When capital matters

Forbes Interview with Robert H. Singletary

(see Armenian version here)

F. Does the Armenian economy being so small and already quite well-financed by banking sector, really need a capital market as a source of financing for the real sector?

Any financial system that consists only of banks is one-dimensional. And while a strong banking sector can help grow a country’s economy to a certain level there is an inherent limit on that growth. This is because the banks, almost by definition, can only extend credits (debt financing) to the real sector. And there is in turn a limit to how much leverage any company can take on. Once a company’s debt-to-equity ratio becomes too high that company becomes unstable – any shock to their business can result in a failure to honor the high debt service obligation and bankruptcy becomes a real possibility.

What a capital market does is to supply many more choices of financing. It can – just as the banks do — supply debt financing to companies (in the form of bonds). But more importantly it can provide equity capital that builds the financial foundation for a company. These shares can be common shares that carry with them the right to vote, or preferred shares that generally do not have voting rights but carry a fixed dividend and are senior in rights to the common shares. The capital markets also open up the possibility of paying employees with share options, providing huge incentives and helping to attract better management talent. The banks simply cannot offer any of these extra choices.

F. Even if the theory is correct, has Armenia really reached this point?

Today several Armenian companies find themselves having outgrown the banks. They are successful and generate a high degree of revenue relative to their financial resources, but they have hit their debt-to-equity ratio limits. In other words, the choice offered by the banks is no longer attractive to them or even responsible to follow.

A recent World Bank study of the 105 largest Armenian companies showed that:

• 13 companies had D/E ratios greater than 10! These are failures waiting to happen unless they can get their leverage down by injecting more ownership capital. Imagine these companies – from a financial stability viewpoint – as inverted Egyptian pyramids.

• 20 companies had D/E ratios between 3 and 9 (a D/E of 3 being a generally accepted leverage watch point). In order to grow, these companies need equity financing through selling shares, not more debt.

• 15 more companies did not have excessive leverage but still needed to grow. They of course would have the choice of taking more bank credit or going to the capital markets to raise more funds, either in the form of bonds or shares.

So out of the top 105 Armenian companies 33 can be said to have outgrown what the banks can offer and 15 more have the need to raise more funds, perhaps through the capital markets.

F. In the current Armenian situation with banks also participating in the capital market, there’s a certain conflict of interest within banks. For example, they’re more likely to offer their corporate customers loans for financing rather than issuing corporate bonds. What should be the way of handling this conflict, or should it be addressed in any way or not?

Clearly the banks – operating as banks – have different goals than banks operating as investment firms. The banks acting as banks want to offer credit. And the truth is in Armenia, except for maybe one or two banks, they have little interest in pursuing any real investment firm business. So yes there is a conflict of their internal business directions. But also this can spill over to damage the banking clients themselves. If for example a client company is already highly leveraged and the bank (given its own interests) nevertheless recommends more debt, then the customer is harmed. Adding more debt to a highly leveraged company is like pouring benzene on the fire. If however the bank is serious about operating as an investment firm and recommends an equity offering then both sides are benefitted. The company gets the financing it needs and the bank still makes revenue through the offering. The problem is that the revenue from lending is higher than underwritings – but that is a whole other topic for another day.

F. But can’t the bank solve the conflict by simply dividing itself into two separate operations that compete against each other?

Yes and no. The other aspect of this dilemma is that the commercial banking culture is different than the investment banking culture. I have known very few bankers who can operate successfully in both “gears”. And so there very often is a simple inability of the commercial banks to embrace and succeed in the investment banking industry. One of Armenia’s banks has adopted the approach you suggest. Let us see how it works out.
For Armenia the question is not so much what the banks are doing (or not) in this sphere, the question is the absence of a “level playing field” for the non-bank-owned investment firms. There are several well managed investment firms in Yerevan not connected to any bank. But they are operating with some severe constraints imposed on them by the system. Chief among these is the inability of the non-bank investment firms to be direct members of the payment system. In this regard alone the banks enjoy a monopoly of access that results in lower operating costs for them. The non-bank investment firms, regulated by the same CBA, must nevertheless perform their fund transfers through a bank or the depository. Imagine being required to pay your competitor a fee just so you can use a government-owned system where your competitor is allowed to be a member, but you are not! And this is not the only example of how the banks operating an investment firm are treated differently (and to their advantage) than the independent investment firms. It is a matter of attitude that could be resolved.

F. Having quite a high level of shadow economy in the country, do you think it is feasible and realistic for companies to go transparent and issue securities?

I have found that there are generally two styles of business management in this part of the world, born during the Soviet days and continuing up to the present. First, there is the company built up by one person or a small group or family. They have built the business under a hostile environment. They like privacy. It has protected them well over the years. They like control; they cannot be expected to sell voting shares. These are not candidate companies for the capital markets. And those persons interested in “converting” these managers to the ideas of a capital market are – in my opinion – wasting their time. Second, there are companies whose management comes from a different generation. They may have been educated in a different system. They probably still recognize the dangers of government corruption but they are willing to take a hard look at the benefits and drawbacks of taking on the transparency obligations. Chief among these is the access to less expensive capital. Another benefit is higher recognition within the general public and the marketing advantage of that. So this second group is the better prospect for participation in the capital markets.

One group where there would seem to be no drawback in tapping the capital markets are the companies already required to issue public financial statements and to make annual reports. These are the banks and insurance companies. They already live under transparency requirements so they are not giving anything up when they decide to raise monies through the securities market.

F. What can be the way forward for developing the capital market development in Armenia? What can be done to raise the interest of real sector to come to the capital market?

The biggest obstacle to the development of the capital markets in Armenia is not the private sector, it is the government. I am not talking about negative attitudes; the CBA has been trying for years to support the securities market. It is the fact that the rates on treasury securities are so high that this “crowds out” the ability of the real sector to issue bonds – or even to some degree issue shares. With 2 year treasuries yielding above 13.5% and 5 year treasuries above 15% it is simply undesirable for the real sector companies to issue bonds at higher rates. And this treasury yield also impacts what investors demand for purchases of shares in terms of the dividend. Even if a company decided to issue bonds at these rates or shares with these kinds of dividends it would not seem they would be around for long thereafter. Who can borrow at 17%, pay their taxes, pay the VAT and customs and still make a profit?

Robert H. Singletary is an international development consultant specializing in financial sector matters. He has worked in 14 countries, either in short-term or resident positions for clients such as the World Bank, Lux-Development (Luxembourg), the FIRST Initiative and USAID.

He was appointed the first Chairman of the National Securities Commission of the Republic of Georgia by President Shevardnadze. From 2006 to 2008, he served as resident Director for the Armenian Financial Sector Development Project focusing on capital markets, banking, insurance and pension. Since then he has been part of several donor sponsored projects consulting with the CBA and private sector participants on the development of the Armenian capital markets.

Source: http://www.forbes.am/am/featured/U613Q9JV8H1V1794