Author: SK

Continuous and barrier regulation

One of the most important pieces of financial regulation in the US and Europe following the 2008 financial crisis is the designation of certain large institutions as “systemically important”, or in other words “too big to fail”. Institutions thus designated have greater regulatory and capital requirements, thus rendering them at a disadvantage compared to smaller competitors.

This is by design – one of the intentions of the “SiFi” (systemically important financial regulations) is to provide incentives to companies to become smaller so that the systemic risk is reduced. American insurer Metlife, for example, decided to hive off certain divisions so that it’s not a SiFi any more.

AIG, another major American insurer (which had to be bailed out during the 2008 financial crisis), is under pressure from its activist investors led by Carl Icahn to similarly break up so that it can avoid being a SiFi. The FT reports that there were celebrations in Italy when insurer Generali managed to get itself off the global SiFi list. Based on all this, the SiFi regulation seems to be working in spirit.

The problem, however, is with the method in which companies are designated SiFis, or rather, with that SiFi is a binary definition. A company is either a SiFi or it isn’t –  there is no continuum. This can lead to perverse incentives for companies to escape the SiFi tag, which might undermine the regulation.

Let’s say that the minimum market capitalisation for a company to be defined a SiFi is $10 billion (pulling this number out of thin air, and assuming that market cap is the only consideration for an entity to be classified as a SiFi). Does this mean that a company that is worth $10 Bn is “systemically important” but one that is worth $9.9 Bn is not? This might lead to regulatory arbitrage that might lead to a revision of the benchmark, but it still remains a binary thing.

A better method for regulation would be for the definition of SiFi to be continuous, or fuzzy, so that as the company’s size increases, its “SiFiness” also increases proportionally, and the amount of additional regulations it has to face goes up “continuously” rather than being hit by a “barrier”. This way, the chances of regulatory arbitrage remain small, and the regulation will indeed serve its purpose.

SiFi is just one example – there are several other cases which are much better served by regulating companies (or individuals) as a continuum and not classifying them into discrete buckets. When you regulate companies as parts of discrete buckets, there is always the temptation to change just enough to move from one bucket to the other, and that might result in gaming. Continuous regulation, on the other hand, leaves no room for such marginal gaming – marginal changes aer only giong to have a marginal impact.

Perhaps for something like SiFi, where the requirements of being a SiFi are binary (compliance, etc.) there may not be a choice but to keep the definition discrete (if there are 10 different compliance measures, they can kick in at 10 different points, to simulate a continuous definition).

However, when the classification results in monetary benefits or costs (let’s say something like SiFis paying additional regulatory costs) it can be managed via non-linear funding. Let’s say that you pay 10% fees (for whatever) in category A and 12% in category B (which you get to once you cross a benchmark). A simply way to regulate would be to have the fees as a superlinear function of your market cap (if that’s what the benchmark is based on).

 

Matt Levine describes my business idea

When I was leaving the big bank I was working for (I keep forgetting whether this blog is anonymous or not, but considering that I’ve now mentioned it on my LinkedIn profile (and had people congratulate me “on the new job”), I suppose it’s not anonymous any more) in 2011, I didn’t bother looking for a new job.

I was going into business, I declared. The philosophy (that’s a word I’ve learnt to use in this context by talking to Venture Capitalists) was that while Quant in investment banking was already fairly saturated, there was virgin territory in other industries, and I’d use my bank-honed quant skills to improve the level of reasoning in these other industries.

Since then things have more or less gone well. I’ve worked in several sectors, and done a lot of interesting work. While a lot of it has been fairly challenging, very little of it has technically been of a level that would be considered challenging by an investment banking quant. And all this is by design.

I’ve long admired Matt Levine for the way in which he clearly explains fairly complicated finance stuff in his daily newsletter (that you can get delivered to your inbox for free),  and more or less talking about finance in an entertaining model. I’ve sometimes mentioned that I’ve wanted to grow up to be like him, to write like him, to analyse like him and all that.

And I find that in yesterday’s newsletter he clearly encapsulates the idea with which I started off when I quit banking in 2011. He writes:

A good trick is, find an industry where the words “Monte Carlo model” make you sound brilliant and mysterious, then go to town.

This is exactly what I set out to do in 2011, and have continued to do since then. And you’d be amazed to find the number of industries where “Monte Carlo model” makes you sound brilliant and mysterious.

Considering the difficulties I’ve occasionally had in communicating to people what exactly I do, I think I should adopt Levine’s line to describe my work. I clearly can’t go wrong that way.

 

Censor Board as a preserver of the Bollywood cartel

The Indian Censor Board (Central board for film certification or something, to take its full name) has come under flak for the last year or so, for imposing excess cuts on movies, and more recently for some hilarious videos that its chairperson has made and uploaded (in the interest of taste I’ll not link to the video here).

The latest instalment is its decision to make over 45 edits to Quentin Tarantino’s latest movie “The Hateful Eight”. The common reaction on Twitter has been that it’s useless to watch a Tarantino movie with so many cuts in the theatre, and it’s better to illegally download and watch the movie. Here is the document listing the cuts:

While the popular narrative remains that the Censor Board has been acting the way it has been because we have a “right wing conservative” Union Government, it doesn’t stand that test that the Censor Board has become especially kooky after the current government came to power (barring the hilarious videos and comments that is). The fact of the matter is that the Censor Board has been kooky with its edits much before the current government came to power.

There is a simpler explanation to why the Censor Board censors as much as it does – it seeks to protect the interests of the “Bollywood cartel”. By Bollywood, I refer to the mainstream Hindi cinema industry based in Mumbai which churns out “family movies” which don’t contain too much sex or violence, all of which seek a “U” (universal) certificate from the board.

The idea is this – Bollywood mostly makes “mainstream” movies, without much scope for the censor board to cut anything, so they’re largely insulated. Foreign language (including English) and offbeat movies, however, are more experimental, and are likely to have much more sex and violence.

Cutting parts of a movie and muting further portions (refer to above document) drastically diminishes the experience of watching the movie. Scenes cut in a non-intuitive fashion, and you are forever guessing what word was muted out.

Given such an inferior experience of watching, the value you gain from watching drops, and you might decide it is not worth watching at all. Those that have the means might instead choose to download the movie via illegal torrents, or watch it online using VPNs (effectively watching another country’s “edition”).

To summarise, competitors of mainstream Bollywood movies suffer due to censorship, by declining viewership, and viewership that moves to illegal media. Bollywood, on the other hand, by not having much that can be censored, is not similarly affected, and is thus relatively better off!

The union government has instituted a panel to review the activities of the Censor Board. The panel is headed by Shyam Benegal, who is an “alternative filmmaker” who doesn’t belong to the Bollywood clique. Hopefully some good will come out of that!

The myth of affordable housing

Cities are unaffordable by definition because of the value that can be extracted by living in them. 

A few months back, my Takshashila colleague Varun KR (Shenoy) asked me if there is any city where housing is not prohibitively expensive. It wasn’t a rhetorical question. While answering “no”, I went off on a long rant as to why affordable housing is a myth, and why housing in urban areas is by definition expensive. I had been planning to blog it for a while but I get down to it only now.

Cities are expensive to live in due to a simple reason – lots of people want to live there. And why do lots of people want to live in cities? Because the density in cities means that there is a lot more economic activity happening per capita that results in greater productivity and happiness.

If you are in a rural area, for example, there are few services that you could afford to outsource, for the small scale means that it doesn’t make sense for people to provide that service. Even when such services exist, lack of competition might mean a large “bid-ask spread” and hence inefficiency. This means you are forced to do a lot more tasks which you suck at, leaving less time for you to do things you are good at and make money from.

Needs of a rural area also means that there is a natural limit on the kind of economic activities that can be remunerative there, so if your skills don’t lie in one of those, you are but forced to lead a suboptimal existence.

Larger agglomerations (such as cities), by putting people closer to each other, provide sufficient scale for more goods and services to become tradable. Transaction costs are reduced, and you can afford to outsource a lot more tasks than you could afford to in a rural area, thus boosting your productivity.

Economist and noted urban theorist Jane Jacobs, in her book “Cities and the Wealth of Nations”, argues that economic development occurs exclusively in cities and “city regions” and proceeds to demolish different theories by which people have tried to create economic value in remote areas (my review of the book here).

The larger a city is, the greater the benefits for someone who lives there, controlling for ability and skill. Thus, ceteris paribus, the demand for living in cities exceeds that of living in smaller agglomerations, which gets reflected in the price of housing.

It might be argued that what I have presented so far is only an analysis of demand, and supply is missing from my analysis. (I don’t understand who is on the left and who is on the right on this one but) One side argues that the reason housing is not affordable in cities is that strict regulations and zoning laws limit the amount of housing available leading to higher prices. The other side talks about the greed of builders who want to “maximise profits by building for the rich”, which leads to undersupply at the lower end of the market.

While zoning and building restrictions might artificially restrict supply and push up prices (San Francisco is a well-known example of a city with expensive housing for this reason), easing such restrictions can have only a limited impact. While it is true that increasing density might lead to an increase in supply and thus lower prices, a denser city will end up providing scale to far more goods and services than a less dense city can, thus increasing the value addition for people living there, which means more people want to live in these denser cities.

As for regulations that dictate that “affordable housing” be built, one needs to look no further than the “Slum Rehabilitation Apartments” that have been built in Mumbai on land recovered from slums (the usual deal is for a builder to commit to building a certain number of “affordable” houses for the erstwhile dwellers of the slums thus demolished apart from “conventional” housing). Erstwhile slumdwellers rarely occupy such apartments, for they are willing to accept a lower quality of life (in another slum, perhaps) in exchange for the money that can be generated by renting out these apartments.

This piece is far from over, but given how long it’s been, I’ll probably continue in a second part. Till then, I leave you with this thought – a city becoming an “affordable” place to live is a cause of worry for policymakers (and dwellers of the city itself) because it is an indicator that the city is not adding as much economic value as it used to.

 

Get togethers and going Dutch

So the wife has written a fairly insightful blog post about why South Indians from the previous generation don’t meet often “without an occasion”. The basic idea is that that generation never learnt how to split bills, or go Dutch. I had a few anecdotes that would add data points to this, hence this blog post.

I had mentioned in an earlier blogpost that my parents used to work at KEB. I remember going to their offices occasionally (I’d visit my mother more often than my father), and though I was rather young then, I remember that my mother and her colleagues had a policy that they would pay for their afternoon tea by rotation.

It was a rather informal practice (don’t think they kept formal track of who paid when), but I don’t remember a single occasion (ok my age was in single digits, and I don’t have too many data points, but I trust my long-term memory) when more than one person paid for the same round of tea.

During a conversation about splitting bills (this was when I was older, and had started going out with friends), I remember my parents having bitched about two of their colleagues, who used to unfailingly split their tea bills. Back in those days, tea in the subsidised KEB canteen cost 35 paise (one paisa is one-hundredth of a rupee), which made it hard to split (since there were no half-paisa coins). So it seems these two worthies had an arrangement where they would alternately contribute seventeen and eighteen paise respectively (story from the early 80s, so one, two and three paisa coins were quite common back then). And my parents looked down upon them, that they couldn’t be so trusting to not “lend” a full half-cup of tea to the other person!

The other data point is the choice of words – my parents referred to the practice of going Dutch as “military style” and that phrase was uttered with a sneer. So when I would tell them that my friends and I had split the bill when we went out, my mother would say “oh military style-aa?”. It was as if civil people (pun intended) never split the bills and were willing to spend for each other occasionally.

This is one of those classic counterproductive things – while it might be noble to pay for each other once in a while, going out only when someone is willing to pay for you (or vice versa) puts a cap on the number of times when you can meet. Of course you need to adjust for the fact that this generation grew up in relative poverty compared to us, and that old frugal habits (of not going out too often) are hard to shake off!

Senior Assistants

A year or two before I was born, my parents both took and passed this exam called “SAS” (no clue what it stands for), following which they were both promoted to officer grade (they used to work for the erstwhile Karnataka Electricity Board (KEB) back then).

Many of their colleagues elected to not take up this exam (or perhaps took and flunked it) and didn’t get promoted for the rest of their careers, remaining “senior assistants”. While they didn’t “progress” in their careers, they didn’t do all that badly financially, with their pay scale growing more or less at the same rate as it would have had they become officers.

This examination-based division into officers and “staff” was not limited to KEB, of course. It was (and is) prevalent across all public sector units. If you passed the exam, you had a chance at career progression, though that also typically meant harder work and longer hours. It wasn’t necessary for everyone to be ambitious, though, since they could choose to remain at a non-officer grade where things were chiller.

While there might have been noble intentions for this bifurcation (making the pyramid thin at a low enough level, for example, and also addressing lumpy/bursty recruitment), the problem with the practice was that it created a rather large cadre of rather unambitious workers.

Given that it is not easy to sack someone from a PSU job (unless there has been gross misbehaviour), the only way to incentivise PSU employees to work is by showing them carrots. While tenure or seniority based promotions have put paid to such incentives, it is still reason enough to keep a section of the officers motivated. For Senior Assistants who have hit a wall on that front, it is simply not available.

Given the shape of the pyramid and the lack of carrots for Senior Assistants (and equivalent) what this policy has created is a large army of government/PSU officials who lack any motivation or incentive to do their job effectively.

With most government departments being monopolies, this is a problem only for the taxpayers and public (and not so much for the departments themselves). Where this hits PSUs hardest is where they compete with the private sectors, in banks, for example.

I’ve maintained that one of the advantages of PSU banks is that the staff there are much more experienced, so if you have a non-standard thing to do, you would rather go there than to a private bank that might throw the rule book at you.

The problem, though, is that while some staff might be motivated enough to use their experience and help you out, not all of them might be that way, for most of the clerical staff belong to the aforementioned “Senior Assistant” category, with no explicit incentive to keep them going. The same is the case with non-customer facing staff as well.

I understand that various other careers can also have “career-limiting moves” (after which you don’t get promoted) but the problem with the Indian PSU system is that such moves happen pretty early on in the career, which creates a lot of deadweight for the system to carry.

Why Delhi’s odd-even plan might work

While it is too early to look at data and come to an objective decision, there is enough reason to believe that Delhi’s “odd-even” plan (that restricts access to streets on certain days to cars of a certain parity) might work.

 

The program was announced sometime in December and the pilot started in January, and you have the usual (and some unusual) set of outragers outraging about it, and about how it can cause chaos, makes the city unsafe and so forth. An old picture of a Delhi metro was recirculated on Monday and received thousands of retweets, by people who hadn’t bothered to check facts and were biased against the odd-even formula. There has been some anecdotal evidence, however, that the plan might be working.

It can be argued that the large number of exceptions (some of which are bizarre) might blunt the effect of the new policy, and that people might come up with innovative car-swap schemes (not all cars get out of their lots every morning, so a simple car-swap scheme can help people circumvent this ban), because of which only a small proportion of cars in Delhi might go off the roads thanks to the scheme.

While it might be true that the number of cars on Delhi roads might fall by far less than half (thanks to exemptions and swap schemes) due to this measure, that alone can have a significant impact on the city’s traffic, and pollution. This is primarily due to non-linearities in traffic around the capacity.

Consider a hypothetical example of a road with a capacity for carrying 100 cars per hour. As long as the number of cars that want to travel on it in an hour is less than 100, there is absolutely no problem and the cars go on. The 101st car, however, creates the problem, since the resource now needs to be allocated. The simplest way to allocate a resource such as a road is first come-first served, and so the 101st car waits for its turn at the beginning of the road, causing a block in the road it is coming from.

While this might be a hypothetical and hard-to-visualise example, it illustrates the discontinuity in the problem – up to 100, no problem, but 101st causes problem and every additional car adds to the problem. More importantly, these problems also cascade, since a car waiting to get on to a road clogs the road it is coming from.

Data is not available about the utilisation of Delhi roads before this new measure was implemented, but as long as the demand-supply ratio was not too much higher than 1, the new measure will be a success. In fact, if a fraction f of earlier traffic remains on the road, the scheme will be a success as long as the earlier utilisation of the road was no more than \frac{1}{f} (of course we are simplifying heavily here. Traffic varies by region, time of day, etc.).

In other words, the reduction in number of cars due to the new measure should mean significantly lower bottlenecks and traffic jams, and ensure that the remaining cars move much faster than they did earlier. And with lesser bottlenecks and jams, cars will end up burning less fuel than they used to, and that adds a multiplier to the drop in pollution.

Given that roads are hard to price (in theory it’s simple but not so in practice), what we need is a mechanism so that the number of cars using it is less than or equal to capacity. The discontinuity around this capacity means that we need some kind of a coordination mechanism to keep demand below the capacity. The tool that has currently been used (limiting road use based on number plate parity) is crude, but it will tell us whether such measures are indeed successful in cutting traffic.

More importantly, I hope that the Delhi government, traffic police, etc. have been collecting sufficient data through this trial period to determine whether the move has the intended effects. Once the trial period is over, we will know the true effect this has had (measuring pollution as some commentators have tried is crude, given lag effects, etc.).

If this measure is successful, other cities can plan to either replicate this measure (not ideal, since this is rather crude) or introduce congestion pricing in order to regulate traffic on roads.

Grofers scaling down

Readers of this blog might be aware that I’m not a big fan of hyperlocal grocery delivery firm Grofers’s business model. The problem is that there are no costs saved to make Grofers its margin – apart from the retail inventory expense incurred at the retailer (from whom Grofers procures), there is also the last mile delivery expense that is incurred which doesn’t leave much profits.

The reason for Grofers scaling back from nine cities in India, however, is not related to this. It is more to do with market size and scale.

Given the uncertainties in terms of demand and service times, a business such as Grofers makes sense only when there is a minimum critical mass in terms of demand. Serving a locality with only one delivery person doesn’t make sense, for example, since uncertainty in demand will mean that either that delivery person is underworked or service levels cannot be guaranteed.

If the average demand in an area can support more delivery persons, though, this can smoothen out the uncertainty (that aggregation smoothens uncertainty is one of the fundamental principles of operations) and higher service levels can be guaranteed without building in too much slack.

While the cities that Grofers has pulled back from are not small (Mysore/Vizag/Coimbatore etc) it is unlikely that any of them would have had the size and density of demand in order to support a scale of operations which would make sense for Grofers. There are several reasons for this.

Firstly, Grofers only captures the incremental demand for grocery delivery, and with most small retailers already offering grocery delivery, the value Grofers adds is to deliver from large retailers. While I don’t have data to support this, my hypothesis is that large retailers have a smaller share in small cities thus cutting Grofers’s natural market.

Next, the transaction cost of travelling to the store is lesser in smaller cities, given shorter travel times (on account of both size and traffic), further cutting demand for on-demand delivery. Thirdly, while smartphones are widespread across the country, my hypothesis (again don’t have data to support this) is that usage is lower in smaller cities (compared to larger cities). Fourthly, smaller cities are likely to be less dense than larger cities (data on this should be available but NED to compile it now) meaning delivery personnel have to cover larger areas.

Some thinking can lead to more such reasons, but the basic point is that not only are these cities small, but demand for on-demand hyperlocal grocery delivery is also much lower (on a per capita basis) than in larger cities for several reasons.

These two factors have together meant that the scale (and density) of demand that is necessary for Grofers to be viable as a business was simply not there in these cities. So it’s a logical move for them to pull out.

This doesn’t answer, however, the question of why Grofers entered these cities in the first place, since the above factors should’ve been apparent before the entry. My hypothesis here is that some fast-growing startups measure their growth in terms of the number of cities they’re in. I’ll elaborate on that on another day.

Two kinds of Customer Acquisition Cost

A few days back, there was a story in Mint (Disclosure: I write regularly for them, and get paid for it) about Urban Ladder’s increasing losses. This was primarily on the back of increased marketing expenses, the report said.

Losses at Urban Ladder Home Décor Solutions Pvt. Ltd grew eight times to Rs.58.51 crore in the year ended 31 March from Rs.7.62 crore in the year-ago period, according to data available with the Registrar of Companies. Revenue rose 60% to Rs.19.21 crore from Rs.11.88 crore.

Advertising and marketing spending accounted for more than half of its expenses of Rs.77.72 crore. The online retailer spent Rs.40.24 crore on marketing, a whopping 11-time increase from Rs.3.57 crore a year ago. Employee costs surged to Rs.16.58 crore from Rs.4.69 crore.

With the startup madness starting to be tempered, with some companies (such as SpoonJoy) shutting down, others scaling back operations (TinyOwl, FoodPanda) and some others firing lots of employees (Helpchat, LocalOye), one of the big concerns in the startup ecosystem is “cash burn”, with a large part of the burn in most companies being accounted for by the cost of “acquiring” customers – you need to let your potential customers know that you exist, and get them to try you out in the hope that they become your regular customers.

All this is in the hope that once you “acquire” a customer, he will become a regular customer and so you defend your spend to acquire him (“customer acquisition cost”) based on the total profits you can make from him over a long period of time (“Life time value”). It’s not uncommon nowadays to see “CAC” and “LTV” being mentioned liberally in LinkedIn posts.

The problem with a lot of startups is that they continue to give “inaugural discounts” well after inauguration in order to achieve higher growth and customer base, only to see these customers disappear when the discounts disappear (US-based HomeJoy is a good example for this). In fact, I had written recently on the “optimal extent” to which a company should discount its products (the level at which the company can be profitable in “steady state”).

The thing with Urban Ladder is that while they are currently spending a lot of money to acquire customers (and a lot of it is through hoardings, known to be among the least effective ways to advertise),  they are not going the discount way. In other words, while they may have the odd seasonal discount the customers they acquire through their marketing activities still have to pay full price for the goods they purchase.

What this means is that customers once acquired have a higher chance of sticking on as long as they like their product – which is likely if Urban Ladder is doing a good job of designing products and marketing them to the right kind of customers. Even if Urban Ladder is going to cut down its customer acquisition spending at some point in time, that will only have an effect on the new customers being acquired, and existing customers will remain in the system.

Contrast this with a customer acquisition strategy built around discounting, where once the acquisition spend falls, existing customers are also affected and become more likely to exit the system.

So while it is fashionable to talk about “customer acquisition cost”, how this cost is incurred is important in determining how long the customers will stay. Spending on “third parties” (!= customers) to acquire customers is more sustainable than spending on customers. It is important to take this into consideration while determining if a company’s acquisition spending makes sense.

 

I delivered an NED Talk

When we finally implemented the NED Talks a year back, we took a policy decision that we wouldn’t be speaking ourselves, and instead remain content with organising, producing and anchoring the event.

With a year of NED talks (where we collected over fifty NED fellows over six episodes) done, there were the interesting situation today where the Takshashila Institution, which I’m associated with an many of whose fellows have delivered NED Talks, organised an NED Talks-like event (they acknowledged it as such) as part of their year-ending bash.

So they requested me to speak at the event and I agreed to talk about the Ramayana and its connection with the current civil war in Syria. I essentially paraphrased what I’d written in this post on this blog, and argued that Europe and the US should back Russia in supporting Bashar al-Assad’s forces.

The event was streamed live on Youtube, and you can find my talk here:

See and enjoy (my talk starts around the 15 minute mark).

PS: I had consumed two glasses of wine before this talk which “lubricated” things and enabled me to talk without feeling self-conscious. I must say this method works fairly well for short talks.