Category: finance

Financial inclusion and cash

Varad Pande and Nirat Bhatnagar have an interesting Op-Ed today in Mint about financial inclusion, and about how financial institutions haven’t been innovative to make products that are suited to the poor, and how better user interface can also drive financial inclusion. I found this example they took rather interesting:

Take, for instance, a daily wager who makes Rs200 on the days she gets work. Work is unpredictable, and expenses too can be volatile, so she has to borrow money for buying vegetables, or to pay the doctor’s fees when her children fall sick. Her real need is for a flexible—small ticket, variable amount, rapid approval—loan product that she can access instantly. Unfortunately, no institutional channel—neither the public sector bank where she has a “no frills” account, nor the MFI that she has previously borrowed from—offers such a product. She ends up borrowing from neighbours, often from the local moneylender.

Now, based on my experience in FinTech, it is not hard to design a loan product for someone whose cash flows are known. The bank statement is nothing but a continuing story of the account holder’s life, and if you can understand the cash flows (both in and out) for a reasonable period of time, it is straightforward to design a loan product that fits that cash flow pattern.

The key thing, however, is that you need to have full information on transactions, in terms of when cash comes in and goes out, what the cash outflow is used for, and all that. And that is where the cash economy is a bit of a bummer.

For a banker who is trying to underwrite, and decide the kind of loan product (and interest rate) to offer to a customer, the customer’s cash transactions obscure information; information that could’ve been used by the bank to design/structure/recommend the appropriate product for the customer.

For the case that Pande and Bhatnagar take, if all inflows and outflows are in cash, there is little beyond the potential borrower’s word that can convince bankers of the borrower’s creditworthiness. And so the potential borrower is excluded from the system.

If, on the other hand, the potential borrower were to have used non-cash means for all her transactions, bankers would have had a full picture of her life, and would have been able to give her an appropriate loan!

In this sense, I think so far financial inclusion has been going on ass-backwards, with most microfinance institutions (MFIs) targeting loans rather than deposits. And with little data to base credit on, it’s resulted in wide credit spreads and interest rates that might be seen as usurious.

Instead, if banks and MFIs had gone the other way, first getting customers to deposit, and then use the bank account for as much of their transactions as possible, it would have been possible to design much better financial products, and include more customers!

The current disruption in the cash economy possibly offers banks and MFIs a good chance to rectify their errors so far!

Why PayTM is winning the payments “battle” in India

For the last one year or so, ever since I started using IMPS at scale, and read up the UPI protocol, I’ve been bullish about Indian banks winning the so-called “payments battle”. If and when the adoption of electronic payments in India takes off, I’ve been expecting banks to cash in ahead of the “prepaid payments instruments” operators.

The events of the last one week, however, have made me revise this prediction. While the disruption of the cash economy by withdrawal of 85% of all notes in circulation has no doubt given a major boost to the electronic payments industry, only some are in a position to do anything about this.

The major problem for banks in the last one week has been that they’ve been tasked with the unenviable task of exchanging the now invalid currency, taking deposits and issuing new currency. With stringent know-your-customer (KYC) norms, the process hasn’t been an easy one, and banks have been working overtime (along with customers working overtime standing in line) to make sure hard currency is in the market again.

While by all accounts banks have been undertaking this task rather well, the problem has been that they’ve had little bandwidth to do anything else. This was a wonderful opportunity for banks, for example, to acquire small merchants to accept payments using UPI. It was an opportune time to push the adoption of credit card payment terminals to merchants who so far didn’t possess them. Banks could’ve also used the opportunity to open savings accounts for the hitherto unbanked, so they had a place to park their cash.

As it stands, the demands of cash management have been so overwhelming that the above are literally last priorities for the bank. Leave alone expand their networks, banks are even unable to service the existing point of sale machines on their network, as one distraught shopkeeper mentioned to me on Saturday.

This is where the opportunity for the likes of PayTM lies. Freed of the responsibilities of branch banking and currency exchange, they’ve been far better placed to acquire customers and merchants and improve their volume of sales. Of course, their big problem is that they’re not interoperable – I can’t pay using Mobikwik wallet to a merchant who can accept using PayTM. Nevertheless, they’ve had the sales and operational bandwidth to press on with their network expansion, and by the time the banks can get back to focussing on this, it might be too late.

And among the Prepaid Payment Instrument (PPI) operators again, PayTM is better poised to exploit the opportunity than its peers, mainly thanks to recall. Thanks to the Uber deal, they have a foothold in the premium market unlike the likes of Freecharge which are only in the low-end mobile recharge market. And PayTM has also had cash to burn to create recall – with deals such as sponsorship of Indian cricket matches.

It’s no surprise that soon after the announcement of withdrawal of large currency was made, PayTM took out full page ads in all major newspapers. They correctly guessed that this was an opportunity they could not afford to miss.

PS: PayTM has a payments bank license, so once they start those operations, they’ll become interoperable with the banking system, with IMPS and UPI and all that.

Dealing with loss of cash

Ever since Rs. 500 and Rs. 1000 notes ceased to be legal tender on Tuesday night, the internet has been full of “human stories” of people for whom tragedy has struck because they are not able to transact.

This is a valid concern – for there is a significant portion of the population without access to banking (numbers in a Mint piece I’ve sent but they’re yet to publish), and access to banking is necessary to do any transaction of reasonable size (there’s only so much you can pay with 100 buck notes).

One fallacy, though, is that people in rural areas, where access to banks and ATMs is lower compared to urban areas, are going to have it harder till the cash gets adequately replaced. While these places may be out of the way, what will help them tide it over is that everyone pretty much knows everyone else.

In Money: The Unauthorised Biography, Felix Martin argues that money is neither a store of value nor a medium of exchange. Instead, it is simply a method to keep track of debts, with the elegance being offered by the fact that money is “negotiable”. If I have a 100 rupee note, all it says is I’m owed 100 rupees. Who owes me those 100 rupees doesn’t matter. “I promise to pay the bearer the sum of one hundred rupees”, the front of the note declares. It just doesn’t matter who the “I” in question is.

In order to illustrate his theory of money, Martin gives the example of Ireland around 1970, when a six-month banking strike left the country’s financial system in tatters. Life didn’t come to a standstill, though, as people figured out ways of maintaining their credits and transferring them.

Initially, people wrote each other cheques. Despite the inherent credit risk, and the fact that they couldn’t be encashed in near future, people accepted them from people they knew. Then the cheques became negotiable, after “reputed community people” such as barmen started vouching for people’s creditworthiness. And so the economy moved along.

Debts were finally settled many months later when the banking system reopened, and people could cash in the cheques they held. A similar story played out in Argentina in the early 2000s when rampant inflation had rendered the currency useless – cities managed to invent their own currencies and life went on.

In a similar fashion, in small towns, and other communities where most people tend to know one another, people are unlikely to face that much trouble because of the cash crunch. Credit is already fairly common in such places, except that it will have to be extended for a longer period of time until the cash supply returns. It is similar in other remote unbanked areas, and perhaps even among tightly-knit communities of businessmen. Systems will spontaneously come up to extend and exchange credit, and life will go on.

The concern, however, is for the urban poor, since they tend to do a large number of transactions with people they don’t know well. In such situations, extension of credit is impossible, and people might find it hard.

Financial Inclusion

Matt Levine had a superb newsletter recently on whether asset managers and pension funds who push customers towards buying high-cost retirement savings plans are doing a good thing or a bad thing. As Levine expertly explained, it all depends upon the context.

 Is bad retirement advice worse than no retirement advice? Like here is a simple hierarchy of things you could do to save for retirement, from best to worst:

  1. Save for retirement in an efficient portfolio of index funds with very low fees.
  2. Save for retirement in a mediocre product with very high fees.
  3. Not save for retirement.

…

So if some slick-talking hustler shows up at your place of employment and talks you into option 2, has he done you a favor, or done you harm? The answer depends on what you would have done if he hadn’t shown up. If you were on your way to Vanguard to buy index funds when he waylaid you, he has moved you from option 1 to option 2, and made you poorer in retirement. If you were on your way to blow your paycheck on lattes at Starbucks, he has moved you from option 3 to option 2, and made you richer in retirement. The context is key.

Earlier today, I was at a post office, trying to cash a National Savings Certificate that my parents had somehow bullied me into investing in, and was reminded of how inefficient post offices are. For a long time, India Post has allowed people to maintain deposits, in so-called “savings accounts” (though India Post is itself not a bank).

And as I’ve experienced while trying to operate such accounts on behalf of sundry relatives, it’s incredibly inefficient. Lines are long. Post offices are understaffed, and staff mostly overworked. Computerisation is minimal – while finally they have a way to print out pass books, it still lags significantly behind even nationalised banks. Things we take for granted at most banks – such as ATM cards – are absent. You need to line up to take your cash out.

The reason I’m describing this is that the “Post Office Savings Bank” has recently received a license to formalise its banking, to become a so-called “payment bank“. The “bank” won’t be able to lend, but can facilitate payments and movement of money. The amount of money in the savings accounts is capped at Rs. 1 Lakh.

The intention behind the license is sound – India Post has a network that goes into all sorts of nooks and corners of the country, and now people in those nooks and corners can have a bank account, and send money to each other! Which is a wonderful thing.

But then, India Post is a really large and slow-moving operations, so it’s unlikely that they’ll adapt much towards modern ways of banking after they become a proper (small) bank. So the customers they’ve “financially included” will need to wait in line to put or get out money, perhaps fill forms in order to be able to transfer funds, and face other inconveniences to be able to “bank”. So is the financial inclusion worth it?

To paraphrase Levine, it all depends on the context. To continue paraphrasing Levine, if India Post Payments Bank (as it will be called) were to waylay a customer who was on his way to opening a PayTM account, it has done a disservice, by replacing an easy-to-use electronic account with one where he will have to face lines, which might dissuade him from banking altogether.

If on the other hand IPPB were to waylay a customer who was on his way to the post office (!) to send a money order to a relative, they are actually doing him a service, providing him a more efficient method for transferring funds.

It all depends upon the context.

Extremes and equilibria

Not long ago, I was chiding an elderly aunt who lives alone about the lack of protein in her diet (she was mostly subsisting on rice and thin rasam). She hit back citing some research she’d seen on TV which showed that too much protein can result in uric acid related complications, so it’s ok she isn’t eating much protein.

Over the last couple of years, efforts to encourage non-cash payments in India have been redoubled. The Unified Payments Interface (UPI) has come in, payments banks are being set up, and financial inclusion is being pursued. And you already have people writing about the privacy and other perils of a completely cashless economy.

Then you have index funds. This is a category of funds that is 40 years old now, but has gained so much currency (pun intended) in the recent past that the traditional asset management industry is shitting bricks. And so you have articles that compare indexing to being “worse than Marxism” and dystopian fiction about a future where there is only one active investor left.

All these are cases of people reacting to suggestions with the perils of the suggestion taken to the extreme. My aunt needs more protein in her diet, but I’m not telling her to eat steak for every meal (which she anyway won’t since she’s a strict vegetarian). The current level of usage of cash is too high, and there might be more efficiencies by moving more transactions to electronic media. That doesn’t imply that cash in itself needs to be banned.

And as I mentioned in another blogpost recently, we probably need more indexing, but assuming that everyone will index is a stupid idea. As I wrote then,

In that sense, there is an optimal “mixed strategy” that the universe of investors can play between indexing and active management (depending upon each person’s beliefs and risk preferences). As more and more investors move to indexing, the returns from active management improve, and this “negative feedback” keeps the market in equilibrium!

In other words, what more people moving to indexing means is that the current mixed strategy is not optimal, and we need more indexing. To construct scary scenarios of where everyone is indexing in response is silly.

Effectively, what we need is thinking at the margin – analysing situations in terms of what will happen if there is a small change in the prevailing situation. Constructing scare scenarios around what will happen if this small change is taken to the extreme is as silly as trying to find the position of a curve by indefinitely extending its tangent from the current point!

Indexing, Communism, Capitalism and Equilibrium

Leading global research and brokerage firm Sanford Bernstein, in a recent analyst report, described Index Funds (which celebrated their 40th birthday yesterday) as being “worse than Marxism“. This comes on the back of some recent research which have accused index funds of fostering “anticompetitive practices“.

According to an article that says that indexing is “capitalism at its best“, Sanford Bernstein’s contention is that indexers “free ride” on the investment and asset allocation decisions made by active investors who spend considerable time, money and effort in analysing the companies in order to pick the best stocks.

Sanford Bernstein, in their report, raise the spectre of all investors abandoning active stock picking and moving towards index funds. In this world, they argue, allocations to different assets will not change (since all funds will converge on a particular allocation), and there will be nobody to perform the function of actually allocating capital to companies that deserve them. This situation, they claim, is “worse than Marxism”.

The point, however, is that as long as there is no regulation that requires everyone to move to index funds, this kind of an equilibrium can never be reached. The simple fact of the matter is that as more and more people move to indexing, the value that can be gained from fairly basic analysis and stock picking will increase. So there will always be a non-negative flow (even if it’s a trickle) in the opposite direction.

In that sense, there is an optimal “mixed strategy” that the universe of investors can play between indexing and active management (depending upon each person’s beliefs and risk preferences). As more and more investors move to indexing, the returns from active management improve, and this “negative feedback” keeps the market in equilibrium!

 

So in that sense, it doesn’t matter if indexing is capitalist or communist or whateverist. The negative feedback and varying investor preferences means that there will always be takers for both indexing and active management. Whether we are already at equilibrium is another question!

May a thousand market structures bloom

In my commentary on SEBI’s proposal to change the regulations of Indian securities markets in order to allow new kinds of market structures, I had mentioned that SEBI should simply enable exchanges to apply whatever market structures they wanted to apply, and let market participants sort out, through competition and pricing, what makes most sense for them.

This way, different stock exchanges in India can pick and choose their favoured form of regulation, and the market (and market participants) can decide which form of regulation they prefer. So you might have the Bombay Stock Exchange (BSE) going with order randomisation, while the National Stock Exchange (NSE) might use batch auctions. And individual participants might migrate to the platform of their choice.

Now, Matt Levine, who has been commenting on market structures for a long time now, makes a similar case in his essay on the Chicago Stock Exchange’s newly introduced “speed bump”:

A thousand — or at least a dozen — market structures can bloom, each subtly optimized for a different type of trader. It’s an innovative and competitive market, in which each exchange can figure out what sorts of traders it wants to favor, and then optimize its speed bumps to cater to those traders.

Maybe I should now accuse Levine of “borrowing” my ideas without credit! 😛

 

Equity financing of books

A rather uncharitable view of the book advances that legacy publishing houses give out to established (non first-time) authors is to look at it as “convertible debt”, as this piece by Matthew Yglesias points out.

An advance is bundled with a royalty agreement in which a majority of the sales revenue is allocated to someone other than the author of the book. In its role as venture capitalist, the publisher is effectively issuing what’s called convertible debt in corporate finance circles — a risky loan that becomes an ownership stake in the project if it succeeds.

Now, as I consider possibly self-publishing my book, while simultaneously attempting to sell it to established publishing houses, I realise that apart from the convertible debt, publishing a book also involves a massive sale of equity.

I’ve finished the manuscript, and edited it once. It needs further editing, but I’ve put it off so far in the hope that I can sell the book to a mainstream publisher, who will then take care of the publishing. However, given that I might end up self-publishing, and from what I read that publishers don’t do a great job of editing anyway, I might need another pass or two.

And then there are other things to be done before the book comes out in print – a cover needs to be designed, illustrations need to be put in, maybe we should get someone to do an audiobook, and all such. Now, if a mainstream publisher picks up the book, I’d expect them to take care of these. Else I’ll need to spend to get people to do these things for me.

When people first told me that royalties in book publishing are of the order of 7.5% of cover price, it was a little hard to believe. However, looking at the costs involved in the publishing process, it’s not hard to see why publishers take the cut that they take. The problem, though, is that it involves you selling equity in your book.

By going for a mainstream publisher (rather than self-publishing), you are saving yourself the upfront cost of getting your book edited, designed and “typeset”, in exchange for a large portion of the equity of the book.

Looking at it in another way, you are trading in your limited downside (what you spend in designing, printing, etc.) for what might be a massively unlimited upside (in case my book is a runaway success). For the most part, considering that most books don’t do that well, it isn’t a very bad deal. However, considering that downside is limited (in terms of costs) I wonder if it makes sense to trade it in for a large stake of what could be a large upside.

In any case, the main reason I’m still pushing to get mainstream publishers is because the self-publishing market is a “market for lemons“. With barrier to entry not being too high, lots of bad books are self-published, and so anyone who thinks they’ve written a half decent book will try to find a mainstream publisher. And this further diminishes the average quality of self-published books. And further dissuades people like me from self-publishing!

 

Intermediation and the battle for data

The Financial Times reports ($) that thanks to the rise of AliPay and WeChat’s payment system, China’s banks are losing significantly in terms of access to customer data. This is on top of the $20Billion or so they’re losing directly in terms of fees because of these intermediaries.

But when a consumer uses Alipay or WeChat for payment, banks do not receive data on the merchant’s name and location. Instead, the bank record simply shows the recipient as Alipay or WeChat.

The loss of data poses a challenge to Chinese banks at a time when their traditional lending business is under pressure from interest-rate deregulation, rising defaults, and the need to curb loan growth following the credit binge. Big data are seen as vital to lenders’ ability to expand into new business lines.

I had written about this earlier on my blog about how intermediaries such as Swiggy or Grofers, by offering a layer between the restaurant/shop and consumer, now have access to the consumer’s data which earlier resided with the retailer.

What is interesting is that before businesses realised the value of customer data, they had plenty of access to such data and were doing little to leverage and capitalise on it. And now that people are realising the value of data, new intermediaries that are coming in are capturing the data instead.

From this perspective, the Universal Payment Interface (UPI) that launched last week is a key step for Indian banks to hold on to customer data which they could have otherwise lost to payment wallet companies.

Already, some online payments are listed on my credit card statement in the name of the payment gateway rather than in the name of the merchant, denying the credit card issuers data on the customer’s spending patterns. If the UPI can truly take off as a successor to credit cards (rather than wallets), banks can continue to harness customer data.

Aswath Damodaran, Uber’s Valuation and Ratchets

The last time I’d written about Aswath Damodaran’s comments on Uber’s valuation, it was regarding his “fight” with Uber investor Bill Gurley, and whether his valuation was actually newsworthy.

Now, his latest valuation of Uber, which he concludes is worth about USD 28 Billion, has once again caught the attention of mainstream media, with Mint writing an editorial about it (Disclosure: I write regularly for Mint).

I continue to maintain that Damodaran’s latest valuation is also an academic exercise, and the first rule of valuation is that “valuation is always wrong”, and that we should ignore it.

However, in the context of my recent piece on investor protection clauses in venture investments (mainly ratchets), it is useful to look at Damodaran’s valuation of Uber, and how it compares to Uber’s valuation if we were to account for investor protection clauses.

“True value” of Indian unicorns after accounting for investor protection. Source: Mint

When Uber raised $3.5 Billion from Saudi Arabia’s Public Investment Fund earlier this year, the headline valuation number was $62.5 Billion. Given the late stage of investment, it is unlikely that the investor would have done so without sufficient downside protection – at the very least, they would want a “full ratchet” (if the next investment happens at a lower valuation, then they get additional shares to compensate for their loss). This is a conservative assumption since late stage (“pre-IPO”) investments usually have clauses more friendly to the investor, usually incorporating a minimum “guaranteed return”.

Plugging these numbers into the model I’ve built (pre-money valuation of $59 Billion and post-money valuation of $62.5 billion), the valuation of the put option written by existing investors in favour of Uber comes to around $1.28 Billion. Accounting for this option, the total value of the company comes out to $39.6 Billion.

Damodaran’s valuation, based on his views, principles and numbers, is $28 Billion. Assuming that investors and management of Uber are aware of the downside protection clauses and its impact on the company’s valuation, Damodaran’s valuation is not that much of a discount on Uber’s true valuation!