In any organization internal controls are a very essential mechanism to ensure people, processes and systems function in a desired manner and flag any actual or potential deviation from accepted norms. Some types of internal controls relate to “horizontal” functions like Processes and Systems while other types relate to “verticals” like in the Finance, Purchase, Manufacturing etc.

At the heart of every internal control is a set of clearly defined steps which tell us the checkpoints which a function must pass through. For example, making a car part involves many processes involving many people. If that is not enough, making a sub-assembly consisting of many parts is more complex. Furthermore, using many sub-assemblies in the manufacture of a vehicle is incredibly more complex. Now that you have some idea of how complex some processes can be, just imagine the hyper complexity of assemblies put together in the making of the Chandraayan rocket to the moon.

The thought that should keep senior management up at nights is “What if a tiny part in the assembly should fail? Or, what if a line of code in the software overlooks a condition or is not designed to handle that condition? In a manufacturing assembly that would mean stoppage of the line, leading to many angry senior management faces, not to mention huge loss of money. In a mammoth endeavour like a spacecraft a tiny fault can result in hundreds of crores of losses, not to mention the time lost, and dreams shattered. In case of an aircraft, it may result in loss of lives. Moving on to finance industry, such scenarios may cause millions of dollars of losses to the company, the public and other institutions in the value chain. These failure-points can be either intentional, as in rogue traders in financial firms or can be accidental such as in an undiscovered part failure in an assembly.

So how does a company take proactive measures to avoid such failures? The answer lies in strict internal controls. A key aspect of internal controls deals with Risk of failure, Quantification of the risk and how to minimize and manage that risk. How to determine at which point one must insert controls? Rather, at what points in the process will a failure expect to cause significant losses? Enlightened companies use data driven methodology to identify the vulnerable points in the process. Other tools like sensitivity analysis aid in getting an understanding of potential losses and therefore play a leading role in designing appropriate control mechanisms to restrict failure.

Internal controls form part of Operational Risk control and mitigation strategies. They are essential no matter which industry the company operates in. In most cases Operational Risk arises out of inadequate checks and balances or failure of operational data / information to be communicated to all appropriate functions within the organization. This failure occurs due to faulty design of operational software. In today’s age where information technology has pervaded into every aspect of an organization’s workings, wrong or inadequate design of critical software can leave the organization exposed to disastrous situations. Following is a description of the famous Nirav Modi scam that occurred as a result of lack of internal controls in banking operations at PNB, India’s 2^nd largest bank at that time.

Punjab National Bank – Nirav Modi and Mehul Chokshi Scam

Perhaps there is no other scam in Indian banking history as the $2 Billion PNB-Nirav Modi scam.

The plot of the scam was hatched in the Brady House branch of PNB in Mumbai, as early as 2010. While diamond billionaire Nirav Modi was the “brain” behind the scam, the execution of the scam was faithfully and quietly being done by “worker bee” and Deputy Manager Gokulnath Shetty. Shetty joined PNB in 2010 in the forex division. As early as March 2011, he became the vortex of the scam when he issued $15 million worth fake bank guarantees (Letters of Undertaking or LOU) to many Nirav Modi firms. Usually when someone wants a bank guarantee from a bank, it would look for collateral or a security deposit. Corrupt bank officials bypassed this requirement and “gifted” Modi with bank guarantees without any collateral.

This is where the first failure occurred – there was no oversight on the process of issuing these LOUs nor was there a red flag that travelled up the corporate hierarchy. As part of a well thought out plan, none of these fake transactions were entered into the bank’s Core Banking System (CBS). The CBS would have caught this scam at some point or other. However, Shetty and gang very cleverly bypassed the CBS and entered the details only in the SWIFT system of the bank. SWIFT is a worldwide financial information messaging system used by most banks and financial institutions in the world. By not entering the data in the CBS, corrupt officials hoped to be insulated from oversight within other parts of the bank. In effect the SWIFT system and the CBS were two isolated “Islands of Automation” with no communication between them.

Modi in turn took those bank guarantees or LOUs and used them as collateral in obtaining billions of dollars of loans from the foreign branches of Indian banks. Now why would not these foreign branches issue loans to Modi, when he is showing bank guarantees from a top Indian bank? With that money he and his uncle, Mehul Choksey closed out their previous loans and siphoned out money to 130 shell companies across the world. For seven years, this gang operated in the shadows, while the bank was completely oblivious of the scam right under their noses. This tight gang acted in a complimentary manner and comprised of people across the hierarchy – from clerks to forex managers, regional office heads and auditors. Lack of strict controls, paper trails, monitoring and integration of the SWIFT system with CBS provided a golden opportunity to the scamsters to execute their plan.

Investigators revealed that PNB’s international banking operations were not integrated with its CBS, leading to islands with no communication. A simple act of daily reconciliation of SWIFT messages with the CBS would have resulted in reports transmitted across senior management and risk management groups, which would have identified the fraud. In addition, false compliance certificates were issued signalling that the branch’s controls were adequate. Funnily, senior managers visited the branch 10 times between 2010 and 2017. None of them questioned the lack of paper trail and existence of so many LOUs issued to the same firms. According to media reports, in 2016, the same Brady House branch flagged 18 observations as critical, and out of that 5 being “zero-tolerance” issues. However, nothing was done by senior management to address this lacuna.

Another contributor to the scam was fact that Shetty, being a junior official had permission to authorize transactions only upto 2.5 million rupees. However, a lack of internal controls and oversight allowed him to far exceed his limits. It was also revealed that a few weeks before his retirement, Shetty used his personal email 22 times to reconcile 18 forex transactions to whitewash his crimes. This was in clear violation of banks email policy. This too went unnoticed by the bank’s internal controls. PNB’s HR policy clearly stated that no officer should remain in the same position for more than 3 years, but Shetty seemed to have dame luck shining on him – his tenure was extended to 7 years – adequate time to issue around 1200 fake transactions, for Nirav Modi.

Such a big scam which cost the bank and ultimately the taxpayer, $1.2 Billion occurred due to either absence of or lax internal controls, breakdown of existing controls, lack of integration of disparate systems and platforms, and senior management either wilfully or otherwise, failing to provide oversight across the branch, region and bank. Cumulatively these issues led to severe losses, dramatic drop in stock price, and a jolt to the banking system. Unfortunately, only 3 people including Shetty were arrested while senior management including Sunil Mehta, MD downwards to Rajesh Jindal, GM of Brady House branch, were either untouched or were granted bail. A government which means business would have ideally sacked the MD of the bank to set an example to other banks to tighten its internal controls.

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The reason this new product seems attractive to loan origination firms is the option of “offloading” the default risk from their balance sheet. Just as banks “packaged” mortgage loans into tradeable securities that could be bought by investors, so too in BNPL the annuity payments could be packaged into tradeable securities by deft financial engineering. As the market for BNPL increases I foresee more of such financial engineering strategies being used since lenders look to offload the credit risk inherent in these loans to buyers of the risk.

This has an eerie similarity with the mortgage loan packaging that took place before the 2008 financial crisis kicked in. Mortgage originators, banks, Credit rating agencies, and institutional investors (who should have known better) took part in this feeding frenzy, trading exotic derivatives which were dependant on mortgage payments being regular and low on default risk. But defaults did happen as banks took their eye away from sound credit risk management guidelines, and this one link caused the entire chain to unravel, causing a huge worldwide crisis.

Just recently the well respected private equity firm KKR announced that it had bought upto 40 Billion Euros worth of BNPL loans from Paypal Europe. BNPL, which saw dramatic rise during the pandemic among millennials and GenZ who were sitting at home and shopping away merrily, is seeing signs of slowdown amidst high interest rates, uncertain economy, jittery job market and high inflation. As a result, BNPL loan origination companies are seeing red flags in their balance sheet due to uncertainty of cash flows from these loans. Many of them are therefore looking to offload this credit risk to other investors.

How many companies join PayPal in this flight away from risk remains to be seen. Given the uncertain global economy I see this flight to safety spread from Europe to the US and across the world. Even Indian companies like Myntra, Nykaa, etc who have been at the forefront of BNPL could potentially suffer. The big banks like Axis Bank, ICICI, Kotak Mahindra all have jumped on to the BNPL bandwagon with a view to prevent the more tech savvy smaller players from stealing market share. Will we see a Déjà vu of the credit default driven financial crisis of 2008? We can only wait and see.

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Fans of Star Trek must surely remember the “Borg”, the collection of organic cum synthetic matter into a single entity of collective consciousness. This consciousness does not manifest as something on its own, rather it represents that of the sum of the “ecosystem” of individual “drones” (as the individual entities linked together in the collection are called).

Proponents of EMH believe that like the Borg (characterization mine!) the market is but a collection of all the thinking and actions of its constituents – millions of individual and institutional investors, traders and speculators. They believe that one cannot “outwit” the market since all the information one needs in order to value a security is already available and that the price of the security reflects this information. Market behaviour too is a reflection of the behaviour of individual and institutional players in the market. An interesting offshoot of this is evident in times of extreme exuberance or fear when market participants, either buy like crazy or dump their shares, which further causes panic buying or selling respectively causing a vicious cycle.

Now what is the trigger that causes this wave? It can be an irrational fear or a rumor, a real disastrous event like the Covid Pandemic, an act of terrorism like the Nov 26, 2008 attack in Mumbai, etc. It is not so much that the event happened that caused the panic in most cases, rather, the constant frothing at the mouths and hyperactive pontifications by media and so-called pundits, which provide fuel to the fire that rages through the minds of millions of investors. This trigger can also be caused by unfounded rumors started by unscrupulous speculators who want to profit from the mass hysteria. A real example is the numerous “Pump and Dump” schemes still prevalent in the market today.

On the other hand, market exuberance can also be triggered by rumors or legitimate reasons. Events like better than expected interest rate cut by central bank, business friendly policy initiative, benefits to individuals like Income Tax rate cuts, etc can excite investors into believing that the “market will rise” whereas in reality, it is their buying of stocks that causes the market to rise. Efficient Market Hypothesis proposes that the market does not have a mind of its own, rather its “mind” is the collection of all market participants. 

The proponents of Efficient Market Hypothesis believe that the market cannot be beaten and that it is outrageous to pay enormous sums of monies to active fund managers who claim to possess the skills to beat the market. And in fact, much of this belief has been proven right by studies which compare total returns of a passively held portfolio versus an actively managed portfolio.

As you can see, except for small cap equity funds both Large Cap and Mid Cap actively managed equity mutual funds over the long term have underperformed the index.

So does this mean that every bit of information is already known to investors, or is the market truly efficient? Does this mean there is no way to exploit inefficiencies in information available to investors and create opportunities? This may be true in the long term, over many business and market cycles. However, there is still that out performance or alpha to be had in actively managing portfolios at least in the short and medium term where we can obtain superior information by applying one of the many research and investing strategies prevalent in the industry. Different business cycles throw up different sets of winners and funds which are able to identify and act on opportunities to make money. 

Even among such active managers there exist multiple strategies for investing – Fundamental, Quantitative, Technical Analysis, or a combination of the three. Even among them there exists multiple types of styles such as Value, Growth, or a combination of the two, Market Capitalization based portfolios, Sector specific, Event driven investment strategies and so on. Each of the above mentioned Active strategies do work in a limited timeframe and business environment.

However, it is very difficult to consistently squeeze out that competitive edge in investing using active management for the long term. Ultimately, any alpha (or excess return) is tempered by Transaction Costs, Management Overheads, Taxes, etc. It seems the verdict is in favor of Index or Passive Management, which is a manifestation of the Efficient Market Hypothesis, when time frame being considered is long term.

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However, good times don’t go on forever. Questionable use of sexy exotic derivatives like Credit Default Swaps (CDS) developed by PhDs and Quants in Financial Engineering departments which “packaged” these mortgages and resold to investors around the world who lapped it up without much due diligence of their own. They brought in the “Greed” component of Fear-and-Greed twins ruling financial markets. Then came the reckoning or in Sanskrit, the Pralay, the Great Flood.

Defaults started happening as these questionable homeowners started defaulting, homes foreclosed, banks left holding unsold inventory of mortgages of defaulted loans. Other banks refused to lend to such banks causing a crisis of confidence. “Fear” took over the markets as participants suspected this was a “contagion” that could affect the entire worldwide financial system. Banks like Bear Stearns, Lehman Brothers went under and disappeared. Central banks of the US and other governments had to step in to stem the losses. We are still feeling the aftershocks of this crisis in some form or the other.

Now why did I write so much about a financial crisis that happened halfway across the world?

Because I can see another crisis emerging in India but under a different avatar, and which has the similar underlying reason – the Buy Now Pay Later. I believe if the regulators do not keep this monster in check, such pay later apps have the power to drown the Indian consumer in piles of debt and spread the disease of financial indiscipline among the young population and families.

What is BNPL ?

It is an acronym for Buy Now Pay Later. That means, a merchant is offering to sell his product to you wherein you pay an initial deposit and promise to pay the rest in instalments. A slew of payment startups backed by marquee global investors are competing intensely to capture share of the market, paying scant attention to risks underlying their operations. Additionally, in their rush to acquire customers many a company is walking borderline on illegal business practices such as false advertising.

How is the Younger Generation getting affected by Buy Now Pay Later? 

The young consumer, especially the GenZ is already in the midst of a consumer boom, driving digital sites like Amazon, Flipkart, Myntra, etc. The “instant gratification” aspirational generation is on a buying spree, spurred on by slick advertisements that bombard their Instagram, Facebook, and Snapchat apps. BPNL companies have removed the one checkpoint between the young consumer and this runaway habit of consumerism by selling them the “good news” that they don’t have to pay for the item now, rather, think about it for later. Thus, the barrier of financial discipline that was protecting the young generation is now removed.

What makes BNPL a Potential Financial Disaster ? 

“Buy Now Pay Now” in a weird way-imposed friction in runaway consumerism, by imposing the hurdle that buyers had to pay for the product “now”. BNPL removes that barrier, bringing into the market those buyers with questionable financial discipline, who might not have the resources to pay “later” instalments. Additionally, the penalty of a missed payment is an interest rate much higher than that of credit card default, and an adverse credit report which stays throughout one’s life, including the time when one wants to apply for any other loans such as education or home loan.

In this we see a similarity with the housing crisis of 2007 where greedy banks lent to homeowners with questionable credit throwing caution to the wind, and finally had to face the music when borrowers defaulted. BNPL also shares the dubious similarity with the now shamed rip off schemes of “Payday Loans” in the US which scammed unfortunate low-income folks by pushing loans onto them and locking them into very high interest penalties upon default. I am convinced that if the BNPL industry does not impose credit risk standards on itself, it will be left holding a huge portfolio of bad loans, which will ripple through the banking system no doubt, but also devastate the young aspirational generation and households. 

Conclusion

BNPL is somewhat like EMIs. However, loosening the system of checks and balances is what is troublesome. The quest for more profits must be weighed against the threat of additional risk injected into the system. In any financial lending entity Credit Risk and Operational Risk standards are the two most important protectors against financial ruin. It seems the new age companies and some of the legacy firms in their obsession with market share and profits are relegating them to the background. Runaway promotion of “Buy Now Pay Later” is sure to end up for the younger consumer as “Buy Now Regret Later”.

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⦁ 68% of CEOs were appointed via internal promotion (up 46% from pre-Covid level)
⦁ 42% have a background in Finance and Banking, despite the fact that only 19% of the firms surveyed were from the financial sector,
⦁ 47% have some form of a post-graduate degree

It would make sense for someone in a CFO position to take over running a company as the business world recovers from the devastating effects of the global pandemic. In a dynamically changing environment, with governments, federal banks, consumers, businesses coming to terms with the new rules of engagement, it is the CFO who has both a ringside as well as a bird’s eye view of the moving parts. With high inflation gripping Europe, Asia and the US, oil prices fluctuating, geopolitical strains pulling at the seams of stability, large layoffs in major industries like IT and manufacturing, and hesitation among consumers to spend their already crimped income on “nice-to-have” items have put tremendous strains on CXO level executives as they plan for the road ahead.
As if there weren’t enough challenges, planning ahead wisely has become even more tricky as we see the banking system dealt with twin blows of Silicon Valley Bank and First Republic gasping for breath as they drowned in turbulent waters of unfortunate asset-liability mismatch in their balance sheets. Why this happened is due to a quirky occurrence of the Inverted Yield Curve, where the short term rates were higher than long term ones. So, banks holding short term (2 year) Treasuries had to pay more to entice customers to deposit their funds with them. By the same token, corporations borrowing money for short term purpose had to pay more as interest, negatively affecting their cash flows.

This downward sloping yield curve affects many sectors, notably the already “under-the-gun” venture capital, private equity, startup ecosystem, corporate credit, credit card, auto loans, just to name a few. Moreover, banks cannot raise short term rates as they wish – as this will severely affect interest income.
This is just one of the hazards a CFO might face as business weigh Capex, gaining market share and profitability, versus hunkering down and conserving cash, green lighting only those projects which result in rationalization in costs and efficiency.
A CFO has the unenviable position of having to juggle multiple sharp knives in the air – we don’t know which one will miss the mark and cause great harm. That is why CFOs who can navigate through these turbulent waters make their mark not only in their own companies but are also sell like hot cakes among senior talent in industry circles.

The post CFO to CEO – A Logical Transition? appeared first on Finance Courses in India | Financial Management Course.

“While 13 million youth join the workforce every year the following statistics about employable youth are increasingly troubling:
·         One in Four MBAs
·         One in Five Engineers
·         One in Ten Graduates
are truly employable.”

Indeed, the above statistic, if true, is troubling. However, the term “unemployable” gets thrown around a lot by many people who either don’t have a skin in the game and are just self-proclaimed pundits without doing a deep dive into its real nature or cause. As we all know, our ability to grasp new concepts and learnings is highest in our younger days, where the so called “neural pathways” for learning are newly established. Our schools and colleges have the dubious distinction of suppressing a child’s creative thinking process by straightjacketing her abilities into a prison of rigid routine of syllabus, tests and grades. By the time the child grows into a young adult and goes into college her intellect is already tamed into going through more of the same routine.

College is the doorstep to the real world. It would seem essential that colleges would prepare youngsters for life outside the hitherto sheltered confines of childhood and teen years by exposing them to real world situations and preparing them to find their way through those situations. Having sat through hundreds of interview processes involving college graduates I find a deep disconnect between what is taught in school (college) and what the real world expects at the minimum, out of these graduates.

So why is that? Why is there a disconnect? I feel the root cause is the inability of our education system to move with times. I would often come across syllabus being taught the same way as it was taught 10 years ago by professors and faculty who had very little exposure to real industry, let alone be part of it. I find well meaning faculty, no doubt steeped in theoretical aspects, but struggling to customize their teaching content or pedagogy in a way that is concurrent to what their students would find in real companies when they graduate from college.

If I were to be the decision maker, I would make it mandatory for college teachers to work in industry for some time, even have them complete an “internship” in a company relevant to the department they are teaching in.

I know this might not be welcome in many cases, but that is what real “industry-academia” collaboration will be – equal and free flow of ideas between the two. I am sure there will be enough “cross-pollination” to ensure students (and teachers, I might add) are exposed to what the industry wants. After all, industry is the “customer” where colleges are in a sense, providers of employable manpower!!

Students entering college are raw, with some basic understanding of the world around them, of foundational knowledge systems, ready to be “moulded” into productive professionals. No one at that stage is “unteachable”. I refuse to believe that some students are “bright” and others not. Every young person has his or her strong points unique to them. Every student is “learnable”. She is like a sponge, ready to absorb a knowledge system that interests her, assures her of a rewarding professional career while doing justice to her personal goal. It is the responsibility of teachers and colleges to foster a learning culture unique to that student, where she will flourish, which might be totally different with another student who will have a different stage from where to excel.

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