Blinkered Policy

In la-la land, there are two banks “Mean and Lean (M&L)” and “Fat and Profligate (F&P)” who had similar balance sheets and profitability figures five years ago. Over the last five years, the two banks have focused on completely different strategies. While F&P has been more aggressive and often reckless in seeking growth, M&L has focused on prudent banking practices.

Over the last five years, the total asset of M&L has grown at a cumulative average growth rate (CAGR) of 15 percent. The top management, including the chief executive officer (CEO) of M&L has focused on quality over quantity while pursuing growth. M&L has maintained excellent lending standards, with rigorous credit analysis, while providing loans to its clients. Their credit analysis not only involves determining the client’s “ability” to pay but also their “willingness” to pay. Often, M&L has rejected loan requests because of either dodgy business proposals or because of the client’s past track record. Moreover, M&L has worked

on maintaining a diversified

lending portfolio.

In line with its prudent strategy, M&L has focused on growing its deposit mix judiciously focusing on both current and savings accounts (CASA) to lower its cost of funds and time deposits to address a potential asset-liability mismatch.

To maintain its rigorous banking standards, M&L has concentrated on retaining and hiring experienced staff; however, it has not indulged in a hiring spree to push its loan products. M&L’s perks and benefits for its staff are on a par with the average industry standards, and its Human Resource (HR) department has devised new and innovative, yet cost effective, ways of retaining quality manpower. Moreover, because of a large number of experienced and long serving staff, the top management of M&L has been able to seamlessly convey its strategic vision to middle and lower level management, which has resulted in operational synergies.

Over the last couple of years, lots of new banks and financial institutions have emerged in la-la land, and, as a result, staff attrition in the banking sector has increased rapidly. However, because of M&L’s focus on quality over quantity, flexible working hours and a not so strenuous job schedule, it has been able to minimize the employee turnover level. Experienced staff coupled with a motivating work environment has increased M&L’s staff productivity, helping to increase its bottom line.

M&L’s focus on quality over quantity in their loan portfolio has helped it to keep its non-performing loans (NPL) to a bare minimum level. Its judicious deposit mobilization has helped it to maintain its interest spread. As a result, the net profit of M&L has increased at a CAGR of 25 percent over the last five years. Shareholders of the

bank have been satisfied with the management’s ability to grow profit and deliver above average returns on equity.

Compared to M&L, F&P’s total asset has grown at a CAGR of 30 percent over the last five years. In order to purse this high growth, F&P has pursued a different strategy to that of M&L. The lending practice of F&P has been lax at best; and often, loan requests have been approved without proper due diligence. While seeking high growth, the top management of F&P has ignored maintaining a diversified loan portfolio. As a result, its portfolio is highly concentrated among a few vulnerable sectors (such as real estate).

In order to pursue rapid growth, F&P has poached a lot of staff from other banks by offering them a higher salary, which has resulted in higher than average salary expenses. However, the top management of F&P has not been able to properly convey its strategic vision to middle and lower level management resulting in lack of organizational coherence. Moreover, long working hours and a demanding schedule have taken their toll among F&P’s staff, reducing their productivity.

Recently, because of a sudden slowdown in the real estate sector, a few major loans of F&P have come under scrutiny. This, coupled with higher staff compensation, has severely undermined F&P’s bottom line. As a result, the net profit of F&P, after growing at a CAGR of 30 percent for the first three years, has decreased at a CAGR of 17 percent over the last two years.

Ignoring other financial information, for comparative purposes, the total asset of F&P is approximately 2.5 times that of M&L currently, while the total staff expense of F&P is two times that of M&L. However, the total profit of F&P is only half that of M&L.

Now, why on earth does Nepal Rastra Bank (NRB), given the above mentioned hypothetical yet plausible scenario, want to have the CEO of F&P earn a higher salary than that of M&L? To put it more bluntly, why does NRB want to have more F&P-like banks and less M&L-like banks in the future? Because by linking the CEO’s compensation to the total asset and average salary expense, NRB has paved the way for formation of bloated financial institutions with the management’s mandate to seek total asset growth irrespective of other factors.

This article was first published on 20th December 2010. Permanent Link:

http://www.ekantipur.com/2010/12/20/business/blinkered-policy/326772/

Fighting Inflation

Inflation averaged 13.2 percent in the fiscal year 2008-09, 10.5 percent in 2009-10 and, according to the Monetary Policy for fiscal 2010-11, is expected to be 7 percent in fiscal 2010-11. Given the persistently high inflation in Nepal for the last couple of years, the Nepali people, I feel, have started to take higher prices as given and adjust with them accordingly. However, having said that, one needs to think about the adverse impact of an inflationary environment and its wide ranging impact on export competitiveness to national savings to the exchange rate.

But before I get into the details of the adverse impacts of inflation, it’s interesting to compare and analyze the government’s inflation projection—set by Nepal Rastra Bank at the start of the fiscal year in its annual Monetary Policy announcement—and actual inflation for that particular year.

For fiscal 2008-09, NRB had projected an annual inflation rate of 7.5 percent; but the actual inflation for that fiscal year was, as mentioned above, 13.2 percent. Similarly, for fiscal 2009-10, NRB had projected an annual inflation rate of 7 percent while the actual inflation for the last fiscal year was 10.5 percent. For this fiscal year, NRB has again projected an inflation rate of 7 percent. What the average annual inflation for the current fiscal year will be remains to be seen. However, given the central bank’s track record, your guess is as good as mine.

Given the above mentioned context of a huge gap between the projected and actual inflation

rates during the last couple of years, it’s easy to realize that

NRB has lost its credibility especially in terms of fighting inflation. Keeping the supply side constraints aside, which is the inevitable excuse that NRB uses when the actual inflation is higher than the projected inflation, if NRB has projected inflation to reach a certain level, why then doesn’t it fight to keep it at that level?

If at the start of the year, I believe that inflation will be 7 percent (guided by NRB), I will plan accordingly; i.e., if I am a wage earner, I will demand a minimum 7 percent wage hike to at least maintain the purchasing power of my income. Similarly, if I am the owner of a manufacturing company, I will increase my product’s price by a minimum 7 percent so that my firm’s profit will at least remain the same in real terms.

However, if at the end of the year, I realize that inflation actually increased to 13.2 percent, then I will be worse off irrespective of whether I am a wage earner or the owner of a manufacturing

company. Hence, at the beginning of the next fiscal year, I start to mark up NRB’s inflation projection by a certain percentage so that I won’t be worse off again. If every decision maker, i.e., individuals and businesses in the country, starts doing the same, then the inflation level will shoot up and become unmanageable.

High inflation then has a multiplier effect throughout the economy. High inflation decreases after-tax real return and reduces the people’s incentive to save and invest. For example, if the tax rate is 25 percent, the interest rate on a one-year taxable bond is 10 percent and the inflation rate is 5 percent, then the before-tax real return will be 4.76 percent, and the after-tax real return will be 3.57 percent (this is what an investor actually cares about).

Now, if the inflation rate rises by 5 percent to 10 percent and the interest rate on a one-year bond also rises by 5 percent to 15 percent, then the before-tax real return will be 4.55 percent, and the after-tax real return will be 3.41 percent.In the latter case, even if the nominal return has increased to 15 percent, the after-tax real return is lower than in the former case because of high inflation, discouraging people from saving and investing.

High inflation also makes a country’s products less competitive in the international market and reduces exports. Because of its adverse effects on exports and imports, in the long run, it also puts downward pressure on the country’s currency.

This article was first published in the Kathmandu Post on Dec 6th 2010

Permanent Link: http://www.ekantipur.com/2010/12/06/business/fighting-inflation/326079/