Alice in Financial Wonderland

Some polarisation between equity and debt has happened with start ups and bank crises. Equity has found new ground in the unlisted space and has ceded forts in the listed space. The listed companies now are prone to taking debt both on balance sheet and off balance sheet for various reasons including equity shares buyback. In the unlisted space, equity owners are not passive onlookers, but make effort to evaluate the top tier management all the time.

Between the debt and equity there is no way defined for a temporal distribution in the context of a hypothetical business. The internal rate of return of any business has a temporal distribution and hence should dictate the debt and equity proportion that it must carry. But the way debt and equity are markedly distinct and can be raised from different set of players having differing expectations, it makes it quite difficult to achieve proportionality of debt and equity.

Either there are safeguards and warning lights built into the levels of debt a company can source, leaving equity holders at the mercy of the collective thinking of the equity market, or we can envisage a differential return between equity and debt holders, that allows splitting of rate of return of the business, and hence breaking the gridlock of coupons and tenure of debt. In the latter case, thus the debt and equityholders are tied to the returns generated by the business.

Thus all financing institutions become safer and trustworthy without the stress of stress-test because they would get higher return in good times and lower or even zero returns in bad times. Presto! we have shrunk the cancerous non-performing assets. Automatically the usurious lending to individuals shall vanish as well.

Clearly this is a quixotic idea because the essential characteristics of debt and equity have been compromised. But if we are prepared to look for new solutions, you would say that this is an intermediate step. Ultimately the method of differential returns depending on tenure of the finance, can only suggest that debt and equity are fungible. Depending on the rate of return coming to a business in the next two to three years, the management should take a call of converting debt into equity or equity into debt. Why would any management incur the cost of engaging with the financial markets until and unless it comes with the agenda of growing size or making an acquisition ? Some autonomy in determining the debt to equity ratio should be in-built and hence could be a powerful signals to hare-brained volatility of the markets. 

Can Financiers take a Hippocratic Oath ?

Equity market is a set of balloons (sector-wise) tied to the bedrock of debt. Debt should be flowing easily enough for the balloons to distend a bit more. That is debt should pay from the economy’s cashflows. Debt can choke on itself and clog the economy if it crosses sustainable limit and if it is not paid from the economy’s cashflows. Rarely do analysts believe debt to exist beyond individual balance sheets. But debt exists everywhere and one needs to knock off the excess above the sustainable limits against the entirety of market capitalisation. (If measurement of debt is a problem, banks can be asked to declare the total debt originated and outstanding against each unlisted / listed company and within conglomerates against each individual business. This is a measure that will help banks to become self-prudential.)

To carry the argument to the sectors, even consumption is backed by (government and private) debt although the individual FMCG company balance sheets and automobile corporate balance sheets are mostly free of debt. The lenders and the stock market have a right to know the financial performance of all players in a sector. And they should knock of the excess debt above sustainable levels against the sector’s performance. This penalises the sector where the new entrants are creating the competitive stress by taking on unwarranted debt, and rightly so. The Hindu Shastras say that individual’s tragedy, stress and unhappiness has to be shared socially and so it should be logically carried into the sector’s performance. Then determination of multiples is a matter of regression. Cannot say what McKinsey thinks on this kind of valuation. Probably if they would concur, they would give us adjustment of capital flows in the economy.

The strangeness of this theory surfaces when we apply it to the banks. They originate the debt, and due to competitive pressure of selling debt are most vulnerable. The central bank should calculate and note the sustainable level of corporate debt in each sector and not allow banks to go beyond it. The market cap of housing sector finance should be adjusted for the excessive mortgage debt, and it is here that the maximum impact is likely to be found. Currently some people think that the banks need to be breaking up, but there is no need if we agree that the exposure can be capped sector wise.

The stock market has a distant / volatile wealth effect compared to the real estate for those who can afford to own it. Especially both stock market and real estate are dependent on the level of debt in the economy. Most likely the sector will end up having zero market cap. So the listing of real estate corporates on the stock market affords some bit of ridicule at the expense of the stock market.

When we read the theorists of the credit market they are heavily dependent on statistics and lightly dependent on the macro-prudential framework. They pretend like the five blind men of Hindoostan feeling an elephant because they are directly / indirectly paid by the banks themselves. When the central banks are targeting inflation and inflation is seen helping loosen/ shrink the millstones of debt, the fact is that they are know about the macro-prudential theory in private but do not bring it out in public domain.

The banks have too much access to data for any non-bank to compete effectively. Hence the banks have to be banned from the stock market. One with stricter moral standards can even ask the banks to de-list because listing of debt originators is tantamount to having your cake and eating it too.

In developing countries, governments have there are two liabilities, infrastructure and pensions. Infrastructure is something that can be mostly done by the state government and local government provided the population has an appetite for it. Technically pensions is part of government’s debt and hence has to be knocked off the total market cap in case it is above the sustainable level.