EXPLOIT and Explore - Success Mantra of Outstanding Companies

No company can have a stagnant strategy to which it can align perpetually. The operatives in the contemporary highly competitive market are dynamic and are constantly changing. No company can sustain with a rigid strategy. Companies must focus on both short term as well as long term and act accordingly. A long time debate in the field of business strategy has been on exploit and explore. In the domain of product development, we often come across the famous 4 Xs – explore, expand, exploit and exterminate. Both are considered essential for any company to prosper the business. By exploration, we mean innovation, risk taking or even players from altogether different business domain and at times even reinventing. They need to look for new opportunities which may be in terms of geographic market area, customer segment or avenues of operating line of business. Exploring these new possibilities, basically, prepares for them for the unforeseen future which can often be adverse. While exploitation points to leveraging the certainties to generate revenues/funds to survive today (and for future too) and also imitating the best practices of the competitors.

Companies have been able to gain market share as well as revenue through exploration. It is widely assumed that innovation leads the way to success which is why a lot of companies spend a lot on research. Unfortunately, we don’t have a single metric or parameter to gauge the exploration quotient or score of the companies on any scale. Albeit, generally a company is said to innovative based on the number of patents it owns, the expenditure on research and development and the new products it comes up with. Of late, Apple has been on the innovation spree and has been credited as the most innovative products – courtesy to gadgets like iPod, iPhone, iPad, etc. which revolutionised multiple industries such as music, mobile telephony.  If patents are weapons, companies such as Motorola, Intel, Canon, Lucent (originally AT&T Technologies) are armed to teeth. No wonder, these companies have tasted success from time to time.

On the other hand, companies have been successful exploiting the current conditions. Companies tend to improve their operations, marketing and sales force and business processes. Amazon rise is heavily propelled by his excellent supply chain. McDonald’s has always focussed on gaining excellence in the operational. Nokia is another example in this list.

In an ideal scenario, companies should keep a balance between exploration and exploitation. These two dimensions of business strategy should go hand-in-hand. They should combine the ability to run operations effectively with the capability to develop new fantastic products which would appeal to the customers. Outstanding companies are able to achieve this. Apple’s success cannot be solely attributed to its innovation. It was led by legendary Steve Jobs who improved the operations drastically, understood the call of the hour and was pivotal in shifting the manufacturing base to China. This reduced the manufacturing costs, keeping the margins high. Through, marketing campaigns Apple is always able to maintain the hype before launching any new product. These all contributed to the overall success of Apple. Unfortunately in real world, most of the companies are not able to attain this balance. Exploring new opportunities munches time as well as resources at disposal for improvement of existing processes.

With this practical issue, the debate arrives a point leading to a tussle between exploitation and exploration – which holds the priority. Companies have been able to compensate for exploration by being excellent exploiters. On the contrary, the reverse – exploration does not compensate for exploitation. Many market leaders are more efficient but may not be more innovative than their competitors. They stress on former at the expense of latter though not totally ignoring exploration. Innovation is vital to companies, but also difficult to perform since there are many ways to approach the subject. Besides, there is no control on the results of research while companies can control the operational processes and marketing campaigns. A perfect example can extracted from the rivalry of Glaxo and Wellcome few decades back. Wellcome had always more patents per sale than Glaxo till 1970s but as we know Glaxo was clearly much ahead in the market share between the two. Glaxo excelled in exploiting existing resources through great marketing and more importantly, it was honest to realise its research constraints. Christian Stadler in his book “Enduring Success” emphasizes on the scope of buying exploration capabilities. Continuing on the same set of companies – exploration became part of Wellcome’s DNA as exploitation became part of Glaxo. Glaxo continued to operate on same model – be competent in certain activity and bear the reward. Though it was indulged in research efforts, it was mainly through acquisitions and takeovers. Its most successful product till date Zantac (medicine for ulcers) was developed in laboratories of Allen & Hanburys, one of Glaxo’s acquisitions. When the expiration year of Zantac was approaching, Glaxo was successful in acquiring Wellcome itself thus adding more weapons in its armoury. It continues to grow and focus on research through taken – an example of late was acquisition of SmithKline Beecham.

Nonetheless, no company should do an excessive exploration. An overkill of innovation is most likely to backfire as was the case in Ericsson. Ericsson was pioneer in multiple technologies e.g. GPRS, 3G, etc. All this was done at the expense of exploiting current market. Huge expenditure on research and excessive bet on future technologies hit its business hard and it had to combine with Sony to save its mobile business.

Subprime Crisis - My Take - Critique

No doubt, Dodd-Frank Act brings up recommendations with good intention to devise tools to address the concerns raised during the financial crisis and also bestows government powers and other tools to the regulatory system to deal with the risk. It also introduces the funeral plans to dissolve the large financial companies/institutions which would certainly help in demystifying their organisational structure.

Dodd-Frank Act, in reality, does little for the government guarantee problem knowing that it has been the part of the financial system for quite long time. It also does not attempt to reform the government sponsored enterprises (GSEs) which were heavily exposed to the guaranteed debt. There is no attempt in Dodd-Frank to address the key problem of government subsidization of mortgage risk, and the exposures of Fannie Mae , Freddie Mac and the Federal Housing Administration are still growing.

The Act recommends a plethora of government powers and agencies/entities with authority in the financial system and economy. The Act requires over 225 new financial rules across 11 federal agencies (Source: The Economist). There has been minimal attempt at regulatory consolidation. The roles of many of these entities are overlapping and may lead to a lot of confusion and in addition, making their funding (often requiring Congress approval) more exotic. Consequently, the financial sector will have to live with the great deal of uncertainty that is left unresolved until the various regulators (the Fed, the SEC, and the Commodities and Futures Trading Commission (CFTC)(refer to figure below). The problem also lies in the way they operate. With officials given power to regulate more intrusively, it makes their functionary more whimsical and thus may push the financial institutions into more red tape. The lack of clarity which follows from the sheer complexity of the proposal will sometimes will serve for the unreliability.

New Government powers/entities per Dodd-Frank Act (Source: JPMorgan Chase)

The Volcker Rule attempts to prohibit proprietary trading within banks. The fundamental problem with that is that it would be hard to define proprietary trading, because obviously, an essential role of banks is to help make markets in various financial instruments and to execute trades for their clients. The problem that persists is to define the limits of proprietary trading. From the myriad complicated responses that they have received, it has become clear that there is no hope of being able to describe what it is the Act is trying to prohibit in a way that can be predictably identified, so that banks can know whether or not are they are in violation(Source:www.barrons.com). The Volcker Rule prohibits banks from proprietary trading, even if against the value of securities they are underwriting and peddling to the public, just as Goldman Sachs, for one, notoriously did. This is certainly in desired direction, but it does very little about high-frequency trading, the largest and perhaps most dangerous of such practices.

The main reasons for the crisis were housing bubble and imprudent lending to the innumerable borrowers into it. To a certain extent, the responsibility also goes to the US government for this mess. The government legislated a high percentage of private-sector mortgages to be on a non-commercial basis, issued exclusive orders to the large pseudo-private-sector Fannie Mae and Freddie Mac to make the majority of their mortgage loans on that basis and kept interest rates and mortgage equity requirements so low for so long, enlarging the liquidity bubble to the extent of the burst. This was certain to lead to mountains of excess residential housing and worthless mortgages (Source: www.nationalreview.com).

The BASEL III framework proposes a paradigm shift in capital and liquidity standards. Most of the proposals appear unfinished and has a very long time line to implement. BASEL III has scientific approach and proposed measure tools to control the problems. Though a sound prudential framework should focus on the systematic risk but BASEL III mostly focuses on the individual risk of the financial firms and reducing the individual risk may fundamentally aggravate the systematic risk. For example, a bank fails to diversify properly even though it is encouraged to do so. In such scenario, the bank will continue to have the same aggregate risk despite diversifying its idiosyncratic risk. As per BASEL III, the unsecured bonds of the banks are not eligible for LCR while they qualify for NFSR while sovereign debts and cover bonds are eligible under both. This indicates that the supply of covered bonds and sovereign debts will increase generally while the supply for the unsecured bonds will increase only for long term to meet the requirements of NFSR. Consequently, the recommendations in BASEL III to address the liquidity will promote a partial swap on banks’ balance sheets. This increase in sovereign debt will lead to increase in sovereign risk in banking as well as insuring sector. The countercyclical buffers introduced to be utilised during stressed period to offset procyclicality. It is problematic to identify the stressed or bad times and coming up with a figure for the capital buffer to counter losses is extremely challenging. Moreover defining the capital ratios again will not solve the problem related with the capital ratio on RWAs. The new proposal boosts the procyclicality with not even addressing the regulatory arbitrage. Another problem with BASEL III is that it is not a legally binding framework which does not mandates any country to follow. Though intended to be implemented across the globe, there is no way to ensure that it will be implemented uniformly around the world. Besides, the implementation timings will not be same. BASEL III recommends the individual countries to consider increasing their national capital requirements in case of unsafe credit creation. Now, many multinational banks have problems in adhering to the countercyclical buffer of any one country but may need to maintain the weighted average of the requirements in all the countries of operations. This adds to the complexity of the rules.

Few recommendations of BASEL III and Dodd Frank concerned with capital control are not consistent. For instance, BASELIII still relies on the external credit-ratings in determining the capital charges for few assets while Dodd-Frank Act recommends the removal of any reference to credit ratings in federal agency regulations. Besides, there are implementation date differences for few provisions where there are consistencies between BASEL III and Dodd-Frank Act. For example, Dodd-Frank mandates exclusion of preferred securities (e.g trust preferred) from Tier 1 capital and gives a timeline of 3 years to implement exempting the smallest banks. On the contrary, BASEL III sets a longer time line to implement this and does not talk about any exemption.

CONCLUSION:

The crisis of this magnitude having adverse impact across the global economy should be immediately be addressed by the government. The investment banks, credit rating agencies, lenders, mortgage brokers and the federal government were the main causes of the financial crisis. Though many reforms were proposed with each one under the global financial industry’s scrutiny, many of them still have some loopholes. Many inconsistencies too exist among these reforms and need to be aligned soon. Another area of concern which the government need to consider is the implementation of different proposals. There is also a potential threat of overregulation or misregulation and should be addressed properly. At the same time, measuring the efficiency of the regulatory changes contributing to the improvement of the financial sector performance will be a tough task to do. There are still several area which have not been addressed. Few of them are the heavy government debts which may be a big subject of concern. The Financial Reform Act also does not adequately addresses the “too big to fail” problem. Nonetheless, no reform can be perfect and these reforms are intended to be in the correct direction.

Subprime Crisis - My Take - Reforms

REFORMS POST-CRISIS

The turmoil created by the sub-prime crisis had rippling effect across the global economy and necessitated urgent reforms in the financial reforms. The confidence of people reached abysmal after the failure of big financial institutions, defaulting of AAA products rated by known credit-rating agencies, inefficiency of the federal government as many claim. Confidence is an important driver of economic activity. As the following figure shows, falls in coincide with economic slowdown.

Crumbling confidence of the business and consumers (Source: OECD Factbook 2010)

Any problem during recession is heavy debt. The governments borrowed money to keep the financial institutions floating and stimulate the economy. In 2008, in OECD (Organisation for Economic Co-operation and Development) countries the government debt rose drastically and reached almost at par with their GDP. There was urgent action required but it had the risk of transferring the crisis from the private sector to the public sector.

Government debts as a percentage of GDP (Source: OECD Factbook 2010)

 While recognising regulatory failings, the governments and many international bodies such as G20 and IMF recommended immediate reforms. Many committees like Dodd Committee, Volcker Committee and BASEL committee (for banking), were given the responsibilities of coming up with corrections. In this report, we will discuss primarily the Volcker rule, few reforms suggested in BASEL III and Dodd Frank’s act.

Dodd-Frank’s Act:

In order to fix the broken US financial system, Dodd-Frank Act was passed in an attempt to create a sound economic foundation to grow jobs, protect consumers, to end bailouts and most importantly to prevent another financial crisis. For the same, among the various reforms were recommended in Dodd-Frank Act, only mortgage reforms, credit-rating agencies’ reforms and Volcker’s rule , the last being an amendment in the act, will be discussed in detail.

Mortgage reforms:

Myriad complications germinated from steering of the borrowers by the mortgage brokers into exotic loans. The Act addresses this problem by requiring the creditor to adhere to a fully amortizing repayment schedule while evaluating the borrower’s capability to repay. It also prohibits pre-payment penalties which trapped many borrowers into unaffordable loans. It also prohibits mortgage originator from receiving from any person, directly or indirectly, compensation that varies based on terms of loan. In this way, it attempts to prohibit the incentives of encouraging the borrower into a costly loan. It also tries to protect the borrowers against the foreclosure for these standards by establishing penalties for irresponsible lending. The Act further protects the borrowers for the high-cost mortgages by reducing the interest rate and fee requirements that define high-cost loans. It establishes Consumer Financial Protection Bureau (CFPB), as an independent body under Federal Reserve Bank (FRB), to prohibit creditors from making residential mortgage loans unless creditor makes good faith determination that at time loan was consummated, consumer had reasonable ability to repay loan according to its terms, and all applicable taxes, insurance and assessments (Source: Mortgage Bankers Association). The Act also addresses adjustable rate mortgages (ARMs) as per which the lender must furnish the borrower a notice that includes the valid reason of reset, estimate of new payment, a list of alternatives and contact information of the borrower counselling agencies. Besides, the Act also establishes an office of housing counselling under Housing and Urban Development (HUD) to boost counselling on house ownership and rental housing. Furthermore, the Act increases the upper-limit for civil liability.

Credit-rating agencies and Investment banks reforms:

During the analysis of the causes creating the financial turmoil, the committee unearthed that the credit-rating agencies played a significant role.  The credit-rating agencies had a high level of public oversight and thus accountability. The increased conflict of interest, which these agencies faced, had to be scrutinized. The Act created an office of Credit-ratings at the Security and Exchange Commission (SEC) with proficiency and its own resources. It also vests SEC to suspend the registration of or fine any credit-rating agency for any security in case it fails to produce credit-ratings with integrity. To address the conflict of interest, the Act mandates the credit-rating agencies to have at least half of members of the board of directors to be independent. To bring more accountability and transparency, the credit-rating agencies are now required to disclose their historic performance and methodology to measure the ratings and to perform various studies and generate multiple reports.

The investment banks were operating with “no skin in the game” since they were selling off the risk and were supposedly “too big to fall” as their failure would crumble the economy. This Act tries to address both these concerns. The Act enforces the investment banks to have minimum risk retention of 5% (except when the loans fulfill the criteria to establish low-credit risk). It means that these firms would face stricter regulation and possibly be required to set aside more capital as a buffer against losses. The immensely big banking industry in US contributed to the “too big to fail” risk to the economy. The Act restricted the merger, consolidation and acquisition of all or majority of assets of other company. As per the Act, big financial firms can be broken up in case their size posed a risk to the financial system, provided the Fed and two-thirds of the regulatory council agreed. In case the big firms failed, shareholders and secured creditors would be required to absorb losses first wherein additional losses would be taken by an emergency fund financed by assessments on big financial firms.

Volcker’s Rule:

This actually is subsection of Dodd-Frank Act but has significant ramifications and thus, has been discussed separately. This rule is premised on the finding that the speculative trading also contributed to the financial crisis. The reform originally did not contain the provisions recommended in by Volcker. This rule prohibits any banks including any affiliates of banking firms from investing in or sponsoring a hedge fund, private equity fund and any pooled investment vehicles like venture capital funds and real estate funds. It also prohibits them from engaging in “proprietary trading” majorly involving short-term trading. It also addresses the moral hazard that the guarantees to the commercial banks are mainly devised to safeguard the payment and settlement system and also ensures the robust lending to the households and corporations.

Flow diagram of the Volcker’s Rule (Source:www.volckersrule.com)

BASELIII:

The Dodd-Frank Act is not very scientific since it does not measure the risk which is taken care in BASEL III. BASEL III is a series of amendments to the precedent BASEL II framework. Even though the banks were adhering to BASEL II, the amount of capital held by them was not preventing insolvency. The financial crisis was a blend of liquidity and insolvency. This necessitated the amendments to be made in the BASEL II. The intention was to provide increased protection from such problems by bringing up the lower-limit of the capital and the liquidity levels. It further builds up on the three pillars of BASEL II framework – capital reforms, liquidity standards and systematic risk. It is planned to be implemented in phases with the final one being in 2019.

Breakdown of the BASEL III proposals (Source: KPMG)

BASEL III raises the resilience of the banking industry by further strengthening the capital framework. It retains the core solvency ratio at 8% of risk weighted assets (RWAs). The common equity component has been raised from the current minimum of 2% to 4.5% while the overall Tier 1 element (comprising of ordinary share capital and retained profits) of the capital (including common equity) will be raised from 4% minimum to 6%. It recommends a “capital conservation buffer” consisting of common equity which should be 2.5% of RWAs (when fully phased). Any firm will be exposed to restrictions on dividend payouts, share buybacks and bonuses if the capital falls within the buffer range. In addition, the BASEL III committee also recommends a “countercyclical capital buffer” which checks the excessive credit growth. It also changes the constituents of the capital – primarily abolishing the Tier 3 capital which was mostly unsecured subordinated debt.

Capital Ratio requirement per BASEL III

Despite having adequate capital levels, many banks and financial institutions did not manage their liquidity prudently and faced severe difficulties during the crisis. This reiterated the significance of the liquidity management. The committee further strengthens the liquidity framework by developing two complementary requirements. The first being – Liquidity Coverage ratio (LCR) introduced to avoid the disruptions over a 30 day stressed period. It will ensure that the financial institutions have enough liquid assets to offset the net cash outflow under sever short stressed period. To address the long term liquidity issues, Net Stable Funding Ratio (NSFR) has been proposed which recommends the banks to have stable funding in place to encounter funding needs over a stressed 1 year period.

The third aspect which also has been addressed in BASEL III is the systematic risk and interconnectedness. Existing approaches of evaluating the credit risk of the bank’s assets remain intact in BASEL III. It fortifies the risk coverage in various areas – adding Credit Valuation Adjustments (CVA) risk and encouraging banks to manage risk more efficiently. It also proposes calibration of counter-party credit risk modelling approaches such as Internal Model Methods (IMM). It also strengthens the standard for collateral management and margining for the OTC derivatives and incentivises to use more central counterparty (CCPs) and increases the capital level for systematic derivatives.

Subprime Crisis - My Take - Cause & Origin

THE CRISIS:

The financial crisis of 2008, popularly referred as “subprime mortgage crisis”, resulted in losses in billions throughout the world. The toll also included few of the most reputed and successful companies of the financial industry. The regulators and the government failed to contain the crisis within the premises of the mortgages which were overloaded with the subprime loans. The fallout was so severe that it not only had sublime effect on US economy but also led to the one of the worst global recessions which had not been recovered.  The exposure to the subprime assets and the gradual loss of confidence in various asset classes was the reason of the spread of crisis to other economies.

Causes and Origin of the Crisis:

Liquidity Bubble caused due to low interest rates:

After the collapse of dotcom bubble in 2001, the US government reduced the interest rates sharply from around 6.5% to 1% to stimulate the economy. Japan too, in order to recover the economic slowdown in 1990s, cut the interest rate to 0%. Low interest rates and zero-equity loans made borrowings extremely cheap and also helped pushing the house-prices higher since loans were available to lower income households. Besides, many countries experienced a huge increase in wealth and were willing to invest it. One of these countries was China which heavily invested in US wealth funds. Overall, this pumped a lot of money in the financial system where potential returns were higher. This, in a nutshell laid the ground for the financial crisis. 

Toxic Mortgages:

There was emergence of a new kind of specialised mortgage lenders in the boom period. With rise of such unregulated lenders, there was also rise of different kinds of mortgage loans such as adjustable rate mortgages, interest-only mortgages, stated-income loans and NINJA loans (no income no job and assets). These loans were provided without any documentation required to authenticate the income or without having to prove any owned assets. Likewise, the mortgage qualifications for loan eligibility were diminishing. These subprime lenders, mostly not operating under the federal banking laws of consumer protection, increasingly targeted the undeserved borrowers. Thus, the risk of defaulting the loans increased significantly.

Residential Mortgage-Based Securities Vs Other Securitised Assets in US

                                      

 Credit-rating Agencies and Investment Banks:

The investment-grade ratings given to these securities by reputed credit-rating agencies were flawed. Many of these mortgage-backed securities (MBS) were rated AAA, generally given to highly reliable and trusted securities like US bonds. Giving high ratings to such products was highly profitable. Besides, the government-sponsored agencies like Fannie Mae and Freddie Mac issued more than half of these MBS’s. Even the investment banks were the underwriters of many private-label securities (PLS) which were very risky. These investment banks took a lot of risks with the borrowers’ money.