On the death of credit cards

An article that was recently recommended to me on Medium talks about the death of credit cards (among other things that are currently incumbent in the banking system). As someone who has worked a fair bit in “FinTech”, I broadly agree with what he says. As someone who has worked a fair bit in “FinTech”, I’m also not sure how easy it is to disrupt.

The article says:

The two primary use cases for a credit card today could be illustrated thus:

  1. I’m at the grocery store, swiped by debit card and the transaction was declined because my salary hasn’t yet hit my bank account. I need to buy these groceries for the family today, so I’ll use my credit card and worry about why my salary hasn’t hit the account later, or

  2. I really want this new iPad Pro, but I can’t afford it based on my current savings. If I use a credit card I can pay it off over the next few months

And proceeds to explain why each of the above situations can be unbundled to some kind of an instant credit scenario, rather than the bank having extended a lien to you through which you can borrow.

While the idea of instant credit (on the lines of Affirm) makes intuitive sense, the problem is with transaction costs. Irrespective of algorithms significantly slashing the time required and marginal cost of underwriting loans, the fact remains that the marginal cost of underwriting and extending new credit can never be brought down to zero.

There are costs to updating the information the bank knows about you. There are costs to creating any kind of legal documentation, and insuring that. If you were to list down all such costs, you would find that even if the cost of actual underwriting itself were to be zero, the marginal cost of issuing a loan is significant.

It is for this reason that banks have traditionally settled down on a model of “approve once, borrow multiple times”. For retail borrowers, this translates to a credit card, where they can borrow up to a predetermined limit, with no questions asked for each borrowing. For corporate borrowers, this translates to something like a “working capital lien” or “overdraft”.

The article I’d linked above talks about one of the solutions being an “overdraft”. In that sense, what it says is that the physical credit card might disappear, but not the fundamental principle, which is “approve once, borrow multiple times”.

In fact, as companies come up with new and innovative ways of slashing marginal cost of underwriting to enable “on-demand approval” (I’ve been involved in such efforts with a couple of companies), the question is whether such costs can actually be brought to zero, and if not, whether the model can be sustainable.

As long as the marginal cost of underwriting remains even mildly positive, it is not profitable for lenders to lend out small amounts with “on-demand approval”. How this problem can be solved will determine how well “FinTech” lenders can disrupt banks (on the lending side).

Admission of errors and bad bank loans

I have a policy that whenever I make a mistake, I admit it. I believe that suppressing an error does more harm than good in the long run, and it is superior to admit it at the time of discovery and correct course rather than keeping things under wraps until the shit hits the fan (a la Nick Leeson, for example).

There is another reason I like to admit to my mistakes – by doing so frequently, I want to send the signal that I’m self-aware and self-critical and aware of what I’ve done wrong. This, I believe, sends a signal that I should be trusted more, since I have a grip on rights and wrongs.

It doesn’t always work that way. There was a company I once worked for, where my responsibilities meant that my errors had an immediate material impact on the company. I don’t know if this (direct material impact) mattered, but my signalling went horribly wrong there.

The powers-that-were came from a prior belief that people would suppress their mistakes as much as they could, and that I was admitting to them only because I couldn’t suppress them further. Their reaction to my constant admission of mistakes (I was writing production code, a bad bad idea given my ADHD) was that if I were admitting to so many mistakes, how many more of my mistakes were yet to be discovered?

In other words, the strategy backfired spectacularly, possibly given the mismatch of our priors, and I later figured I might have done better had I tried suppressing (or quietly fixing) rather than admitting. That, however, hasn’t led to a change in my general strategy on this issue.

I was reminded of this strategy when State Bank of India and Punjab National Bank released their quarterly results last week. Their stocks got hammered on the back of drastically reduced profits on account of higher provisions – an admission that a significantly higher proportion of their loans had gone bad compared to their earlier admissions.

The question that comes to mind is whether the increase in provisioning and admission of bad loans should be taken as a credible signal that these banks are cleaning up their balance sheets (which is a good thing) or whether it only indicates a bigger tip of a bigger iceberg (in which case I’d be paranoid about my deposits).

Not knowing what strategy these banks are playing (though statements from the RBI suggest they’re likely to be cleaning up), I guess we have to wait for results over the next couple of quarters to learn their signals better.

No Chillr, Go Ahead

This is yet another “delayed post” – one that I thought up some two weeks back but am getting down to write only now. 

After some posts that I’ve done recently on the payments system, I decided to check out some of the payment apps, and installed Chillr. This was recommended to me by a friend who has a HDFC Bank account, who told me that the app is now widely used in his office to settle bills among people, etc. Since I too have an account with that bank, I was able to install it.

The thing with Chillr is that currently they are tied up with only HDFC Bank. You can still sign on if you have an account of another bank, but in that case you can only receive (and not send) money through the system. So your incentive for installing is limited.

Installation is not very straightforward since you have to enter some details from your netbanking which are not “usual” things. One is a password that allows you to receive money using the app, and the other is a password that allows you to send money. Both are generated by the bank and sent to your phone as an SMS which the app automatically reads. I understand this is part of the system itself and this part won’t go away irrespective of the app you use.

Once you have installed it, you will then be able to use the app to transfer money to your contacts who are also on the app without requiring to know their account number. The payment process is extremely smooth with an easy to use second factor of authentication (a PIN that you have set for the app, so it is instant), so if more people use it, it can ease a large number of payments, including small payments.

The problem, though, is that it is currently in a “walled garden” in that only customers of HDFC Bank can send money, and hence the uptake of the app is limited. The app allows you to see who on your contact list is there on the app (since that is the universe to which you can send money using the app). The last time I checked, there were four people on the list. One was the guy who recommended me the app, the second was another friend who works in the same organisation as this guy, the third a guy who works closely with banks and the fourth a Venture Capitalist. And my phonebook runs into the high hundreds at least.

In terms of technology, the app is based on the IMPS platform which means that in terms of technology there is nothing that prevents the app from transferring money across banks using its current level of authentication. This is very good news, since it means that once banks are signed on, it is a seamless integration and there are no technological barriers to payment.

The problem, however, is that the sector suffers from the “2ab problem” (read my  argument in favour of net neutrality using the 2ab framework). Different tech companies are signing on different banks (Chillr to HDFC; Ping Pay to Axis; etc.) and such banks will be loathe to sign on multiple tech companies (possibly due to integration issues; possibly due to no compete clauses).

Currently, if HDFC Bank has a users and Axis Bank has b users, and they use Chillr and Ping Pay respectively, the total value added to the system by both Chillr and Ping Pay is proportional to a^2 + b^2 (network effects, Metcalfe’s law and all that). But if these companies merge, or one of them gets the account of the other’s bank, then you have a single system with a+b users, and the value added to the system by the combined payments entity is (a+b)^2 which is a^2 + b^2 + 2 ab. Currently the sector is missing the 2ab. The good news, however, is that there are no tech barriers to inter-bank payments.

Postscript: The title is a direct translation of a popular and perhaps derogatory Kannada phrase.

Perverse regulations

So Uber has tied up with PayTM to process its payments without a second factor of authentication in order to comply with RBI regulations. This is a major win-win for both companies. Uber can now gain access to the part of the relatively affluent Indian population that does not own a credit card (this is a significant segment). PayTM now has a compelling reason to sign up users for its Wallet solution, since all Uber customers now form a sort of a captive audience for this solution.

While discussing this on twitter, someone suggested that once the new Payment Bank regulation is brought in by RBI, wallet solution providers such as PayTM can then set themselves up as Payment Banks.

The problem with that is that if PayTM becomes a payment bank then it will have to comply with RBI regulations of second factor authentication and thus Uber users will not be able to use their PayTM wallets (now accounts) for seamless payment!

#Thatzwhy we need strong regulations.

S&P’s Responsibilities

Reading through some of the reactions from “experts” to the S&P’s downgrade of US debt, I see words such as “irresponsible”, “misguided” and “inappropriate” being bandied around. These experts seem to be of the view that in view of all that the US is already going through (given the debt crisis et al) it was not correct for the S&P to push it further down into the abyss by downgrading its debt.

Now, the S&P is a rating agency. Its job is to rate debt, categorizing it in terms of how likely an issuer is to honour the debt it issues. It is a privately held firm and it is not the job of the S&P to prevent global crises and save the world. In this case, the S&P has just done its job. And having been following the crisis for a while I’m of the opinion that it’s done the right thing (check Felix Salmon’s article on this; he says the downgrade is more due to the risk of the US’s willingness to not default, rather than its ability; given that there is no permanent solution yet to the debt ceiling and it issues all debt in its native currency).

If a simple move like this by a private company is going to bring down the world, it is because of screwed up regulations (read Basel 2 and Basel 3) that ended up giving way too much importance to firms such as this. And I’m sure the US had adequate representation at that meeting in Basel where the accord was adopted, so it can be partially held responsible for the enormous power that rating agencies currently wield.

The bottom line is that excessive regulations based on dodgy parameters have been responsible for a lot of the mess that we see today. #thatzwhy we need strong regulations.

Ratings and Regulations

So the S&P has finally bitten the bullet and downgraded US federal debt to AA+ from its forever rating as AAA. While this signals that according to the S&P US Treasuries are no longer the least-risky investments, what surprises me is the reaction of the markets.

So far, since the rating change was announced after US market hours on Friday evening, only one stock exchange has traded – the one in Saudi Arabia, and that has lost about 5%. While it can be argued that it is an extension of severe drops in the markets elsewhere in the second half of last week, at least a part of the drop can be explained by the US debt downgrade. Now, when markets elsewhere open tomorrow after the weekend, we can expect a similar bloodbath, with the biggest drop to be expected in the US markets.

Now, the whole purpose of ratings was supposed to be a quick indicator to lenders about credit risk of lending to a particular entity, and help them with marking up their loan rates appropriately. It was basically outsourcing and centralization of the creditworthiness process, so that each lender need not do the whole due diligence himself. You can argue in favour of ratings as a logical extension of Division of Labour. If lending is akin to making shoes, you can think of rating agencies analogous to leather tanners, to save each shoe maker the job of tanning the leather himself.

However, over the course of time, there have been two consequences. The first was dealt with sufficiently during the global crisis of 2008. That it is the debt issuer who pays for the ratings. It clearly points out to an agency problem, especially when the “debt issuers” were dodgy SPVs set up to create CDOs. The second is about ratings being brought into the regulatory ambit. The biggest culprit, if I’ve done my homework right, in this regard was the much-acclaimed Basel II norms for capital requirements in banking, which tied up capital requirements to the ratings of the loans that the banks had given out. This had disastrous consequences with respect to the mortgage crisis, but I’ll not touch upon that here.

What this rating-based regulation has done is to take away the wisdom of crowds in pricing the debt issued by a particular issuer. Normally, the way stock and bond prices work is by way of wisdom of crowds, since they represent the aggregate information possessed by all market participants. Different participants have different assumptions, and at each instant (or tick), they all come together in the form of one “market clearing price”.

In the absence of ratings, the cost of debt would be decided by the markets, with (figuratively) each participant doing his own analysis on the issuer’s creditworthiness and then deciding upon an interest yield that he is willing to accept to lend out to this issuer. Now, however, with ratings linked to capital requirements, the equation completely changes. If the rating of the debt increases, for the same amount of capital, the cap on the amount the banker can lend to this particular issuer jumps. And that means he is willing to accept a lower yield on the debt itself (think about it in terms of leverage).

Whereas in the absence of ratings, the full information known to all market participants would go into the price of debt, the presence of ratings and their role in regulation prevents all this information flowing out to the market in terms of the price of debt. And thus the actual health of the issuer cannot be logically determined by its bond price alone – which is a measure that is continuously updated (every tick, as we say it). And that prevents free flow of information, which results in gross mispricing, and large losses when mistakes are discovered.

I don’t have anything against ratings per se. I think they are a good mechanism for a lay investor to get an estimate of  the credit risk of lending to a particular issuer. What has made ratings dangerous, though, is its link to banking regulation. The sooner that gets dismantled the better it is to prevent future crises.

Successful IPOs

Check out this article in the Wall Street Journal. Read the headline. Does this sound right to you?

MakeMyTrip Opens Up 57% Post-IPO; May Be Year’s Best Deal

It doesn’t, to me. How in the world is the IPO successful if it has opened 57% higher in the first hour (it ended the first day 90% higher than the IPO price)? To rephrase, from whose point of view has the IPO been the “best deal”?

What this headline tells me is that makemytrip has been well and truly shafted. If the stock has nearly doubled on the first day, all it means is that MMYT raised just about half the cash from the IPO as it could have raised. If not anything else, the IPO has been a spectacular failure from the company’s point of view.

The US has a screwed up system for IPOs. Unlike in India where there is a 100% book-building process where there is effectively an auction to determine the IPO price (though within a band) in the US it is all the responsibility of the bank in charge of the IPO to distribute stock (as far as I understand). Which is why working in Equity Capital Markets groups in investment banks is so much more work there than it is here – you need to go around to potential investors hawking the stock and convincing them to invest, etc.

Now, the bank usually gets paid a percentage of the total money raised in the IPO so it is in their incentive to set the price as high as they can (and the fact that they are underwriting means they can’t get too greedy and set a price no one will buy at). Or so it is designed.

The problem arises because the firm that is IPOing is not the only client of the bank. Potential investors in the IPO are most likely to be clients of other divisions of the bank (say, sales and trading). By giving these investors a “good price” on the IPO (i.e. by setting the IPO price too low), the bank hopes to make up for the commission it loses by way of business that the investors give to other divisions of the bank. If most of the IPO buyers are clients of the bank’s sales and trading division (it’s almost always the case) then what all these clients together gain by a low IPO price far outweighs the bank’s lost commission.

It is probably because of this nexus that Google decided to not raise money in a conventional way but instead go through an auction (it made big news back then, but then that’s how things always happen in India so we have a reason to be proud). Unfortunately they were able to do it only because they are google and other companies have failed to successfully raise money by that process.

The nexus between investment banks and investors in IPOs remains and unless there are enough companies that want to do a Google, it won’t be a profitable option to IPO in the US. Which makes it even more intriguing that MMYT chose to raise funds in the US and not here in India.

Discontinuous Yield Curves

I think that the equity markets have topped out and have cashed out all my equity and equity mutual fund holdings, and am thus sitting on a pile of cash, which I’m looking to invest in debt. Happened to check out the websites of a few banks where I hold accounts and what caught my eye was the discontinuity in the yield curves.

Here is HDFC Bank:

1 year 1 day – 1 year 15 days Below Rs.15 Lacs 6.00% 6.50% May 18, 2009
1 year 16 days Below Rs.15 Lacs 6.50% 7.00% August 03, 2009
1 year 17 days – 2 years Below Rs.15 Lacs 6.00% 6.50% May 18, 2009
2 years 1 day – 2 years 15 days Below Rs.15 Lacs 6.00% 6.50% May 18, 2009
2 years 16 days Below Rs.15 Lacs 7.00% 7.50% August 03, 2009
2 years 17 days – 3 years Below Rs.15 Lacs 6.00% 6.50% May 18, 2009
3 years 1 day – 5 years Below Rs.15 Lacs 6.00% 6.50% May 18, 2009

Notice the discontinuity? About how for a couple of randomly chosen dates the interest rates suddenly shoot up?

Similarly with ICICI Bank:

391 days to 589 days 6.25 6.25
590 days 6.25 6.25
591 days to less than 2 years 6.25 6.25
2 years to 789 days 7.00 7.00
790 days 7.00 7.00
791days to 989 days 7.00 7.00
990 days 7.25 7.25
991 days to less than 3 years 7.00 7.00

Again same story. On certain “magical” days, interest rates shoot up. The degree of increase in rates here is much less dramatic, though. Nevertheless this is extremely interesting, and I wonder why. I remember last year going to Karnataka Bank and asking for a 1 year deposit, and they asked me to make one for 400 days saying that I’ll get 0.5% per annum better for that.

This morning I went to State Bank of India and found that they don’t offer these special rates. I had a friend check at another nationalized bank and found that they too don’t offer special rates. Wonder why the private banks are offering it, though. Why it makes that big a difference to them that the deposit is for 990 days as against 991 or 889. Or is it some way to prevent early closure?

In other news, SBI is offering teaser rates for home and auto loans. Their ads have been there all over the airwaves for the last few weeks. They offer 8% for first year, 8.5% for second and third years and then what they call as “normal rates” after that. If SBI is getting into teaser rates, god only save Indian finance.

Taleb’s Recipe

No, unlike the previous post, this has nothing to do about food. It is about Nassim Nicholas Taleb’s recent op-ed in the Financial Times where he gives his “recipe” for saving the global financial system. Two of my favourite bloggers Arnold Kling and Felix Salmon have responded to it, but I didn’t like either so I thought I should post my response as well.

I borrowed The Black Swan from Aadisht sometime in late 2007. I tried starting to read it several times but never got past Taleb’s childhood stories of his hometown Amioun. I took a couple of months to get past the first 50 pages, I think. And then it was easy reading. I loved the sub-plots. I broadly bought into the main plot. By the time I had finished reading the book, I wanted to ask Taleb to accept me as his sisya. I  bought and read Fooled By Randomness, and liked that too. And then decided to read The Black Swan yet again. It was only a couple of months back that I finally returned the latter book to Aadisht (in the meantime he had bought two other copies of it, and read it).

Till very recently, I would read up any article of Taleb’s that I could find. I wrote to him a couple of times with my CP, and he even responded. I infact wrote to him about “Positive Black Swans and the World of Romance” and he responded with a “Thanks Karthik, Ciao, Nassim”. I had become a worshipper.

However, now I think he’s kinda lost it. I don’t think he intends to write another book and so he has nicely settled down to peddling his last theory (black swan). In response to a recent post on studs and fighters, Kunal had said, “He that is good with a hammer tends to think everything is a nail.”. The same disease affects Taleb I think, as he goes around the world trying to force-fit his black swan model to every conceivable problem.

And then I have a problem with people like Taleb and Satyajit Das, and actually with all those ibankers who are asking for bailouts. These guys made full use of capitalism, and made heaps of money, when things were good. And now that their money has been made, they call for government intervention, and socialism. Taleb and Das are different from the other wall streeters because they are calling for full-scale government intervention, unless the other bankers who are only calling for a bailout!

Now that the elaborate intro is done, let us get to the point. Taleb’s essay consists of ten points. The headings are italicized and there’s a detailed explanation. For purpose of brevity I’m putting only the headings here, and writing my comments after each of them. Go to the FT site to read the full points that Taleb has written.

1. What is fragile should break early while it is still small.

I agree with this. And my take is that competitors need to keep each other in check. For example, if this round of bailouts were not to happen and the biggies were let to fall, no one would grow so big in the future, and even if they did, they would make sure that they were insulated enough from one another. This round of bailouts will make the next crisis (whenever it will happen) worse.

2. No socialisation of losses and privatisation of gains.

Agree with this.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.

Taleb has clearly not learnt his own lessons (fooled by randomness). I might have crashed the school bus once, but it may not be my mistake. the one data point of one bus crash should not be used to decide my career as a driver. One should look at how the driver drove before the crash to determine whether he gets a second chance. Blanket banning of people involved will not help.

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks.

It’s all about structuring. Taleb was a trader and he forgets about structuring. As long as incentives of the employee and the employer are reasonably well aligned, there is no problem with an incentive bonus. The problem in ibanking was that too much emphasis was placed on short-term performance of employees. It’s tragic that the fall of the financial system has brought to an end what was an excellent compensation system (in principle, mind you; not the way it was practised) – where each person was paid fairly based on his/her contribution.

5. Counter-balance complexity with simplicity.

I think the simplest way would be to leave things to the market. Government intervention would lead to a new form of complexity, and in the overall scheme of things increase complexity rather than decrease it. None of the stuff that Taleb has mentioned is easily implementable.

6. Do not give children sticks of dynamite, even if they come with a warning .

Again Taleb prescribes mai-baap sarkaar. Does he realize that if governments had always had tight control over the markets, the markets wouldn’t have crashed on October 19 1987, and he wouldn’t have made any money? (Taleb has reportedly made 97% of his life’s earnings out of this one event). What is “complex derivatives”? And how can you ban it? If you ban it, it’ll go to the black market. You are better off collecting hefty security transaction tax.

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”.

I agree

8. Do not give an addict more drugs if he has withdrawal pains.

Agree once again. We need to structurally change things to get to saner leverage than what was practised 1-2 years back. Regulations should be simple and principles-based, minimizing chance for regulatory arbitrage. Remember that the purpose of creation of most “complex derivatives” in the last 25 years is regulatory arbitrage.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement.

Bullshit. The point on markets not containing information, that is.

10. Make an omelette with the broken eggs.

None of this makes any kind of practical sense. It’s just an old man ranting. Thanks, guru (pun intended).

Tenure Matching

One of the fundamental concepts of finance is to match the tenure of assets and liabilities. That the tenure of source of funds (equity, debt, etc.) need to match the tenure of what they are used for. So, if you need money to tide over till your next payday, you need to take an extremely short-term loan. If you need to borrrow to fund a house – an application that has a long tenure – you need to take a longer-term loan. And so on.

In fact, a common refrain about banking crises is that they happen mainly due to the tenure mismatch – banks borrow by means of short-term deposits, and then invest these in long-term loans. Most theories regarding liquidity crises cite this as a common problem.

Now, my contention is that this banking/finance rule is just a special case of a much larger rule in life. Remember that funding, or raising money, can be looked at as a “problem”. By classifying it as a problem, I’m not necessarily saying it’s a very tough problem. All I’m saying is that it’s a problem. And when you do raise money, it is a solution to the problem. Thus, the generalized form of the rule

The tenure of the solution needs to match the tenure of the problem.

So before you look for a solution for any problem in life, you need to first figure out about the tenure of the problem. And then generate a list of possible solutions which have similar tenures, and then pick the best among them. And based on my limited anecdotal experience, most people don’t really appreciate this concept when they suggest, and sometimes even implement, certain solutions.

So on Monday I called up a friend and told her that I was going through a strong bout of NED and we should meet up. She started philosophising and said that this is a fundamental problem and that I should think of a fundamental solution. That I should get a new hobby, or learn a new instrument, or some such long-term thing. Of course, I know myself better than she does, and so I knew that my problem was short-term, and so all I needed was a nice evening out. A short term solution to a short term problem.

On the other hand, during my previous job, I used to go through prolonged periods of NED. A little analysis revealed that the fundamental reason for this NED was my job, and that until I got a new one, I wouldn’t be happy. It was a long-term problem that deserved a long-term solution – of finding another job. However, most of the advice I got for my NED was of the nature of “go get drunk, you will be fine”.

My mother also doesn’t seem to appreciate this tenure concept. Nowadays I’m afraid to crib to her about anything, because if I crib, she assumes it’s a long-term problem and suggests that I should get married and that she’ll intensify her efforts in the arranged-marriage market.

Yes – people not appreciating this tenure concept is a long-term problem. The solution to this should also, thus, be long-term. They need to be taught such a lesson regarding this, that they won’t forget this concept for the rest of their lives.