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Lecture 2Poonam Mehra
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Overview
Financial markets involve allocation of resources
Financial institutions are intermediaries
Finance markets are unique
y Financial operations are complexy High Technological Innovation
y Three Premises: inter-temporal trade, risk andinformation
Pervasive Market Failure
Case for Intervention
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External Regulation
Financial Regulation could be external orinternal
Until recently, most of financial regulation wasexternally imposed
Monopoly of Regulators in decision making But with complexity in operation and speed of
innovation , external regulation finds it difficult tomaintain pace
Emphasis on internal controls Incentives??
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Issues in Incentive Design
Asymmetric Informationy Regulators and/or depositors do not have perfect
information about risk taking behavior of managers
y If regulators can observe the portfolio risks of a bank onlyimperfectly, is it possible to keep systemic risk low simplyby introducing regulation??
Problem aggravated due to technical progressy Complex derivative products
yTransfer of funds
Traditional accounting practices inadequate
Incentive Issues of Regulation design
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Principal-Agent problem
Principal: Owners of Capital, represented by Regulator
Agent: Financial Institutions
Example from the mutual fund Industry
Issues:
y
Management Capability of the institutions unknownto regulator: Adverse Selection
y Inability to monitor the Institutions: Moral Hazard
y Residual Risk
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Adverse Selection
Principal lacks information about the type of the agent
It refers to the case of hidden information
Example: Quality of risk management techniquesvaries across institutions
Should the same regulation apply to all?
Solution:
y Screening
y Signaling
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Screening
Uninformed party (regulator ) offers a contract
Tries to screen the different pieces ofinformation the
informed party (financial institutions) has
Menu of Contracts: Self-select Group
All choose the same: Bad may mimic the good
Carrot and Stick Approach
Problem: bad drives out the good
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Signaling
Signaling: contract offered by informed party, tries tosignal its abilities
y Adoption ofBest Practices
y Ongoing relationship: Reputation
y Contract with right incentives and credibility
y Delegation
Internal Audit
External Audit
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Moral Hazards
Moral Hazardarises when the principal cannotmonitor what the agent does
Moral Hazard gets reflected in the form of hiddenaction
There is no perfect solution to the problem
Solution to Moral Hazardy Use of Incentives : Pay Structure
y Regulation
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Pay Structures and Risk
Established controls may not induce favorable actionby agents
A
gents respond to pay off structure
Loss due to downward risk < potential upward gain
i.e. a convex pay structure induces agents to take morerisk
Typical pay structure induces differential response torisk and return
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Pay offstructure and Risk
Red: risk averseYellow: risk lover
Success of risky action
Reward to Agent
Minimum bonus outcome
BasicSalary
BonusCap
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Regulation
In bankingindustry, moral hazard could arise due toaction of
y managers
y
investors
Possible solution
y Official regulation
y Encouragement of Private sector lending
y Impose cost on those who commit mistakes
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Forbearance
Ex ante: high punishment and strongincentive required toensure good governance
Ex post: is it always sensible for regulators to stick to originalrules
May be not
Other factors affect decision of the regulator
y Political: an election year
y International reputation
y Other parties affected
A
ll this factors may lead to forbearance Forms of forbearance
y Delayed intervention and disclosure
y Financial aid
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Cost Benefit Analysis ofForbearance
Advantage Disadvantage
Systemic Consequence
Forced liquidity may notalways yield proper value
Going Concern Value
Bankruptcy entails highcost
If forbearance failsy Actual cost to public
increases
y Lock in effect
Reduces future Incentiveto follow regulation
A cost benefit analysis offorbearance is notpossible ex ante
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Size Matters
Forbearance applies more to large/ core sectors
BigFirms feel regulation is more for SmallerFirms
Large Firms are more diversified and more creditworthy
Too Big to Fail- doctrine
Medium Sized Firms may be induced to expand thebalance sheet
Large Firms may take excessive risk
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Example: Bail outto RBS
RBS bailout costliest worldwide
Government's total bailout of the bank equals 45.5billion pounds or about 74 billion dollars.
Consequently 84.4. percent of the stakes of the bankwere held by the government
Issues:
Series of bailout: example of lock in effect
Provide stability
Alternative was bankruptcy
Ex post: bank survived
Tax payers as stakeholders may gain in themedium and long term
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Individual vs. System
Erosion can be caused by
y Behavior ofinstitutions managers
y Adverse Market Movement
Manager should be blamed more for theirindividualfault, whether due to lack of effort, lack of skill,willingness to take excessive risk
Not punishing a managerin case of market movementmay encourage herdingbehavior
Extreme outcomes cannot be predicted
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Case Study: Satyam
Satyam Scam in the contemporary corporate
world:A Case Study in Indian Perspective
Founded in 1987 by B. Ramalinga Raju
Provides IT services
Listed in NYSE & Euronext
7th Jan, 2009 Raju confessed of manipulating accountsby $ 1.47 billion & resigned
In the study, we try to look at liability of:
y Promoter, Director
y Independent Directors
y Auditors
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Confessions ofMr. Raju
Inflated (non-existent) cash & bank balances of Rs.5040 crores on the balance sheet as of September 30,2008
Non-existent interest of Rs. 376 crores accrued
Understated liability of Rs. 1230 crores on account offunds
Overstated debtor position to the tune of Rs. 490crores
For 2nd quarter of 2008 alone, artificial cash and bankbalances were raised by Rs. 588 crores
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History of Ownership Pattern (%
ofEquity Holding)Date Promoter
s holding(%)
Mutual
Funds
(%) - Non-
Promoters
Banks,
FI's,
Insurance
Cos. (%) -Non-
Promoter
s
Foreign
Institutio
nal
Investors(%) - Non-
Promoter
s
Corporate
Bodies
(%) - Non-
Promoters
Individual
s (%) -
Non-
Promoters
Other
Non-
institutio
ns (%) -Non-
Promoter
s
Custodians
Totalequity
holding
(%)
Mar 2001 25.60 17.24 1.90 33.76 4.46 15.98 1.05 0.00 100.00
Mar 2002 22.26 12.11 2.33 37.67 4.08 10.94 10.60 0.00 100.00
Mar 2003 20.74 8.88 4.37 43.02 3.90 8.47 10.61 0.00 100.00
Mar 2004 17.35 7.39 4.33 51.27 2.95 6.06 10.65 0.00 100.00
Mar 2005 15.67 7.58 3.32 56.06 2.24 4.47 10.65 0.00 100.00
Mar 2006 14.02 5.70 1.74 52.48 2.06 4.06 19.94 0.00 100.00
Mar 2007 8.79 6.00 5.63 47.22 0.94 10.64 1.27 19.52 100.00
Mar 2008 8.74 4.88 8.13 48.22 0.59 8.75 1.24 19.46 100.00
Source: Study by Prof. Subrata Sarkar, IGIDR
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Liability as a Director, Promoter
Criminal Conspiracy
Cheating
Criminal breach of trust
Forgery
Falsification of records
Additional chargesy Breach of fiduciary duty
y Violation of companies Act
y Misrepresentation ofBS and P&L statementy Omission & falsification of company documents
y Serious Frauds Investigation Office
y US shareholders can file law suit
Arrested on these charges Non-bailable
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Liability ofIndependent Directors
Counterbalance weakness of management
Ensure legal and ethical behavior
Extend the reach of company
Clause 49 of listing Agreement
y At least 50% of the board should comprise of non-executive directors
y Independence of Judgment
y No material Relationship
y No Pecuniary Relationship
Under SEBI and Company Law, all directors cannot be heldresponsible as institutional and independent directors arenominated and nominated directors are not legally liable
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Liability ofPWC in Satyam Case
PWC was paid double the normal fees usually paid toauditors
Re-appointed seven times
Section 227, 233 require auditors to accurately, fairly and
diligently review and audit company account Failure results in a penalty upto Rs. 10,000
Section 62, 63 says any persons issuing false propsectus isliable to 2 years imprisonment and fine upto Rs. 50,000
ICAI can initiate disciplinary proceedings against an audit
firmy Leading to disqualification from eligibility to act as
statutory auditors
y Suspension/debarment
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Conclusion
Satyam: one of the very successful and sought aftercompanies can also go wrong
y Questions the belief large or successful institutionsshould be above regulation
Moral Hazard
y Monitoring difficult
y Independent directors need to be made liable
y Auditors: How reliable they are?
Relook at Regulation
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History of Board of DirectorsClassificationMarch 2008 March 2007 March 2006 March 2005 March 2004
B Ramalinga Raju Promoter ExecutiveDirector
Promoter ExecutiveDirector
Promoter ExecutiveDirector
Promoter ExecutiveDirector
Promoter ExecutiveDirector
B Rama Raju Promoter ExecutiveDirector,
Promoter ExecutiveDirector,
Promoter ExecutiveDirector
Promoter ExecutiveDirector
Promoter ExecutiveDirector
Ram Mynampati Directorin wholetime employment
Directorin wholetime employment
MangalamSrinivasan (Dr.)
(Mrs.)
IndependentDirector
IndependentDirector
IndependentDirector
IndependentDirector
IndependentDirector
Krishna G Palepu Non-executive,Gray Director
Non-executive,Gray Director
Non-executive,Gray Director
IndependentDirector
IndependentDirector
Vinod Dham IndependentDirector
IndependentDirector
IndependentDirector
IndependentDirector
IndependentDirector
M Rammohan Rao(Prof.)
IndependentDirector
IndependentDirector
IndependentDirector
T R Prasad IndependentDirector
IndependentDirector
V (Prof.) IndependentDirector
IndependentDirector
V P Rama Rao(Retd.) (I.A.S.)
IndependentDirector
IndependentDirector
IndependentDirector
IndependentDirector
C Satyanarayana(Retd.) (I.A.S.)
IndependentDirector
Board Size
9 10 7 6 7% of IndependentDirectors
55.56 60.00 57.14 66.67 71.43
Source: Study by Prof. Subrata Sarkar, IGIDR
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Board of Directors: Financial Year 2008
Directors Name Director
Designation
Director
Classification
Board MeetingsAttended
Total Number of
Directorships
Total Number of
CommitteeMemberships
B Ramalinga Raju Ch Promoter ExecutiveDirector
4 3 0
B Rama Raju MD Promoter ExecutiveDirector
3 4 1
Ram Mynampati Exec. Director &President
Directorin wholetime employment
4 4 0
MangalamSrinivasan (Dr.)(Mrs.)
Director IndependentDirector
3 2 0
G Palepu Director Non-executive,Gray Director
4 3 0
Vinod Dham Director IndependentDirector
1 9 0
M Rammohan Rao(Prof.)Director
IndependentDirector4 6 4
T R Prasad Director IndependentDirector
4 9 4
V. S. Raju (Prof.) Director IndependentDirector
4 4 2
Source: Study by Prof. Subrata Sarkar, IGIDR
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Directors Remuneration: Financial Year
2008
DirectorsName
Designation Salary Sitting Fees Bonus/Commission
Otherpayments
TotalRemuneration
B RamalingaRaju
Ch 18,00,000 18,00,000 24,43,355 60,43,355
B Rama Raju Md 16,80,000 16,80,000 10,47,725 44,07,725
Ram Mynampati Exec. Director &President
3,52,28,512 3,52,28,512
MangalamSrinivasan (Dr.)(Mrs.)
Director 80,000 12,00,000 12,80,000
Krishna GPalepu
Director 40,000 12,00,000 79,51,000* 91,91,000
Vinod Dham Director 10,000 12,00,000 12,10,000
M RammohanRao (Prof.)
Director 1,20,000 12,00,000 13,20,000
T R Prasad Director 1,20,000 11,33,333 12,53,333
V. S. Raju(Prof.)
IDirector 1,30,000 11,33,333 12,63,333
Source: Study by Prof. Subrata Sarkar, IGIDR
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Auditor Details for Satyam
TotalAuditFees ( in lakhs)
Out of PocketExpenses*
Non-AuditFees*
TotalPayments
to Auditors*
Non-Audit Fee%
Mar 2001 PriceWaterhouse &Co.
21.00 0.00 21.00 42.00
50.00Mar 2002 Price
Waterhouse &Co.
21.00 3.03 23.22 47.25
49.14Mar 2003 Price
Waterhouse &Co.
55.00 1.83 9.00 65.83
13.67Mar 2004 Price
Waterhouse &Co.
55.00 1.28 9.00 65.28
13.79Mar 2005 Price
Waterhouse &Co.
55.00 1.37 9.00 65.37
13.77Mar 2006 Price
Waterhouse &Co.
100.00 1.00 14.00 115.00
12.17
Mar 2007 PriceWaterhouse &Co.
248.00 1.00 118.00 367.00
32.15Mar 2008 Price
Waterhouse &Co.
362.00 5.00 6.00 373.00
1.61
Source: Study by Prof. Subrata Sarkar, IGIDR
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