There is always more to come
- vanshikamalpaniblo
- Aug 10, 2022
- 7 min read
Updated: Sep 1, 2023
Sundar Pichai is popular for sharing interesting anecdotes from his personal life with valuable lessons. In one such speech he traces this fascinating theory, where he alludes how he was sitting at a restaurant when he saw that out of the blue a cockroach flew and sat on a lady. Panic stricken, the lady screamed at the top of her voice and tried her best to get rid of the cockroach. To her relief, the cockroach flied away but now sat on another lady. This lady too made sure she screamed enough to scare the cockroach away. It flied and sat on another lady. The drama continued. This made Mr Pichai wonder how‘The Cockroach Theory’ applies to human beings in self-development, behavioural finance, and economics.
The Cockroach Theory by its name sounds so peculiar, too hilarious to be called a ‘theory’ in behavioural finance and economics. However, more shocking than the name of the theory is the fact that it has ability to incur long run damages from bank runs to depressions to global financial crisis. An article from The Hindu outlined this theory as a phenomenon that “companies that report unexpected bad news to their investors may report even more negative news in the future”. Just like when we discover an unwanted cockroach say in the kitchen which suggests that there may be more cockroaches hiding somewhere, the bad news serve as a warning signal that suggests there may be more bad news upcoming. This theory becomes important for businesses to analyse the effects of negative news shared with a ‘rational being’, who is more than often, ‘not so rational’.
On a macroeconomic level, The Cockroach Theory becomes a cause of concern because of the ‘trickle-down effect’ that it has the power to create in the economy. Every corporation is affected by internal and external causalities and if one company announces a negative news caused by an external cause, more so than often, other companies belonging to the same industry are not immune to that cause which poses a question of concern. This leads to greater government interference, who start investigating and scrutinising financial books of the companies in that sector. More importantly, this uncertainty leads to lowering of investor’s confidence, and if the news if negative enough, they would not hesitate to unload the shares of the companies of these sectors. This causes prices to fluctuate and leads to dampening effects in an entire sector, disrupting the economy. Thus, this theory proves to have far reaching consequences both on a micro (because it affects that particular company) and on a macro level. It is practically impossible for a cockroach to bite us to death, but after understanding The Cockroach Theory, can they?
This flowchart explains the effects of The Cockroach Theory in the economy-
crisis of confidencecrisis of liquiditycrisis of bankruptcy
Examples of The Cockroach Theory in work are numerous. To take up a famous case, the Enron Scandal in late 2001,the biggest corporate bankruptcy to ever hit the world at that time and the largest audit failure can be traced to our theory. This is a story of the ‘riches to rags’ of the Wall Street darling which shook everyone to the core. The New York Times cited that when at its peak, the shares were trading at $90.75 which plummeted to $0.25 at the time of the scandal. A complaint to the US Securities and Exchange Commission revealed that the top leadership basically made a fool out of everyone by off the book accounting practices (MTM- Mark to Market accounting), SPEs (Special Purpose Entities) and fake holdings to hide the mountain of debt that the company was crumbling over. This is where the cockroach comes in our story. The investors started losing confidence, selling their shares which led to more negative news, and it turned into a ‘vicious cycle’. The fall of one of the biggest US corporations because of malpractice and accounting fraud implied that other corporations, metaphorically more cockroaches may be involved in similar kinds of fraud. This was indeed true. BBC reported that Arthur Anderson accounting firm was guilty of similar charges. Over the course of time, WorldCom, Tyco, and Adelphia were brought down as well. Not only this, but the government also went on to implement the Sarbanes-Oxley act of 2002 to make accounting and audit regulations more vigilant. The Wall Street could not keep their calm seeing this cockroach therefore, the trickle-down effect from a macroeconomic perspective came into play.
Whenever we think of the greatest economic adversities to have hit the world, the 2008 global financial crisis tops all lists. It is fascinating to see how this crisis was triggered by The Cockroach Theory at play. Lax lending rules(this credit goes to the Federal Reserve which deviated from its main role to maintain financial stability and focused on keeping interest rates extremely low), cheap credit and excessive risk taking by the banks that led to the burst of the real estate bubble crumbling the entire economy. A publication by The Harvard Business School examines the case study of New Century Financial Corporation, one of the largest subprime loan originators and how it fuelled the 2008 crisis. After enjoying years of rapid economic progress, the financial company started facing liquidity issues, a classic case- because of an increase in the number of defaulting borrowers, bad loans and NPAs (non-performing assets). It was forced to file for Chapter 11 bankruptcy protection and became the first contributor to the subprime mortgage meltdown. The existence of this cockroach hinted towards the existence of other cockroaches which was ultimately true. Reuters elucidates what New Century said in a court filing, “Without a prompt sale of the debtors’ mortgage loan servicing business and loan origination platform, those businesses will not be viable, and the value will be destroyed”. Another cockroach- American Home Mortgage Investment, was the next to tread its footsteps and declare bankruptcy followed by many other cockroaches. According to the Bankruptcy Examiner assigned to investigate New Century, the company's troubles "were an early contributor to the subprime meltdown" increasing government intervention, forcing banks to take losses around $250 billion in mortgage-linked securities and fuelling international financial crisis. Here too, The Cockroach Theory fits in perfectly leading to the viscous cycle of bad news and trickling down effects in the economy.
An interesting view to ponder regarding this theory is how the failure of one company may negatively affect other companies even if other companies have good financial books. Oliver Blanchard, a French economist said that “Fear that a bank will close can actually cause it to close”. This is The Cockroach Theory and behavioural economics at work again. If one bank fails because of the negative news that bad loans have increased, it causes depositors of other banks to panic and withdraw their money as well forcing other banks to close. The discovery of one cockroach creates enough fear about the existence of other cockroaches which causes havoc among the public. The US financial history in the 1930s is full of such bank runs. The first of the bank runs were in Nashville, Tennessee which kicked off a series of bank runs. Around 650 banks failed in 1929 and the number rose to a whopping 1300 the next year. New York’s bank, which had more than $200 million deposits fell as well, making it the single largest bank failure in American history. The increase in the money demand in lieu of the deposits reduced the money multiplier effect which reduced the money supply and spending, dragging the economic growth for years to come. According to Ben Bernanke, the former US Federal Chairman, it was essentially the Federal Reserve System and the economic damage caused directly by bank runs that triggered the Great depression, which had staggering impacts worldwide. This is the power that our small cockroach has which at one point of time caused the largest economy of the world to dig into the deadly shallows of the Great Depression.
Interestingly enough, I see The Cockroach Theory work in the banking crisis that India is facing currently. While RBI has been cleaning up the cooperative banks for a while now, the crisis at the large Punjab & Maharashtra Cooperative bank, a cockroach in the present banking crisis had led to renewed attention. The collapse of PMC, because of fraudulent transactions to HDIL through fictitious accounts and violating banking regulations exposed the presence of other cockroaches as well. Upon investigation, it was found that PMC was not the only cooperative bank to default.Moneycontrol elucidated that RBI cancelled the license of CKP Co-operative Bank because of the mounting NPAs(approximately 97%).Restrictions were also placed on Bengaluru-based Guru Raghavendra Sahakara Bank Niyamitha and Kolkata’s Kolkata Mahila Cooperative Bank. RBI also cancelled the license of Mapusa Urban Cooperative bank for financial failure. More so importantly, fear of the failure of the private sector banks can have devastating effects on the economy. The Indian forum cited, “These banks were licenced amidst huge hype and expectations, yet nearly half of them have run into financial trouble.” The case of Yes Bank wasextremely shocking which is the next big cockroach in our story. Despite once being a cynosure of Indian banking system, this bank was unable to raise capital because of the growing losses in NPAs leading RBI to bail them out. We have already detected a few cockroaches biting the banking system of India and both the RBI and the government of India are equally responsible for the same. The former Finance Minister Mr P Chidambaram said,“First, it was the PMC Bank. Now it is Yes Bank. Is the government concerned at all? Can it shirk its responsibility? Is there a third bank in the line?” The banking crisis has exposed the lack of governance and the need to revise the Banking Regulations Act, 1949(another revised version after 1960) to bring some stability into the system and keep up the investor’s confidence.
Coming back to Sundar Pichai’s observation at the restaurant, we can relate to this theory on apsychological aspect as well. He explained it beautifully in a speech, “It is not the cockroach, but the inability of the ladies to handle the disturbance caused by the cockroach that disturbed the ladies. I realized that, it is not the shouting of my father or my boss or my wife that disturbs me, but it's my inability to handle the disturbances caused by their shouting that disturbs me. It's not the traffic jams on the road that disturbs me, but my inability to handle the disturbance caused by the traffic jam that disturbs me. More than the problem, it's my reaction to the problem that creates chaos in my life.” Through this we should learn the lesson that instead of reacting, we should always respond, whether dealing with finance, economics, or life.
REFERENCES AND FURTHER READING
7. Oliver Blanchard - Macroeconomics (2017, Pearson).pdf(Chapter 4)
Interesting read!