issue has been ad-dressed to some extent. However, this is not my point of focus for this article.

I had established that it is not possible to estimate the intrinsic value of gold. So the question was why is there a frenzy of buying gold as an invest-ment? One of the possible explanations is that

I am enchanted by the movement in gold prices. I suppose most of you are too. I am not a valua-

tion expert for any asset class, let alone gold. But I have observed this euphoria of buying gold as an investment and not only for making jewellery. I don’t intend to generalize a craze to buy gold from my observations but this is the sense I get almost everywhere. However, this observation has made the novice in me to make an attempt to under-stand what moves gold prices.

Let me begin with a story from 2011. Gold prices were rocketing. I had worked for about a year by then, and had some sort of an amount which could be invested. I had to make my first invest-ment decision. I was advised by most to park the money in gold. I happened to be studying for my CFA those days, and was curious to understand this unanimous advice. I wanted to make an at-tempt to value gold before making any investment.

I must confess that I did not invest in gold purely because I had decided post 2008, not to invest in assets/businesses which have more than doubled

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ARTHAARTH ISSUE IV GOLD


gold has historically been viewed as an alternative to paper currency. Periods in history where lack of trust in the paper currency had increased have al-ways coincided with rising gold prices. Thus, any debasement of paper currency by inflation increas-es the value of gold. In other words, gold is viewed as a hedge against inflation.

The above graph shows how there was significant increase in gold prices in periods of high inflation.

Gold has also been viewed as an instrument that provides security. In times of turmoil, like recession or sovereign debt crisis, investors find solace in holding some gold along with paper currency.

Rising real interest rates hurt gold. However, peri-ods with negative real interest rates coincide with rising gold prices. Therefore, it can be established that the reason for preferring gold as an invest-

ment, is more for the insurance against cata-strophic risks like hyperinflation, sovereign de-fault war, etc.

Let’s get back to the question of buying gold as an investment. Do we stuff our entire portfolio with only insurance? No, it is not advisable. Buying gold as insurance is a good idea for the risks you are insuring. But this decision should purely be a financial one and not emotional because you have made some good bucks with your past gold in-vestments.

Let me leave you with the thoughts of the legend-ary Warren Buffett on gold. Gold being a non-yielding asset, he says, “Assets that will never pro-duce anything, but that are purchased in the buy-er’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future.


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This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but ra-ther by the belief that others will desire it even more avidly in the future.”

The gold stock in the world is more than 170,000 metric tons which works to a valuation in excess of USD 8 trillion. Beyond the staggering valuation, the annual production of gold in dollar value works out to USD 130 billion at today’s prices. Using the simple demand-supply rule, someone will have to look at gold as productively as the buyer did just a few days ago to maintain equilibrium prices. The additional supply needs to be absorbed to sustain prices. And this supply, year-after-year has to be absorbed to maintain current prices, let alone ap-

preciation.

I only wanted to reiterate to be careful while in-vesting big sums of money in gold. However, even at current prices, it may be considered for the portfolio as insurance.

Finally, Indian investors who have earned stag-gering returns over the past years need to do an exercise. The return earned on gold needs to be separated from the rupee depreciation to under-stand actual appreciation from the Indian retail investor point of view. Rupee depreciation has a bearing on the gold prices in Indian Rupees to prevent arbitrage opportunities. Gold as an invest-ment has not been as lucrative as it is believed to be by most of its advocates.

Disclaimer: I do not own gold

Naimish Shah, PGP 1

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It goes without saying that investment bank-ing has always been the most glamorous

and talked about area of finance. However, there is another area of finance which has come to the limelight and one about which we have started to hear more often- private equity. Private equity is simply a form of investing in a company which has grown to a level where the owner capital is not enough and there is a need of outside financial resources for further growth of the business. In return, the investors get an appro-priate share of the company upon investment of capital in the business. An appropriate example would be the recent private equity funding of around $200 million to Flipkart by private equity funds like Accel, Tiger Global, Naspers and Iconiq Capital. However the above example of Flipkart falls under a type of private equity, development capital. In a broader perspective, private equity has four types- development capital, leveraged buyouts, distressed investing and venture capital. Development capital

refers to investment in a relatively mature compa-ny which needs funds to grow operations. It is quite evident that the funds raised will help Flip-kart in continuously expanding its operations and put it in good stead to become the major player in Indian ecommerce market. Leveraged buyouts are buyouts of public compa-nies to make them privately owned entities. In such transactions, the buying party buys all the shares of the company. Such deals are financed mainly by debt and hence the name leveraged buyouts. A recent example of a leveraged buyout is that of Dell Inc. Michael Dell, along with several investors took the company private in a $25 bil-lion leveraged buyout. Raising capital by issuing debt securities loans is all but common among companies. However, not all such companies are able to make payments in the future due to poor financial situation. In such cases, the debt is said to be distressed. Several in-vestors look for companies which they believe are facing financial difficulties temporarily. Savvy in-vestors buy distressed debt from the holders of distressed debt at a discount to their face value expecting to recover the whole value of the debt security when the financial condition of the com-pany improves. This is a type of private equity and is called distressed investing. Yet another form of private equity is venture capi-tal. This form of investment is generally made when the company is at its nascent stage and re-quires money form the basic setup of the compa-ny. It is generally a risky form of investment and

ARTHAARTH ISSUE IV PRIVATE EQUITY

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Private Equity

variety of industries & geographies and growth equity in established industries. Goldman Sachs and Bain Capital were able to raise capital of $24.6 bn and $19.4 bn respectively in the last five years as per the PEI 2013 rankings. Goldman Sachs affiliated funds sold their stocks in China’s biggest bank, ICBC ltd., and made an exit raising $1.1 bn. The global investment activity has not seen much improvement since the downturn in 2008 and the graph has remained flat in the last three years. The PE firms had huge amounts of dry powder after the downturn in 2008 and this aging dry powder faced competition from more recent vin-tage funds and hence was under a lot of pressure. Due to fall in interest rates the cost of debt for LBOs was reduced significantly and this led to in-crease in demand for debt which in turn resulted in issuance of leveraged loans and high-yield bonds. Since the financial crisis the size of the deals had reduced considerably signifying sub-dued animal spirits. Majority of the deals concen-trated in the middle-market investments lying in the range of $500mn to $5bn. This can be at-tributed to the macroeconomic uncertainties prevalent in all the major economies. As the confi-dence in the US market improved over the course of the year, the reliability of PE firms’ forecasts built into their valuation models increased and, with availability of low-cost debt, they were more inclined to close the deals. This period also saw an increase in the average purchase price multiple of large US corporate LBOs to 9.1 times EBITDA as compared to 8.6 times and 7.9 times in previous quarters of 2012.

has a high failure rate. However, it is a popular form of private equity as it is a high risk high re-turn investment method. An example of a success-ful venture capital investment is that made by re-nowned investor Peter Thiel. Thiel made an in-vestment of around $500,000 in Facebook at a very early stage and by the time Facebook went public his investment was worth $1 billion. Global Scenario The Top 10 private equity firms in 2013 as per Private Equity International’s(PEI) annual ranking are TPG, The Carlyle Group, The Blackstone Group, Kohlberg Kravis Roberts, Warburg Pincus, Goldman Sachs, Advent International, Apollo Global Management, Bain Capital, CVC Capital Partners. These ten firms were able to raise cumu-latively a mammoth sum of around $259.6 bn in the last five years. Out of this TPG alone has raised $35.7 bn and has managed to remain the market leader for three consecutive years. It has made some big deals in the last 12 months which in-cludes the acquisition of NYSE-listed Par Pharma-ceutical for $1.9 bn by the affiliates of TPG and the buyout of Australia’s largest poultry producer, Inghams Enterprises Pty Ltd, in March 2013 which was valued at $900 mn. The Carlyle group, an American-based asset man-agement firm specialising in private equity, has been able to accumulate $32.8 bn in the last five years primarily for buyouts and growth capital investments across the globe. The Blackstone Group, which raised $29.5 bn in the last five years, focuses typically on leverage buyouts (LBOs) of mature companies, minority investments, cor-porate partnerships, industry consolidations in a


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Globally, the value of buyout-backed exits was off by 18% to just $219bn and their count decreased by 6%. Buyout-backed exit is a strategy widely fol-lowed by PE firms to sell off their stake in a firm to either another PE firm or the current management of the firm in which case it is called Management Buyout. The exit activity had some traction only in North America where the count and value both were up by 18%. The situation was grim in Europe and Asia-Pacific where fewer assets were sold at lesser value than last year. Sales to strategic buyers remained the major exit channel and accounted for 62% of the total value of buyout-backed exits across the globe. The struggling IPO environment has further narrowed the range of exit options. In 2013, low interest rates and strong debt market provide suitable lending conditions for leveraged buyouts and other debt-financed deals. As per a recent survey conducted by KPMG LLP, the merger & acquisition activity is expected to increase in 2013 and this bodes well for PE-backed exits. Scenario of Private Equity in India. Private equity is

affected by factors outside and inside India. The year, 2012, has been a volatile year. As per Bain & Company’s India Private Equity re-port 2013, Europe is struggling to maintain a co-herent fiscal policy in the face of internal schisms and debates about the future of the Euro. Spain's request for a $125 billion rescue for its financial sector was seen by many as a preliminary step to-wards a full bailout. On the other side of the At-lantic, politicians continued their game of brink-manship over economic policy and brought the US to the edge of the so-called “fiscal cliff”. How-ever, the close of the year saw anxieties easing. President Obama's reelection guaranteed a certain level of continuity in US economic policy. Even Europe began to show some signs of cheer, with Ireland on its way to participating in the bond markets towards the end of 2013. In 2012, venture capital (VC) and private equity funds were more cautious about the selection of their investments and less willing to pay outsized valuations. Investors also began to demand a clear


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exit road map from the start, which resulted in more money committed through early-stage in-vestments. Throughout 2012, the slowdown in the Indian economy caused increasing concern for pri-vate equity funds. Following were the major issues which affected the deal flow. First, the logjam in India's political landscape, with fitful attempts at reform, worried investors. Second, the high infla-tion that began in 2011 continued for most of 2012. While it appeared to be stabilizing by late 2012, average inflation was 7.5% during 2012. In the second quarter of 2013, the inflation was around 5%, which was beneficial for PE invest-ments. Third was the low Index of Industrial Pro-duction growth, which was negative in some months causing concern. In 2013 also there have been negative industrial production growth rates in some months (negative 2.6% in June, negative 1.8% in July). Fourth, the weakness of the rupee, which hit a historic low of INR 57 to the US dollar, affect-ed investors' willingness to commit. Currently the exchange rate for this November stands at INR 62.60 to the US dollar. Finally, regulatory uncertainty was an issue throughout the year and played a large part in scaring investors away from India. The threat of retrospective tax on foreign investors that had tak-en controlling stakes in Indian companies provoked widespread debate. This was compounded by the prospect of the government imposing a capital gains tax on PE investment returns. In an environ-ment characterized by mounting pressure to exit (with target IRRs in the high teens), the possibility of a capital gains tax was a cause of negative senti-ment among investors. At the beginning of 2012,

the Indian private equity market had seemed to be on an upward trajectory, but by mid-year, the road ahead seemed increasingly bumpy. Despite these setbacks, there is no doubt that pri-vate equity has become a viable source of patient capital in India. The number of deals in 2012 grew by some 4% from 2011, indicating that more and more promoters and entrepreneurs are comfortable with the idea of PE investment. Also the year, 2013, began on a high note, with opti-mism about the increased deal flow and the gen-eral future of the PE market. However, that opti-mism dwindled in first quarter but bounced back in second quarter. After a dismal first quarter, the PE investments in the second quarter of 2013 have bounced back with more than double the value of investments. PE firms have invested 2.33 billion USD across 82 deals in this quarter despite a 3.5% drop in the volume of deals. (Source: PricewaterhouseCoopers India Pvt. Ltd) There are a few key reasons for the drop in invest-ments, mostly linked to India's wider financial and political landscape. The decline of capital expan-sion plans across industries brought about a de-crease in the demand for growth capital. Addi-tionally, many large sectors—like infrastructure, energy and telecom—suffered due to inadequate political momentum and saw investments almost completely dry up. Ongoing regulatory uncertain-ty compounded this problem.

Kamaljeet Saini, Rajesh Kumar, Vinayak Shrestha, PGP1

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Restructuring of European Banks post Eurozone crisis

nancial crisis, the biggest banks of Europe are in-creasing their efforts to trim their assets so as to boost the capital bases and thus improve the re-turns from assets. Many of the European banks are considering selling their business lines across various geographies and segments in order to simplify their businesses. One of the biggest banks, Deutsche bank AG has their plan to shrink its bal-ance sheet while UK’s 2nd largest bank Barclays PLC is planning to sell the shares so as to cut assets and increase capital holdings. The greater zeal shown by European banks through their balance sheets is due to the tougher terms from European Central Bank. Under its pol-icy banks are required to follow the rigid Basel III standards and thus maintain the minimum lever-age ratio of 3% and a buffer of 2% over and above it. Leverage ratio compares the total equity to total assets of banks and shows the banks’ ability to meet its obligations. The biggest banks in order to maintain the minimum level started shrinking their assets according to the imposed EU stand-ards. BNP Paribas, the largest bank of France by market value touched the two year high (July 2013) after shrinking to meet the capital and lev-erage levels. Commerzbank, Germany’s second-largest bank soared to a 21 % high in trading floors of Frankfurt which helped to beat the ana-lyst’s estimates. The biggest Swiss bank, UBS AG made to a 29 months high (July 2013) in Zurich trading after announcing their plans to boost cap-

The European banks incurred losses of nearly 1 trillion euros with the out-

break of Eurozone financial crisis in 2009. Many of the banks were undercapitalized and faced li-quidity problems. Apart from financial implica-tions there were many political and social impli-cations as well. There had been power shifts in as many as 8 European countries and highest unem-ployment rate in Greece and Spain. The European Union (EU) states ultimately in 2010, created Eu-ropean Financial Stability Facility (EFSF), a legal entity to maintain financial stability through re-capitalizing the EU banks. The first bail-out plan worth 100 billion euros was sanctioned for Span-ish banks on July 2012. Apart from this, EU also provided state aid for banks up to 4.5 trillion eu-ros between 2008 and 2011 which promoted many economists to refer this as a banking crisis rather than a sovereign debt crisis. Nearly five years after the beginning of global fi-

Image:tudogs.com


ARTHAARTH ISSUE IV EUROZONE CRISIS

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ital ratio. The European banks still need to shrink and thus trim their balance sheets by at least 1.5 trillion euros as per the estimation by Ernst and Young. Basel III rules are scheduled to be implemented globally by 2019 and it plans to set a minimum capital level for larger banks at 7% and 3% addi-tional capital buffers for more systematical and im-

portant banks. Under the standards of Basel III norms, the median capital ratios of 16 biggest Eu-ropean banks stood at 10% from 9.1% six months prior. The increase in capital ratios shows the banks capabilities to meet the liabilities and other risks. The ratio is further expected to grow to 10.9% and 11.9% by the end of 2014 and 2015 respectively.

As shown by the chart, European banks are consid-ering to sell as much as 400 to 725 of their busi-ness lines to simplify their businesses and strength-en the capital base to be more profitable in fewer segments. Many of the deals took place in the pre-vious year with Virgin money acquiring Northern rock, a British bank as a part of consolidation in domestic markets. Another acquisition by non-European bank is Citigroup’s acquisition of ING’s security and custody services in 7 eastern European

countries. According to McKinsey, these acquisi-tions by non-European banks play a big role in banking sector restructuring by bringing in better capitalization and thus outsize the returns with the acquired assets. The necessity of restructuring the European banks was realized early and has already started. Re-cently there was a restructuring plan made for three Portuguese banks by European Commission. But there are several hindrances which need to be dealt with alongside restructuring; firstly there is a need to restructure Non Performing Loans (NPL)

Chart: Opportunities in EU banks

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ropean market and take the market share away from European banks. It should be realized that out of top 20 banks more than 16 are non-European. Even though it seems a threat, it is ap-parently paramount for EU economy to allow their entry as they are well capitalized and trade at much better multiples than European banks. Although government intervention in saving banks seems correct, there have been growing concerns about its role in the bailout of the banks with heavy investments and excessive use of tax payer’s money.

and strengthen the legal framework of several Eu-ropean countries. For example, in countries such as Greece and Italy the recovery of collateral in case of nonpayment is very challenging and same cannot be recovered in the set timeframe. Second-ly, there is a need to instill market confidence among investors. This can be done by bringing in greater transparency in functioning of the banks, and disclosing the policies in relation to NPLs, LGD (Loss Given Default – it is the amount of funds lost by a bank to defaulting borrowers), and probabil-ity of defaults. Another issue is sooner or later the Non- European banks will make an entry into Eu-


Above is table that illustrates public expenditures in EU banking sector. Clearly there have been hefty investments in banks and more is to follow. The flip side of the government investment is banks are los-ing their independence as funds coming from gov-ernment come with certain constraints and condi-tions. In view of some great economists such as Thorsten Polleit, government intervention is only delaying the true outbreak of crisis and is just masking the real economic problems. There is a growing voice in the market that banks should self-correct it and go it alone. More than 530 billion euros are lent to banks and this easy flow of con-

stant money may make banks addictive to easy financing and delay the recovery process. There is a need of supervision on central banks as well as European government’s part to pressurize banks along with carrying out the restructuring process. Basel III norms are considered to be hard on banks and they are constant under pressure to implement the tough capital requirements. A right balance of regulation and restructuring needs to be achieved by the financial industry to bring about positive results in the end. Deepak K S & Rabbi Kumar , PGP1


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