PNB Fraud: Privatise more banks, says Stern School of Business Dean Rangarajan Sundaram

With the Punjab National Bank’s (PNB) Rs 11,000-crore fraud case coming to the limelight recently, Stern School of Business Dean Rangarajan Sundaram told CNBC TV-18 that he was startled, but not surprised by the case.

He explained the fraud was bound to happen because banks need a better risk management system and said he has seen bigger heists in other trading rooms.

Sundaram questioned the existence of public sector banks by saying investors find private banks more attractive and there is no reason for holding on to nationalised banks.

"The only way forward should be discipline of the market and it is time to be more aggressive and try privatising more banks."

Sundaram explained that volatility is a symptom of markets adjusting to a new reality.

He said asset prices have been inflated because money was cheap. "It is a difficult period for the financial market and it is a period of adjustments that we have to take."

Below is the verbatim transcript of the interview:

Q: First on volatility. Is this recent fall that we saw in global financial markets largely because of Credit Suisse product, the inverse of volatility or do the roots go deeper?

A: I think the roots of the volatility themselves just come from monetary tightening that has to occur. We have been through a period that is extraordinary by any standards of historical financial market. We look at ten years of extraordinarily low interest rates and there was a period about 12 years before the crisis began where every year when I used to talk about derivatives market I used to talk about certain standard patterns in derivatives markets. Those patterns suddenly inverted when interest rates became so low that dividend yields became higher and the S&P futures curve, for example got inverted. Initially we kept thinking this is going to be short run phenomenon. Now I had an entire generation of students who have grown up with that as normal. So when that changes, necessarily we are going to see a period of considerable flux while markets adjust.

Volatility spiking is one symptom of the markets adjusting up to ten years of being in stupor to adjusting to a new reality to the fact that money has greater cost then they imagine.

XIV – the ETF that cost all the problems – those are derivatives that take leverage bets on volatility. The XIV was a particular leverage bet on volatility remaining low and having a particular kind of term structure. When short-term uncertainty goes up and spikes develop, you lever yourself from bet – dangerous things can happen. That was more a symptom than a cause to what happened.

Q: So the cause of what happened. You are saying that ten years ago it was normal that the cost of money could rise and then for the last years the cost of money was absolutely next to nothing. So now how does it look as money gets more expensive after all the ten year yield has gone to over 2.9 percent?

A: This is going to be a period of adjustment for everybody. Asset prices that have perhaps been inflated because money was so cheap and so things will have to adjust. Now what form that adjustment is going to take – nobody has a crystal ball to be able see but it is going to be a difficult period for everybody in financial market. So for example every time over the last few years the Fed has even hinted that it is thinking of raising interest rate - markets, if you remember, immediately reacted. So it is going to be a difficult period but it is a period of adjustment we are going to have to take.

Q: You said asset prices got inflated.

A: Asset perhaps got inflated.

Q: Yes. If that is the case then there are a lot of people who are saying that there is enough evidence of earrings growth and therefore these asset prices can be justified by future earnings. You don’t buy that?

A: That’s why I used the word ‘perhaps’ because there are lots of reasons to believe on a fundamental basis that these prices are not unusually high. They certainly are on the high side when you look at PE ratios, for example or other things but they are not unusually high by historical standard. On the other hand a period of very low interest rates had led to tremendous credit buildup. So corporate credit has gone up very substantially. So at some point when interest rates go up and some of these corporations are going to be more difficult, there is going to be issues.

Q: Now as the cost of money increases – where may the pain be felt first? Is it likely that it will be in the credit markets and the debt markets?

A: That is a much more difficult question to answer. When you mortgage rates for example as low as they have been in the US, property prices get affected; it becomes easier to borrow. Corporate have taken on lot more debt. So in general you have seen debt increase. Now where is the pain going to be felt – that is the crystal ball issue I spoke about. It is going to be difficult how asset prices are going to adjust, if at all.

Q: What should an emerging market (EM) investor worry about as the cost of money increases? Is it likely that EM credits will be impacted or will it be EM equities? What is a good guess at this juncture?

A: I think anything that happens in global markets, even a very large country like India, anything that happens in global market automatically has repercussions on everything. For simple things like funds flowing out of India. So one reason emerging markets did well was yields have become very low elsewhere money was chasing yields. If yields become higher you automatically going to find money going out. So there are going to be effects on margins. How well emerging markets are going to be able to adjust to this is a question of policies they follow at that point and we are reasonably well prepared.

Q: Yields – recently somebody was making the argument that yields in the US are rising not just because of inflation but also because the bond market is telling you nobody wants to buy treasuries – which a lot of it is going to be issued by the Trump administration and there isn’t appetite for it. So can that also be despite inflation being where it is, do you think yields can still rise. Is that a possibility?

A: It may happen but the US currency still remains the port to which everybody goes in times of the first sign of trouble. As long as that is there…

Q: You do not think yields will rise that much?

A: Perhaps not. It is very difficult to make predictions these things.

Q: Is there a red flag on say 3 percent ten-year. Is there a point at which things can exacerbate?

A: I do not want to comment on something so specific but by historical standard 3 percent rate is a very-very low rate. So when you take a longer-term historical perspective – touching 2.9 percent last week and rising to 3 percent doesn’t – from a historical perspective 3 percent doesn’t look like a very expensive rate. So to give you an idea 30 year mortgages in the US, the borrowing rate used to be 7-8 percent for a very long period of time. Many years now it has been 3-4 percent; households can borrow for 30 years.

Q: What is the sense you have of the recent volatility? Have we seen in the last of it now and things are stabilizing or do you think it can happen several times this year?

A: I do not think so. I think as the Federal Reserve Board takes a stance on monetary policy -- the new Chairman has already given indications that interest rates are going to continue to rise, there is going to be further tightening. I think we will see a continuous period of adjustment over a period of time. I do not think this is something that is going to die out very quickly.

Q: You think that the markets are not pricing adequately the number of hikes that will come. Is it that even the Fed should be saying four hikes?

A: I would never make the bet of assuming that markets are not pricing in things. I am sure investors are being very careful but the question is nobody knows the extent to which hikes are going to occur and the size of the hikes that are going to occur and as long as there is uncertainty about that and how market is going to react to that there is always going to be additional uncertainty. We had a period of very low volatility. Historically we never had a period of volatility like this. So if you look at the volatility prior to financial crisis the average level of VIX was at about 20 percent spiking up to 30 percent occasionally and more and post financial crisis you had a period of 11-12-13 percent absurdly low volatility for a very long period. So all we are doing is seeing returns to more normal times.

Q: Have there been such periods before and are they normally followed by extreme volatility or more normal adjustments?

A: There have been periods of low interest rates before of monetary expansion, they never lasted anything like this. I have been to the United States in 1984 when the Ronald Reagan’s first term was ending and the deepest recession since the Great Depression was well on the way – US was just coming out of that and that was a period of considerable monetary expansion followed by tightening when interest rates were raised several times in a very short span. At that time if you remember, the crash of October 19, 1987 – you must have read historically – the markets fell 20 percent in one day and that 20 percent fall literally wiped out so much of wealth. So we have had periods of time where markets have reacted violently but we have never had a period of time where interest rates have been so low for so long and volatility has been so low for so long.

So there is no historical parallel for what is going on, there is no textbook – the standard thing we do is turn to the past to see what happened in the past when this happened but in this case, there is no past to look back on. We are in completely virgin territory in terms of what is going to happen.

Q: That is interesting and also scary. Let me come to the big topics in India. The big elephant in the room in the Indian economy are the public sector banks and the fact – the bad loan problem is not only public sector banks, there are some corporate facing private sector banks who have them but there is way more acute in public sector banks. Any thoughts on how this can in future be tackled?

A: Let me emphasize that what I am going to give you is my personal opinion as an economist. The nationalisation of banks that occurred in a big way particularly in 1969 was historically a very different period than the one we are in. Banking then affected very few people, most people were outside the formal economy and issues like we are nationalising banks to make the most socially responsible resonated.

We are now in a completely different world and it is not obvious that if you look at today’s world, nationalised banks have any natural role to play in what is going on. Private banks have thrived precisely because they are able to provide services to large numbers of people that people find attractive.

Is there any good ideological reason for holding on to nationalised banks? My personal opinion again, probably not. I think one of the things that a nationalised bank has is this implicit safety net that the government is going to bail us out anyway. So somewhere I read recently that of the USD 200 billion of impaired loans in the system is something like a 180 billion are in various public sector banks which makes the recent recapitalisation of USD 32 billion seem like if not a drop in the ocean, at least - inadequate, that is the right word.

So what is the best way to solve this problem, my personal opinion is, it is time to bring in the discipline of the market much more into play.

Q: When you say bring the discipline of the market, are you saying that even ownership should be probably privatise some of the banks?

A: That is exactly what I am suggesting. I am suggesting that it is time to be a lot more aggressive than we have been in terms of – when we have privatised, ICICI and HDFC got privatised, those institutions have changed beyond recognition from what they were in 1991. That is a sign of what can come about through market incentives. Maybe you could try that on a few more banks.

Q: At the moment that doesn’t seem to be part of the political ideology but of course things can change. The more important question for the financial sector is the bankruptcy code and the fact that we have successfully sent a few cases to the bankruptcy courts, is this an institution you can bet on now. Are you satisfied with what has happening in that space?

A: Let me word this a little bit more carefully. I think betting on any quick resolution is a very dangerous thing because the bankruptcy codes are just one step in a process that is required to clean out the bad debt that is there in the system. So we have had a few cases to go through but it is very easy to see given for example that any creditor can take a co-operation to the bankruptcy code, it is very easy to see the system again getting overwhelmed. So what we need first of all is adequate planning to make sure that the bankruptcy system doesn’t become like courts and get backlogs. It is nice to have a 270 days limit but for that 270 day limit to be practical, we will need to have a huge amount of supporting staff to be able to do what we need to do.

So it is a very important step but can we declare the battle won and withdraw? The answer is no.

Q: Just to come back to the public sector bank issue. This week of course the headlines have all been about one public sector bank Punjab National Bank (PNB) finding inadequate in risk processes. What is your comment when you saw that? I mean it looks like two or three officials could actually allow somebody to misuse the bank’s money and they didn’t even get into the core banking system and to the higher echelons. What are your first thoughts, is it that there can be these red flags in more places?

A: I will see this, it startled me when I saw this. But did it surprise? No. We have seen similar things occur in allegedly sophisticated financial institutions worldwide. You remember the Societe Generale case when Jerome Kerviel lost 5 billion euro what was then USD 7 billion. He was not even supposed to be trading. Now how does a non-trader trade USD 7 billion; his notional positions were USD 50 billion and Societe Generale’s systems could not track it. A non-trader having USD 50 billion of positions. We have seen this happen repeatedly time and again and I think this is a global problem and yes what happened at PNB was awful. But I think we should be careful not to make too much of it, I think all banks need much better risk management systems than they have in place today but I wouldn’t want to single them out as having something particularly bad.

Q: That even very sophisticated place can have these kinds of people risk or process risk.

A: Yes.

Q: My final question to you is about bitcoins. Is that an area you take interest? Do you think crypto was a distraction that will go away or will they prevail?

A: Again, let me emphasize that this is my personal opinion on the matter. Cryptocurrency are fascinating creatures for variety of reasons. As an economic experiment they have no parallel because the only currencies we ever have had in this world have had some form of state banking, at least in the modern world had some form of state banking and now we have something that is trying to subvert the state and to create a currency.

How successful is that effort being? Hardly successful when you look at it. You look at bitcoin, you look at Ethereum they are hardly used by anybody. So, how can something that is hardly used have any value - this is a reasonable question for anyone to answer? Sometime ago Jamie Dimon said that bitcoin was a complete waste of time and even he has backtracked, and I wouldn’t quite go that far but it is hard for me to see - there is potential of course if the crypto work.

Q: Some countries have allowed taxes to be paid in crypto?

A: Yes, there have been so for example Starbucks allows you to buy coffee, even Amazon allows it. So, there are a few prominent companies and countries that have embraced bitcoin. But between that and it is actually becoming a currency, currencies have two major role, they are a medium of exchange and store of value. Bitcoin is so volatile it can hardly be a store of value and as a medium of exchange is not -- so if you look at it as an economist you will be likely to view this whole bitcoin thing as a bubble.

But it is a fascinating bubble what is happening nonetheless. I just had a PhD student, he is just finishing dissertation who has done his whole study on the way bitcoin works and how that market is changing. I think it is a fascinating topic, but we are in the early stages of topic where it reminds you of so many other historical bubbles like South Sea Bubble and Tulip Bubble and many other crazes.

Q: Will it be the first victim of rising interest rates?

A: I don’t think rising interest rates have any direct correlation I think this is just people punting on what looks like a great way to make easy money. People always love easy money.