Can crooks improve governance?

We have always regarded our businessmen as crooks, and foreign companies as more trustworthy, warts and all. The stock markets have always given foreign companies higher valuations than comparable Indian ones, believing that foreign companies are less likely to cheat.

Should this perception change after mind-boggling corporate scandals involving the biggest multinationals and investment banks of the world? Enron, Arthur Anderson, and WorldCom have gone bust after revelations of skullduggery. The latest scandal involves the biggest firms of Wall Street, which produced reams of bogus research to trap ordinary investors into buying shares of dodgy companies whose new issues they were managing for a fat fees. A top analyst of a Wall Street firm called a company POS (piece of shit) in an internal memo, yet later recommended it to investors as an excellent buy. Between 1999 and 2002, two firms belonging to JP Morgan Securities made payments of $1.3 million to other banks to write bogus reports praising new issues that they underwrote. US Bankcorp Pipar Jaffray, Morgan Stanley, Bear Stearns and UBS Warburg made similar dirty deals.

US authorities investigated the 10 biggest Wall Street firms. The Terrible Ten have now settled out of court, paying $1.4 billion. They have also signed a pact promising $432 million over five years for independent research, and stop dubious practices like bribing CEOs with shares in hot new issues. Two top analysts, Grubman and Blodget, have been barred from the securities business.

This will not end wrong-doing. But the stars of Wall Street have, not for the first time, been pilloried and penalised. They know they are in the public gaze, and that improves conscience and behaviour.

What does this imply for India? No matter how crooked the top Wall street firms are, they can help improve governance in Indian markets. First, they will create pressures to improve operating conditions in India to global standards. Second, they will bring higher standards of governance because they will worry about being jailed for misgovernance in the US, whereas Indian firms have virtually no fear of being jailed by slow courts. Third, Wall Street firms bring additional competition, which benefits common investors.

Until very recently, Indian stock markets were dicey places. Promoters of companies disappeared without trace after a public issue. Controlling families of companies siphoned profits off the books at the expense of ordinary shareholders. The Bombay Stock Exchange was replete with price-riggers and crooks who enriched themselves at the expense of investors. One-tenth of all share certificates were forged. The delivery of shares could take months.

When foreign institutional investors (FIIs) entered India in the early 1990s, they said it was impossible to do much business in such an environment, and asked the government to upgrade this to global standards. They sought this for their own selfish ends, but the end result aided all investors. The National Stock Exchange came up as a world class rival to the Bombay Stock Exchange, with computerised trading that made price rigging through telephone calls impossible. Paper shares were dematerialised into electronic shares, ending forgery. Delivery was tightened and expedited to happen two days after purchase. The Bombay Stock Exchange was forced to imitate the high standards of the National Stock Exchange to survive. The net result is that India today has one of the best and most modern stock exchanges in the developing world, Ketan Parekh notwithstanding.

Second, FIIs have brought in higher standards of research, and forced companies to provide more pertinent information on a regular basis. Companies that fail to live up to their profit predictions are penalised heavily by sharp falls in their prices, a sea change from the bad old days.

Finally, competition has improved governance. In the bad old days, the UTI dominated a thin, riggable market. The UTI could not dump wholesale the stock of any group no matter how crooked — there was too much political pressure. But the FIIs ended the quasi-monopoly of the UTI and brought in competition. Unlike the UTI, they dumped wholesale the shares of companies with suspect practices, whose prices crashed. And they paid premium prices for companies with a reputation for good governance. They did this for their own self-interest.

Yet the result was that, for the first time, the stock market began to systematically reward promoters with good governance over promoters with political connections or the ability to rig markets. Many Indian companies still cook their books enthusiastically, but are easily recognised by the low price-earnings ratios the market gives them.

What this shows is that competition, even between crooks and semi-crooks, can improve outcomes for ordinary investors. What FIIs sought was improved trading conditions for their narrow self-interest. Yet in the process they improved conditions for all investors, and helped push our stock markets to become among the best in Asia.

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