26th February 2018
26th February 2018
25th February 2018
24th February 2018
23rd February 2018
My Prof at IIM-A once said that every subject in management has its roots in some mother subject. For example, he said, Economics has its roots in Psychology. Finance is a derivative of Economics (Micro-economics, to be precise). HR has its roots in Organizational Behavior, which in turn borrows from Social Science. Operations Management is loosely based on Applied Mathematics (Graphs, Queues, and Optimization techniques).
However, Marketing is the only subject which is a creation of Management studies. It is partially true. Because Marketing also has links with Psychology.
My other professor at the Lancaster University, UK gave a very interesting perspective. He said:
Basic law of Economics is: “People pay a lot for things they like”
Basic law of Psychology is: “People like a lot the things they pay for”
Between these two ends you embed all your functions: Strategy/Sales/Production/Finance/Pricing/Marketing/Distribution/Branding/Advertisement.
If you ponder over this, the idea is so fundamental. I will build on this and borrow from the great Management Guru Peter Drucker.
Let’s start with what the UK prof said.
Basic law of Economics is: “People pay a lot for things they like”. This simple looking sentence has many complex themes within itself. It suggests that “value” is always “perceived value” and not absolute value. The perceived value is based on the key concept in economics called “Utility”. I am willing to pay more for iPhone because I like it. That in turn is because I perceive more value/more utility in it. So if you can manage the “perceived value” part, you can sell a product for good price – probably a lot more than other similar products.
At the other end, the basic law of Psychology says, “People like a lot the things they pay for”. This is natural human tendency. You tend to overvalue your own possessions and downplay what others own. This is true of material possessions as well as opinions, and beliefs,…or achievements. One always feels that his/her success is hard earned and the other’s success is more of luck or chance. Dan Ariely, the author of bestsellers such as “Predictably Irrational” and “The Upside of Irrationality”, conducted an interesting experiment to prove this basic law of psychology. In one of the lectures he gave away signed copy of his book for free – but only to few “select” people chosen at random. Those who got the books felt “lucky”. Then he asked people who had received the book how much would they want to give away the book to others. i.e. how much would they sell it for. People who owned the book quoted significantly high price – because they valued the book, which they got exclusively, much more! Then Dan asked people who didn’t have the book how much would they pay for the book. And that set of people quoted very low number – as if they were downplaying the worth of the book.
This happened even when people who got the book got it for free! Now imagine what would happen if they had paid for it. They would have been “forced” to like their possession even more…because “People like a lot the things they pay for”.
Now let’s focus on Marketing. Marketing, in simple term is, converting wants of people into the needs. Job of marketing function is to change people’s habit; to make them buy more and more, as if they “need” things. And that is where these two Basic laws become relevant for Marketing.
To achieve the effect of Basic Law of Economics, the job of Marketing is to create the visibility and brand perception of their product and develop special “liking” for their product. To achieve the effect of Basic Law of Psychology, the job of Marketing is to maintain the aura of brand through advertisement, promotion. The idea is to constantly hammer the message: “As a buyer of this product, you belong to an exclusive club!”.
For many decades people and businesses focused only on the Basic Law of Psychology and thus focused on branding, advertisements, strategy of differentiation and product niche etc.
In recent years people are understanding that the Basic Law of Psychology is more significant. It is the backbone of Luxury goods. Also, it is the basis why “freebies” and “price war” is now seen as a bad strategy. If people like a lot the things which they for, it also suggests that there is no such liking for freebies. Yes, the customers would lap up anything given free; but they would also not hesitate to criticize and dislike such products, because there is no skin in the game. On the other hand, if customer pays for the product, it is also in his interest to “like” the product. He doesn’t want to be “seen” as a fool. And the more he pays, the stronger this feeling, and hence stronger the liking. It is very unlikely for someone to buy an expensive Diamond or a luxury car and not like it. And that is the cornerstone of all luxury goods.
I have experienced this myself so many times (I also admit that I have conformed to this law, willingly). I attended a 3-day Value Investing workshop last year. The workshop was conducted by a very famous professor who is perceived to be a great Guru on Value Investing. The program fee was Rs. 35,000. He has been running same workshop for last few years and have consistently increased fees – from Rs. 18,000 4-5 years back, to Rs. 25,000 3 years ago, to Rs. 30,000 2 years ago, to Rs. 35,000 last year.
To be honest to myself, the program was mediocre. You could have got the same Gyan from 2-3 books (worth Rs. 1500 max). The delivery was also nothing extraordinary. In fact it was monotonous and boring beyond a point.
However, nobody who attended the program admitted that the program was mediocre, or not great. Mainly because of the Basic Law of Psychology. How could you pay Rs. 35,000 for a 3-day program and say that it was all crap…you were fool to attend it? So the good perception of the program continues. People still find some good facets to justify the fees. For example, they would say “It was a great networking opportunity. I met so many good participants and exchanged good ideas, that the fee was totally worth it”. Or, “it was not just about the course content, but about having face time with the Professor. I learned so much from 1-on-1 interactions with him during breaks”. Or most ridiculous: “I got a selfie with the Professor, which means a lot to me!”.
Another example. A person who is earning decent salary but is stuck with job. He decides to pursue an expensive MBA thinking the perceived brand and quality of education would do wonders to his career! He leaves his job; spends 1 or 2 years and few lakhs (often more than his gross salary for 1-2 years) and attends the MBA program. Do you think he would ever say (in public) that the program was useless and he was a fool? 99.99% of the people would not (the rest 0.01% is Yours’ Truly, or that kind).
This is exactly what the Basic Law of Psychology says. And the more you spend the more you “like” it.
So whether you are a Marketing professional or not, do remember the two basic laws which form the boundary of Marketing!
As Peter Drucker said:
“Because the purpose of business is to create a customer, the business enterprise has two–and only two–basic functions: marketing and innovation. Marketing and innovation produce results; all the rest are costs. Marketing is the distinguishing, unique function of the business.”
Lastly, understand the connection between the two basic laws. Economic theories are based on many assumptions. But the key assumption underlying all of Economics is that the man is a rational animal and would always behave rationally and in self-interest. Psychology is the subject which addressed the very assumption of Economics. It addresses question: “What if man is not rational, or does not always behave rationally?”. Both taken together complete each other and enhance our understanding of the world.
22nd February 2018
21st February 2018
20th February 2018
Understanding The PNB Scam!!!
What actually happened in PNB scam? Let’s start from the concept.
First, The Concept
Let’s understand how things work.
Some importer, let’s call him Nirav Modi or NM, wants to import pearls or diamonds and then sell them. The purchase requires money, so NM approaches a bank, say Punjab National Bank (PNB).
PNB says look, I’ll give you a loan but it will be like at 10%.
NM thinks hard and says, no, that’s too much. Wait, why don’t I take a foreign currency loan instead, after all I’m buying in dollars? Much lower interest rates no? I can get at LIBOR+2% and LIBOR is like 1.5% so I’ll have the money at 3.5%!
But who will give NM a foreign currency loan? A bank abroad? They don’t know NM. They don’t have any history of NM, so why will they give him money?
SO NM goes to PNB and says, boss, you’re my banker, so please help some foreign bank give me some money to buy diamonds. Say that you will guarantee my loan by giving me a “Letter of Undertaking” (LOU).
PNB now should be saying look, if you want me to give Rs. 100 cr. guarantee, you give me stuff worth 110 cr. at least. As collateral.
But PNB, for some strange reason, doesn’t ask for collateral. More on that later.
So now the foreign bank is ready to lend NM the money. Because PNB will guarantee it. And the foreign bank trusts PNB. Why does it trust PNB?
Because PNB sends a message on SWIFT – the banking message service – that PNB guarantees Rs. 100 cr. of money for 180 days for Mr. NM at an interest rate of, say, LIBOR + 2%. It’s like a message – written in stone, effectively – that says PNB will pay if NM doesn’t pay.
In fact the foreign bank trusts only PNB. So it gives the money to PNBs account with it, called by PNB as a “Nostro” – the account that PNB maintains with banks abroad, where the other bank will send money meant for PNB customers.
PNB’s nostro account gets the money.
PNB then gives NM the money from the Nostro account, usually paid off to whoever NM is buying his diamonds from. This payment is to someone outside India usually, to fund a purchase of diamonds or whatever.
Note this carefully: The other bank gives money to PNB’s Nostro account. Not to NM. They don’t care about NM. They only know that PNB has given a guarantee on the SWIFT channel.
Note: the other bank is nowadays mostly the foreign branches of Indian banks. Because the phoren banks have realized something sinister – that PNB’s guarantee is a strange beast that isn’t backed with much, but we’ll come to that
The foreign bank couldn’t care less about whether NM was buying diamonds or bitcoin – to them, PNB would pay back even if NM’s bitcoin wallet got stolen.
Why does PNB give a guarantee? Fees. Each year, a bank may charge upto 2% to give the LoU.
So What Happens When It’s Time To Pay Back?
NM has to get the pearls in India, sell them, receive the money and pay PNB. On the due date written on the LoU.
Then PNB will pay back the foreign bank saying okay, we got the customer’s money so we’re giving it back to you. With interest etc.
That’s what is supposed to happen. But in reality, things went a little berserk, it seems.
The Reality: A Bit of a Ponzi
NM might not pay back at all. NM might use the money to speculate in the markets. Or do something else.
What if NM in the above example simply didn’t have the money to pay back? Instead, he asks a PNB official to open ANOTHER LoU. For the amount owed plus interest. So if we had the first LoU at $10 million the second one is $11 million to cover the interest on the first.
The money from the second LoU is used to repay the first. It’s just rolling over of credit. Over and over. Standard definition of a ponzi scheme.
This can easily balloon into a larger amount, so large that it’s too much. In effect many such arrangements have turned into semi-ponzi schemes, with one LoU being opened to repay another and so on.
Which is what is likely to have happened.
We don’t know the details, but it looks like:
Nirav Modi took loans from foreign branches of Indian banks through an LoU issued by PNB
This was done through a SWIFT based LoU issued through a rogue employee (or many of them) at PNB
The orders never showed up in the core banking system for monitoring
LoUs were rolled over all the way since 2011, and possibly increased over time too.
The rogue official retired in 2017, and the replacement refused to roll over the LoU which came due in Jan 2018 because he couldn’t find the past transactions in the system
No rollover means a default, since there was no money to pay. So PNB quickly files an FIR saying oh goodness we have lost 280 cr. on the Jan LoUs
Then someone said, “Abeyaar, is there more of these not-in-system LoUs? Someone check no?”
Then someone checked.
Oh gawd. 11,400 crores.
That’s a lot of crores.
Everyone in the bank panicked.
Why couldn’t Nirav Modi just pay it back? He must have the original money no?
Because if it was ever intended to be paid back, the rollovers wouldn’t have been required. At some point, things got so out of hand that rollovers were required in order to stay current.
Typically this would not be a problem. If PNB had done things right, they would have had collateral worth the amount of guarantee, and they would have sold that collateral and paid the foreign bank.
But, and here’s the real issue: PNB didn’t have any collateral.
Why did PNB give a guarantee without collateral?
If you and I go for a loan to a bank, they’ll ask us for income proof, and collateral. Only small tiny personal loans and credit card loans come backed without collateral. For something of the order of 11,000 cr. you would think they would ask for collateral.
Especially after the scene with Mallya where loans to Kingfisher were given on nearly no collateral (though even there they had a house and some promoter shares pledged)
Why did PNB give this guarantee then? It’s typical – banks give guarantees for more the amount you give as collateral. Because business relationships etc. And then:
Because nearly every bank is doing it.
The loan was not a “fund based limit”. In a fund based limit like a term loan, the bank pays out money. In non-fund-based limits, the bank will only pay if someone else defaults or an event happens – like a Bank Guarantee or an LC or an LoU.
Meaning, PNB assumed that the foreign bank was giving a loan directly to Nirav Modi and that PNB needed to pay only in case Nirav Modi defaulted. So in the eyes of PNB it was always an “non-fund-based” loan.
But this is how a significant part of import financing works. They all rollover credit, and they all use LoUs for much higher than they can offer as collateral.
From my sources, the scale is huge. For every Rs. 100 that a bank has collateral, they will easily provide LOUs for upto 6x the amount. This is a real problem – that most public sector banks do not keep much collateral against non-fund-based limits given to importing customers.
So even if a bank has collateral, it’s nowhere near enough. And then, such unfunded liabilities are not even reported to RBI!
Basel Reporting: No Disclosure
PNB has “unfunded” exposure of 11,000 cr. they say. But they don’t even reveal it in their latest Basel III disclosure:
The funded exposure to “Gems and Jewellery” is shown at 1860 cr.
Unfunded to the same sector: 842 cr.
This doesn’t even add up. So, in effect, PNB didn’t reveal that it was funding massive quantities of “unfunded, contingent exposure”. They will of course pretend that they didn’t know, because the transactions weren’t in the core banking system.
Did Employees Hide it? Was PNB Responsible or was it a fraud?
Can employees be responsible? Could they have hidden the credit and the rolling over of LoUs? But honestly, how does a 11,000 cr. credit pass muster without top management realizing it?
Think of it – your nostro account with these other banks keeps getting big credits that add up to 11,000 cr. Will you not reconcile it in the accounting? The “why is this money even here?” question should have been asked by someone who audits accounts, one thinks?
And the SWIFT messages. It’s a specific kind of message. Why wouldn’t PNB audit the SWIFT trail? Reconcile it with the core banking system? How many more such skeletons will tumble if they do?
Their excuses are
Data wasn’t entered into the core banking system. (Of course, otherwise you would have had to report it)
LOUs weren’t authorized. (Hard to believe, because the amounts are very large. Surely someone on the top would know?)
The SWIFT system was illegally used. (Again, hard to believe that a bank like PNB would not audit its SWIFT messages regularly. Or its auditors. Or RBI.)
On the face of it, it looks like the ex-employee is being used as a scapegoat. It’s likely that a lot of people were in on this thing. And that it generated massive, fat fees for PNB all these years.
Fees wise: Imagine 11,000 cr. worth LoUs being renewed each year – that’s upto Rs. 200 cr. in fees that was all hitting PNB’s top line. You could bribe an employee to maybe give you a small increase – say 10-20 cr. but when you hit numbers like 11,000 cr. this is surely something the top management would know.
What’s the Scale of this scam?
While PNB reported it as a 11,000 cr. scam, they filed an FIR with the CBI for only Rs. 280 cr. This has probably expanded since then but even if the total outstanding is as much as that, there’s a good chance that the actual loss amount will be lesser.
All of it will be borne by PNB right now. Whether someone abused their SWIFT usage is not relevant, if PNB’s SWIFT message said they will pay, they have to pay if there is a default.
But think about the fallout. The problem was that some liabilities were not in the system. There could be more such LoUs. From the same branch or others. Other banks could have such LoUs too. It’s trivial to start looking – and we know that Nirav Modi will not be an isolated case.
Also, the issue was that the limits had no collateral behind them. If all banks are told to verify their non-fund-based limits and demand collateral against them (say at least 25%) then the scale would be absolutely massive. It’s not like this is happening only with Nirav Modi or Choksi. A very large number of importers of commodities have been doing this, and rotating credit. A change in regulation here can change the game dramatically for every other bank (and import account) in the system.
The simple point: this particular transaction will result in a lower loss than 11,000 cr. for PNB. Because of recoveries and such. But if RBI asks all banks to pull up collateral on such lending and stop such practices, the scale is many times larger.
What about the PNB stock?
It’s fallen 17%. But note that it already has 60,000 cr. of gross NPAs. Another 11,000 cr. will hurt it but not kill it. It won’t die – the government will take it over. Shareholders might suffer, but come on as a shareholder of a public sector bank you’re used to suffering.
The problem really is: There is never just one cockroach. When you go deeper, you are likely to find more dirty, dark secrets, and none of them will be any good.
PNB is gonna hurt for a while, but so are others who will find their books similarly tarnished once they investigate.
Will This Bring The Market Down?
Have you been living under a rock? Nothing will ever bring the market down, nowadays.
But the one thing that does bring markets down is the outflow of liquidity. What if so much of the “ponzi” credit – essentially money that was rolled over very month – is being invested directly, or indirectly, into stocks? If RBI tightens up, liquidity will pull money out of stocks, and that will hurt.
Of course, this hurts the fiscal deficit since PNB has to be rescued. So bond yields are up to 7.6% and therefore we’d avoid any long term funds or bonds. Short term it will have to be.
But overall, we wouldn’t worry too much. Just react, don’t predict. What would you do if stocks fell? Better to answer that than to say they will, or they will not.
(And no, not buying PNB)
Our View: Fix it.
This is the Indian public sector banking system. Fix it.
How can you have transactions on SWIFT outside CBS? Fix it.
Why would you not reconcile the nostro accounts? Suspend the auditors. Fire top management. Fix it.
Closing the door behind Modi, who’s already left the country, is probably useless. If you find fraud, invoke their personal guarantees, and file cases to attach their personal properties. After that, file in NCLT to make these companies insolvent. Take the hit, and try to recover.
Find out more such instances where collateral cover is too low. Find out if the LoUs or LCs are just getting rolled over or is the customer actually paying back through the Indian current account. And if not, demand more collateral to avoid further spread of the ponzi.
But this is quite unlikely to happen because the banking system is going to take massive hits now, and we’re going to have to deal with the fallout of really horrible systems. It’s amazing that our banks have been this lax, but they have been allowed to; with no bankers being investigated, the rot inside the banks has been ignored and instead, industrialists have been the target of outrage. It’s time to look at banks as malicious players too, and to fix that rot.
Note: Based on WhatsApp forward and publicly available information. Attributed to Deepak Shenoy, but I have not verified.