The Game of Valuations

“A 7-billion dollar company which is yet to make profits”, how strange does that sound at the first place?  A mere online book store in 2007 to a billion dollar company, little did the world know that the next Indian Alibaba was in the making. By now you might have guessed what I am talking about! “Yes its Flipkart”, the new sensation in the Indian e-commerce sector. 

Its way of handling logistics, its loss-leader strategy and its smart inventory management made it popular in no time. The Bansal duos from IIT-D indeed are doing a great job.  Flipkart is today considered to be valued between $5 billion to $7 Billion. In a span of 3 years there has been a drastic change in the whole equation, from $1 billion to $7 billion a 5x-7x growth in valuation. This is not just amazing it’s incredible!  The recent acquisition of Myntra and a rapid spree of funding -  Flipkart has certainly taken it to new levels. 

 Image Source - www.dazeinfo.com

 But as they say, the higher you go, the deadlier the consequences of a fall. The question today is, how long can a company survive on valuations alone?  No doubt that VC, PE funding is critical towards growth of a startup, but can overdoing it cause harm? It looks easy to see an entrepreneur in his early 20s with a smart idea and backing of capital funding becoming a millionaire in no time, but a sneak peek into historical data can be alarming. A research taken up by Shikhar Ghosh a lecturer at Harvard Business School says “about 75% of VC backed firms do not return investors”. 

But yes, we can be always optimistic and consider Flipkart to be in the other quarter (the rest 25%). Facebook was once considered as a business model which would never actually make money, but is now known to be among one of the greatest companies in the world. Founded in 2004, Facebook did not really have a proper revenue model in place for quite some time, but investors were pretty hopeful and did pour in a lot of money and faith into the business. It saw  profits in early 2008, four long years after being founded. Flipkart - the King of Indian dot com ventures - apparently is growing at a similar pace. Interestingly, some of the investors like Tiger Global, Naspers, and ICONIQ who invested in Facebook are also investors in Flipkart, clearly proving that investors are pretty hopeful about Flipkart being the next revolution in Indian or perhaps world e-commerce space.

Funding can be like runways, its important for startups to have a long runway.  It’s quite evident that startups do run without any earnings for the first few years of  establishment and this is when funding provides a runway to cover these firms, by providing capital to make the right investments in Infrastructure and Human Resource.  Having said that, profits too are a very crucial part of any business,  something that cannot be ignored for long. It’s a fact that today many Indian startups are surviving on Valuations alone. Flipkart might already seem to be “Too big to fail” but then thats what the Lehman’s were known for as well. 

This Article is written by Prakash Philip Zacharia (PGDM 2013-15)

Word on the Street - Collateralized debt obligation (CDO)

A structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors. A collateralized debt obligation (CDO) is so-called because the pooled assets – such as mortgages, bonds and loans – are essentially debt obligations that serve as collateral for the CDO. The tranches in a CDO vary substantially in their risk profile. The senior tranches are relatively safer because they have first priority on the collateral in the event of default. As a result, the senior tranches of a CDO generally have a higher credit rating and offer lower coupon rates than the junior tranches, which offer higher coupon rates to compensate for their higher default risk.

Source - http://www.investopedia.com/terms/c/cdo.asp

Read more about how CDO's Lead to the Subprime Crisis in 2008 at:  http://bonds.about.com/od/derivativesandexotics/a/CDO.htm

Risk Management In Banking Sector

Risk management is a relatively newer practice, but has already shown to increase the efficiency of the workings and procedures of these banks. In times of fluctuations and uncertainties in the market a bank should be able to prove its stay by withstanding these situations. Hence, a reliable risk management system is required to conquer these internal and external risks. Indian banks are facing a lot of technological advancements, expansions, greater market share etc. which in return are making them more prone to risks. Higher the returns, greater are the risks involved. Therefore, the evolution of risk management systems in banks is a fast growing trend.

In recent news, our finance minister Arun Jaitely pointed his views on tightening the risk management systems in banks, while responding to the recent scandals which raised his doubts on the lending practices of the state banks. Mr Jaitely has decided to initiate an investigation on whether Syndicate bank took bribes to extend a loan towards Bhushan Steel. A major part of the Indian banks are into extending bad loans. Therefore, a powerful risk management system is the need of the hour. The risk management systems should therefore focus on the following areas:

1. organisational structure

2. comprehensive risk management approach

3. periodical review and evaluation

Adopting these methodologies by the risk management teams would probably help in reducing such internal and external risks. The primary power of such risk management should be vested into the hands of the Board of Directors ensuring that the risks are appropriately managed. The risk-bearing capacity of the banks should also be taken into consideration by the top management in order to increase the returns of these financial institutions.

Keeping into mind the fast growing technological advancements, risk management is a newer and powerful device or check on the financial institutions that is proving to be one of the major tools of managing the financial resources of our country. The risk management system in the banking sector is therefore a step towards the economic growth, betterment and welfare of the society on the whole.

This Article is written by Anindita Chatterjee (PGDM 2014-16)

Word on the Street - Pradhan Mantri Jan Dhan Yojana

Pradhan Mantri Jan Dhan Yojana is an ambitious scheme for comprehensive financial inclusion launched by the Prime Minister of India, Narendra Modi on 28 August 2014. He had announced this scheme on his first Independence Day speech on 15 August 2014.On the inauguration day, 1.5 Crore (15 million) bank accounts were opened under this scheme.


SBI had opened 11,300 camps for Jan Dhan Yojana over 20 lakhs accounts were opened as on August 28.

Source - http://en.wikipedia.org/wiki/Pradhan_Mantri_Jan_Dhan_Yojana

Source - http://cartooncorner-bl.blogspot.in/2008/05/financial-inclusion.html

Read More at - http://www.business-standard.com/article/economy-policy/pmjdy-sees-opening-of-500-000-banks-accounts-in-state-114082801127_1.html

This word is suggested by Vinita Jagannathan (PGDM 2013-15)

Domestic Systematically Important Banks:An analysis of long -term benefits (PART II)

Merits

The main merit of following these frame works would be enhanced ability to withstand stress situations, a bank’s financial fighting strengths and competitiveness. However, it will lead to higher lending rates and lower deposit rates. Thus, loans would be available only for safe customers. Meeting capital requirements of public sector banks, which would be in tune of Rs. 2.4-2.8 trillion, will be a huge challenge for banking industry and government. However, private banks will benefit as they enjoy better current capitalization and internal accruals. The prime motto of this move is to reduce the frequency and severity of banking crisis.

Analysts and bank experts are in opinion that following banks would make it into the final list- State Bank of India, Punjab National Bank, Citi Bank, Standard Chartered Bank, ICICI Bank, HDFC Bank and Bank of Baroda.  

Feature of DSIBs Image Source: Economic Times

These guidelines should not prove to be a problem for banks profitability, as most of Indian banks have capital well above the proposed regulatory level. Banks would be in a better position to absorb severe losses, with more equity, thus ensuring financial stability in economy. These measures will act as a buffer for government, as banks will not depend on it to mitigate losses. Also, this would discourage banks from taking irrational risks.

Higher capital requirements are an essential instrument in strengthening the financial stability of the banking sector. They ensure that banks are in a better position to absorb risks and compel banks to improve their risk control, as they bear the costs of those risks themselves. The result will be that banks will reduce their risks and will control them more effectively. This will strengthen the banking sector. Banks with a healthy business model will be able to keep up their lending and remain competitive.

The Financial Stability Board has studied how banks practically respond to increased capital requirements in reality. And, it has found two key things. Firstly, they reduce their risk-adjusted balance sheets (lending less risky business) and secondly by raising equity. Both these measures make a bank, more efficient and safe in functioning.

Testimony of the benefits of increased capital adequacy is the two papers released by the Financial Stability Board and the Basel Committee on Banking Supervision. Both papers conclude that stronger capital and liquidity requirements bring significant benefits for banks- and doesn’t affect much adversely, as perceived. These researches emphasize that such measures will help to insulate efficient banks from problems faced by weaker ones. These measures would result in reduced frequency, severity, and public costs of financial crises.

The significance of Domestic Systematically Important Banks can also be understood by the fact that all G 20 leaders have committed to increase the levels of capital and liquidity in their national banking system.

Image Source: http://www.shrinews.com

So, the decision of Reserve Bank of India (RBI) to categorise important banks as Domestic Systematically Important Banks (DSIBs) would help Indian banking industry in the long run and ensure a robust financial system. It is a justified reform to make Indian banks more competitive and safe.

Word on the Street - Collective Investment Funds/Schemes (CIS)

Any scheme or arrangement made or offered by any company under which the contributions, or payments made by the investors, are pooled and utilized with a view to receive profits, income, produce or property, and is managed on behalf of the investors is a CIS. Investors do not have day to day control over the management and operation of such scheme or arrangement. 

Source - http://www.sebi.gov.in/faq/cis_faq.html

Recently SEBI came cracking down on a company called PACL (Pearl Agrotech Corporation) for its involvement in a large-scale illicit money pooling scheme. PACL raised Rs 44,376 Cr through Collective Investment Schemes. SEBI on Aug 23rd ordered the company and its promoters to refund over Rs 44,376 crore that it collected until March 2012. 

Read more at http://indianexpress.com/article/business/business-others/sebi-tells-pacl-to-refund-over-r44k-crore-in-three-months/

In what appears to be a similar case to that of PACL a few months ago SEBI had also cracked down on Sahara India for its fraudulent CIS Scheme, which ultimately led to its chief Subrata Roy's arrest. 

Read more at http://www.firstpost.com/india/how-sahara-has-run-circles-around-rbi-sebi-supreme-court-1412263.html

This word is suggested by Prakash Philip Zacharia (PGDM 2013-15)

Domestic Systematically Important Banks:An analysis of long -term benefits (PART I)

Taking lessons from the global credit meltdown, Reserve Bank of India came up with “Frame work for dealing with Domestic Systemically Important Banks (D-SIBs)” on July 22 2014 and soon it became a common topic of discussion among Indian Bankers.

This declaration by India’s central bank immediately raised many questions among public and investors, such as,  “Are private banks going to benefit from this move?”, “Will Public Sector Banks need fresh capital infusion?”, “If yes, how does the government plan to meet this requirement- via capital infusion through budgetary allocations or disinvestments?”, “Will the cost of borrowing increase for banks?”, “How will performance of banks be affected?” and many others.

What are D-SIBs?

D-SIBs are banks of national economic importance whose failure can severely strain the entire banking system. These banks would be subjected to differentiated supervisory requirements and higher intensity of supervision, based on the risks they pose to the financial system.

These measures are part of Basel III norms on Risk Supervision, to be implemented in phases, during 2016-2019. The ultimate aim of this categorization is to minimize the possibility of financial crisis and instill financial discipline among top Indian banks. In 2008 crisis, it was observed that when a handful of large, highly interconnected banks, were subjected to financial distress,  there was a system-wide collapse and public money was required to rescue the financial system.

Image Source: http://www.quora.com/What-are-domestic-systemically-important-banks-D-SIBs-What-is-RBIs-framework-to-identify-them

How may a bank fail ?

The main sources of funds for any bank are equity and deposits. As a bank expands and grows, its deposits also grow, but share capital remains the same, resulting in abnormal equity to deposit ratio. Depositors start playing a dual role of fund supplier as well as risk taker. In case of any loss of confidence, it may lead to a situation of Bank Run, and the bank is unable to cope up with the demands made by depositors as advances made to customers can’t be reclaimed in such a small time. These series of events lead to busting of the bank and engulfing the whole economy, if it is large and interconnected with financial system of that country. 

Image Source: http://www.rbi.org.in/

The present frame work asks for additional common equity tier (CET 1) requirement ranging from 0.2% to 0.8% of risk weighted assets (RWA).Selection of such banks would be done in a 2 stage screening process. Firstly, Indian and foreign banks having assets beyond 2% of Indian GDP would be taken as sample. Secondly, based on following parameters and associated weightage, their systematic importance shall be calculated:-

• Size-40%,
• Interconnectedness- 20%,
• Availability of Substitute -20%,
• Complexity- 20%

Accordingly, a level 1 to 4, systematically lower to higher systematic importance will be created and applicable norms will be implemented.

Apart from capital adequacy, norms like liquidity surcharges, tighter large exposure restrictions, will also be incorporated in the frame work.

The first list of such banks is expected to be declared by RBI in August, 2015 and the frame work will be implemented and monitored in a phased manner, starting in April, 2016. It would be an annual calculation exercise, done on basis of annual financial statements of selected banks.

From recent banking developments, we know, Indian public sector banks are sound in terms of capitalization, but need capital injection from government to meet additional capital requirement. But, they are poorly capitalised, when compared to banks of other emerging economies. Analysts believe 9% would be comfortable level for any Indian bank. But, India’ largest lender SBI and 2^nd largest public lender Bank of Baroda, just touch this magical numbers, with 9.5% and 10.1% respectively. On the other hand private banks enjoy a better position, as their range is 12-14%.

This Article is written by Anshu Kumar (PGDM 2014-16)