Niveshak November 2009

NIVESHAK THE INVESTOR



VOLUME 2 ISSUE 10

GREEN SHOOTS IN INDIAN ECONOMY PG.09



NOVEMBER 2009

SYSTEMATIC RISK FINANCIAL REGULATION pg. 17

FROM EDITOR’S DESK Niveshak Volume II ISSUE 10 November 2009 Faculty Mentor Prof. S.S Sarkar

THE TEAM Editor Biswadeep Parida Sub-Editors Amit Choudhary Nilesh Bhaiya Sareet Mishra Sujal Kumar New Team Bhavit Sharma Durgesh Nandini Mohanty Hitesh Gulati Sumit Kedia Tanvi Arora Upasna Agarwal Design Team Bhavya Aggarwal Sarvesh Chowdhury Swarnabha Mukherjee Tripurari Prasad

All images, design and artwork are copyright of IIM Shillong Finance Club ©Finance Club Indian Institute of Management Shillong

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Dear Niveshaks, As the Sensex kisses the 17,000 mark and the DJIA fiddles with the 10,000 level, it may seem that the Bull which almost seemed to be resting in peace for the past six quarters, has returned. Economists and Analysts have started to have a short look back at the reason of the crisis, a deep look at the extent of its effect on the world economy and a long look at the road to recovery ahead. But in this discussion, did we notice one thing – Recovery is taken for granted. Can we afford to take this as granted? Let me throw a word of Caution. Huge bailout packages, lowering of interest rates and opening of multiple liquidity windows to flush out the menacing bear from the markets has created a huge problem. Firstly, this has pushed most of the countries into a severe fiscal deficit, in the 8-10% range which may take governments a couple of years to bring them down to 2-3% range. This can have fatal impacts leading to lesser government spending in the next few years leading to lower growth rate. The value of major currencies with the dollar has been very volatile over the past few months. Problems with huge inflow and outflow of money, heavy volatility in currency values, fiscal deficit prevailing in most of the countries may lead them to taking drastic measures on capital account convertibility. So the possibility of a Currency bubble also may not be ruled out. The billions of dollars bailout packages rolled out in the west found greener pastures in the emerging economies. As a result, these economies defied earnings positions of companies & negative market forces and continued to rise up since March’09. The BSE Sensex for instance was trading at 8-10 times P/E during the recession is now trading at 21 times P/E. This can be attributed to the formation of an asset bubble in the emerging economies. When liquidity starts to dry out, investors will be seen running for cover pulling down the market. In its last quarterly review, Reserve Bank of India, the regulator, marked an end to the easy money era which was continuing since the recessionary times. Now credit would not be as easy as it was until now. This so-called start of liquidity squeeze may have an impact on the expansionary plans of corporate India. This month credit growth recorded single digits for the first time in last fifteen years. This is not just the case in India, many economies of the world have tried to control fiscal deficit and overheating of economy due to drastic recovery steps by marking an end to the easy money regime. Now this may stop the economy from recovering at the rate at which it was earlier expected. Earlier we have mentioned that the Chinese have set out on a misadventure of going on a buying spree and have been stock piling inventory which was then available at a very low price. Now this led to rise in commodity prices all over the world. Indicators like the Baltic Dry Index pointed that there in heavy shipping of commodities across the world. No one was wrong. But the reason was deceptive. There was not much increase in consumption in China, rather it was stock piling for future use. After a few days, the largest buyer in the commodity market will be on leave and consume from its stockpile. Now as the dust settles and the smokes clears, we join the dotted lines and one thing will become clear - The recovery in was not for real. We may fall back again but not as much as we fell last time but after that the recovery will be real. Let us wait for the best times to come back soon and in the mean time let us go through some really insightful articles that our friends from across all B-Schools have penned down. Hope you find this an interesting read. Happy Investing!

Biswadeep Parida (Editor-Niveshak)

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears no responsibility whatsoever.

CONTENTS Niveshak Times

04 The Month That Was

finsight

20 Indian Banking Profile

A Risk

Cover Story 15 The Great Run is it a bubble again?

fingyaan

11 Derivative Instruments in the Indian energy market

article of the month

17 Systematic Risk

and Financial Regulation

14 Fin-Q PERSPECTIVE

06 Agro Futures: Is it really

helping the farmers?

09 Green Shoots in Indian

Economy- Hope versus Concerns

finlounge

Niveshak Times

www.iims-niveshak.com

The Month That Was Tanvi Arora

IIM, Shillong

nies to help them reduce their debts by around Rs The last one month saw a lot of fluctuation at 60,000 crore. The Cabinet committee on Economic both the BSE and the NSE. The week ending 23rd Oc- affairs has taken this decision for 12 PSUs in which tober saw a decline of 515.20 points on Sensex (from the government share is more than 90%. Even before formulating this policy, the governthe previous week) to close at 16,810.81 points. This sharp downfall of 2.97% was majorly due to the fall ment had approved the proposal for 2 major disinin prices of the petrochemical giant RIL. Its effect vestments, from Rural Electrification Company (REC) was also visible on Nifty which fell by 144.75 points and from NTPC. The government currently holds 81.80% in REC which would be reduced to 66.8% post (2.82%) flattening out at 4,997.05. In the following week, markets plunged fur- the FPO which would raise around Rs 3500 crores. ther down due to the announcement by the RBI to REC plans to employ this money fund the on-going hike SLR rates. The BSE faltered by 5.44% to close electrification projects with this money. Market Watch

at 15,896.28, i.e. 914.53 points less than the previous week’s closing price. This was a fall of 10% from 17th October when the prices had soared up to 17,493. Similar results was reflected on Nifty as well, which ended at 4,711.70, a decline of 5.71% or 285.35 points. The major reasons for this downfall were derivative segments rollover positions and troubled second quarter results of 2 key players, RIL and Bharti Airtel. The first week of November showed affirmative signs on both Sensex and Nifty. This positive sentiment of the market was dominated by huge investments by the FIIs. The Sensex rose by 1.65%, 262 points above last week, to close at 16,158.28 points and Nifty expanded by 84.45 points or 1.79% to reach 4,796.15.

The Government has also cleared the proposal for sale of 5% of its equity in NTPC in which it has a share of 89.50% as of now. The follow-on offer would help them raise around Rs 9000 crore at current market price. Second Quarter results – Black and White As the companies declared their second quarter results ending on September 30, 2009, the market experiences a bag of some unexpected and some disappointing net profits. It turned out to be a bad quarter for the airline sector. Jet airways reported a loss of 6%, around Rs 407 crore. Kingfisher Airlines also posted a loss of 13%, reduced from Rs 483 crore last year to Rs. 419 crore.

With intense competition cropping up among telecom operators, Bharti Airtel did not perform as The week ending 13th November saw further per expectations. Their revenue increased by only rise at Sensex by 690.55 points or 4.27 % compared 9% and net profits was up by 13% to reach Rs 2,321 to the previous week to reach 16,848.83, while Nifty crore. closed at 4,998.95, up 202.80 points, or 4.23 per cent. Automobile was one sector where the comThis rise could be attributed to the increase in global markets and government’s reform initiatives. The ro- panies performed well. Tata motors reported a net bust growth data lifted the spirits of steel and auto profit of 110% to reach Rs 729 crore in this quarter. sectors. This increase was the best weekly gain in Mahindra and Mahindra also reported a net profit of 288%, a whopping increase of Rs 456 crore from the last 11 weeks. last year. Disinvestments to fund Government’s marInflation surges to 1.34% in October ket borrowings The new monthly index launched on 14th NoThe cash strapped government has decided to dilute a part of their equity in public sector compa- vember, declared a 0.50% increase in the WPI-based

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Niveshak Times

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The Month That Was inflation to reach 1.34% in October. Though fruits and vegetables became cheaper by 11%, the heightened prices of a few commodities like wheat and rice highly affected the index. An increase of 0.1% was also seen in the fuel and power category during October, majorly because of the increase in prices of furnace oil by 3% and bitumen by 1%. L&T strengthens Power sector, reduces stake in Satyam The last two weeks saw 2 major acquisitions by L&T, driving company’s growth in thermal and nuclear power sector. Immediately after bagging the Rs 6897 crore order from Mahgenco- Maharashtra for 3 super critical Boiler – Steam Turbine Generator Package of 660 MW capacity, L&T entered into another deal with the Madhya Pradesh Power Generation Co. Ltd. (MPPGCL) on turnkey basis. This Rs 1635.30 crore Balance of Plant (BoP) contract was signed for two Coal fired plants of 600 MW each. L&T faced tough competition from domestic BoP bidders for the project.

30, 2009, GVK Power and Infrastructure Ltd (GVKPIL) headed to acquire 12.2% stake in Bangalore International Airport Ltd (BIAL). Flughafen Zurich (Unique), Zurich airport operators sold 12.2% of their shares at Rs 485 crores to GVK Airport Developers Pvt. Ltd, a fully-owned subsidiary of GVKPIL. Unique still holds a 5% stake as an operator whereas GVK would center their attention on the management aspect. GVK is the largest shareholder of Mumbai Airport and works for its modernization. Acquiring stake in BIAL is a strategic move by GVK to be a part of one of the biggest airports in the country. They also intend to look out for any further stake sales by other shareholders of BIAL, namely L&T and Seimens. Essar arm issues bonds to raise funds

Essar Group’s holding company for telecom services, ETHL Communications Holdings Ltd (ECHL) issued zero-coupon bonds to raise Rs 4280 crore. The amount would be spent to finance the group’s steel and refinery businesses. Non-convertible debentures were launched in two series of Rs 2,250 crore each On the other hand, L&T is also planning to with one maturing in July 2011 at 9.15% and anothsell one-third of its 6.9% stake in Mahindra Satyam er one in December 2011 yielding 9.25%. Vodafone which would fetch around Rs 304 crores. It is being group has backed these debentures by a put option. seen as a strategic move to book profits as the mar- RBI diversifies kets recover. The Reserve Bank of India has followed the States speak about GST footsteps of the Central Banks of China, Russia, PhilThe much awaited discussion paper on GST ippines and Mexico and increased its gold reserves was released on November 10 communicating the and diversified its holdings. The RBI would soon buy proposed framework in India. The paper discusses 200 tonnes of gold for Rs 31,490 crores from the IMF. about the administrative and threshold aspects. This pronouncement by the RBI resulted in an imThere was broad consensus among various states pulsive rise in gold prices to reach a record high of on GST. The two-tier structure was proposed to en- $1,093.10 per ounce. joy concessional rates for some goods by the states, though it would raise the GST rate. The final law however, would be passed by the central government. GVK acquires Unique’s stake in BIAL A week after declaring a 45.19% increase in net profit for the second quarter ending September

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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Amit kumar

Is it really helping the farmers? XLRI, Jamshedpur

Perspective

Through a statistical study of impact of future prices on spot prices in few commodities the article attempts to resolve the debate of future of agro futures in India on farmers.

What are Agro-Futures? Every year farmers face the risk of what price they would get of their harvest. This – of course depends on the quality of harvest (which up to some extent is under their control). However, it also depends on the demand supply forces, which is absolutely not under their control. The farmers thus start the crop season under tremendous uncertainty of what price they would eventually get of their produce, which makes it difficult for them to take more informed production decisions. Enter Agro-Futures – the commodity futures market for agricultural based commodities. The farmers can hedge their price risk by getting into a futures contract at the start of the season itself. How this works is like this – say the three months futures price for sugar is Rs 2500 per 100 Kg. In a good year the farmers can get as high as Rs 3000, while in a bad year it can go as low as Rs 2000. This is an unnecessary risk which the farmer is taking up. The farmer can sell a three month futures contract at the start of the season and be certain that he is going to get Rs 2500 for 100 Kg of his produce. A brief explanation of how this works is as follows. If the actual price of sugar at the time of selling the farmer’s produce three months hence happens to be Rs 2000 – the farmers gains Rs 500 from the contract while he loses Rs 500 on the actual sale of sugar. In case the actual price happens to be Rs 3000, the situation just reverses – the farmer loses Rs 500 from the contract but gains Rs 500 on the actual sale of sugar.

(like metals) because their production is seasonal in nature. Moreover, the producers are very small players (as against the producers of metals – the big mining companies). Also, even though the price of the agrogood may fluctuate heavily throughout the year, the farmers are forced to sell their produce immediately rather than “hoard” and wait for prices to rise. Hence futures trading seems to be a good way out to protect the interests of the farmer community. The other side of the trade Wholesale buyers also benefit from this mechanism as they can lock in the prices at which they buy the farm produce – thus reducing their price risk as well. Enter Speculators! Apart from the hedgers - farmers who act as the sellers of the futures contracts and wholesalers who act as buyers of the contracts, the other important category of market participants is the speculators. In simple terms, speculators do not have any position in the underlying – they only take a certain view about the price of the underlying and thus enter a futures contract. The whole idea of a futures market is that it transfers the price risk from the hedgers to the speculators. However, commodity markets in general are attracting lots of speculators who enter it to make a quick buck. The “financial leverage” aspect of derivatives makes it easy for someone to make (and of course, lose as well) with a relatively small investment.

The hot debate! Why is this important for The matter of argument is farmers in particular? whether futures trading of agro Agricultural commodities are based commodities should be different than other commodities banned in India. One view is that the extremely high degree of speculative

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Is Futures trading really benefitting the farmers? The big question thus remains – is futures trading just being used by speculators and large corporations with no benefits to the farmers? The participation of farmers in futures trading in India is abysmally low – primarily because of the complex nature of the commodity markets and the lack of awareness amongst the farmer community about them. Moreover, the high lot sizes of futures contracts also discourages the small farmers to directly participate in these markets. The membership fees are also exorbitantly high considering the small farmers and also the daily margining requirements act as further roadblocks for those few farmers who are really interested in hedging their price risks via futures markets.

Futures trading has largely become just another asset class in an investment portfolio rather than a hedging vehicle.

Thus, futures trading has largely become just another asset class in an investment portfolio rather than a hedging vehicle. The ex- Finance Minister Mr. P Chidambaram had tried to curb this by introducing a Commodities Transaction Tax on Options and Futures – just like the Securities Transaction Tax. It has also been suggested that India should start imposing different margin requirements for hedgers and speculators – thus being more lenient on hedgers and harsher on speculators. Another possible measure that has been doing the rounds is that we should switch to “Delivery Based Forward Trading” rather than “Paper based derivatives trading”. Data analysis and interpretation For understanding the behaviour of spot prices of commodities vis-a vis their future prices, following three commodities were selected and regression analysis was performed over them. • Wheat • Tur • Urad Wheat The details about the data under considerations are given below: Commodity – Wheat Duration- 1st July 2009 to 5th Sept2009 Contract- 18th September 2009 expiry futures contract of wheat traded on MCX.

Perspective

activity in the futures market has led to price volatility in the spot market – thus negating the basic purpose of setting up a futures market. The government set up an expert committee to investigate into this. The major conclusions of the study are as follows: • The price rise in agro commodities was indeed a major reason for the inflation in 2006-07. Also, most of the food grains showed a rise in price after the introduction of futures trading for them. • However, the post futures rise in prices cannot be attributed to the introduction of futures – since the prices were very low before the introduction of futures – hence the base was low, and an increase in prices was anyway due. • No conclusion was drawn regarding whether the introduction of futures trade has caused an increase or decrease in the volatility of spot prices. However, in stark contrast to the results of the above mentioned report, a recent study carried out by the United Nations Conference on Trade and Development (UNCTAD) has concluded that futures trading in commodities does affect spot prices of the underlying. This study, however, was carried out at a global level and is not India specific. The study reveals concerns that speculators do tend to take up extremely large positions compared to the size of the market which have the power to move spot prices despite the prevalent demand supply forces. The study has thus highlighted the importance of a comprehensive regulatory framework to keep a check on the speculative activity in the futures markets.

Regression of Spot against Future prices Due to moderate coefficient of determination (R2) value (69%) and low probability –value (0.0000), influence of future prices on the spot prices of Wheat is significant and can’t be denied. This suggests Spot prices are getting driven by Futures prices to an extent but not very much. There could be also be some other factor responsible for inflation. The sample chart showing the regression results is given below: (Table 1) Coefficient

Std. Error t-Statistic Prob.

C(1)

-755.3289

166.3

-4.541118

0.0000

C(2)

1.617043

0.143

11.24145

0.0000

R-squared

0.696753

Mean dependent var

1114.2

Adjusted Rsquared

0.691239

S.D. dependent var

34.891

Speculators do not have any position in the underlying. They only take a certain view about the price of the underlying and thus enter a futures contract.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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S.E. of regression

19.38765

Akaike info criterion

8.801607

Sum squared resid

20673.45

Schwarz criterion

8.873293

Log likelihood

-248.8458

Hannan-Quinn criter.

8.829466

F-statistic

126.3703

Durbin-Watson stat

0.697448

Prob(F-statistic)

0.000000

Regressions of spot against volume of future trades Due to very low R2 value (22.77%), influence of futures trading volume over spot prices proves to be very less.

Perspective

Standard deviation comparison Standard deviation of Spot prices = Rs 34.89 Standard deviation of Future prices =Rs 18.01 Interpretation The standard deviation comparison proves that futures trading in wheat is not adding to the fluctuations in spot prices, rather it is helping in curbing the same. Hence, this can be said that future trading in wheat is fulfilling its intended purpose. Tur The details about the data under considerations are given below: Commodity – Tur Duration- 28th sept 2006 to 20th dec 2006 Contract- 20th dec 2006 expiry futures contract of Tur Regression of Spot against Future prices Poor R2 value(0.49%)and high probability figures(56.19%) suggest that Spot prices are not at all influenced by future prices of Tur. Regression of Spot against volume of future trades Poor R2 value (0.03%) and high probability figures(87.77%) suggest that Spot prices are not at all influenced by volume of future trades of Tur. Standard deviation comparison Standard deviation of Spot prices = Rs 177.25 Standard deviation of Future prices =Rs 43.96 Interpretation The standard deviation comparison proves that futures trading in Tur is not adding to the fluctuations

in spot prices, rather it is helping in curbing the same. Urad The details about the data under considerations are given below: Commodity – Urad Duration- 10th feb 2006 to 18th aug 2006 Contract- Aug 2006 expiry futures contract of Urad Regression of Spot against Future prices High R2 value (81%) and low probability figures (0.0001) suggest that Spot prices are substantially influenced by future prices of Urad. Regression of Spot against volume of future trades Poor R2 value (1.11%) and high probability figures(19.01%)suggest that Spot prices are not at all influenced by volume of future trades of Urad. Standard deviation comparison Standard deviation of Spot prices = Rs 173.74 Standard deviation of Future prices=Rs 229.7 Interpretation The standard deviation comparison proves that futures trading in Urad is adding to the fluctuations in spot prices. Conclusion of analysis Thus we observe that Spot prices of Wheat are moderately affected by its futures trading, spot prices of Tur are not influenced by its future trading but, Futures trading in Urad is causing its spot prices to inflate. Further, it can also be inferred that futures trading in wheat and Tur are helping in risk management in trades but the same in case of Urad is helping in speculation. As we have also got mixed results on the limited data analysis that we performed, it is clear that there is need for further research specific to the Indian context on the impact of futures trading on the spot prices of agro commodities. However, there is certainly an urgent need to make the farmers more aware about futures trading as a hedging instrument and to regulate the extent of speculation in this market.

The farmers start the crop season under tremendous uncertainty of what price they would eventually get of their produce, which makes it difficult for them to take more informed production decisions. 8

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VOLUME 2 ISSUE 10

NOVEMBER 2009

Green Shoots in the Indian Economy Hopes &

Concerns

Souradeep Dey & Rakesh Kumar Choudhary

MDI, Gurgaon

Foreign inflows have started to comeback to India in steady and sustained manner as India has been identified as a clear growth destination in this recession scenario.

cit to be 6.8% of the GDP. All these measures have boosted demand in India and helped the economy to be back in track without much hassle. In spite of slowdown and high inflation Congress-led UPA government staged a convincing victory in the parliamentary election early this year. This has raised the hope for a stable government in centre which can strongly implement regulatory reforms important for a sustainable growth of Indian economy and good governance. Also, foreign inflows have started to comeback to India in steady and sustained manner as India has been identified as a clear growth destination in this recession scenario. There has been substantial FDI inflow in 2009H1 in India as multinationals realized the potential of investing in this country. Portfolio investors have been quite sceptic about investing in Indian securities. In spite of that, they have pumped in $10 billion. Sensex has gained more than 100% to reach a level of almost 17400. In addition to all this, companies have started hiring again in the midst of this kind of activities after freezing hiring process for more than one year. All these have raised hopes about growth, investments, employment and overall prosperity of the Indian economy. But at the same time economic news is not unambiguously well. There has been below average rainfall this year. Till mid of august

There are some positive developments and challenges in Indian economy in the context of global economy which is trying to heal itself from recession. There is a gloomy side of the picture and challenges lying ahead. This balancing approach has been used to assess the green shoots in Indian economy and put forward optimistic views about future.

Perspective

The global economic meltdown had forced a cyclical slowdown in Indian economy in 2008-09, though Indian financial system was broadly insulated from the typical problems of derivative related crisis and credit freeze that pushed most of the world to the worst recession ever after ‘The great depression’. This was due to the fact that Indian banking and financial system is still actively regulated by the government and RBI. After that, time has passed and due to coordinated effort of governments in USA and other developed countries the economies across the world have shown signs of improvements. India along with China and Brazil has been at the forefront of growth in this scenario. But experts and economists are still sceptic about the scenario. They have called these as ‘green-shoots’. Industrial output for the month of July was 7.2% higher than July 2008 and in the month of August it was 10.4% higher than last year. The passenger vehicle segment grew by more than 20% in both July and August after contracting double digit in 2008 Q4. Imports and export levels have shown pronounced sign of improvements in spite of the fact that they are still below the level of previous year. The reason for this better growth has been due to huge fiscal deficits and sharp tax cuts that Indian government implemented to minimise the effect of slowdown. In fiscal year 2009-10 also Indian government has projected its fiscal defi-

But at the same time economic news is not unambiguously well.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

9

Perspective

the aggregate rainfall have been 28% below the normal. This has affected the Kharif sowing. Paddy, pulses, bajra, cotton, soy bean and sugarcane are the crops whose production is expected to be below average. Lower production of crops will hamper the economy as agriculture constitutes 17% of the GDP. At the same time the deficiency of food grains will cause inflation in the economy. Fiscal spending and tax cuts have played major roles in improving the economic situation. But it is unlikely for the government to extend such measures as the debt level is already too high (59% of GDP at the end of 2008-09). So it is important for the government to get back to the path of fiscal stability. Too much government borrowing is a concern as it may restrict the borrowing opportunity of the private sector. The reserve bank has supported the economy by a series of CRR and SLR cuts in the time of slowdown to enhance liquidity. They also lowered repo- reverse repo rate to enhance easier lending. But, very recently they have hinted about tightening monetary policies to combat inflation. Along with this, the commodity prices are increasing very sharply with oil reaching $81/barrel. This kind of inflation in commodity price will hamper the growth of economy in India as it is dependent for oil on import mostly. American and European countries are the main demand drivers in the world economy. Though the situations in these countries have improved, they are still not out of the woods. Until and unless there is a clear emergence of growth, Indian economy will face problems as it is integrated to the world trade and economic structure. There are genuine concerns ahead of us which should be tackled by government aptly. The government should not hurry in withdrawing all the lifelines it has extended to support the economy at one go. Otherwise the green shoots of economic recovery may turn in to yellow weeds at any point of time. There lies huge opportunity ahead of India in these uncertain times as this recession gives India opportunity to strengthen its position in realignment of global economic powers. We expect India to stand firmly and prosper with these green shoots blossoming into colourful and aromatic flowers.

FIN-Q Solutions OCTOBER 2009

1. Agreement on Technical Barriers to Trade (TBT Agreement) 2. X = Bears Sterns , Y = JPMorgan Chase 3. CRISIL , Independent Equity Research Reports 4. Kit Kat 5. Tom Peters 6. Purchasing Managers’ Index, Manufacturing Firms/HSBC 7. Raj Rajaratnam 8. Troubled Asset Relief Program (TARP) 9. Goods and Service Tax (GST)

Too much government borrowing is a concern as it may restrict the borrowing opportunity of the private sector.

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Derivative Instruments i n t h e In dian Energy Market

Shitij Chhabra

IIM Lucknow

IEX (Indian Energy Exchange) IEX has state-of-the-art trading software provided by NASDAQOMX of Sweden and Financial Technologies India Ltd. IEX has been modeled based on the experience of one of the most successful international power exchanges, Nordpool. While IEX takes care of the financial aspect of the transactions, Regional Load Dispatch Centers (RLDCs)/ State Load Dispatch Centers (SLDCs) ensure the electricity supplies and withdrawals correspond to the contracts entered on the Exchange. As of September 2009, Discoms (37), generators (37), Trading licensees (14), CPPs (48), IPPs, cogeneration plants and wind generators from 23 states & 3 union territories have converged on the IEX platform for better management of their energy portfolio. The key features of this exchange are: 1. Transparency for trading

India needs huge investments in the power sector to sustain its growth. Investments in this important infrastructure component can be attracted by a well functioning and competitive wholesale electricity market. Power exchanges are a recent phenomenon in India but they lack the derivative instruments which are traded in successful exchanges around the world.

FinGyaan

Indian infrastructure scenario: The Indian economy has seen its gross domestic product (GDP) growth rate dip to 6.7 per cent in 2008. According to reports, to aim for an annual growth rate of 9 to 10 per cent India needs to make huge investments in infrastructure development. According to a McKinsey report, significant progress has been made in the field of physical infrastructure like roads and airports and telecommunication but a lot needs to be done when it comes to the infrastructure in the power sector. The poor performance of SEBs due to low average tariffs and high cross subsidies to agriculture and household sectors has stifled the growth of this sector. Progress was made in this regard with the Electricity Act 2003 moving generation and distribution out of ‘License Raj’ regime, demolishing the ‘Single Buyer’ model and opening access to national grid. However, a lot of restructuring is yet to be done in this regard. If India were to grow at a rate of 9% during the next five year plan (2009-2014) the country’s demand for power would grow at a slightly greater rate of about 10% i.e., from the present 120 GW (2008) to about 210 GW by 2014. The installed capacity needs to grow from the present 145 GW to 256 GW in 2014. The growth in demand would be fuelled by growth in the residential consumption, continued growth in the services sector and greater penetration of electricity into the hinterlands of India.

According to George Diekun, the Delhi based mission director of the United States Agency for International Development (USAID), about 500MW of additional capacity has to be installed every week over the next 25 years, to ensure 8 percent GDP growth in India. To achieve such a growth, investments to the tune of $600 billion would be required in the power sector by 2017. On a linear estimate a further $300 billion would be required in the next plan. Investments in the power infrastructure can be attracted by a well functioning and competitive wholesale electricity market.

If India were to grow at 9% in the next five year plan, our power demand should jump from 120GW to 210GW requiring an investment of US$ 300 Billion. © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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FinGyaan

electricity. 2. Diversified portfolio such as trading in smaller quantities and for smaller number of hours. 3. Payment security as the exchange is the counter-party for all trades. 4. Few transaction overheads/charges. 5. Efficient portfolio management as a function of consumption or generation. From September 2009, these exchanges will be able to undertake trading in four additional contracts — intra-day contracts for trading on a daily basis, day-ahead contingency contracts for meeting sudden demands for power, daily contracts for trading power to be delivered in the following week and lastly, weekly contracts for power to be delivered in the following month. A comparison of some of the best exchanges in the world with the IEX is carried out in the below table. IEX

Nordpool

NEMMCO

Participation

Compulsory for day ahead market (DAM)

Voluntary for day ahead and adjustment market

Compulsory day-ahead short-term energy market

Market offerings

Day-ahead spot for each hour

Day-ahead spot, hour ahead, Forwards, Futures

Day ahead spot

Pricing rule

Zonal Pricing

Zonal Pricing

Zonal Pricing

Type of bidding

Double-sided closed

Double sided

Double sided

Risk Management

Currently trading in the spot market

Forwards, Futures on Nordpool

Bilateral OTC, Derivatives on Sydney Futures exchange

Congestion Management

Market splitting

Area splitting and zonal pricing

Locational signals for transmission tariff

Transmission Losses

Payable in kind from delivery point to its grid connection point

Included in zonal Price

To be borne by generators

The comparison shows that the Indian Energy Exchange is comparable to these exchanges in most of the features and products offered. However, the IEX lacks the diverse derivative instruments present in these markets. Need for diverse derivative instruments in the Indian Electricity market: Trading in an electricity market is risky because electricity is very different from other commodities as it is non-storable; it has a low demand elasticity, there are certain transmission constraints and price control related issues. The prices at IEX touched an all time high of Rs 15/unit (kWh) in the pre-election period and rates went as low as 13 paisa/unit (kWh) in June’09. This reflects the volatility in demand and supply and its impact on the price discovery for the

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instantly perishable electricity. In September 2009, the Central Electricity Regulatory Commission (CERC) imposed a cap of Rs 8 per unit on the price of power traded bilaterally and at the two power exchanges — Indian Energy Exchange (IEX) and Power Exchange India Ltd (PXIL). The corrective move by the regulator has come as a strong reaction to the findings of the latest reports of its “market monitoring cell”, which indicated abnormally high prices of power sold during certain trading hours at the exchanges last month. Volatility in the price of traded power in India increased from 13 per cent on August 3, 2009 to 41 per cent on August 10. The ceiling on power tariff at Rs 8 per unit will be applicable for 45 days, ending mid-October this year. However, blanket caps on the trading of power may not be the best solution for an efficient market. In order to hedge the congestion of prices and facilitate trading in power markets, few derivative instruments need to be introduced. These should be a part of the energy risk management strategies. For the futures market to fully develop in India, high volumes should be encouraged. Estimates put the figure to be a regular trading of the order of 15GW. Indian Energy Exchange (IEX), went on to clock the peak daily unconstrained trading volume of 29.33 GW worth Rs.22.86 Crore on October 03, 2009. The average trading volume has been around 11 GW. Thus, this seems the right time to do the back ground work to introduce diverse derivative instruments. Some of the instruments to be introduced could be forwards, transmission rights, load-dependent futures contracts, swing options. Electricity forwards, futures and swaps Electricity derivatives such as forwards, futures and swaps can play a primary role in offering future price discovery and price certainty to generators. These instruments introduced in the exchange would enable the flow of investments in this sector as the price risk gets mitigated. Getting new investment is extremely important in the Indian context hence these instruments could play a pivotal role in the development of India’s power markets. Financial Transmission rights (FTR) It provides FTR owners with the right to transfer an amount of power over a constrained transmission path for a fixed price. These can be used to hedge congestion charges on constrained transmission paths. These are important in the Indian context as a lot of electricity demand is concentrated in and around the metro cities. Physical Transmission Right (PTR) PTRs are tradable rights to use transmission capacity and represent the right to use the physical transmission system. PTRs guarantee an efficient

VOLUME 2 ISSUE 10

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of one unit of electricity. India generates about 50% of its electricity from Coal. Going forward sources like nuclear power (after the nuclear deal) and other renewable sources (after full development of carbon credit market) are going to become important in the Indian context. Dealing in these contracts makes would enable a speculator to bet on electricity units based on the knowledge of future prices of Base-load and peak-load futures particular fuel types. This will create new investment As India has predominantly had a focus of opportunities from parties who have specific knowlbuilding base load plants rather than peaking plants edge about new fuel types. these instruments would enable Tolling contracts stabilization of peak load prices if a This requires payment differential pricing scheme is adoptof a pre-agreed amount to the ed. Thus this would provide greater owner of a power plant. These incentive to develop peaking plants contracts give the buyer the in India. This has been missing till right to either operate and connow. trol the scheduling of the power Options on electricity assets plant or simply take the output Physical generation assets electricity during pre-specified may be considered as options on time periods subject to certain spot electricity. Market prices would constraints. This would bring in exhibit the risk adjusted expectainvestments from parties who tions of the future cash flows from bring with them superior manthe particular electricity asset. This agement skills and know how would lead to greater scrutiny of electricity genera- to effectively operate power plants. This could lead tion assets and better valuations of the assets. This to greater operational efficiency of existing and prowould clarify the criteria for new market entry as posed power plants. more information becomes available in the system. Future Challenges and Conclusion: Swing options Power quality and demand side management Swing options were widely used in the regu- issues under electricity trading would be a challenge lated Scandinavian market to address the problems in Indian electricity markets. A pool-based electricity created by the non-storability of electricity. The vari- market coordinated by a system regulator provides ations in the demand and generation of electricity a strong foundation for building a wholesale market tend to smoothen out over time. An electricity mar- with open access and tradable transmission propket swing option gives the buyer the right to use erty rights as mentioned in the paper. energy up to a certain limit at a fixed price during a In designing an efficient electricity market, fixed time interval. It may include the obligation to electricity derivatives play an important role in esuse at least a certain amount of energy during the tablishing price signals, enabling price discovery, same interval. India being a very large country the facilitating risk management, leading to greater marginal utility of electricity in different parts of the investments in generation and transmission. This country given scarcity of supply in different seasons would lead to electricity demand fulfillment at afis bound to differ. Buying these options would en- fordable rates to the Indian consumer. Custom desure businesses to secure their requirements at a sign of electricity financial instruments as per the critical portion of the year when they expect supply needs of the Indian market can provide energy price to be unstable. certainty, hedge volumetric risk and synthesize generation and transmission capacity. Spark spread options use of transmission system capacity and to allocate transmission capacity to those users who have the most utility. These are important in India as electricity demand is concentrated in and around the metro cities and the right to a transmission line would be important for any power business house which is ramping up its facilities.

FinGyaan

Spark spreads are cross-commodity options paying out the difference between the price of electricity sold by generators and the price of the fuels used to generate it. The holder of a spark spread call option written on a fuel at a fixed heat rate has the right, but not the obligation, to pay at the option’s maturity an amount equal to heat rate times the fuel price at maturity time and receive the price

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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FIN-Q 1. What was created by an eminent M&A lawyer in 1982, which is used to deter takeover bids? 2. I was appointed as the Secretary of the Treasury in a leap year and resigned in the very same year of my appointment. I share my name with a city. Who am I? 3. Identify him

FinLounge

4. What minimum percentage of stake does the UPA government plan to hold in the PSUs after its disinvestment venture? 5. I was the first discount broker of the US. Not one bank failed during my tenure as the Superintendent of Banks of New York, despite nationwide failures. However this is not what I am famously known for. Identify me and what I am famous for? 6. What is the single largest stake-holder of the Tata Group nicknamed as?

All entries should be mailed at [email protected] by 5th December 2009 23:59 hours One lucky winner will receive cash prize of Rs. 500/--

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VOLUME 2 ISSUE 10

NOVEMBER 2009

?

MANAV JAIN Stock markets are unique in their own way. They love playing the game of hit-and-run. They tickle you with hope and lend dreams, and to catch you early, run unabated till you become a blind-follower. For a Sensex, which took approximately 28 years to touch 12,000 and only one more year thereafter to climb to a historical statistic of 21K, the fizz never fizzles out! The crises, so to say was culminating. And it surfaced in full form once the spark came up in one end of the globe. Financial crises, or global meltdown, or sub-prime crises were just mere terms; the gravity of the situation was enormous. The era of praise for securitization landed into a dark reality, with one of the greatest innovation of the finance field turning ugly. Investment banks, known for their financial engineering, were at the receiving end, with most of them sinking. The crises couldn’t have shaped up the way it did, had it been restricted to such banks only. It spread, and spread fast. The chain of institutions involved was too long to sustain. Commercial banks, credit rating agencies, insurance sector, central banks and the government, all became major stakeholders of the same and the world experienced what is now referred to as the ‘bubble burst’. Monetary policies were implemented but to no true discourse. Short-term relief did not extend forward for too long. The creators of such meltdown became the victims themselves and had to be supported by governments and bailed out. Fiscal stimulus became the word of the day and financial institutions turned beggars. But what about India? With a more restricted economy and not much financial re-engineering in this part, the impact of such crises was presumed to be less. It was, indeed, less but the globalization impact made sure the economy did not go scot-free. The Sensex crashed 1408 points on January 21, 2008 despite good Q3 earnings. The financial meltdown had reached India. A few days later, the Sensex gained 1139 points (January 26, 2008), thus proving how volatile it can get. The sentiment was low until March 2009, which saw a low at 8160 points. But there was no stopping

Cover Story

n u R t a e The Gr

IIM Shillong

the bull after that. The Sensex has risen more than 100% and is hovering around 17000 lately. What is it that is fuelling such a sharp rise? Is the market basing itself on fundamentals or just going with the flow? Is the path to recovery so robust or is the path not even visible in the mist of rise? It’s surely not the fundamentals. The balance sheets and profit statements haven’t been as inspiring to register such a booster confidence in the market system and the economy. The sentiment, despite all this, has been quite optimistic. Some analysts say that a super bubble is being created and the reasons for them calling it so have to be observed. A Business Line editorial dated September 09, 2009 captures the picture right. “In a mere six months, the mood in the stock market has swung from unrelenting gloom to sunny optimism. When the stock market rally began in March, it was a case of prices ‘reverting to mean’ from extreme pessimism. The initial leg of the rally did have strong moorings in fundamentals, backed by resilient domestic macro-indicators and the improving corporate earnings picture. However, six months down the line, with the Sensex almost doubling, the worry is if investors are overtaken by excessive optimism.” One important evidence of this bubble formation is the Price-Earnings Ratio in the current capital market, which is over 21 for most stocks. A P/E ratio of 21 is not well-supported by economy fundamentals and such a drastic rise in this ratio indicates that earnings have not grown proportionately with the market, which is feeding in air into itself each passing day. Stock prices are highly inflated, as so is the market in general. The earnings do not justify the rise, and factors that are leading to a situation like this are purely technical and propagated by optimism that is so very untrue. Indian markets still seem attractive to investors among large stock markets all over the world. Though the Indian market is currently trading at a premium with respect to markets of other developing economies, the future outlook is positive. The economy is expected to grow at more than 5%. Also,

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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Cover Story 16

the country’s low dependence on exports and the high rate of savings are major factors for the optimism. With a savings rate a staggering 38%, India ranks second only to China, but the problem herein is the fact that only 3.5% of the savings are invested in the stock market. However, given the large population and subsequently the large amount of savings, a small percentage increase in this rate would mean huge investment in the stock market. A half percent rise in this rate would imply an increase in domestic capital investment of $15 billion, equivalent to about $10 billion foreign investment. Such an investment from the savings side would create a valuation bubble in the Indian economy. The Real Estate Sector is another area of concern that has contributed highly to the current bubble. Housing prices in India are reaching new highs and this is reminiscent of the US housing scenario before the first bubble burst. And such high prices are a fancy for speculators who engage in this market and inflate stock valuations, thereby raising prices further. Ground reality suggests that the demand for housing is not as high to rightly explain the price rise; neither has supply been inconsistent. What led to the meltdown in America is being manifested here in India now, and if this continues, suspicions being put up now shall take actual form in a few months from now. The fiscal packages and the stimulus provided by the government also impact the valuations of the stock markets. Currently, most of the growth being experienced in the country is due to the huge government spending through stimulus packages. The government lends out hefty sums of money to needy institutions and for other sectors as part of fiscal policy measures. What’s important is the questions as to the source where from the money is provided. The money lent as stimulus is firstly borrowed by the Government from its various sources within the nation and/or abroad. There would come a point where the government would cease to provide further stimulus. And when such an incident happens, growth of the Indian economy would slow down to a trickle. Liquidity also plays an important role in analyzing any market. Markets which are more liquid are generally more stable as compared to those which are not. Illiquidity, as the term is called affects valuations in a magnified manner. The low free float

NIVESHAK

of the market implies that the Indian stock market is among the most illiquid markets throughout the globe. Given the situation such as this, a miniature investment in the market would mean inflated stock market indices. The lower liquidity has the impact of raising up valuations every time new equity enters into the system. Also, since India does not have a well-developed vast bond market, people generally look forward for equity market for investment, and therefore the scope of valuations inflating rises even further. However, there are several reasons to make believe the fact that this bubble would not enlarge and come down to its mean figure. First and foremast is the issue of credit availability. The revival of credit has mostly been to the corporates, and large cap companies, the middle and small cap companies being left out. For a sustained recovery to take place, there should be even recovery in all sectors and all companies. The biased nature of credit availability can be sustained by this new bubble only for a short period of time, and ultimately it would bring it back to its normal shape. Another major point of concern is the recovery in the developed world. Emerging markets might be doing well, but if the developed economies dampen the recovery path, even developing nations will be hard hit. Recovery in the west is not expected to be too fast and therefore, emerging markets might have to suffer corrections every now and then. With new capital issues for qualified institutional buyers on the rise, the stock markets are facing a situation where there is a flurry of QIPs. Companies coming out with plans to raise money through this medium enjoy a rise in their stock prices, which further raises the index. Where do we stand? In brief, we’re at a juncture wherein the markets are showing excessive volatility and valuations do not suggest the intrinsic values that ought to be. Stocks and indices are overpriced and the sentiment is highly optimistic and positive. The bubble has all the ingredients to grow further; but it has all the more reasons to burst and impact the economy in a hard way. The path to recovery is charted, but the path doesn’t allow us to run. Emerging markets can jog, developed nations will follow, and the world would be a happier place quite soon.

VOLUME 2 ISSUE 10

NOVEMBER 2009

Systematic

& Financial regulation Ajay Jain & Piyush Chandak

IIM Bangalore

banks would thrust themselves into an inherently political role. It would be difficult for them to maintain the independence that they require to conduct monetary policy and thus this task should be handed over to a separate independent authority. Finally, in the last section, the learnings from the previous sections are applied in Indian context and need and the structure of systemic risk regulatory agency in India are discussed. Need for a Systemic Risk Regulator The current financial regulatory structure is institution specific. So, we have independent regulatory bodies for institutions like banks and large insurers while some other like hedge funds and private equity funds go unregulated. In fact a whole gamut of these bank-like institutions such as investment banks, hedge funds, mortgage brokers, venture capital firms etc. grew outside the regulatory framework of banks. Such unregulated financial entities constituted the shadow banking system and their growth, which was largely outside anyone’s control, was a major source of the current crisis. This system became far more important source of credit than the more heavily regulated banking system. Highly leveraged firms supplied large amounts of capital without having to expose their activities. These entities created opportunities for regulatory arbitrage as banks shifted risk to balance sheets of affiliated entities in the shadow system and evaded capital requirements. The existing regulations adopted a micro prudential view and focussed on systemically important individual institutions, not recognizing that systemic stability could be threatened even if individual insti-

The current regulatory system has gaps that need to be filled and the Systemic Risk Regulator is the potent tool for eliminating systemic risk and supervising the SIFI’s. The structure of SRR prior to implementation needs to be thought upon. SRR holds significant importance in Indian context as well for putting all regulatory measures in place.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

AoM

“You only find out who is swimming naked when the tide goes out”, says the Oracle of Omaha, Warren Buffett. The global financial crisis of 2008 has exposed many such loopholes in the financial systems across the world. Prominently, it has exposed weaknesses in the current regulatory and supervisory frameworks. Even as governments continue to fight probably the biggest financial meltdown ever, the focus has already started shifting towards deciding the face of new financial regulation framework which can create a safer and sounder financial system for the future. The financial meltdown, which brought the world down to its knees, has escalated the need for fundamental rethinking on the regulatory policies pertaining to financial sector. A need has been felt for setting up a systemic risk regulator mandated with broad responsibility for the whole financial system, charged with spotting regulatory gaps and market pressures that might destabilize the system. It is believed that regulators failed to head off the recent crisis because no one was explicitly charged with spotting risks that could lead to system failure. Such regulator gaps and overlaps need to be eliminated. EU has already formed one such agency while U.S. is still debating on the structure of the agency they want to bring in. This article opens with a discussion on why there is a need for systemic risk regulator and what are the gaps in the regulatory system that they might help to fill. The next section argues upon what should be the ideal shape and structure of such an agency. While some believe that the central bank is the right candidate to become the super regulator, many others feel that by taking on supervision and regulation, central

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tutions within the system are stable. Focusing on individual institutions while overlooking the overall financial system can only lead us to win battles not wars. The system failed because of lack of a macro level systemic risk regulator as each regulatory authority focused on risks within their purview only and no one was in charge of spotting regulatory gaps and market pressures that might destabilize the system as a whole. It is important to keep an eye on the whole system simultaneously for the simple reason that these institutions do not exist in independence and there exist heavy interactions among them. Failure of one financial institution to pay can impose severe losses which might threaten the existence of its creditors as well. This is known as systemic risk. It is the risk that simultaneous failure of one or more key financial institutions destabilizes the overall financial system. The havoc caused by crisis has brought to fore the need of a Systemic Risk Regulator. The mandate of this agency would be to constantly search for gaps, weak links and perverse incentives serious enough to threaten the system. It has become necessary that the Systemically Important Financial Institutions (SIFI) —banks, insurance firms, investment firms, and hedge funds—should be subjected to consolidated supervision by a single agency. A Systemic Risk Regulator (SRR) is needed because it is not possible to eliminate systemic risk. Besides, even if systemic risk is curbed for the current scenario, history proves that with the advent of new technologies, new bubbles are created; new financial innovations come into force, which bring together a whole new dimension of systemic risk. The financial industry is so dynamic that 80% of the products sold today did not exist even 2 years ago. The housing price bubble was aggravated (and some may argue it was caused) by the financial stupidities: injudicious mortgage lending, excessive high leverages and short sighted insurances. With an effectively working SRR, we believe these kind of foolishness would be reported and curbed much before they cause any significant damages. At this point, it would be prudent to define the exact responsibilities of an SRR (what form can this SRR take is discussed in the next section): 1. Reduce systemic risk to the extent possible

2. Have clear rules to identify and include or exclude SIFIs 3. Standards for liquidity and capital (leverage) requirements to be employed by SIFIs. Ideally, the requirements for SIFIs should be stricter than for non SIFIs 4. Be alert to catch signals of when the institutions under their watch may be developing problems. This can be easily achieved by taking note of stable sources of market discipline the interest rate on subordinated debt 5. Implement measures like long term debt convertible to equity when a firm’s financial condition deteriorates below a point. This would prevent crisis like situations from deepening. However, the SRR must be confined only to point of providing regulations. Resolution of failed/distressed institutions should be left for other appropriate agencies. 6. Enforce minimum early intervention by “early closure and loss sharing plan” for SIFIs so that timely actions are taken to prevent bankruptcies. Structure of an SRR We propose 4 structures for an SRR and subsequently discuss their merits and demerits: (1) A new consolidated financial solvency regulator (2) Broadening the scope of Central Bank to include the financial regulation as its responsibility (3) A new SRR agency (4) Simultaneous working of the current set of financial regulators A new consolidated financial solvency regulator A good way to consolidate current multiple regulatory agencies is to club them in two heads, one for solvency and another for consumer protection. The consumer protection regulator would include bodies like SEC in U.S. and SEBI in India but would fall outside the purview of this article. The financial solvency regulator would be assigned with the responsibility of reducing systemic risk as much as possible. It would oversee and regulate all the financial institutions with special focus on SIFIs. Though the SRR would be headed by the Central Bank, it would be the SRR which would have the final say.

Regulators failed to head off the recent crisis since no one was explicitly charged with spotting risks that could lead to system failure. Such regulator gaps and overlaps need to be eliminated through SRR. 18

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The Central Bank would just have regular consultations and interactions with the solvency regulator, including the right to receive in a timely manner all information about SIFIs that it believes is important.

Indian Context Even in the midst of crisis, India’s financial sector remained relatively safe and sound. Does this mean that India is decoupled from the ill effects of the west and can continue to ignore the idea of a systemic risk regulator? We believe that it will be a folly to believe that there is something inevitable about India’s financial stability. As India further integrates with the rest of the world, it will get exposed to forces of globalization. If financial stability anywhere in the world is jeopardized, India’s financial stability will become vulnerable too. Thus India also needs to consider setting up a systemic risk regulatory authority. While RBI could have been handed over the reins of being a systemic risk regulator given that it is equipped to deal with financial stability because of its macroeconomic perspective which enables it to conduct macro prudential regulation, we believe that forming a council of regulators would be an ideal structure in Indian context. The role of systemic risk regulator might make it difficult for RBI to remain independent in order to conduct monetary policy. Also, the central bank may lack the expertise to engage in supervision, where micro-knowledge, such as on accounting and legal issues, is required. India already has an informal setup in form of a High Level Coordination Committee on Financial Markets (HLCC-FM) comprising all the regulators from financial sector - RBI, SEBI, IRDA and PFRDA and the Finance Secretary. It serves as a forum to deal with inter-regulatory issues arising in the financial and capital markets. The authorities should consider upgrading the HLCC-FM to a formal structure. Also, in India there are no specific regulations for the financial conglomerates which pose bigger risks to the system than single product service providers. Setting up of a council of regulators would make it easy to get regulatory measures for them in place as well.

AoM

The Central Bank In U.S., the Fed Reserve has literally acted as the lender of last resort to the distressed companies and as such an obvious implication is to make Fed the systemic risk regulator. The Central Bank’s monetary policies are hugely impacted by the failure of SIFIs. Including systemic risk regulation as a responsibility for the Central Bank would only be a logical extension. However, in order to avoid agency infighting before crises and finger pointing after the crises, the responsibilities must be defined in a non-ambiguous and explicit way so that the only authority over solvency and associated reporting requirements is the Central Bank. In spite of all these precautions, the idea is fraught with many dangers: • Asking Central Bank to regulate would compromise its focus on monetary policy • The Central Bank needs complete independence in order to carry an effective monetary policy. Assigning explicit systemic risk responsibility to it would make it responsible to the Government and thus take away its independence • Significant political risks underlie the premise and the Central Bank might be inappropriately forced to loosen or tighten the regulatory stance to favour some political gains • The Central Bank might be extremely risk averse and in the process it might curb some possible innovations • Finally, with the current capacity Central Banks across the world are very ill-equipped to handle the regulatory work. While they have huge command over the monetary issues, the same cannot be said about their accounting and taxation prowess. Also, infrastructure and staffing issues need to be taken care of On account of so many issues, it is probably better to have a consolidated financial solvency regulator as compared to assigning risk authority to the Central Bank. We out rightly reject the last two options as they do not have any merit. Creation of a new SRR agency without consolidation would just add one more player to the already over-crowded

regulatory market. It would be redundant and would not add any value. Simultaneous working of the current set of financial regulators would provide huge coordination problems and in case of crises would only lead to putting on the blame onto each other’s heads.

As India integrates with the rest of the world, it will get exposed to forces of globalization increasing the vulnerability of getting destabilized. Thus India needs to consider setting up a systemic risk regulatory authority. © FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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Indian Banking Amit Agarwal & Abhinav Berdia

A RISK PROFILE

XLRI, Jamshedpur

FinSight

The current economic slowdown paves the way for the banking system to improve their portfolio quality and move towards lower default risks. Some of the steps to improve banking industry and reduce risks have been suggested in the article.

One question that currently bothers most of the bankers is about the shape of banking in days to come. Will banks be doing business differently in future? What are the changes that are likely to take place? A thorough analysis is needed to understand the issue and the probable outcomes. DEPTH OF INDIAN FINANCIAL SYSTEM Healthy growth of the assets of commercial banks in the recent period, driven primarily by credit growth and sharp rise in credit-GDP, depositGDP and M3-GDP ratios clearly point out that we have a significant financial deepening in India. While the ratio of bank assets to GDP has increased significantly to around 93 per cent in 2008-09 from 48% in 2001 as a result of high credit growth in recent years, it is still lower than some of the other emerging countries. Financial deepening, hence, has been taking place on an accelerated pace on a macro basis in recent years and banking productivity has improved significantly. Also, the rate of domestic savings has picked up in the recent period during 2003-04 to 2007-08 against the backdrop of financial sectors reforms, rise in total factor productivity and investment boom, which had led to acceleration in the growth performance, whereas, in the developed countries like the US and Japan, the rise in financial deepening has had a limited effect on the savings rates of the economies.

INDIAN BANKING SYSTEM: TRENDS & FINANCIAL HEALTH Though public sector banks (PSBs) account for around 70 per cent of commercial banking assets and 72.7 per cent of the aggregate advances of the Scheduled commercial banking system (as on March 31, 2008), competition in the banking sector has increased in recent years with the emergence of private players as also with greater private shareholding of PSBs. Listing of PSBs on the stock exchanges and increased private shareholding have also added to competition. The new private banks which accounted for 2.6 per cent of the commercial banking sector in March 1997 have developed rapidly and accounted for nearly 17 per cent of the commercial banking assets by end March 2008. But, one area that needs to be watched continuously due to recent crisis is the off-balance sheet (OBS) exposure of the banks. The spurt in OBS exposure is mainly on account of derivatives whose share averaged around 80 per cent. The derivatives portfolio has also undergone change with single currency IRS comprising 57 per cent of total portfolio at endMarch 2008 from less than 15 per cent at end-March 2002. INDIAN BANKING INDUSTRY: RECENT PERFORMANCE The graphs below depict the state of the Indian banking industry in the recent times:

Innovations in the form of complexity and sophistication of products and services, coupled with profitability and competitive considerations, have completely changed the dimensions of risks faced by banks. 20

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VOLUME 2 ISSUE 10

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Financial deepening has been taking place on an accelerated pace on a macro basis in recent years and banking productivity has improved significantly.

During the Q1FY10, top 12 Indian banks restructured asset worth Rs 32,530 crores, taking total restructured assets to nearly Rs73, 000 crores. However, as a proportion to total advances, it is still within a comfortable level of 4.0%. Significant variation was observed among the individual banks in restructuring of loans. Among them, public sector banks showed a higher percentage of restructured loans to total loans as compared to private sector banks.

FinSight

Analysis of the first quarter results of the Indian Banking Sector (12 top banks covering 61% of total credit) by CARE Research reveals the following five key observations: • High treasury gains boosted the operating income of the banks • Net profit zoomed by 55.2% y-o-y, however adjusted for treasury gains, net profit declined by 8.1% y-o-y and 25.4% q-o-q • Net Interest Margins (NIMs) have declined due to lower lending rates and higher cost of funds resulted in lower Net Interest Income (NII) growth • Overall provisions charged to profit and loss account (excluding tax), decreased by 17.0% y-o-y and 24.7% q-o-q. However, provision for NPAs increased by 3.5 times over the previous year. • Restructuring drive continued in Q1FY10, the top 12 banks restructured assets worth Rs 32,500 crores. Most of the banks booked the treasury gains on their SLR investment portfolio which improved the operating income significantly as compared to the corresponding period last year. Total operating income of the top 12 banks was up 25.8% y-o-y during the quarter ended June 2009. However adjusted operating income increased by 14.3% y-o-y. Treasury gains constituted 11.6% of the reported operating income and 13.1% of the adjusted operating income in Q1FY10 as compared to 2.7% and 2.8% in Q1FY09 respectively. Also, lower lending rates pushed up the credit offtake for majority of the banks but relatively lower NIM resulted in submissive NII growth.

Healthy growth of the assets of commercial banks in the recent period, driven by credit growth and sharp rise in credit-GDP, depositGDP and M3-GDP ratios clearly point out that we have a significant financial deepening in India.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG

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RISKS FACING THE INDIAN BANKING INDUSTRY

FinSight

CREDIT RISK GROSS NPAs IN INDUSTRY CREDIT TO ALMOST DOUBLE IN 2009-10 The gross non-performing asset (GNPA) for the industry is expected to surge from 2 per cent in 2007-08 to 3.7 per cent in 2009-10. The GNPAs for large corporate and SMEs within the industry are expected to rise from 1.6 per cent and 3.1 per cent, respectively in 2007-08 to 2.9 per cent and 3.7 per cent, respectively in 2009-10, as reported by Crisil Research.

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SECTORAL RISK As per the Crisil research, the increase in delinquencies alongside a tightening in bank underwriting standards and exposure limits will cause the growth in credit to SMEs and large corporate to moderate over the medium term. Therefore, the estimated GNPAs in industry credit comprising of large corporate and SMEs is likely to increase as the repayment capability of corporate would deteriorate due to leveraged balance sheets, declining profitability due to reduced sales, and lastly, increased costs due to extended working capital cycles and idle capacities. The sectoral risk can be classified as: • Business risk: Demand-supply gap Nature of fragmentation and competition across industry • Financial risk: Profitability Leverage indicators (debt-equity ratio and interest coverage ratio) BUSINESS RISK Business risk scores for 2007-08 and 2008-09 provide the outlook for business in the short term for large corporate and SMEs across sectors on the risk paradigm. As the business risk score is a forward looking indicator of the performance of a sector in the short term, a low business risk score in 2008-09, with reference to 2007-08, is an indication

NIVESHAK

of higher stress going forward, in terms of the financial and business performance of customer profiles across sectors on the risk paradigm. Parameters

Low risk

200708 E Large 4.81 SME 3.10 Industry 4.39

200809 E 4.98 2.78 4.51

Medium risk 200708 E 3.99 2.88 3.74

200809 E 3.77 2.61 3.50

High risk 200708 E 2.46 2.04 2.31

200809 E 2.54 2.08 2.36

RESTRUCTURING OF ADVANCES Banks have been given the option of restructuring the non-performing accounts to avoid increasing their sub-standard and doubtful assets. The restructuring practice implemented by the banking system involves: • Increasing the moratorium period from 90 days to around 120-180 days.  • Reducing the rate of interest. The increase in GNPAs across sectors is expected to influence the lending behavior of banks across sectors. Although, the banking system would be flush with liquidity, their approach towards lending would be cautious. This cautious lending approach adopted by the banking system will help them control the inflated level of GNPAs in their corporate credit portfolio going forward. The current economic slowdown paves the way for the banking system to improve their portfolio quality and move towards lower default risks. Banks may curtail lending to high risk sectors and deteriorated customer credit profiles, while borrowers will be required to demonstrate improved balance sheet strength in order to raise funds from banks. The banking credit market in India is currently witnessing a major shift from the buyer’s market to the seller’s market with bankers adopting selective lending with covenants. RISK MANAGEMENT BY THE BANKING INDUSTRY One key line of defense against financial instability is an improved framework of financial regulation, supervision and oversight. A holistic approach is necessary, covering stronger safeguards for instruments, markets and institutions. This means putting in place improved mechanisms to assess the suitability and risks of new financial instruments. It implies encouraging greater centralization in clearing, settlement and, possibly, trading. Though more inclusive regulation may be required in some areas, the solution to the crisis is not putting in more regulation. Innovations in the form of complexity and sophistication of products and services, coupled with profitability and competitive considerations, have completely changed the dimensions of risks faced by banks. The Committee on Financial

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KNOW YOUR CUSTOMER (KYC) It comprises of three main components. ‘Knowing their customers’ is not enough for banks, they should also know the ‘business’ of their customers; and if the banks know the business of their customers, the banks can certainly assess the ‘risks’ associated with each of their customers. KYC is not only a risk management process but it also makes a good business sense. TREATING CUSTOMERS FAIRLY (TCF) This requirement is the key to operation of an efficient retail market for financial services. TCF is also central to consumers having confidence in the

financial services industry. This principle must be adopted and supported by the leadership of financial firms, and embedded throughout a firm’s operations and within its culture. In addition, in a competitive marketplace, TCF should be an important element (alongside service levels, pricing and customer satisfaction) in determining the success of a bank in acquiring and maintaining market share. There should be a blend of regulatory and marketbased solutions to delivering fairness to customers. Banks need to examine what most effectively constitutes fair treatment of customers. Banks’ senior management needs to assess their current performance against the requirement to treat customers fairly, identify possible areas for improvement and ensure that the principle of fairness is embedded in their work-culture. PROPER RISK MANAGEMENT Systemic risk is becoming more and more prominent with the increasing complexities and the associated risk factors in the banking activities. The banks need to have a proper understanding of all the risk factors and at the same time they have to ensure that their customers also understand and appreciate the associated risk. In the event of such banking activities leading to the emergence of systemic risks, the central bank may intervene which might result in stricter regulation and supervision. CONCLUSION While the global banking developments have offered innumerable perspectives, important perceptions are emerging from the Indian banking developments. Given the long term objective of achieving 9.0 per cent of GDP growth, there is a need to understand that there are significant challenges for Indian banking industry. Of these, the major challenge would be to achieve financial inclusion through improved financial penetration in thus far uncovered areas, which in turn would enable inclusive and sustainable growth for the economy. Proper risk management tools need to be in place and effective implementation of the same would help fight against the challenges faced by the Indian banking industry.

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FinSight

Sector Assessment (CFSA) has argued that the present global financial crisis has highlighted the limitations of the present Basel Core Principles in as much as the assessment does not specifically cover areas like SIVs/NBFCs or aspects like dynamic provisioning and countercyclical norms. Hence, CFSA has felt that the Basel Committee on Banking Supervision should revisit the Basel Core Principles to cover the new areas. CFSA has also noted that, though BCPs are not strictly applicable to financial institutions other than commercial banks, the efforts to extend the scope of BCP assessment to other sectors are commendable in the current context of the potential linkages of such institutions and their impact on the stability of the financial system. The Reserve Bank has already been extending such principles to non-bank entities, subject to certain thresholds and the nature of their operations. As highlighted by Dr. Y.V. Reddy, the former Governor of the Reserve Bank of India, some of the reasons for India’s insulation from the current crisis are: (1) The nascent stage of development of the credit derivatives market; (2) Regulatory guidelines on securitization do not permit immediate profit recognition; (3) Perseverance of prudential policies which prevent institutions from excessive risk taking and financial markets from becoming extremely volatile and turbulent; and (4) Close co-ordination between supervision of banks and their regulation. In order to improve the banking industry, a few steps which should be implemented by the banks are:

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NIVESHAK

VOLUME 2 ISSUE 10

NOVEMBER 2009

TEAM NIVESHAK

ARTICLE OF THE MONTH

The article of the month winners for November 2009 are Ajay Jain & Piyush Chandak of IIM Bangalore They receive a cash prize of Rs.1000/-

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Team Niveshak invites article from B Schools all across India. We are looking for original articles related to finance & economics. Students can also contribute puzzles and jokes related to finance & economics. References should be cited wherever necessary. The best article will be featured as the “Article of the Month.” and would be awarded cash prize of Rs.1000/Instructions »» Please submit your article with the file name and the email subject as <Title of the Article>__ by 10 December ‘09. »» Article must be sent in Microsoft Word Document (doc/docx), Font: Times New Roman, Font Size: 12, Line spacing: 1.5 and maximum of 5 pages. »» The cover page of the article should only contain the Title of the Article, the Author’s Name and the Institute’s Name »» Mention your email id/ blog if you want the readers to contact you for further discussion »» Also, if certain entries which could not make the cut to the Niveshak will get figured on our Blog in the ‘Specials’ section

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