Banks, DFIs, and Markets

The large financial institutions of the country are faced with the challenge of redefining themselves. An entity like IDBI today finds itself involved in the activity of raising funds, by borrowing from the public through bond issues, and lending to industrial projects. Is this viable? What value-added does IDBI contribute in this activity that can be the foundation of profits?

In tangible terms, does it make sense for IDBI or ICICI to lend to (say) TELCO? The interest rates that a company like TELCO commands on the bond market are close to those that an IDBI can command. In which case, the disintermediation approach is better for TELCO: instead of paying for IDBI's cost of funds, evaluation expenses and profits, TELCO is better off eliminating the middleman, and directly approaching the bond market.

More generally, we may ask the question: what is the role for banks and development finance institutions (DFIs) in a world where many companies in the country have good access to primary markets where bonds and shares can be sold?

As the TELCO example illustrates, once a company has good access to the primary market, it needs agents like investment bankers to distribute the paper that it is issuing; it does not need the services of intermediaries who bear principal risk like IDBI. The large, liquid securities of the country, e.g. the companies who make up Nifty, are likely to be well placed in terms of being able to command resources via both debt and equity issues. Liquidity in the equity market is superior to the bond market, so that an additional 500 or so companies have a fairly well functioning market for equity, and not for debt.

Even though these numbers appear small when compared with the thousands of listed companies that exist, these major companies are disproportionately important, accounting for between 65% to 85% of India's corporate sector by a variety of measures.

When we deal with the remaining thousands of companies in the country, in terms of access to resources, the picture is drastically different. When these companies issue equity or debt instruments, market liquidity is extremely poor. This lack of liquidity hurts investors in two ways: first, by reduced returns through transactions costs at entry and exit, and second, by enabling a variety of accidental or orchestrated anomalies in secondary market prices. Illiquid securities are the main target of market manipulation. Illiquid securities are vulnerable to odd fluctuations of prices, thus generating unusual risks for investors.

At the essence, illiquid securities are characterised by poor information, poor research, and frequent gaps between the secondary market prices and a true valuation of the security. Illiquid securities often have market prices which do not accurately reflect future risk and return. Investors face an informational asymmetry when they buy these securities, on the secondary market and particularly on the primary market.

This incomplete information, and consequent insecurity in the minds of investors, turns into a heightened cost of capital. The gulf between the securities in Nifty or Nifty Junior in P/E or P/B valuations, as compared with the remainder of securities, is drastic. Investors demand higher interest rates for illiquid, thinly traded bonds, and investors demand high prospective returns (i.e. are willing to pay low present valuations) for illiquid, thinly traded shares.

It is here that there is a vital role for information intermediaries. This title, which applies to banks, DFIs and venture capitalists (VCs), characterises financial intermediaries with (a) skills in project evaluation and (b) mechanisms for sourcing funds which imply that their assets do not need to be highly liquid.

An information intermediary can closely evaluate a project, accurately assess the risk and return involved in a financing decision, and thus charge the project a `fair' cost of capital.

This is in sharp contrast with financing through an illiquid market, where few professional traders are available to pay close attention to a security and thus ensure that the market price is honest.

The information intermediary can thus expect to earn a revenue for contributing this unique value-added.

The venture capitalist (VC) is an extreme case of an information intermediary, who takes an equity stake in a project, participates in nursing it to a financially sound situation with a good track record, from which it can then go public on the IPO market. Most of India's IPOs would strongly benefit from a three-year incubation period with VCs before coming to the IPO market.

Credit rating agencies are also information intermediaries who work on the other side. When a firm obtains a credit rating, it reduces the informational asymmetry between investors and itself. The credit rating agency performs the task of closely evaluating the project and emerging with an evaluation of the risk of default. If credit ratings were well-respected by markets, then the credit rating would be an adequate passport to obtaining a low cost of capital on the bond market. The future growth of skills in the credit rating agencies will hence enlarge the elite club of companies who can access the bond market.

There are obviously many projects where the informational insecurities are too large to be bridged by a credit rating which are therefore ideally suited to the skills of the DFIs, banks and VCs. It should be clear, however, that the thousands of projects which fall into this category account for no more than a third of India's corporate sector by measures such as market capitalisation, annual investment, gross block, etc. Hence the importance of DFIs and banks in such a world would obviously be much smaller as compared with the way things worked before the blossoming of the capital markets in the mid-eighties. It is also easy to see that the venture capital industry could easily enjoy meteoric growth rates in the coming years, owing to the unique combination of equity financing prior to the IPO coupled with close participation in the management of the company.

What does this reasoning imply for companies who seek to raise funds? The single message which stands out is the value of reliable, clean disclosure. When a company can convince markets that it will tell them the truth, the market will be willing to pay a fair risk/return valuation for the securities of the company. Obfuscated accounts, tardy continuous disclosure, and an unwillingness to call press conferences to reveal bad news are all short-sighted strategies on the part of companies. The companies that scrupulously play clean in their disclosure will be best able to directly access capital markets, avoiding the markup of intermediaries, and be able to source funds at the lowest cost of capital.

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