The business world is being disrupted by the combined effects of growing emerging economies, shifts in global demographics, ubiquity of technology and accountability regulation. Infosys believes that to compete in the flat world, businesses must shift their operational priorities.

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November 30, 2008

Mark-to-Market Rules - Worsening the Credit Crisis?

With Citi being forced to seek the help of the U.S. government once again, it is apparent that banks will continue to feel the effects of a deteriorating housing market for some time to come.  While the viability of Citi’s Universal Banking model is being debated, it is becoming increasingly clear that, regardless of Bank-type, mortgage-backed securities are drowning our financial institutions in a sea of red ink. 

Many question whether this deluge of losses is actually necessary.  Bankers are pressuring regulators and lawmakers to make adjustments to FAS 157, the mark-to-market accounting rule in the US.  Put in place in response to the Enron crisis (Enron overvalued its assets to the point of bankruptcy) mark-to-market accounting requires corporations to value assets at their "fair value"; the price the asset would command on the open market. 


For example, say the 100 shares of stock that I purchased for $25 two months ago are now worth $35 (unlikely in these current market conditions, but bear with me).  The corresponding mark-to-market value of the shares would be $3500.  Under FAS 157, my personal balance sheet must value the stock at $3500. Or a more realistic example would be – I live in a home, pay a mortgage determined by the purchase value and the loan that I originally availed to finance the home; now the value of the home has fallen, should the bank call me to post more collateral to compensate for my loan-to-value increase, even though I have been regular in paying my monthly mortgage?

Despite the fact that the majority of MBS owned by banks are not in default, the fair market value for them is very low.  Why?  The market is illiquid, no one is buying them.  The spread between the bid and the ask is too large—and mark-to-market values assets based on the bid.

Normally, it would be fair for banks to value securities at the price they are fetching on the open market.  But these aren’t normal times, and most Banks argue that the value of the securities they are holding is actually much higher than their current market value.  Meanwhile, the value of bank balance sheets are plummeting—forcing them to write-down losses and seek outside funds to maintain required capital ratios. European regulators suspended mark-to-market accounting in early October, 2008.

Proponents of mark-to-market accounting argue that the rule helps prevent banks from understating the gravity of their situations.  Investors and creditors have the right to know the true value of publicly-traded companies.  Says Dane Mott, Analyst with JPMorgan Chase:  "Blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick."

This is a great analogy, but to what extent should you believe the doctor?  In the current situation it could be said that using mark-to-market accounting on mortgage backed securities is like the doctor telling you that you have brain cancer when in fact you are just suffering from stress-related headaches. I am keen to hear your views!

November 25, 2008

Offsetting the Rhetoric Against Offshoring

A new take on making the outcries against outsourcing less worrisome

The past few years have seen mounting trepidation over job losses in the US, particularly to developing regions such as India and China.These have been accompanied by sporadic outcries againt outsourcing and offshoring of jobs, which the ravages of the current financial crisis will only accentuate. With large banks collapsing and General Motors, once the mightiest corporation in America, sending out frantic distress signals, the crisis has brought the unthinkable to pass. These traumatic events are hardly likely to make Americans –whether government, intellectuals or the public - more tolerant to the steady outflow of jobs from the economy.

Now come two substantial new arrivals - a book and a study - that should go a long way towards allaying any backlash that may be brewing in the ateliers of the protectionists.

The book is a thoroughly researched, eloquently argued and highly persuasive piece, titled The Venturesome Economy - How Innovation Sustains Prosperity in a More Connected World. It's central thesis is that technological innovation is a complex, multiplayer game in which America still leads the world by a long way. American scientific, technological and economic pre-eminence are thus not going away anytime soon. The book goes on to argue that "neo-protectionist" fears are unwarranted, and shows how they will probably undermine America's economic might in the long run.

The book comes with impeccable credentials. It is authored by Amar Bhide, the Lawrence D. Glaubinger Professor of Business at Columbia University. Prof Bhide is also a co-researcher of Edmund Phelps, 2006 Nobel Laureate in Economics who is an authority on, among other things, the relationship between investment in education and research on the one hand, and economic growth on the other.

And Prof Bhide could hardly have chosen a better time to weigh in, as anti-offshoring rhetoric can be expected to rise over the next few months. It must be noted that the primary purport of the book is not to support outsourcing or offshoring,and I am sure nothing could be farther from the author's mind than to be painted as a torchbearer for the outsourcing brigade. Nonetheless, the arguments presented therein can be read as making a substantial case for a more liberal approach toward outsourcing.

The author marshals an astonishing array of evidence in supporting his thesis, stitching together data and information from diverse disciplines. He presents data to show that protectionist  fears in  the 1980s that the US would soon be overtaken by Germany and Japan, which focused on rigorous planning  of their scientific manpower, proved baseless as  the US prospered while  the ostensible aggressors largely floundered.  He says things are no different this time, with China and India.

The  book's  arguments  can  broadly  be  summed  up  as  follows:
*  Wealth  arises  not  so  much  from  creating  new  technological  breakthroughs  as  from  the  capacity  to  benefit  from  those  breakthroughs. 

*  This  'capacity  to  benefit'  is  a  higher  order  capacity  that  includes  elements  such  as  the  ability  to  create  products  based  on  those  technological  breakthroughs,  the  ability  to  market  those  products  well,  the  ability  to  take  risk  and  freedom  from  over-regulation. In  particular,  "venturesome  consumption"  -  the  propensity  of  consumers  to  embrace  products  based  on  new  technologies  -  is  vital. 

*  The  US  has  most  parts  of  this  diverse  puzzle  -  particularly  venturesome  consumption  -  and  is  hence  best  positioned  to  benefit  from  new  technologies.  This  is  true  even  of  new  technological  innovations  produced  abroad.  As  an  example,  the  author  avers,  the  exceptional  ability  of  US  companies  to  use  IT  has  been  a  strong  reason  why  US  productivity  has  outpaced  that  in  Europe  in  Japan.   

*  Hence  allowing  technological  breakthroughs  to  happen    abroad  certainly  does  not  hurt,  and  possibly  benefits  ,  the  US.  The  author  offers  the  example  of  the  iPod,  much  of  whose  technology  originated  in  Europe  and  Asia,  but  which  wouldn't  have  achieved  the  success  it  has  without  venturesome  US  consumers  -  who  have  in  turn  reaped  huge  benefits  by  so  consuming  the  device. 

*  This  higher-order  capacity  is  deeply rooted in various economic, social, cultural and psychological structures and is hence highly  sticky, which makes it difficult  for  the  US  to  lose it -  and  for  other  countries  to  acquire it.   

The  author  also  introduces  the  notion  of  "nondestructive  creation"  (innovation  that    creates  new  products  and  services  without  displacing  existing    ones)    in  addition  to  the  familiar  Schumpeterian  creative  destruction.  Such  nondestructive  creation  creates  new  jobs  without  eliminating  existing  ones.  At  least  in  the  nontradable  services  sector,  these  new  jobs  will  have  to  stay  in  the  US  and  cannot  migrate  to  low  cost  locations. 
Thus,  Prof.  Bhide  assures  us,  there  is  unlikely  to  be  a  giant  sucking  sound  anytime  soon.   
One  potential  objection  that  occurs  to  me,  that  protectionists  may  raise:  relying  too  strongly  on  the  'nontradable  services'  argument  may  amount  to  standing  on  shifting  sands  at  best.  Several  services  thought  to  be  nontradable  have  turned  out  to  be  tradable  after  all.  IT  services  themselves  were  thought  to  be  nontradable  for  long,  until  Indian  IT  service  companies  showed  they  could  cross  borders.  Even  advertising,  which  is  highly  culture-  and  context-  specific  -  has  been  offshored  (Lenovo  has  headquartered  all  its  marketing  activities  outside  China  in  Bangalore). 
The  book  also  perhaps  bypasses  one  major  theme  on  the  subject  of  'how  innovation  sustains  prosperity  in  a  connected  world'  (and  this  is  also  my  favorite  argument  in  favor  of  why  developed  economies  including  the  US  should  not  be  chary  of    allowing  high-end  work  -  and  high-paying  jobs  -  to  flow  abroad):  a  lot  of  the  prosperity  that  so  'leaks  away'  from  developed  economies  comes  right  back  in  the  form  of  demand  for  products  and  services.  As  an  example,  Indian  IT  outsourcing  companies  are  perhaps  the  largest  airline  customers  in  the  world,  as  tens  of  thousands  of  workers  travel  each  year  between  India  and  the  countries  where  clients  are  located.  These  airlines  such  as  United  and  Lufthansa  are  mostly  headquartered  in  developed  countries.  Similarly,  the  same  India-based  outsourcers  lap  up  the  laptops,  PCs,  servers  and  networking  equipment  made  by  Dell,  Sun  and  Cisco.  They  are  huge  buyers  of  software  produced  by  Microsoft,  IBM,  Oracle  and  SAP.  These  companies  (and  their  employees)  can  safely  be  assumed  to  have  an  insatiable  appetite  for  the  latest  cellular  phones  and  so  forth  from  the  likes  of  Apple,  Nokia  and  RIM.  These  companies  also  employ  legions  of  workers  at  or  close  to  client  locations  -  workers  who  pay  taxes  and  pump  money  into  local  economies.  Many of these companies are listed on US and European stock exchanges, allowing people there to participate in their wealth creation. Thus,  prosperity  'leaking'  abroad  contributes  to  prosperity  in  the  developed  economies  -  not  in  some  nebulous,  long-term  sense  but  in  a  way  that  is  direct  and  almost  immediate. 
These  are  but  minor  quibbles  -  the  book  cuts  a  wide  swathe  in  making  its  elaborate  argument  convincing. Along  the  way,  the  author  explores  the  question  of  why  companies  buy  IT.  The  notorious  'Productivity  paradox',  which  held  that  IT  has  not  contributed  to  productivity  gains  in  business  -  is  firmly  laid  to  rest.  He  avers  that  IT  has  brought  new  ways  of  doing  business,  and  also  delivered  significant  benefits  to  the  customers  of  those  businesses  that  used  IT,  which  are  ignored  by  conventional  productivity  statistics.  Another  interesting  topic  examined  is  that  of  why  people  acquire  education  (particularly  higher  education),  and  how  universities  perceive  the  economic  value  they  impart  to  their  graduates.    

The study I have referred to in the beginning of this post should reassure many who are alarmed by the outsourcing from the US. This Booz  study  released  on  Oct.  21,  2008  found  that  the  U.S.  was  the  leading  recipient  of  R&D  investment  from  abroad.  So,  other  nations  are  outsourcing  large  amounts  of  R&D  to  Americans!

And  so  it  appears,  in  an  increasingly  connected  world,  what  goes  around  does  come  around.

November 10, 2008

Innovation through Collaboration: Addressing Flat World Challenges in the Hi-Tech Industry

The world of business has never seen such fierce competition. Neither has it seen such an abundance of information or opportunity! This creates the perfect recipe for “Collaboration 2.0” – which can give organizations that competitive edge, while also offering the world better products and services – practically created by the consumers. Read more about this trend here. I shared my thoughts on this at Oracle Open World. You could also view my presentation here.

November 8, 2008

Now Showing: Government vs. Free Market (Part 2)

As the financial crisis reverberates thru the world economy, redrawing the lines between government and free markets, here are some objective principles that define the role regulators should play in the new world financial order. 

The extent of regulation in general, and financial regulation in particular, plays a large role in defining the business landscape. In addition to determining the broad business environment in an economy, it has several micro, firm-level implications in areas such as governance, risk management and the use of Information Technology. In the first part of this essay we asked the question, How much financial regulation is "just right"? Or, where do we draw the line between government and free markets?

This admittedly difficult question has taxed the finest financial brains over the years, and we must clearly not expect any easy answers. People will approach it differently depending on their personal predilections, ideology, historical experience with regulation, current economic conditions and so forth. However, I believe it is possible to lay down a few principles that should help provide an objective basis for arriving at the "right" level of regulation, or at least to evaluate a regulatory regime once it has been devised. Here they are.

We begin with two preliminaries. The first is an admonition from C. A. E. Goodhart, eminent economist and former member of the Bank of England's Monetary Policy Committee: 

"Occasional regulatory lapses and failures must be regarded as the necessary cost of devising an effective system of regulation. The degree of regulatory intensity that removes all possibility of failure would almost certainly be excessive.." (Financial Regulation, published in association with the Bank of England, 1998,  p. 14).

The second preliminary needs a brief digression to understand the concept of “levees” in business. Uncovered by our research into business model de-risking and innovation, this is a concept that finds application in multiple industries. In business, there are often abstract barricades that inhibit the free play of market forces, or hold legitimate competitive pressures from being transmitted to a company.  These are the "levees" in business  (for details see here , or send me an email).  Four classes of levees exist, but only two of those interest us here - barriers against the flow of information ("information levees"), and barriers against exit from an industry ("exit levees").

With this background, I now proceed to enumerate the principles that can be used to determine the right level of financial regulation.

Principle 1. Good regulation focuses on demolishing information levees.

In recent years, ever more complex and innovative financial instruments such as credit default swaps and collateralized debt obligations have allowed risk to be parceled and “traded away”. However, the lack of transparency fostered by these complex instruments is a levee, affording an illusory protection from erosion in asset value. If a company’s risk exposure is hidden behind the levees of non-transparency and complexity, that risk can come home to roost with devastating consequences, as happened with Lehman Brothers, AIG and other institutions. One test of whether excessive complexity is creating levees via information opacity: if you can’t explain a particular financial instrument to a 12-year old, it’s probably too complex (can you explain to a 12-year old what a ‘collateralized debt obligation’ is ?!).

It is important to note that demolishing information levees does not necessarily mean greater disclosure to the regulator or to the investing public; it often simply means that risk should be in plain sight to the the institution's own management. If exposure to “hidden” risk must exist there should be good – preferably quantitative - estimates of that risk. In other words, a financial institution should be required to know what it doesn’t know about its business and its environment.  

Principle 2. Good regulation means the judicious creation of exit levees.

Performing their vital role of guarding systemic stability often needs regulators to erect new levees, or to strengthen existing ones. The most important kind of levees that regulators must erect are those that prevent a financial institution from exiting its business (whether planned or catastrophically !) .  Indeed, in fulfilling their fundamental role as lender of last resort, regulators act as a levee. And sure enough, several  solutions propounded by various quarters to address the predicament faced by Lehman, AIG, as well as other imperiled Wall Street institutions - emergency lines of credit, deposit guarantees, brokering a ‘shotgun marriage’ with a robust institution, equity injection - were illustrations of creating exit levees, or strengthening existing ones.  

Creating levees is often a solution that demands a high degree of innovativeness. The $700-billion bailout fund created by the US treasury dept. in the past month is another example of such a levee being created. The US Fed's decision to backstop the commercial paper market on Oct. 7th is yet another example.

Principle 3. There should be enough regulation to satisfy principles 1 and 2, and no more.  

Thus, in addition to prescribing what regulation should “do”, principles 1 and 2 help us determine the limits of judicious regulation. Any regulatory action that goes beyond what principles 1 and 2 specify would probably be what Goodhart would call excessive regulatory intensity.

A regulatory action that claims exception to this principle must pass the strictest cost-benefit test. Needless to say, both private and social costs as well as benefits must be borne in mind.  

As an illustration, it is often tempting to suggest that a financial regulator must lay down limits to activities that an institution may engage in. But any such measure must be subjected to the above cost-benefit argument. Example: the 1933 Glass-Steagall act - a piece of regulation that prohibited banks from performing commercial banking and investment banking functions simultaneously - was created in the Depression era, when the benefits of eliminating the potential conflicts of interest and fraud engendered by mixing the two operations were judged to be high. The act was repealed in the 1990s, primarily on the grounds that such a forced separation prevented banks from realizing their full potential (or in other words, incurred a high cost in terms of lost business opportunities).  

As another illustration, a group of regulators may get together to coordinate their actions. This too is a high-cost approach and must be resorted to in rare and exceptional situations only. (Indeed, the Nov. 15th world summit itself is an example of such coordinated action, but no one would deny that the current financial crisis is an extremely rare event !).    

Other oft-mooted regulatory actions such as placing limits on executive pay** at financial institutions do not follow from either principle 1 or 2, and almost certainly will qualify as excessive regulation.

The edifice of capitalism, which teetered on the brink for a few short weeks, has now been saved. But now the world faces the momentous task of fashioning a new financial regulatory regime that envisages a greater role for government. And so, as we expand the role of government in market regulation, the above principles help decide how much regulation is “just right”.      __________________________________________________________________________

** actually each of the illustrative regulatory actions  above - specifying limits to activities, coordinated action , capping executive pay  - is in itself an example of levee creation. However, these are not covered by principle 2 as the levees being created by these actions are not of the "exit" kind - they belong to other classes of levees.