June 2007
Economy & Policy

By Madhukar SJB Rana

A veritable managerial revolution is taking place throughout Asia . This is added to the revolution that had already taken place with the ushering in of a distinct ‘Japanese style of management’ that has gained global recognition, since the 1980s, for its contribution to the art and science of management.

The whole world has learnt aplenty from the Japanese, for example, on leadership; total quality management; participative process management; inventory management and not least on strategic management. What most impressed this author about their style is the recognition that managers must be after not just ‘economies of scale’ but also ‘economies of scope’, where, indeed, even the small can be competitive and profitable at the same time while maximising choices for consumer satisfaction without compromising on the goal of profit maximisation.

A solid indicator of this new dynamic revolution across the Asia-Pacific is the unprecedented demand for MBA degrees in business and management in the entire region. Students’ demand for placements far exceeds supply. Nevertheless, the US produces around 80 per cent of all the MBA graduates and leads the field, by far, with its own home grown ‘American style of management’. In the UK , MBA courses have grown by 35 per cent in the late 1990s and it is one of its main exports. Yet, one does not speak of a ‘European style of management’. So dominant is American managerial practice in Europe .

It is estimated that in the US , in 2004, the share of business undergraduates rose to 21 per cent from 14 per cent in 2001. Almost 25 per cent of all masters’ degrees granted is the share of MBAs as compared to only 11 per cent in 2001. Foreign students account for 25-30 per cent of the MBA student in the US .

Whereas only 10 per cent of American CEOs and founders of companies had MBA degrees in the 1960s, it is now over 60 per cent. The growth has, indeed, been phenomenal. There is a market and the product is the determining factor. Supply is the critical constraint everywhere, even here in Nepal . In China there are 80 MBA schools with 40 run in partnership with Americans.

In India there were just 82 business schools in 1982. Now they are facing a short fall of at least 50 business schools to meet the demand. So much so that Indian management gurus and professors, serving abroad, are returning to start their own schools there, especially in south India . India is said to have 1,000 business schools in 2003 with a total enrollment of 72,000 students with around 500,000 applicants seeking admissions.

Why the boom globally? The fundamental reasons are career and income enhancement. The driver of the growth in East Asia is the E-MBA degree where 75 business schools from around the world are engaged in offshore education in collaboration with local universities and colleges (e.g. INSEAD, IMD, Columbia , London , Wharton, Kellog, Chicago, Cranfield etc).

Yes, the growing popularity of MBA degrees will definitely enhance the societal role of entrepreneurs and managers. Arising from this growth phenomenon, the culture of democracy prevailing will deepen in Asian societies by counterbalancing the excessive hold on our current lifestyle dominated by politicians, administrators, landlords and NGOs and the lack of institutionalisation of markets and market forces.

This is the real revolution taking place in Asia , especially South Asia . After all, it is the entrepreneurs and managers who are the vanguards of economic growth and social modernisation leading to industrialisation and urbanisation—the greatest harbinger of structural societal changes. These forces, consequently, will lead to the shedding of the proverbial ‘feudal mindset’ that saps our creativity, innovation and sense of professionalism.

The greatest threat to the MBA programme is its commercialisation. It has been described, by the UK Economist (2004) as being “vague, shifting, rather formless”. Hence the fundamental need for a definite curriculum strategy pursuant to each institution setting out, after rigorous brainstorming for strategic planning, its purpose, vision, mission, values, goals and objectives.

This is precisely what the newly-found South Asian Institute of Management (SAIM) has consciously, collectively and collaboratively with the Kathmandu University undertaken as seen from its website ( www.saim.edu.np). SAIM seeks to produce entrepreneurial and managerial leaders who will serve to act as agents of social change in Nepal as well as producing managers to work in South Asia and the emergent South Asian MNC. Towards this aim, SAIM hopes to sponsor young academic talent to do their PhDs in the quest of the South Asian style of management in foremost international universities.

The other critical challenges facing all business and management schools today could be core issues as follows: what mix of skills, knowledge and ethics to incorporate in the emerging scenario of globalisation and regionalisation? The late Professor Sumantra Ghosal of the London Business School had, as early as 2005, raised the issue of the lack of “any sense of moral responsibility” (Economist; May 2007) by business schools. This sounds true when one considers the fact that the notorious CEOs of Enron and WorldCom were distinguished Harvard MBAs.

Yet one more burning issue is this: should one deliver a one-year MBA as in Europe or the two-year MBA as in the US ? A distinct ‘American MBA’ (offered by Harvard, Kellogg, Manchester and even London etc) and ‘European MBA’ (offered by IMD, INSEAD, Ashridge , Michigan etc ) have emerged. The intellectual contest is over how much academic rigour is required in the curriculum (hence two years) and the issue as to the role that real-life business learning and experience itself can play in management education for garnering practical skills. Pros and cons of each type must be well understood and considered by all South Asian schools of management. The Indian Business School in Hyderabad has pioneered the one-year MBA and its success is bound to impact all, sooner than later.

The excessive emphasis on teaching practical skills has been criticised for its shallowness due to its lack of good grounding on theory that provides the very foundation for life-long learning. Yet, the great pitfall in the US academic curriculum is the emphases on models and crunching of numbers that are far removed from reality—while being academically elegant and sophisticated it could suffer from ‘analysis-paralysis’.

Some critics lament the fact that far too much emphasis is given to the ‘science of management’ while neglecting the ‘art of management’ (Prof. Henry Mintzberg of McGill University , Canada ). While others suggest that the curriculum lacks rigour because the profession is not as developed as law, medicine and religion. And for that to happen, MBA products must learn the art of ‘renunciation’ towards the pursuit of social good and responsibility and not just profit maximisation. Hence courses, it is suggested, must actively seek to change the values, attitudes and behaviour of students upon entering business schools (Prof. Rakesh Khurana of Harvard University) similar to the noticeable behavioural changes as occurs when one enters and leaves a military academy, for example.

Such is the state of art or science in management education. The Economist (2007) reports that recruiters find that only 20 per cent of the international executives polled thought that MBA degrees prepare people for real-life management. This is indeed a startling observation. It would be ideal if SAIM, together with KUSOM, could join hands with other MBA schools and, with the financial support of the ILO, get to exchange experiences and obtain feedback from our business community as to what they really expect from management and business courses.

We could start this university-business dialogue in Nepal with the insightful thoughts of Professor Niren Vyas of South Carolina University , who told us at SAIM recently, that as per the latest dialogue between academia and business in the US , seven fundamental attributes were identified and curriculum changed accordingly.

Namely, how to be: (a) a global thinker; (b) a critical thinker; (c) entrepreneurial; (d) a change agent; (f) a good communicator; (g) a team player and (h) an excellent problem identifier and solver. In keeping with South Asian ethos, he added two more attributes (i) spirituality or listening to one’s inner voice as ethical codes are, to him, insufficient since ethical behaviour varies from one culture to another and, finally, (j) to be a lifelong learner that imbibes learning from observation, reflection and experience; that knows how to distinguish knowledge from wisdom inherited from past centuries. These are the life-jacket, as it were, for coping with the rapid change in the information era.

Interestingly, Vyas reported that in an international academic management education conference in Australia in 2006 it was felt that if business schools could teach their students to ‘learn how to learn’ during their college years they would have done their job for meeting the challenges of the unfolding knowledge society of the 21 st century.

(Rana is a former Minister of Finance)

Credit Derivatives:
Great Potential for Nepali Financial Sector

By Promod Pandeya

Apart from the general Credit Risk Management, Credit Derivatives can be a useful tool for Asset Liability Management (ALM) for Banks and Financial Institutions.

During recent times, banking literature in Nepal has been concentrating on the proposed BASEL II and WTO regime and their implications on the domestic financial system. There shall be no doubts that these are the important aspects for the future of the domestic banking industry. While, banking honchos are continuously brainstorming on the various facets of these developments, Credit Derivatives, which are becoming increasingly popular globally, doesn’t seem to have captured the attention of the Nepali banker to a great extent.

This article seeks to give the broad features of some common Credit Derivative products and their implication on credit risk and ALM management.

Types of Credit Derivatives:

In the market, we can generally find three major types of credit derivatives viz:

 Credit Default Swap (CDS)

 Total Rate of Return Swap (TRORS)

 Credit-Spread Put Options

 Collateralised Debt Obligation (CDO)

Among these instruments CDS is the most widely-used derivative, which reportedly accounts for around 80 per cent of the global transactions in the segment.

Credit Default Swap (CDS):

A CDS is defined as a privately negotiated contract in which one party, usually known as the protection buyer pays a fee or premium to another, generally referred to as protection seller to protect himself against the loss that may be incurred on his exposure to an individual outstanding credit as a result of unforeseen development. The development is referred to as a “credit event” indicating the borrower on which the CDS has been written is unable to honour his obligation.

The following figure illustrates the operational mechanism of a CDS.

Total Rate of Return Swap (TRORS):

As the name suggests, a TRORS transfers the returns and risks on an underlying asset from the Total Return Seller to Total Return Buyer. In fact, it is a customised transaction, which allows the transfer of the total economic performance of a specific asset or a portfolio of assets from the seller to the buyer in lieu of designated return and risk.

The following figure illustrates the operational mechanism of a CDS.

Credit-Spread Put Options:

A credit-spread put option is a contract in which the pay-out depends on the spread irrespective of the reasons of the movement of the spread. The spread put buyer pays a upfront fee or premium to a spread put seller in exchange for a contingent payment if the spread breach a mutually agreed threshold limit.

The following figure illustrates the operational mechanism of a CDS.

Collateralized Debt Obligation (CDO):

CDOs are a way of bundling credit exposures and selling it off to various interested counterparties depending upon their risk -return profile. For this, credit exposures with different risk-return profile are bundled together and assigned to a Special Purpose Vehicle (SPV). The SPV, in turn, splits the bundle in the small tranches and sell them to prospective investors. Financial institutions having exposure in Consumer Credit can reap the benefits of CDO to a great extent.

Important Aspects of Credit Derivative:

Premium:

The premium price or fee is what is charged or earned by the protection seller. It is quoted in basis points per annum of the contract's notional value.

Size of the Credit Derivatives:

Although there is no such specified size of Credit Derivatives, we find them ranging from a few millions to several billions of dollars with maturities ranging from one year to many years. But most commonly, these instruments range from $10 million to $20 million with a maturity period of five years.

Pricing of Credit Derivatives:

We neither have a robust theoretical model nor a rigorously tested empirical model to price the Credit Derivatives. However, pricing depends on various factors like maturity of the instruments, probability of defaults, credit rating of the Swap counterparty, expected recovery value etc.

Settlement:

The settlement of a claim made by the protection buyer is done either by physical settlement or cash settlement depending on the terms of the contracts entered into.

In case of physical settlement, the protection seller agrees to buy the distressed loan/asset at a pre-determined price/par. This distressed loan/asset is known as the "deliverable obligation". This is the most common means of settlement in the CDS market and will generally takes place within 30 days after the "credit event".

In case of cash settlement, the protection seller pays the buyer the difference between the notional value of the distress loan/asset and final value of the same loan/asset. This settlement typically takes place within five business days of the credit events triggering payment.

Credit Events:

ISDA defines following events that will trigger a payment by the protection seller in the Credit Derivatives market. These events are:

Bankruptcy:

This refers to counterparty's insolvency or inability to honour outstanding obligations. This is the most visible event that triggers the payment on Credit Derivatives.

Failure to Pay:

This is the situation when the counterparty fails to honour the outstanding principal or interest in the stipulated time period including the grace period.

Obligation Default:

This covers the situation other than failure to pay, where the relevant obligation becomes capable of being declared due and payable as a result of default by the counterparty.

Moratorium:

This covers the situation where the reference entity or the government authorities disaffirm or otherwise challenge the validity of the relevant obligation or if the entity or the government authorities stops payment on such an obligation.

Payment Procedure on Occurrence of a "Credit Event":

The mere occurrence of the credit event is not sufficient to trigger the payment in case of Credit Derivative. A "credit event notice" indicating that trigger event has taken place must be served in respect of any transaction before the credit protection becomes payable. Furthermore, two sources of publicly available information describing the occurrence of the credit event must be provided. In case the transaction is to settle physically, the protection buyer must serve a notice of intended physical settlement.

ALM and Credit Derivatives:

Apart from the general uses for credit risk management, Credit Derivatives can be a useful tool for ALM of banks. Banks who follow strategies based on Gap analysis will be concerned about certain rate sensitive assets or liabilities. Credit Derivatives provide another additional tool for the banks for their ALM.

Conclusion:

Even in the Indian financial system, Credit Derivative market is in a nascent stage. So, at this stage, it will be extremely hypothetical and pre-mature to draw the conclusion about the prospect of Credit Derivative in the Nepali turf but alarming level of the NPA, credit indiscipline by the borrower as well as banks/ financial institutions and proposed Basel II regime amongst others force us to rethink introduction of these instruments in our financial system. But before all these, the Nepal Rastra Bank and other regulatory agencies will need to frame clear guidelines for the development of a Credit Derivatives market. These guidelines need to be flexible according to domestic needs while taking care of potential misuse of these instruments. In fact, I understand it as a great challenge.