How to avoid using tax payers’ money and maintain optimum capital structure to maximize shareholders value?

Every organization or banks main aim or motto is to maximize shareholders value. However shareholders were always concern about financial distress situation where they have to dilute their share to pay debt holders or govt. need to step in and use taxpayers’ money to bail out banks/institutions.

We have faced these kind of similar situation during 2008 financial crisis where billion of $ i.e. tax payers money were used to bail out several banks. How to undo this kind of financial distress situation & avoid using tax payers’ money? One answer to this question is adding contingent capital (coco bonds) in capital structure.

What is contingent capital? Contingent capital is a debt that converts automatically to equity after some triggering event like decline in the market value of equity or capital below threshold limit. Contingent capital is likely to play a very important role in new BASEL III agreement. As per estimate banks need to issue $ 1 trillion of contingent capital to replace existing security that no longer qualified as regulatory capital.

However generally contingent capital (coco bonds) are tied with certain regulatory ratio like capital ratio (core Tier 1 capital), once the banks breaches the ratio then the debt automatically gets converted into equity to avoid financial distress situation. However problem with this concept is that it is regulatory based not market based and it transfers wealth from shareholders to bondholders and kills the main motto maximizing shareholders value (Creating value for shareholders means creating value for all the stakeholders) as conversion takes place at predefined price or at current market rate.

Capital ratios are calculated on quarterly basis and doesn’t provide true market impact of current situation & can’t handle market manipulation properly.

 Mean & Median (Core Tier-1 Ratio in 2008) of 50 major banks (%) 

	March 31	June 30	Sept. 30	Dec. 31
Mean	8.07	8.14	8.16	9.12
Median	7.88	7.92	7.89	9.14

By comparing September 30 ratio with March 31 and June 30 ratio we can hardly make out occurrence of any financial distress situation but market reality was totally different as we saw during the crisis.

COCO bond seems ideal instrument to maximize shareholders value however they are not. In February 2011 Credit Suisse issued a coco bond that gets converted into equity whenever bank’s core tier 1 capital falls below 7%. However regulator can also force conversion if it sees that credit Suisse will need public fund to avoid insolvency. The conversion price was fixed at minimum of $ 20. As per these characteristics this bond seems risky.

First, trigger is based on capital ratio which is an accounting number therefore will be different from the market based measure of financial leverage, especially during financial crisis. Hence, there is no way to predict stock price at the time of conversion.

Second, if the stock price at the time of conversion is less than $ 20 then bondholders will incur significant loss.

Third, the possibility that regulators can force conversion before the trigger is reached creates an additional risk which is difficult to price. Though the bond was successful among retail investor but its base was very limited due to its riskiness.

Better contingent capital should be linked to current market situation and triggers are based on current stock price / market value of asset.

Generally market based trigger are criticized as they create instability. Bondholders has incentive to short sell shares to trigger conversion and at the same time fear of huge dilution makes shareholders sell their share and create death-spiral for a company.

What’s the challenge?

Main challenge in issuing these kinds of debt instrument is that instruments should carry minimum risk so that it can be catered to mass risk-averse investors and simultaneously protecting the motto of maximizing shareholders value. In normal convertible bonds wealth gets transferred from equity holders to debt holders. Shareholders don’t prefer these instruments in company’s capital structure.

What will be the ideal instrument that avoid share dilution, protect the money of contingent bondholders and handle market manipulation or panic perfectly?

CALL OPTION MARKET TRIGGER CONVERTIBLE (COMTC) BOND can be ideal contingent bond that can be issued above 20-30 basis point of risk-free bond and caters to mass risk-averse investors who know they will be paid at the time of financial distress situation.

How does COMTC works?  

COMTC bonds target to risk-averse investors and provides return above normal risk free bond. This instrument carry forced right to get paid at the time of financial distress situation. It carries a conversion trigger point which is less than then current market price. However in order to avoid market manipulation & panic shareholders got pre-emptive rights to buy-back shares from bondholders so that they can avoid any conversion that results from market manipulation or panic. At the same time in order to avoid huge dilution shareholders got the right to issue share (right issue) at the same conversion price and pay back the bondholders and maintain proper capital structure.  As bondholders will be paid back they have no incentive to hedge their investment by shorting the stock when the leverage ratio approaches the trigger point.

Why conversion trigger price is lower to current market price?

Conversion price of COMTC bond should be less than the trigger price. Suppose the market price of $ 10 share will come down to $ 5 during financial distress situation. In this case conversion price of the bond should be fixed at below trigger price say $ 1. We can understand this with an example.

Example:      Senior Debt    –     $ 1000

Equity Capital –   $ 10*7 = $ 70 (7 share with face value of $ 10)

COMTC          –        $ 30

Scenario 1    (Financial Distress Situation) = Market Price $ 5

Conversion Price = $ 5 (Conversion price = Market Price)

New diluted Share price = (6*5+7*5)/13 or (30+35)/13 or 65/13 = $ 5 per share

(Assume that repayment will be made after conversion)

Total Value of Assets = 1000+65 = $ 1065

Shareholders will exercise his option of right issue & pay back bondholder at its par value till the time value of assets is $ 1065. If value goes below $ 1065 shareholders will not exercise his call option and all the value above $ 1000 will be shared between bondholders & shareholders at the time financial distress or bankruptcy.

Scenario 2    (Financial Distress Situation) = Market Price $ 5

Conversion Price = $ 1

New diluted Share price = (7*5+30*1)/ (7+30) or (35+30)/37 or 65/37 = $ 1.76 per share (Assume that repayment will be made after conversion)

Total Value of Assets = 1000+65 = $ 1065

Shareholders will exercise his option of right issue & pay back bondholder till the time value of assets is $ 1037 or market value of share is $1. If the market value goes below $1 or total assets value becomes less than 1037 shareholders will not exercise his call option and all the value above $ 1000 will be shared between bondholders & shareholders.

Thus with $ 1 conversion price, bondholders become shareholder when value falls below $ 1037. With $ 5 conversion they become shareholders when value falls below $ 1065. Lower conversion price clearly reduces riskiness of convertible debt which lowers financial distress and makes the security more marketable among fixed income investor.

How COMTC bonds are different from COCO bonds?

COMTC BONDS	COCO BONDS
COMTC bonds are market triggered bonds that provides true financial leverage	Normally COCO bonds are regulatory triggered bond i.e. capital ratio. Such mechanism are accounting measure and  doesn’t work when company’s capital structure deteriorate rapidly
Regulators can’t intervene as it is totally market based	Regulators are aware that capital ratios are stale, they may be tempted to intervene and pull the trigger themselves and this regulatory risk may difficult to asses, even for major credit rating agency.
COMTC bonds are risk-averse bond, it can easily marketable & cater to mass market.	COCO bonds are difficult to market as investors know that capital ratio doesn’t provide true picture so in order to mitigate risk they demand higher spread however issuer thinks firms financial distress risk is lower and reluctant to pay higher risk premium.

Conclusion

COMTC bonds are risk-averse bond that can be targeted to mass market as it provides assurance that bondholders will be paid at the time of financial distress. These are market related bonds triggered at certain market price or market value of assets. It considers current financial leverage and provides absence of regulatory intervention. All the normal bonds carry tax deductible interest rate and in order to make COMTC bonds attractive it should also be tax deductible. These bonds can be issued by any institutions apart from bank to prevent financial distress situation and maintain optimal capital structure.

COMTC bonds are superior to COCO bonds and one of the best debt instruments to be part of organizations/banks capital structure.

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Financial Innovation with Inclusive growth

India is embarking towards robust growth to achieve the position within top 5 economies of the world. In order to achieve that feet India requires huge development in infrastructure, industrial & manufacturing front. These are the core factors for countries growth however in order to achieve it every country requires financial innovation.

Financial innovation is a key to development but India should learn from the mistakes made by western countries while doing financial innovation. We have seen the consequences of unregulated financial innovation like securitization, off balance sheet funding etc. In western countries these innovations were made without keeping proper check point on risk involvement like high exposure or excessive leverage etc. We have seen the consequences of it, as global economy is suffering from great recession since the great depression.

India should keep in mind all these factors before taking a road ahead towards top 5 economies. However the current recession has showed the robustness of Indian economy particularly in banking & finance sector. Global financial sector are turmoil with the current recession but Indian banking and finance sector is unscathed by it due to robust regulation in Indian financial system. Today, Indian banks are highly capitalized & profitable.

Yesterday itself, the banking regulator has asked banks to divulge a host of details in the notes to account in the balance sheet from the year ending March 2010 onwards, which will vastly increase the level of transparency. Among the information that banks are required to disclose include concentration of deposits, advances, exposures and non-performing assets (NPAs). In addition, banks will have to disclose
sector-wise NPA’s.

Disclosures relating to concentration of deposits include total deposits of 20 largest depositors and the percentage of deposits of these 20 largest depositors to total deposits of the bank. Similarly, banks are required to display total advances to 20 largest borrowers and the percentage of advances to 20 largest borrowers to total advances of the bank. In connection with NPAs, RBI has asked banks to reveal which are the top four borrowers who have defaulted. They also have to disclose the extent of non-performing assets that banks have in respect of each industry. Banks will also not be able to sweep bad loans under the carpet as they now have to declare gross non-performing assets at the beginning of the year and gross NPAs added during the year. If there is a reduction in bad loans, banks will need to provide a break-up of how much of these were due to upgradations, recoveries and write-offs. A new disclosure also requires banks to disclose all the SPVs that they have sponsored in India as well as abroad.

This kind of initiative enhances transparency in the system without eroding growth factor. Today the challenge in bank regulation, underlined by the financial crisis, is to strike a balance between stability and innovation. It is a balance that can and must change over time. Innovation should be made considering the benefits available to up-gradation of Indian society rather than producing bonuses for bankers.

Today India needs financial deepening and financial inclusion. It is possible to have financial deepening, a bigger banking system, without inclusion. That is not what India wants today. Indian wants deepening of financial innovation with inclusive growth.

India needs a fresh set of players who can design business models for financial inclusion. Now, India is a second fastest growing economy in the world and every investor wants to share a pie of its growth. There are lots of foreign banks eyeing to take a banking license in Indian Financial system. India should take an advantage of this opportunity, as global economy is not going to achieve high growth for quiet some time so investors can pump money in a growing wheel like India.

India should ask a question to foreign investors, banks & corporate seeking banking license in India, you want a banking license then why don’t you enter where you could make a difference? Why don’t you start from the bottom of the pyramid, the rural area? The onus should be given to foreign banks to innovate in the rural market. It will require them to combine local talent and IT in creative ways. It is a serious bottom-of-the pyramid challenge and it can translate into enormous payoffs worldwide and in India.

Foreign firms are doing the same thing in manufacturing sector like establishing industry in tier-3 cities so why not they can do it in banking front. Foreign banks are the one who introduced retail lending & cash management in Indian banking industry, afterwards all the private sector & public sector banks followed it.

In order to catch investors seeking banking license, India can propose some incentives like – in phase I entry into rural areas, in phase II allowed acquisitions of regional rural banks and in phase III access to the main market.

Considering the current global situation, growth of Indian economy and above mentioned incentives I think foreign banks can ready to upgrade bottom of the Indian pyramid, innovation of foreign banking in rural area. It will make huge benefit for India in terms of inclusive growth with deepening in financial system. Seeing foreign banks in rural area, private & public sector banks will also jump into this and makes the market more competitive and enhances further growth.

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How to control & reduce “Systemic Risk” to avoid future Financial Crisis?

Systemic risk is very dangerous for economy, as we have seen in last 200 years majority of the financial failure occurs due to systemic risk. In United States’ history from the founding of the republic until 1933 it experienced banking panics roughly every fifteen to twenty years. When the Great Depression struck, it was “in a league of its own in severity” and the banking system near to collapse, government responded with federal intervention into the marketplace including creation of federal deposit insurance, securities regulation, banking supervision, and the separation of commercial and investment banking under the Glass-Steagall Act. This happens because of systemic risk involved in the system where failure of one bank leads to failure of another and every banks are interrelated which causes nearly total banking system failure.

However US govt. followed implicit strategy where they insured and regulated the most systemically dangerous part of the system, the commercial banks, and exercised a much lighter touch elsewhere, leaving the rest of the financial system to innovate, be dynamic, and do everything that markets do so well.

This has worked for US govt. for the next 50 years, they didn’t see any crisis during that period however significant financial failures returned to the marketplace in the late 1980s with the savings and loan crisis, followed by a rash of bank failures in the early 1990s that forced the government to recapitalize the FDIC’s Bank Insurance Fund. Long Term Capital Management, a largely unregulated hedge fund, came perilously close to collapse in 1998, threatening the global financial system. The tech bubble burst in 2001. Accounting scandals destroyed Enron in 2001 and WorldCom in 2002. And the current global financial crisis, the worst since the Great Depression, has yet to run its course.

As the country experienced no major financial crises for the longest period in the history lawmakers not only weakened or dismantled New Deal-era regulations, they also failed to enact new regulations to keep up with financial innovation spurred by technology and globalization of markets. Over time, a huge amount of financial activity migrated away from regulated and transparent markets and institutions and into the lightly regulated or unregulated shadow markets encompassing mortgage brokers, hedge funds, private-equity funds, off-balance sheet structured-investment vehicles, and a booming market in opaque derivatives, especially credit-default swaps. By the summer of 2007, the Treasury Department estimates, the shadow banking system had accumulated assets reaching roughly $10 trillion, equivalent to total assets in the entire U.S. banking system.

While new systemic threats had emerged along the way, there was little effort to regulate them, undercutting the original New Deal strategy of targeting such threats. As a result, the American financial system was left more vulnerable than ever to a major shock.

Today, financial institutions deemed too big to fail already have a huge marketplace advantage – hundreds of billions of federal bailout funds unavailable to smaller firms in financial trouble. That gives big, complex firms a dramatic advantage that is inappropriate.

Since last fall, there’s also an implicit guarantee of government rescue for any firm that in the future may be identified as too big to fail. “What’s worse, these firms impose costs on society by creating systemic risks that they don’t have to bear on their balance sheets.

Implicit strategy has worked for the govt. in the past however it has created a trend where every big company feels that they can be protected by government whatever they do. This makes them to create more systemic risk by spreading their wings beyond the limit in the form of high leverage and overlooking regulated procedures etc.
After the Great Depression & till mid eighties there were not very risky financial innovation due to which even little unregulated environment doesn’t create panic. But after mid-eighties we have seen lot of volatile & risky financial innovations like mortgage brokers, hedge funds, private-equity funds, off-balance sheet structured-investment vehicles, derivatives and securitization etc. which requires healthy regulated environment but lawmaker & govt. always overrule it and these innovations were highly unregulated that ultimately causes biggest crisis since the Great Depression.

In order to protect future of financial market, government should follow Explicit Strategy rather than implicit. Following steps need to be taken-

• First, identify industry/firm/sector that poses systemic risk and then replace unlimited implicit guarantee with government defined limited explicit guarantee for the first time.

• Second, companies that create systemic risk should bear the cost of insuring against it, just as commercial banks pay into an FDIC insurance pool. And the government should insist on appropriate capital standards and liquidity requirements to limit the type of risks that these firms impose on society.

• Third, creating a receivership process would allow an efficient handling of failed companies. It really need to change the perception that no institution is too big to fail. In this process all systemic institutions would get limited support during a period of economic turbulence but if that turns out not to be enough then they are going to be taken into the receivership process and liquidated or restructured.

One thing that we don’t fully understand that the world in which we live right now will continues. It’s one of massive implicit guarantees that are open-ended, we need to be honest about these implicit guarantees, to define and limit them. That’s the purpose of this whole proposal, not to put systemic firms at a competitive disadvantage but rather to prevent them from imposing undue costs on the rest of the financial system.

“Implicit approach enhances systemic risk, Explicit approach controls and reduces”

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What business model your organization follows “Structure-Shapes-Strategy” or Strategy-Shapes-Structure?

Does your organization’s corporate strategy based on an environment or your organization creates a strategy that shapes the environment? Does your organization follows “structure-shapes-strategy” approach or “strategy-shapes-structure” approach?

For last 30 years majority of the company follows “structure-shapes-strategy” approach where they develop corporate strategy by analyzing the industry or environmental conditions in which they operate.

They assess the strength and weaknesses of their competitors. They carry out industry and competitive analysis and develops a distinctive strategic position where they can beat their competitors by building a competitive business strategy. In order to differentiate from their competitors they choose a strategy where either they charge premium price or pursue with low costs. In this kind of business strategy there is always a value-cost trade off. Either you provide high value or you charge low cost. There can’t be a situation where organization provides high values to customer at low cost. This kind of business strategy can’t be catered to mass segment because if an organization provides high value services then they charges premium price and this makes them to fix their product to a particular small market segment. This type of organization aligns its value chain accordingly, creating manufacturing, marketing, and human resource strategies in the process and on the basis of these strategies financial targets and budget allocations are set.

This type of corporate strategy put the organization in Migrators category of business. They can survive in this category by continuously beating the competitors either by providing value added services or charging low cost. Competitors continuously battle to gain market share and in this process it reduces their business margin and after some point of time it becomes very difficult for them to survive in this business.

If any organization likes to serve in a migrators category of business for a very long period of time then they have to do some incremental innovation to achieve operational excellence so that they can beat the competitors and maintain required margin.

Merger & Acquisition can also help in a great deal for a business to survive for a long period of time either by expanding existing market or achieving economy of scale. Migrators can survive for a long period if they continuously carry out M & A activity whether it may be acquisition or divestiture.

Underlying logic here is that this kind of strategic options are bounded by the environment i.e. structure shapes strategy. According to it, a firm’s performance depends on its conduct, which in turn depends on basic structural factors such as number of suppliers and buyers and barriers to entry. It is a deterministic worldview in which causality flows from external conditions down to corporate decisions that seek to exploit those conditions.

On the other hand there is another kind of corporate strategy where organization creates a strategy which shapes the environment i.e. “strategy-shapes-structure”. This kind of business strategy is called Blue Ocean strategy that shapes the environment by creating disruption with value innovation. It serves to mass market and breaks the barrier of value-cost trade off by providing high value product at low cost.

In this kind of strategy a company’s performance is not necessarily determined by an industry’s competitive environment. It shapes new environment and industry trend.

We have lot of example of this kind of strategy like. Apple’s i-pod, Ford Model–T, Nintendo, SouthWest Airlines etc.. Organization gets benefited by these kinds of strategy for a very long period of time. The products they serve are called Pioneers. These kinds of products provide majority of company’s revenue for a long period of time. The blue ocean strategy framework can help companies systematically reconstruct their industries and reverse the “structure-shapes-strategy” sequence in their favor.

Blue Ocean strategy growth is called endogenous growth and its central paradigm point is that the idea and actions of individual player can shape the economic and industrial landscape. We called this approach as “Reconstruct Approach”.

The first task of an organization’s leadership is to choose the appropriate strategic approach in light of the challenges the organization faces. Choosing the right approach, however, is not enough. Executives then need to make sure that their organizations are aligned behind it to produce sustainable performance. Most executives understand the mechanics of making the structure approach work however they are not familiar with reconstruct approach.

How to focus and align an organization to deliver high and sustainable performance through reconstruct approach?

There are three factors that determine the right approach: the structural conditions in which an organization operates, its resources and capabilities, and its strategic mind-set. When the structural conditions of an industry or environment are attractive and you have the resources and capabilities to carve out a viable competitive position, the “structure-shapes-strategy” approach is likely to produce good returns. Even in a not so attractive industry, the “structure-shapes-strategy” approach can work well if a company has the resources and capabilities to beat out the competition. In either case, the focus of strategy is to leverage the organization’s core strengths to achieve acceptable risk-adjusted returns in an existing market.

But when conditions are unfavorable and they are going to work against you whatever your resources and capabilities might be, a “structure-shapes-strategy” approach is not a smart option. This often happens in industries characterized by excess supply, cut throat competition, and low profit margins. In these situations, an organization should adopt a reconstruct approach i.e. “strategy-shapes-structure” and build a strategy that will reshape industry boundaries.

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Reverse Innovation a “BLUE OCEAN STRATEGY” for US & EUROPEAN MNCs to survive

Glocalization is dominant today because it has delivered in the past. The model glocalization came to prominence when opportunities in emerging markets were pretty limited—when their economies had yet to take off and their middle or low-end customer segments didn’t exist. Therefore, it made sense for multinational manufacturers to simply offer them modifications of products for developed countries. Initially, GE, like other multinationals, was satisfied with the 15% to 20% growth rates it‘s business enjoyed in developing countries, thanks to glocalization.

However in a last decade or so developing countries are growing very fast particularly in Asia region. This has made global MNC to revisit their business model and start doing Reverse Innovation which is opposite of glocalization. In glocalization products traditionally are created in rich nations and repackaged for emerging ones. But in reverse innovation products are created in developing countries and repackaged for developed economy. General Electric, Nokia, and others are involved in reversing the process.

Largely because of glocalization and reverse innovation, GE’s revenues outside the United States soared from $4.8 billion, or 19% of total revenue, in 1980, to $97 billion, or more than half of the total, in 2008.

How GE did Reverse Innovation

GE Healthcare’s primary business is high-end medical-imaging equipment. The company aimed to be number one in ultrasound. Over the next decade, GE Healthcare expanded its presence in the market. It built an R&D facility for developing new ultrasound products near its headquarters, in Milwaukee, and made acquisitions and entered into joint ventures around the world. By 2000, GE Healthcare had established solid market positions in rich countries around the world.

GE could not sell this model to developing countries like India and China. Because these countries cost of living is not very high and this high cost model ultrasound requires sophisticated hospitals however in these countries have very few sophisticated hospitals. Maximum treatment was done at local clinic or low cost hospitals. But these countries are huge market for ultrasound.

GE develops a new R& D unit from the scratch in China and recruited local people to know the requirement and cost affordability etc. It develops the compact ultrasound system that can be connected to a laptop and sold at $15 k compare to $100k of sophisticated ultrasound. Now GE has developed huge market for these ultrasound in developing countries and simultaneously it transferred the technology to US where use of this compact machine is little different as compare to developing countries. In US these machines were used in emergency room & ambulance squads. However in India & China it is used in hospitals.

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