Gold and the Union Budget 2015 -16 : How We Can , and Cannot , Reduce Gold Imports
                                       
                                                        By VK Sharma
                                              Former Executive Director
                                                 Reserve Bank of India
                                 vksvs2009@gmail.com    +919820267474

1.       Hon’ble Finance Minister deserves unreserved compliments for explicitly and unequivocally acknowledging in his Budget speech the imperative of reducing gold imports which were the single cause of the unprecedented 30+ year-high current account deficit of 4.7% of GDP in FY 2013 with gold imports accounting for 3%+ !

2.            The main reason for this was that under the then current import regulations(cf RBI’s FEMA Master Circular), there was preferential, and more favourable , treatment for gold imports as compared to import of any other item,including essential imports, in that import of gold was permitted 1) on consignment basis 2) on unfixed price basis and 3) metal loan basis. This preferential treatment made gold imports free from both price and currency risks for overseas consignors of gold borrowed overseas as effectively it amounted to their short selling such borrowed gold in India and simultaneously covering their short position abroad, with both the risks being borne by end buyers of jewellery and gold ETFs ! This was not the case though with other items,say,coal,edible oils etc , imported on direct import basis. I had accordingly , in December 2012, suggested to the then Governor, Dr Subbarao and the present Governor Dr Raghuram Rajan , then Chief Economic Advisor, Ministry of Finance , to create a level playing field between gold and non gold imports by aligning gold import regulations under FEMA with those for non gold but essential imports . And indeed, aligning gold import regulations with the rest of imports by RBI had the desired effect of taking away this significant, unwarranted and perverse incentive and delivered the desired outcome of dramatically reducing gold imports in double quick time, merely by creating a level playing field between the two kinds of imports so much so that ,as its direct consequence , the current account deficit narrowed dramatically to 1.7 % of GDP in FY 2014 ! And this was achieved , as I said, not by imposing curbs and restrictions on gold imports , as was widely made out in media campaign by some quarters , but merely by creating a level playing field between gold and non gold imports , by aligning gold import regulations under FEMA 1999 with those for non gold , but essential, imports like , as I mentioned above , edible oil and coal !


3.            But surprisingly , RBI only recently rolled back these entirely wholesome and fair measures and no wonder , according to media reports , gold imports have again surged and the current account deficit for the latest fiscal quarter has increased to 2.1% from 1.2% of GDP ! Against the background as somber as above, to reduce gold imports, Hon’ble Finance Minister has proposed in his Budget three schemes and his verbatim statement on which in the Budget Document is as follows:
” India is one of the largest consumers of gold in the world and imports as much as 800-1000 tonnes of gold each year. Though stocks of gold in India are estimated to be over 20,000 tonnes, mostly this gold is neither traded, nor monetized. I propose to:

(i)     Introduce a Gold Monetisation Scheme,which will replace both the present Gold Deposit and Gold metal Loan Schemes. The new scheme will allow the depositors of gold to
earn interest in their metal accounts and the jewelers to obtain loans in their metal account. Banks/other dealers would also be able to monetize this gold.

(ii)      Also develop an alternate financial asset, a Sovereign Gold Bond, as an alternative to purchasing metal gold. The Bonds will carry a fixed rate of interest, and also be redeemable in cash in terms of the face value of the gold, at the time of redemption by the holder of the Bond.


(iii)      Commence work on developing an Indian Gold Coin, which will carry the Ashok Chakra on its face. Such an Indian Gold Coin would help reduce the demand for coins minted outside India and also help to recycle the gold available in the country. ”


 4 .         The proposed Sovereign Gold Bond Scheme is ,in its design and logic, exactly like a Gold ETF ( Exchange Traded Fund) with the difference that the latter doesn’t pay any interest but delivers gold returns to investors by investing the entire proceeds of subscription in metal gold which is held in demat form ! Significantly, all the 14 Gold ETFs in India ,between them, hold no more than 40 to 50 tonnes of gold, which is a mere 5% of annual gold imports of 800 to 1000 tonnes mentioned by Hon’ble Finance Minister! So a gold ETF does not at all reduce metal gold demand and all it does is substitute gold demand from individual metal gold investors with like demand from a professionally and expertly managed gold ETF instead  ! Exactly so will also be the case if the Government does the same to deliver gold returns to Sovereign Gold Bond holders on redemption ! In the highly unlikely event of Government even remotely contemplating using the subscription proceeds for a purpose other than investing only in metal gold will expose it to extreme price risk as it will be committed to delivering gold returns to bond investors on redemption at the ruling gold price ! This is because this will amount to Government incurring  huge short position in gold potentially  exposing the exchequer to gold price increases !   A sense can be had of the enormity of this proposition by considering the fact that gold price moved all over from a then all time high of $ 850 per oz in late seventies to a life time low of $ 270 in the late nineties and then back up to an all time high of $ 1920 in September 2011 !! Assuming the worst case , and hence the most prudent and conservative scenario , of gold price rising from its recent low of $ 1180 per oz to its all time high of $ 1920 ( 65 % increase) due possibly to potential monetary stimulus in Japan and Eurozone , the resulting shock could be fiscally overwhelming and way too disruptive . The rationale for this is that if we again assume conservatively that Gold Bonds would attract the equivalent of 1000 tonnes of annual gold import demand , it will translate into the rupee equivalent of ₹ 1.5 lakh  crores ( $ 25 billion ) of net loss on redemption not counting the interest paid which will ,all else being equal , increase fiscal deficit by like amount because of subscription proceeds not being invested fully in metal gold ! Any multiple of 1000 tonnes will have multiplier effect and in the extreme scenario of the theoretically maximum subscription equivalent to the entire metal gold stock in India of 20000 tonnes , will translate into a whopping net loss of around ₹ 30 lakh crores ($ 485 billion) to the exchequer on redemption at the assumed ruling price of gold of $ 1920 per oz and ,as stated before , will , all else being equal, increase fiscal deficit by like amount, representing 20% of the current GDP ! Not only this , large investors in Sovereign  Gold Bonds could also cause  the so called short squeeze , close to the due date of redemption , to profit at the expense of Government by speculatively pushing gold price higher fully aware that the Government is hugely short in gold , making the above mentioned whopping net loss to the exchequer even worse !


 5.            Contextually, in February 2013 , someone from Commodity Exchange space , who should have known better, had proposed a variant on the theme of the above Gold Bond Scheme . He suggested that the subscription proceeds of the sovereign gold bonds be invested in infrastructure projects and to deliver gold returns to bond holders without price risk and loss , Government may hedge its price risk by buying gold call options ! But this hedging proposition , involving buying gold call options covering ,as stated in the preceding paragraphs, 1000 tonnes worth of annual gold import demand , while tenable in theory of options , will be untenable in practice as this will inundate call option writers/sellers and result in call options getting deep-in-the-money because of resultant price increase way above the starting strike price at which Government will buy these call options , pushing the delta hedge ratio to almost 1 which would mean call options writers will have to physically buy almost 1000 tonnes of the metal , leaving the physical metal gold demand in the domestic market pretty much the same, if not more, and which anyway, as now, will only be imported ! This will also apply just as much to Government seeking to hedge against gold price increase by buying gold futures because given the sheer size of the the hedging demand , call options and futures will both have the hedge ratio of 1 meaning that the demand for the metal gold will be about 1000 tonnes; only that it will shift from Government to the metal gold market and which , if not supplied in the domestic market will , as now, have to be met through imports ! This is the very basic theory and practice of futures and options hedging and pricing which is governed by the so-called no-arbitrage argument or,what is the same thing as,the law of one price. In other words, there can be no free lunch or the case of eating one’s cake( investing cash proceeds of gold bond sales in projects and not in gold) and having it too( replicating and delivering gold returns without investing in physical gold)  !! In a lighter vein , if only to dramatise to best effect , the analogy of futures and options hedging with a dialogue of the character Gabbar Singh in film Sholay is most apt and I quote : ” Oh village folks if there is anyone who can save you from Gabbar, he is none other than Gabbar himself !” So also ” If there is any asset which can deliver gold returns with gold price risk, it is none other than gold itself !” Of course, the same holds for any other asset like equity stocks, bonds, foreign currency, real estate etc ! So to conclude, the proposed Sovereign Gold Bond Scheme will not deliver in practice !


  6.               Turning to the other Budget proposal on the so called monetisation of 20000 tonnes of domestic stock of gold which ,as Hon’ble Finance Minister very rightly observed in his speech, is mostly neither traded nor monetised, I will begin with his own statement that the domestic metal gold stock is mostly not traded . Of course, globally, deep and liquid metal gold deposit and lending markets exist but only for two reasons; the first being active trading and the second gold miners borrowing metal gold to raise money at ultra low interest rates to fund their capital investment in either new mines or in expansion of their existing mines . And there there is no third reason for this !


 7.               The dynamic of the global gold deposit and lending markets in New York, London, Singapore and Hong Kong involves gold borrowing demand coming from short sellers and large gold miners . In particular, short selling arises from speculators, hedge funds and other participants betting on declines in gold price so that they can make profit from their bet coming right by buying back gold at a price lower than the price at which they originally short sold and repaying the metal gold loan  ! But since there is the market discipline of delivery into a short sale, short sellers have necessarily to borrow metal gold to deliver into the short sale which gets adjusted after some time when short sellers either buy metal gold back to cut their losses due to stop loss limits or to book their profits and using the gold so bought back for repaying the borrowed gold !


8.                  Another reason for short selling metal gold is engagement by market participants in cash futures arbitrage when gold futures are cheaper relative to the spot market i.e. when no-arbitrage argument /law of one price of derivatives is violated . What then they actually do is buy cheaper gold futures and short sell expensive gold in the spot market and carrying the arbitrage trades into maturity and earning totally risk free profits due to such mis pricing. Such arbitrage trades continue until, as a result of these trades , such price discrepancy eventually disappears ; the faster this happens ,the more efficient the markets ! Since globally there is large scale demand for such borrowed metal gold , supply comes from gold deposits and , like in any bank deposit and loan market , there are deposits and lending/borrowing rates known as gold lease rates and these are way too low compared to currency rates because they are in theory and practice nothing but the difference between the uncollateralised currency interest rates and and those collateralised by metal gold . Specifically, when gold is short sold , the sale proceeds of short sale are used by the short sellers to collateralise their borrowing of metal gold borrowing which amounts to lending by short sellers of cash from short sale to metal gold lenders at an interest rate lower than the interest rate they will lend at otherwise ; the more desperate the metal gold borrowers are to borrow, the less interest rates they will charge to the lender of the metal gold and so much higher will be the metal gold lease rates ! On the other hand in an aggressive bull market in gold when prices shoot up , the demand for borrowed gold will relatively be far lower and ,therefore, gold lease rates will be lower and can be, and have indeed been, negative !! These gold lease rates are in both theory and practice a fraction of a currency ‘s interest rates ! Illustratively, currently these are 0.09 % , 0.11% , 0.15 % , 0. 25% and 0.40% for 1 month , 2 months, 3 months, 6 months and 1 year , respectively! Incidentally, in the Indian context , there has been frequent demand from some quarters that interest rates paid on gold deposits be higher than currently paid without appreciating the fact that each asset has its own yield curve like for example just as you cannot pay Indian Rupee rates on yen and dollar deposits , so also you cannot pay Indian rupee interest rates on gold deposits ! Coming back to gold lease rates , they have also been negative during the episodes of aggressive bull market in gold when lenders of metal gold far exceed the borrowers of gold to a point that lease rates become zero but there are still storage and insurance costs which make effective lease rates negative!


9.             As I mentioned above , other than short sellers and arbitrageurs there is only one more kind of metal gold loan borrowers , namely, large gold miners who borrow metal gold for longer periods to sell the metal in the spot market and use the sale proceeds to fund capital investment in new mines or in capacity expansion of their existing gold mines and have a natural hedge against gold price rise as they use the metal gold mined to repay their metal gold loans without any price risk and thus have the natural advantage of raising capital at a fraction of cost of debt and equity capital unlike other non gold businesses !


10.           Significantly, as regards lending gold to jewellers , to call it a metal gold loan is an oxymoronic misnomer because, effectively and substantively, it is simply nothing but a sale and purchase transaction as , both in finance theory and practice, a deposit and lending transaction is one where whatever is borrowed has necessarily to be repaid like ,for example, businesses in India borrow in rupees   and generate rupees and thus repay in rupees . So also, jewellers borrowing metal gold will only generate rupees by selling jewellery in the domestic market , and certainly not gold , and so will have necessarily to buy metal gold back  from the domestic market and which, if not supplied locally , will again only be imported  to repay gold borrowed , and to that extent it is no brainer to see that the proposed monetisation scheme will not deliver in terms of reducing gold imports   ! In other words, one will be back to a square one !!


11.             So to conclude whether the proposed gold deposit and lending scheme will deliver in practice will depend critically on whether we have in India both active gold trading involving ,as I said before, short selling and arbitraging and gold mines of global scale ! And as we already know the above necessary and sufficient conditions are not satisfied in the Indian context . In view of the foregoing reasons , both the Sovereign Bond Scheme and Gold Monetisation Scheme will not deliver ! What , however , will is what actually and effectively did only as recently as in 2013-14 , that is, restoring by RBI of the status quo ante by again creating level playing field between gold and non gold imports by stopping gold imports on 1) consignment basis 2) unfixed price basis and 3 ) metal loan basis ! 

Unearned and Unshared Prosperity are Unsustainable

                      UNEARNED AND UNSHARED PROSPERITY ARE UNSUSTAINABLE

                            Keynote Address at International Leadership Symposium hosted by World Forum For Ethics In Business in partnership with World Bank Institute at European Parliament , Brussels, on 30 November 2012
                                                                       By
                                                                 VK Sharma
                                                     Former Executive Director
                                                         Reserve Bank of India


                 As is invariably the case with any major crisis, the ongoing global financial and economic crisis, including lately, of course, the eurozone crisis, have unleashed a passionate debate over the design of a new architecture of finance, capitalism and globalization.   However, the trouble has been not so much with the inter-temporally evolved architecture of finance, capitalism and globalization as really with how it was actually worked in practice.  The apocalyptic denouement, almost bordering on a veritable global financial and economic nuclear winter, happened not because the existing systems and best practices failed but because those responsible for implementing, and enforcing, them failed them !  After all, of all risks to regulators and regulatees alike, human resources risk is by far the most serious as it is the source of all risks as confirmed by the ongoing financial and economic cataclysm.  Effective and credible systems are not about right architecture but about right people for right people can make a wrong architecture work while wrong people can’t make even a right architecture work !  This “right people-wrong people” trade-off is substantively, and effectively, about “ethics-expediency” trade-off, with the overwhelming anecdotal evidence of
‘expediency’ prevailing over ‘ethics’ !  The crux of the matter is what we need is not more, or less, regulation, but good regulation, and governance.  This has been the undoing of regulators/supervisors and financial firms/banks alike.  But unfortunately broad-spectrum and generic failure of an inertial regulatory and supervisory system worldwide, especially in the West, precipitated the unprecedented global financial crisis and the resulting great recession.  This regulatory and supervisory inertia and imperviousness to the early warning signals of unprecedented underpricing of risk, which were galore, and aplenty, pre-crisis, is graphically epitomized by the most no-holds-barred acknowledgement of this - though it came much later only recently - was when Donald Kohn, former Vice Chairman of the US Federal Reserve apologized by saying, “The cops were not on the beat, resulting in the worst economic recession and loss of millions of jobs” !   At the end of the day, the problem is not not knowing the problem, but knowing it and dithering, agonizing over choices, temporizing, procrastinating and doing nothing credible, timely, tangible and decisive about it.  In other words, in my considered opinion, we don’t really have to rethink capitalism and globalisation, for paraphrasing John Ruskin, what finally matters is not knowing what must be done but actually doing what must be done and doing it when it must be done !! And indeed the current policy and action paralysis in the European Central Bank over QE ( quantitative easing), in spite of never-before sub-zero inflation readings, is by far the most glaring and egregious example of this failing of public policy in the euro zone !

2. The cataclysmic financial crisis has thrown into sharp relief, as never before, the critical and important role of ‘asset price’ inflation/asset bubbles also, as opposed to that of shop floor/products/services inflation alone, as a key variable, in monetary policy response.  For what happened was unprecedented in that with monetary policy focused only on traditional CPI, interest rates were kept low in spite of exploding prices of assets like real estate/property, credit assets, equity and commodities.  And this was all made possible because of the huge pre-crisis current account surpluses in China and other Emerging Market Economies (EMEs), and huge private capital inflows into EMEs in excess of their current account deficits, getting recycled back as official capital flows into government bonds of reserve currency countries, especially the USA, resulting in compression of long term yields which, in turn, translated into lower long term interest rates even for the riskier asset classes mentioned above.  This chasing of yield, due to global savings glut, in turn, led to a veritable credit bubble, characterized by unprecedented underpricing of risk as reflected in the all-time-low risk premia with junk bonds spreads becoming indistinguishable from investment grade debt !  Such a low interest rate environment coupled with luxuriant supply of liquidity, created enabling environment for excessive leverage and risk taking.  This financial syndrome was a classical case of “’too much’ and ‘too little’ – too much liquidity, too much leverage, too much complex financial engineering, too little return for risk, too little understanding of risks”.  This syndrome of too much of arcane rocket science and financial alchemy in the financial sector, almost entirely for its own sake to almost complete exclusion of the needs of the real sector, created a massive ‘financial sector – real sector imbalance’ which, being, intrinsically unsustainable, culminated eventually into the now-all-too-familiar apocalyptic denouement.

3. Significantly, the above pre-2007 story of massive and unprecedented current account imbalances was almost replicated in the  eurozone with large and persistent current account imbalances between the core, proxied by Germany, and the Netherlands, and the crisis-hit periphery, with the surpluses of the core being almost mirror image of the current account deficits of the periphery.  Indeed, it is noteworthy that current account surpluses of the core increased dramatically after the launch of the single currency because of significant depreciation of the real exchange rate in the core and appreciation of the real exchange rate in the periphery.  Such large, and persistent, current account imbalances between the core and the periphery would not have been possible but for the explicit moral hazard of fixed and stable exchange rates created by the single currency because the respective national currencies of the periphery would have depreciated in real terms resulting in timely automatic rebalancing of the current account imbalances !  Incidentally, but significantly, these current account imbalances between the ‘core’ and the ‘periphery’ were, to an extent, the result of post-1999 fiscal convergence to fiscal divergence story in the eurozone for, unless net private savings offset it, fiscal deficit typically tends to spill over into current account deficit and, therefore, post-euro launch, there ought to have been a credible, effective and functioning institutional enforcement mechanism to ensure ongoing compliance on Maastricht fiscal parameters.  Of course, this post-1999 fiscal convergence to fiscal divergence story in the ‘periphery’ would not have mattered if, like in the case of Japan, net private savings more than offset the comparable net public dissaving (fiscal deficit) of -9.5% !  So the way out of the current crisis is unwinding these imbalances through higher productivity and competitiveness in the periphery relative to the core.  This is exactly what happened post-crisis in the case of unwinding of the imbalances between China, on the one hand, and the United States, on the other, with the United States current account deficit halving from almost 6% in 2007 to 3% currently and that of China’s current account surplus shrinking steeply from 10% in 2007 to 2.6% currently !  Thus, in the framework of “unearned - unshared prosperity”, it was the case of ‘unearned’ prosperity for the ‘deficit’ periphery and ‘unshared’ prosperity for the ‘surplus’ core !  But as in the case of China and the United States, there is some good news that real wages in Germany have gone up by 3% and those in Greece have gone down by 7%.  Going forward, this then holds the promise of unwinding such imbalances by export of goods and services from the ‘periphery’ and import of goods and services by the ‘core’, and indeed, this has alreay started happening with the fiscal deficits in the periphery shrinking and current account turning into surplus as a result of net private savings offsetting the net public dissavings( fiscal deficits) !

4. As I said, these large and persistent current account imbalances represented ‘unearned’ prosperity for deficit reserve currency countries and ‘unshared’ prosperity for surplus countries.  Such a global economic order was inherently unsustainable, and unstable, from the word go. But the greatest good, and the highest virtue, as it were, of sustainable globalization is that, it does not permit, except in the very short term, ‘unearned’ and ‘unshared’ prosperity but delivers ‘sustainable prosperity’ only if they are ‘earned’ and ‘shared’ prosperity ! And mind you, ‘unearned’ and ‘unshared’ prosperity are no socialistic/egalitarian platitudinal rhetoric but pretty compelling real-politik and geo-economic imperatives given the current irreversibly globalised and, increasingly integrated, and interdependent, world.  Sustainable globalization is about macro economic equilibrium, balance and harmony.  In fact, the whole thing can be likened to cosmic balance/equilibrium/harmony where stars, suns, planets, all orbit within the inviolable discipline of their elliptical orbits which do not permit deviant behavior beyond the shortest and the longest distance from suns and stars of orbiting planets !  Any deviant behavior/conduct, inconsistent with the cosmic harmonious balance and equilibrium, will invite, and inflict, extremely retributive backlash; the more severe and prolonged the disequilibrium and imbalance, the more wrenching and excruciating will be the resulting pain as is currently being experienced, especially in the euro zone, where, it is no brainer to see that, in the event of the break-up of the euro, it is the surplus/creditor ‘core’ that has far more to lose than the deficit/debtor ‘periphery’ !  For if the surplus/creditor ‘core’ exit the euro, value of what is left of the euro will be worth much less in terms of national currencies of the exiting surplus/creditor countries.  On the other hand, if the deficit/debtor ‘periphery’ exit, they will simply default on their euro-denominated debt owed to the surplus/creditor ‘core’ because of the collapse of their national currencies against the euro ! In other words, in sustainable globalization, there can be both winners, and losers, only in the short term, for such is the nature of sustainable globalization that, in the long term, there can only be all winners and no losers !  To conclude, therefore, if we earn and share, we prosper together, and if we don’t, we perish together !!

Making Make in India Sustainable

Making " Make in India" Sustainable

by
V.K. Sharma
Former Executive Director
Reserve Bank of India
 Keynote Address delivered at Jaipuria Institute of Management, Lucknow on 22 March 2015

First , and  foremost, I deem it an honour and privilege to be addressing this very august and discerning academia-industry audience  on " Make In India" , which from all accounts, is  by far  the most contemporary national agenda, with the promise and potential of delivering sustainable inclusive economic growth .However, after going through the Conference agenda , I have decided not to speak about how  to ' make ' "Make in India " happen , but ,instead, to speak about how to ' ensure ' that "Make in India " ever remains a commercially, socio-economically and financially viable and sustainable proposition as it actually happens !

2. What with the cataclysmic and apocalyptic events like, first, the global financial crisis followed by the US downgrade , and later ,Eurozone sovereign debt crisis , followed by the end of Quantitative Easing by the U.S. Federal Reserve, and more recently , the beginning of  long overdue Quantitative Easing by the European Central Bank,   overwhelming the world and India, the last few years have been characterized by unprecedented excessive volatility in asset prices,  currency values and commodities prices, catapulting the critical imperative of Financial  Risk Management to the centre-stage , like never before,  in making " Make in India " sustainable !
3.   As a direct consequence of these spill-overs from the ongoing veritable global financial and economic nuclear winter ,  the rupee depreciated against the dollar by about 24% between March 2008 and March 2009 (Rs. 39.80 to Rs. 52.20) with the volatility doubling to about 12% (as measured by annualised standard deviation of daily percentage changes).  And during the second episode , between August 5 and and December 15 ,2011 , the rupee depreciated by almost 18% in less than 6 months , with the volatility almost doubling from about 5% to 12%. However , during the 2013 episode, the rupee depreciated against the dollar by 23% in less than 7 months between February 5 and August 28 , 2013 wih the volatility doubling from the previous high of 12% to 26% !   Equally deserving of the attention is the fact that since March 2010 to date, the Reserve Bank hiked key policy rates 14  times, raising the effective policy rate from 3.25%, (the effective   rate then being the Reverse Repo Rate) to 8.5% (the effective rate            currently being the Repo Rate), resulting in a cumulative tightening of 5.25% in a matter of a little over 1-1/2 years ! Only later did RBI start easing monetary policy with the current Repo Rate being 7.5%.  However, unlike the previous two episodes, what made the latest episode exceptional was not only the steep and precipitous fall of the rupee to an all time low of Rs 68.80 and its associated unprecedented volatility but also equally the unprecedented volatility in the domestic bond and equity markets with volatilities overshooting to 40% and 36%, respectively. Volatilities on this scale, and of this magnitude, can, under the current maximum permissible limits for forex, equity, credit, on and off balance sheet interest rate, risk exposures, potentially wipe out, over one year horizon, 760% of the net worth of the Indian banking system unless Indian banks recalibrate their risk limits to a sum of no more than 100% of networth !   This episode of exceptionally excessive volatility was triggered by abrupt reversal of capital flows in domestic bond and equity markets through a combination of an unsustainably high current account deficit and a mere prospect of a Fed taper program ! Significantly, it was foreign institutional investment in debt that played spoilsport for out of $ 38 bn worth of FII in debt, $ 9 bn, constituting 24% of the total, was pulled out as against only $ 3 bn pulled out of $ 138 bn worth of FII in equity, constituting a mere 2% !! . Thus, it is no brainer to figure out how much more devastating and disruptive would have been FII outflow from debt market if only foreign investment in debt were of the same order as FII in equity viz; $ 138 bn, or if the then current debt limit of $ 81 bn were fully invested; net FII outflow from debt could have been anywhere from $ 20 bn to $ 33 bn !  In other words, FII in debt is far hotter, and more fickle, than FII in equity ! Equally significantly, global commodity prices have been just as volatile since the crisis of 2008; crude oil prices, after rising steeply to US $ 147 per barrel in July 2008, fell precipitously to $ 32 per barrel in December 2008, and then again rose   from US $ 32 to around US $100 and then dropped  again precipitously to US $ 50 now !  The reason why I have broadened the canvas to also include interest rates and commodities is to approach the subject matter of Generic Financial Risk Management holistically, as it is not just currency risk alone, but interest rate and commodity price risks just as much, that represent significant sources of risk not just to businesses themselves but equally to financing banks and thus potentially to systemic financial stability and , therefore , axiomatically and tautologically , to the very sustainability of " Make in India " itself ! !        
4. In an increasingly globalised trade and investment environment, business and industry have inevitably to contend with, and manage, not just their normal core business risks, but also financial risks like foreign exchange, interest rate, and commodity price risks.  While it will be presumptuous on my part to even contemplate, much less attempt, telling this discerning  audience  how to manage their normal business risks, I do consider it my dharma to attempt shining light on financial risk management, comprising foreign exchange, interest rate and commodity price risks.  Accordingly, I have crafted, and propose to deliver through my keynote address,  what I think, given my own intellectual sense of practice, a practical, nuts-and-bolts, and do-it-yourself tool-kit, elucidating the ‘what’ (i.e. what must be done), the ‘why’ (i.e. why it must be done), the ‘how’ (i.e. how it must be done), and the ‘when’ (i.e. when it must be done) of financial risk hedging, which in my reckoning is as close as, or, the closest, practice could get to theory.
5. Before I proceed further, I would like to put the subject matter of Financial Risk Management in appropriate perspective.  Risk Management is not about eliminating , or which is the same thing as completely hedging out, risk but about first determining , like one’s pain threshold, risk tolerance threshold and then aligning  an entity’s existing risk, be it currency, interest rate or commodity price risk,  with its risk tolerance threshold.  Having said that, it would also be in order to have a sense of how risk itself is defined and measured.  Risk is uncertainty of future outcomes such as cash flows.  In finance theory and practice, it is typically measured by annualized standard deviation of a time-series of percentage changes in asset prices.  While courting financial risks in pursuit of financial return is the staple and dharma of banking and finance industry, it is not so for industrial and manufacturing businesses !  The staple and dharma of business and industry is courting their normal core business risks in pursuit of delivering  market-competitive stable returns on equity to shareholders.
6. I turn now to the subject-matter proper of financial risk management.  I propose to deal, in some detail, with the specifics of risk management strategies for hedging foreign exchange, interest rate and commodity price risks.  I would very strongly encourage business and industry to invariably hedge their actual risk exposures without exception as a base-case strategy.  To say the least, this is by far the most conservative and prudent strategy. As this learned, and discerning, audience will readily recognize, the excruciating and wrenching volatility, experienced recently, unquestionably attests to the credentials of such a base-case strategy of being fully hedged.  Of course, it does mean that risk is being completely eliminated and, therefore, so is being financial return. But then, this is just as well because, as I said before, this is not the dharma of business and industry whose cardinal principle it must be to earn their market-competitive return on equity from their normal core business risks only to the complete exclusion of foreign exchange, interest rate and commodities price risks !
7.   As regards forex risk exposure of business and industry, I would like to take this discerning audience back in time to the late 1990s when the Indian corporate sector went in for large scale ECBs.  These ECBs were almost completely for domestic rupee expenditure and were mostly un-hedged and LIBOR-linked-floating-interest-rate based.  Indeed, so also was the case with the corporates in Thailand and Indonesia which became repositories of unhedged currency and interest rate risk exposures creating credit risk for the domestic banks.  The saving grace was that, unlike in East Asian countries, ECBs by corporates in India were subject to overall limits under Automatic and Approval routes. As this learned audience will recall  , such un-hedged and floating-rate-based foreign currency exposures culminated eventually into the now-all-too-familiar apocalyptic denouement, entailing huge forex losses in India and the East Asian Currency crisis in India’s neighbourhood !  I would, therefore, very strongly commend that business and industry be not tempted and enticed by nominally low interest rates and invariably rigorously evaluate such foreign currency borrowing options, benchmarking them against the comparable rupee borrowings.  Only if business and industry find that the long-term foreign currency borrowing costs are lower, on a fully-hedged basis, than the comparable rupee borrowing costs, must they choose such borrowing options !  I also regret to have to say that the current popular, but uninformed and totally untenable, refrain has been that forward cover for foreign exchange for longer term such as five years, or so, is not available; what is available is out to one month, three months, six months and maximum one year and not beyond.  But I would like to enlighten the discerning audience  that a long-term forward foreign exchange hedging solution can be easily customized by banks by recourse to what is known as rolling hedging strategy which simply involves simultaneously cancelling, and rebooking, a short-term forward exchange contract until the desired long-term maturity.  Incidentally, such simultaneous cancellation and rebooking of forward contracts for rollover is exempted from the RBI restrictions introduced on 15th December, 2011.  Of course, precisely the same strategy can be replicated in the exchange-traded foreign currency futures markets as well.  Contrary to the popular perception, this strategy is fairly simple and perfectly do-able and locks in the original starting spot exchange rate. What, in other words, this entirely unexceptionable, and highly desirable, strategy does is substitute volatility of the spot exchange rate with that of forward margins at each roll over date.  It is empirically, and anecdotally, established that volatility of forward margins is far less onerous than that of the spot exchange rate.  Therefore, I would very strongly encourage business and industry to routinely avail of this hedging solution both to cover forex risk of long-term imports and long-term foreign currency borrowings.
8.   I turn next to the other very popular foreign currency funding option, namely, Foreign Currency Convertible Bonds (FCCBs).  I must confess that I have been very intrigued by what I have read in business and finance newspapers.  The sense that I got was that corporates use FCCBs to raise long-term fixed rate foreign currency funds hoping that overseas investors will exercise the option embedded in FCCBs and convert into equity ! And precisely for this reason, it has been noticed that corporates do not make provision of fully-hedged domestic rupee and foreign currency resources !!  In fact, such basic motivation underlying the FCCB-based funding strategy is completely antithetical to both corporate finance theory and international best practice and turns the entire rationale of such funding strategy on its head ! This is because the very raison d’être of FCCB funding option is to lower borrowing costs below that of an otherwise comparable plain- vanilla non-convertible foreign currency bond. The short point is that the FCCB borrower is baiting the overseas investor with an equity option kicker/appetizer, embedded in an otherwise comparable plain- vanilla non-convertible bond.  Effectively, in this structure, overseas investor in FCCB purchases an embedded option and pays an option premium in the form of lower coupon on FCCB.  I hardly need belabor the point that equity is always more expensive than debt capital of whatever kind, including even junk/ high-yield bonds !  So I would urge business and industry to fully provide fully-hedged domestic rupee/foreign currency resources to meet potential liability under FCCBs, rather than hope that FCCBs will be converted which, in fact, if anything, can be the case of overseas investors, but certainly not, of issuers of FCCBs !  Ths is precisely what happened to a host of corporates, including  Suzlon Energy , which is laden with about $ 600 million worth FCCBs , with the triple whammy of unhedged forex exposure , no rupee resources and the entirety unintended consequential high leverage as conversion did not happen as fondly hoped because of the stock price trading at 70% discount to conversion price ! So also also was the case with the pharmaceutical and biotechnology major Wockhardt which incurred whopping losses of ₹550 crores again , not because of its core business,  but because of unhedged exposures on its FCCBs  ! This is simply because an option exercise will invariably happen when it is in favour of the option buyer and , therefore , axiomatically against  the option seller i.e, upon conversion , FCCB issuers simply give away their shares cheap much below the ruling market price thus raising their cost of equity !
9. Although as serious as foreign exchange risk, interest rate risk has not compelled as much attention in the Indian debt market space.   If only to have a sense of how significant, and serious, it can be, I invite attention to what I said about the key policy rates rising cumulatively by 4.25% since March 2010 to date !  Just like unhedged foreign currency exposure, long-term floating rate loans represent a source of significant risk not only to businesses themselves, but equally to financing banks as they transfer interest rate risk from lenders to borrowers, effectively substituting interest rate risk of lenders with potential credit risk in terms of creating potential non-performing loans !  At another level, as fixed rate loan has more certainty, and hence less risk, both for borrower and lender, it should be preferred both by borrowers and lenders alike.  Thus, for interest rate risk management, the base-case, risk-neutral strategy, is invariably fixed rate long-term funding by corporates.  Contextually, the current popular refrain in the policy debate is that absence of a competitive, liquid, deep and efficient corporate bond market has been the undoing of infrastructure financing which typically involves long-term fixed rate funding.  And as to why banks cannot make long-term fixed rate infrastructure loans, the stock refrain is that this will create asset liability mismatch in banks’ balance sheets as their liabilities are mostly short-term.  Even then banks had a combined infrastructure loan portfolio of about Rs.6 trillion (US $ 110 bn), representing about 9% of the total bank assets in India of Rs.71 trillion (US $ 1.35 trillion) as of 31st March, 2011.  As against this, corporate bond market was around Rs.9 trillion (US $ 170 bn).    In this background, it is noteworthy that back in 2012 ,  the Planning Commission  estimated infrastructure funding requirements, over the next 5 years, at close to Rs. 55 trillion.  While prima facie this may seem a daunting and tall order, on a closer scrutiny, it turns out that it is not really so.  Why I say this is because of the fact that bank assets have grown at a Compounded Annual Growth Rate (CAGR) of 20.5% during the last six years and real GDP has grown at a CAGR of 8.2% during the last seven years.  Thus, it is readily seen that given total bank assets of Rs. 83 trillion as of 31st March, 2012, a CAGR of 20.5%, total bank assets will grow to Rs. 210 trillion over the next five years and assuming that, as against 10% of total bank assets now, banks can finance infrastructure upto 15% of total assets, they would easily be financing about Rs. 32 trillion in infrastructure loans.  And further, assuming the current leverage in infrastructure firms of about 4 times, equity capital of about Rs.14 (55 ÷ 4) trillion will be required, leaving a gap of about Rs. 9 trillion which can easily be financed by corporate bond market, which also, assuming the current bond market to total bank assets ratio of 12.5%, will have grown to Rs. 26 trillion !   But this common and popular, but again uninformed and counter-intuitive, refrain that banks cannot fund long-term fixed rate infrastructure assets is untenable in that banks have not thought of using a very ‘vibrant’ Interest Rate Swap (IRS) market, where outstanding notional principal amounts aggregated Rs 60 trillion (US $ 1.14 trillion) (almost 82% of total banking assets in India as also of the nation’s GDP) !  For  banks can easily transform their short term liability into a long-term fixed rate one and thus create a synthetic long-term financing solution for long gestation infrastructure projects by doing the following :
(i) Receive fixed rate for one year and pay floating overnight rate in the IRS market. (Assuming banks’ average liability is about one year)
(ii) Receive floating overnight rate and pay 5/10-year in IRS market. This effectively synthetically transforms a one-year floating rate liability of banks into a synthetic 5/10-year fixed rate liability.  By loading margin over this rate, banks can make a 5/10-year fixed rate loan to an infrastructure company. And, significantly, considering that IRS now  trades about 70 to 80 basis points below sovereign yield curve , it is win-win for both banks and infrastructure companies who, even after bankers’ spreads/ margins, will be able to borrow at around 5/10 year Govt. bond yield (currently 7. 80% ).  That is as simple as it can get in terms of creating two-in-one fixed-rate long-term market-based financing solutions for infrastructure.
Incidentally, another uninformed and untenable, refrain against use of IRS market is that this strategy entails ‘basis’ risk and ‘liquidity’ risk.  It has been established that there is a statistically significant and positive correlation between one year IRS rate and one year bank deposit rate of 0.75 which will improve further to near perfect level of 0.90 to 1 once this strategy is actively engaged in.  As regards ‘liquidity’ risk, banks have never so far experienced this and will not as their deposits have grown by 18%-plus every year.  Indeed, large corporates, can themselves do it in-house by accessing the Rupee Interest Rate Swap Markets.  As I said before, corporates must treat fixed rate long-term funding as the base-case, or risk-neutral, strategy.  Considering that the five year OIS (Overnight Indexed Swap) are now trading about  70  to 80 basis points below the corresponding maturity government bond yields, corporates can, and should, swap their short-term floating-rate loans into fixed rate long-term loans and yet pick up the above negative yield spread, effectively borrowing long-term funds much more cheaply than perhaps would be the case if they were to borrow either from banks, or for that matter, from the corporate bond market.  This is totally risk free arbitrage strategy corporates can, and must, engage in.  Of course, when this starts getting done on a large scale as it indeed should, but has not so far happened, such negative yield spreads will automatically be arbitraged away.  In fact, CFOs in corporates must routinely compare the two fixed rate long-term funding options to continually assess if they can borrow fixed rate long-term funds cheaply by borrowing in the short term market where they might have a comparative advantage.  But the reverse viz., corporates borrowing fixed rate long-term and swapping loan proceeds into overnight floating rate funds must be scrupulously avoided.  Nothing supports this better than the recent period of tightening cycle which caused overnight floating rates to go up from 3.25% in March 2010 to 8.5% in October 2011 i.e., effective cumulative rise in overnight interest rates of 5.25% !  Having said that, it is both counter-intuitive, and disturbing, to note that some corporates have consistently been ‘receiving fixed’ and ‘paying floating’ !  What this means is that corporates have been speculating by courting interest rate risk by paying ‘overnight floating rate’ and receiving ‘fixed rate’.   Why I say this is for the reason that if corporates first borrowed fixed rate long-term funds and then swapped them into overnight floating rate, then they were exposed to interest rate risk because of 5.25% increase in interest rates.  On the other hand, if they speculated in IRS market without any underlying exposure in the fixed rate long-term loans, then they would  obviously be paying overnight and receiving OIS fixed rates and, therefore, they lose both on the floating rate side as also on the fixed rate side because during the same period, five year OIS rates also increased, though only,  by 0.6%.  We thus see if they  speculated in interest rate markets, rather than hedge, they lost both ways any which way one looks at it !  What I have said about management of rupee interest rate risk applies just as much to floating rate Libor-linked long-term foreign currency loans as well and I would, therefore, strongly commend to business and industry to go in for interest rate swap-enabled fixed rate long-term financing solutions both in domestic and foreign currencies.  While still on the subject of Interest Rate Swaps denominated in Indian rupees, I would wish to address the question as to whether counterparties exist on the other side.  My answer would be, yes they do, and, in fact, one too many !  This I say because the outstanding notional principal amount of IRS, as I said before, was a whopping Rs. 60 trillion (about 82% of total banking assets) (USD 1.14 trillion) and of which, disturbingly, only less than 2% was accounted for by the real sector i.e. business customers and the rest was accounted for by speculative trading of bank dealers, mostly foreign and private sector banks !  In other words, the remaining 98% interbank exposure of about Rs. 59 trillion represented super-abundant/ overwhelming potential supply of counterparties as the hugely negative spreads to G-Secs yields only mean fixed-rate receivers far exceed, and out-number, fixed-rate payers.  This compares very poorly with outstanding OTC forward exchange contracts, where customer (real sector) foreign exchange contracts account for about 40% of the outstanding contracts !  This clearly highlights what is referred to as the ‘financial sector – real sector imbalance’, which was the cause of the last global financial crisis and the resulting  worst recession . In fact, the situation here in IRS segment, unlike forex OTC forward segment, is almost getting to the point where the IRS market, instead of being a means to an end of sub-serving the real sector is, to all intents and purposes, existing almost entirely for its own sake to almost complete exclusion of the needs of the real sector, creating a massive ‘financial sector-real sector imbalance’ ! But This imbalance itself is the reason  enough for corporates to exploit this opportunity for  obtaining low cost fixed rate financing , more so , as the IRS market is fairly liquid, deep and efficient up to 5 year maturity, and with the right policy mix, it can easily get so upto 10 years and beyond. For internationally, IRS dealers typically, and routinely, make markets quoting IRS yields as a mark-up over corresponding maturity government bond yields.  For example, if a counter-party wants to pay 10 year fixed, and receive overnight floating, in IRS market, a dealer will immediately hedge by shorting a 10 year government bond, and investing sale proceeds in overnight repo market.  However, this cannot be done in India for want of short selling and HTM (Held to Maturity) and no MTM (Marked to Market) accounting.
10. As regards commodity prices, business and industry can use international commodity exchanges to hedge dollar price risk, and domestic commodity exchanges to hedge rupee price risk.  In fact, whenever some commodities, like crude oil, are in backwardation (the futures price being lower than the current spot price), in addition to buying price protection, business and industry also earn what is known as ‘rolling’, or ‘convenience’, yield.
11. By now, I am sure this discerning audience must have got a fairly good sense of the repertoire of derivatives to choose from in management of financial risks business and industry need to contend with day in and day out.  However, as regards derivatives, I would like to quote Financial Times Columnist Wolfgang Munchau and the legendary investor Warren Buffett who famously described derivatives ‘as probably the most dangerous financial products ever invented’ and ‘financial weapons of mass destruction’, respectively !  Perhaps, they had the global energy giant Enron Corp in mind which filed for the largest bankruptcy in the US history by assets of $ 50 bn all because of straying into derivatives as a profit centre , courting financial risks in pursuit of financial returns , rather than using them for hedging ! But I would beg to differ because, to my mind, they are as strong statements as saying that cars and driving are most dangerous because they might lead to accidents !  The problem is not so much with derivatives, or with cars, for that matter, but with how we use them !!  In this context, as this learned audience will recall , not long ago ,the instances of egregious forex losses of hundreds of crores to thousands of crores of rupees, more than offsetting, in some cases, the net profit from normal core businesses, were legion and the print media replete with them ! These losses arose primarily because derivatives were used by business and industry not for hedging, but for speculative, purposes.  As reported in the media, huge losses were sustained by business and industry on account of complex structured and synthetic, but so much less transparent, derivatives.  In other words, business and industry must go in for plain vanilla derivatives which upfront, transparently, and explicitly, disclose cost of hedging strategy rather than arcane, complex, synthetic and structured derivatives which camouflage risk.  As regards prudent use of derivatives, the touch-stone that business and industry can use with profit is that any derivatives strategy which promises reduction, or elimination, of hedging cost, or promises enhancing income, is intrinsically speculative and the one that involves incurring hedging cost and promises no income enhancing is intrinsically a hedging strategy.  And as regards convincing businesses that over the long haul, the cost-benefit calculus of hedging is net positive, at its most basic and fundamental, it is as net positive as that of insurance for crop, earthquake, health, property, factory, fire, theft, machinery, accident, etc.
12. As non-financial businesses, unlike financial businesses like banks, have a typical leverage/Equity Multiplier of 2 to 3 times, their assets are funded to the extent of 50% to 33% by common equity shareholders and the remaining 50% to 67% by banks and bond holders; funded to the extent of 42% with bank debt and 8% with bond finance and 55% with bank debt and 12% with bond finance, respectively.  It is significant to note that because of such typical corporate finance structure of non-financial businesses (very low leverage), globally there is no regulation and supervision of such non-financial businesses in the same sense as regulation and supervision of financial businesses like banks primarily because, unlike in the case of the former, any imprudent and risky behavior, on the part of the latter, represents significant risks to depositors and systemic financial stability.  The point that I am making is that in the case of non-financial businesses, because of the typically low leverage, common equity holders take the bulk of risks and losses from their acts both of commission and omission.  Unlike in the case of banks, where acts of commission of shareholders, directors, business managers are either proactively and preemptively front-stopped, or reactively back-stopped, by regulators/supervisors save the latter’s  own acts of omission themselves, there is no such supervisory/regulatory supervention in the case of non-financial businesses to make them practise the tool-kit delivered in this keynote address, potentially culminating in the inevitable consequences of higher costs of both equity and debt capital, and in extreme cases, even insolvency/bankruptcy !  However, in India, since bank debt accounts for roughly up to 55% of the financing of assets of non-financial businesses, the paragraphs 102 and 103 of the RBI’s Second Quarter Review of Monetary Policy 2011-12, which require that while extending fund based and non-fund based credit facilities to corporates, banks should rigorously evaluate the risks arising out of unhedged foreign currency exposure of  corporates and price them in the credit risk premium,  will have the effect of delivering the required chastising and chastening, with banks pricing unhedged financial risk exposure of businesses into credit risk premium, provided they are effectively enforced in practice.
13. Significantly, businesses not practising the nuts-bolts-what-why-how-when regimen, commended in this keynote address  does not make it theory anymore than does a patient not practising a medical practitioner’s regimen make it theory.  So if the patient does not practise the medical practitioner’s regimen, he will pay the price with his deteriorating health and, in the extreme case, even with his life. So also will businesses, which do not practise the nuts-bolts-what-why-how-when regimen in this keynote address , will pay the price with much higher costs of debt, and equity, capital and, in the extreme case, with insolvency/bankruptcy due to financial risks , of course, at the expense of the very sustainability of " Make in India " ! Just as in the case of a patient, close relations and friends may try, and secure, medical regimen compliance and practice, so also in the case of non-financial businesses, shareholders, through their elected directors, independent directors and ‘activist shareholders’ on their boards, must do what they can to practise the nuts-bolts-what-why-how-when regimen in this keynote address !   As someone has said “once we make a choice, we choose its consequences as well”.  So, if businesses choose, whether because of enormous pressure from shareholders, or for that matter, because of heads-business managers-win-and-tails-shareholders-lose incentive structure, to “behave not rationally” and “not play for the long-term” and take completely avoidable financial risks, they choose the inevitable consequences as well of being backlashed, and chastised, by capital markets comprising equity and debt (both bond and bank debt markets).  Such imprudent behaviour will, in equilibrium, result in capital markets exacting higher equity risk premium (lower share price) as well as higher credit risk premium (lower debt price). Therefore, if they choose not to practise, one need not feel compunctious as they simply will also choose the inevitable consequences of their own choice which will entail much higher equity capital costs and borrowing costs in banking credit and bond markets, and, in the extreme case, insolvency/bankruptcy, thus, not maximizing, but minimizing, and even destroying, shareholder value and wealth , again ,  as I said before , at  the expense of the very sustainability of " Make in India " !!
14. To sum up, such is the insidiousness of risk that its under-pricing, as reflected in excessively low volatility, is perceived as low, or no risk, and, therefore, economic agents including banks, business and industry are caught unawares and unpleasantly surprised when risk suddenly eventuates. Since unhedged financial exposures represent significant risks not just to businesses themselves but equally to financing banks and thus potentially to systemic financial stability , and no less, of course , to sustainable " Make in India " itself , it is imperative that banks actively and constructively engage with their unhedged corporate clients on risk management with a view to saving banks from their corporate clients and corporate clients from themselves ! Therefore, to my mind, nothing conveys and expresses the Risk Management mantra more trenchantly than the following : “Just as you make friends when you don’t need them, not when you need them and certainly not after you need them, so also you hedge when you don’t need it, not when you need it and certainly not after you need it”.  Complete internalization and ingraining of this holistic risk management culture, attitude and temper by business and industry will, in equilibrium, reduce cost of both debt and equity capital by reducing volatility of ROE as markets will perceive them as much less risky and more safe !  If I have succeeded in alerting and sensitizing this learned and discerning academia-industry audience to the Financial Risk Management imperative enough, I will feel vindicated that I have delivered on my dharma !  And, I have no doubt, if acaemia  and industry completely internalize and ingrain this mantra and dharma, they will exemplify the following fairy tale ending viz. “And they lived happily ever after” !  Finally, with the fond hope that I have not unwittingly come across as pontificating on the mantra and dharma of Financial Risk Management, I conclude my keynote address and , going forward , wish academia and industry a truly blissful Risk Management nirvana and , through their ongoing synergistic and symbiotic Interdependence , Integration and Cocreation , sustainable ' Make In India ' !

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Economic Consequences of Higher Regulatory Capital

Economic Consequences of Higher
           Regulatory Capital for Banks
                       By VK Sharma
             Former Executive Director
                 Reserve Bank of India


Pre- crisis , luxuriant supply of liquidity in an exceptionally low interest rate environment led banks any which way to expand credit and inflate in the bargain the now infamous credit bubble with all its cataclysmic  consequences. All through the inflating of this bubble, banks actively engaged in excessively leveraging their balance sheets with no questions asked by regulators ostensibly beacuse banks were all this while fully Basel 2 compliant based on their risk weighted assets ! And one very compelling reason for this was banks looking for ways to pay excessively high  executive compensation . This ,for a given NIM ( net interest margin) and a given level of borrowing costs,, resulted in ever increasing compression of RoA ( Return on assets) parameter which, in turn, left no choice for banks but to correspondingly increase leverage with a view to keeping shareholders happy by delivering market competitive equilibrium ROE ( Return on equity) to a point where  hedge funds,traditionally considered byword for leverage , came to look like apostles of defensive strategy in comparision  ! So, if anything , the worst financial disaster, bordering on a veritable global financial and economic nuclear winter, happened , not in spite, but because , of Basel 2 !!

After the fact, regulators became wiser and thought up Basel 3 which mandates  a minimum leverage ratio of 3% or a  maximum leverage of 33 times ! Given that even this 3% is rather low, one can imagine where banks were on this parameter before the cataclysm  ! And no less, even this rather modest number seems very ambitious if one reckons with the fact that even this has to be complied with only by March 2018 ! But significantly, this is a redeeming feature  because any quicker transition would be counterproductive for the real economy given the state in which it currently is .

To have a sense of what a quicker transition could mean for the real economy , it is instructive, intuitively appealing  and insightful to model changes in output/growth in the real economy  through an analogy of ICOR ( incremental capital to output ratio) by conceptualizing  IAOR (incremental assets to output ratio) ! Any quicker increase in regulatory capital will, as it already has, result in deleveraging or shrinking of,or no growth in,  bank balance sheets hurting output and jobs . Specifically, the IAOR for India is empirically estimated at 2.5 which means that for 1% decline in  bank assets, output will decline by 0.4 % ! This then is the  powerful and intuitively compelling way to model the impact of  an increase in the regulatory capital or lverage ratio  for banks on the real economy and explains the caution on the part of  regulators in  calibrating the phasing in of higher regulatory capital and leverage ratio.

The other way higher regulatory capital and leverage ratio will hurt growth/output/jobs is through Taylor Rule. In this formulation, higher regulatory capital or leverage ratio  would mean involuntary monetary tightening as it were ! This would happen because all else being equal, which means NIM-RoA also remaining unchanged, RoA would need to rise for banks to be able to continue to deliver  market competitive equilibrium return on equity (RoE) to attract equity capital . With no further cost cutting and efficiency gains immediately possible, this, in turn, will, through corresponding increase in NIM, increase borrowing costs for the real economy  the effect of which would be the same as that of involuntary monetary tightening. It is precisely to mitigate this adverse impact on growth/output/jobs that calibrated  transition to higher regulatory capital/leverage ratio has been envisaged although 3% leverage ratio itself is rather low and needs to be higher at around 5 % to 7% ! Indeed, Indian banks are already here and therefore  already 2.5 times Basel 3 compliant ! Of course , the upside of longer transition would be that inspite of inreasing RoA, banks may even succeed over time  in reducing , or  even minimizing , NIM-RoA via endogenous business process re engineering and technology upgradation, resulting in reduced  borrowing costs for  the real economy !

Incidentally, but significantly, Indian banks being already 2.5 times Basel 3 compliant with leverage ratio of 7% plus will need to increase equity capital only to maintain their existing leverage ratio i.e to remain compliant with themselves and not at all to comply with Basel 3 as is widely,but erroneously, made out in many quarters ! This conclusion will very much be valid even if the denominator of the leverage ratio is inflated to include all off balance sheet liabilities which in the case of Indian banks are about 100% of the aggregate assets because this will only reduce the leverage ratio from 7%+ to 3.5%+ which is still higher than Basel 3 requirement of 3% !!

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Must Reserve Bank of India Pay Interest on Required Cash Reserves

“Must Reserve Bank Pay Interest On CRR Balances ?”
               
                      There has been passionate demand in some quarters that the Reserve Bank pay interest on the so- called cash reserves maintained with it by banks as part of its monetary policy. The current applicable Cash Reserve Ratio (CRR) is 4% of Net Demand and Time Liabilities (NDTL). But there is no logic and reason to paying interest on CRR  because CRR is about impounding liquidity with a view to reducing M3 (Money Supply) through adjustment to reserve money/primary liquidity/high-powered/base money which can universally be created /withdrawn ”only” by a central bank ! Typically, under the fractional reserve banking, required reserve ratio (CRR) sets the theoretical maximum limit on broader money banks can create through making loans out of their deposits. Thus, if CRR be 4% of NDTL, as now, then the theoretical maximum M3 is 1/0.04=25 times the required reserves, i.e. the money multiplier (MM) is 25.  But in actual practice, public preference to keep a chunk of their deposits in the form of cash/currency and banks choosing to accumulate excess reserves, act as a drain on broad money creation resulting in much smaller actual/empirical/observed money multiplier ! Thus, currently the actually observed money multiplier (MM) is about 6, obtained by dividing the current M3 of about Rs 90 trillion ( currency worth Rs 12 trillion and deposits worth Rs 78 trillion) by Reserve Money of about Rs 15 trillion (currency worth Rs 12 trillion and CRR worth Rs 3 trillion) . It is not that RBI cannot, and should not, pay interest on CRR as demanded in some quarters. Only that to have the desired extent of impounding of liquidity to influence aggregate demand in the real economy, M3 will still need to be contracted by a certain amount. What will happen if interest is paid is that the effective/ substantive contraction/withdrawal of money will be less to the extent of interest - reserve/ primary/base money - paid by RBI and so CRR will have to be so much higher than, say 4% at present, to achieve the required contraction in M3 (Money Supply) to achieve the required compression in aggregate demand in the real economy ! More generally, if C% be the CRR without interest payment by RBI and i% be interest to be paid by RBI, and C1 be the new/corresponding CRR accruing interest at i%, then interest accrued on C1 will be i/100*C1 and so effective impounding with payment of interest will be (C1-i/100*C1)=C1(1- i/100) which must equal the monetary  policy neutral objective/goal of C i.e. C1(1- i/100)=C or , C1= C/ (1-i/100). So, if i= 6.75 % (Current Reverse Repo Rate) and C=4%, as now, then the required CRR C1 with payment of interest will be: C1=4/(1-0.0675)=4/0.9325=4.29% . In other words, the choice is simple: either have monetary impact neutral CRR of 4% without payment of interest, or have CRR at 4.30% with payment of 6.75% interest by RBI !
 
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The how and how not of Bank Financial Performance Analysis

" How, and How Not, to Analyse Bank Financial Performance : Uncluttering the Clutter "
By VK Sharma,
 Former Executive Director,
                                 Reserve Bank of India                                    

                        Come quarterly/annual bank financial results and investors and readers of business and financial newspapers are all agog over some analyst gushing ‘ Bank A’s net profit rises 35%, and some other analyst emoting ‘ Bank B’s NIM is highest at 5 or 6 % ! And all these are taken by readers and investors as holy grail  suggesting that banks concerned  have been exceptionally efficient and profitable ! This need, and may, not at all be so. But before seeing why, it would only be instructive and value-adding to consider the business model of a typical competitive , efficient, safe, and sound bank.  A bank is typically characterized by relatively high financial leverage, which, in turn, is measured by what is known as Equity Multiplier (EM), which, in turn, is nothing but total assets of a bank divided by its common equity/ shareholder funds. Multiplying this leverage (EM) by what is called Return on Assets (ROA) gives Return on Equity (ROE) for a bank. Typically,competitive, efficient, safe and sound banks have had historically an average ROA of about 1% and a reasonably safe EM of about 15, implying an average market-competitive equilibrium ROE of about 15%. In the recent period, the Indian Banking System has had leverage of about 13 to 14 times. Significantly, and hearteningly, to the credit of RBI and the Indian banking sector, this corresponds to an average leverage ratio ( inverse of EM) of 7%+ which,  at about 2.5 times, is way higher than 3% mandated by new Basel 3 capital rules to be complied with only in 2018 ! In other words, the Indian banking sector is already more than 2.5 times compliant on this critical Basel 3 parameter !! In this context, another key financial parameter is what is known as Net Interest Margin (NIM) which is the difference between interest earned and interest expended as a percentage of a bank’s assets. Collectively for Indian Banks in the recent period, NIM has varied between 2.5% to 3%. If we deduct ROA from NIM, we get what can be called Non Interest cost of Intermediation. In fact, it is this critical parameter/ objective function viz (NIM-ROA) which, for a given ROA derived, in turn, from a given ROE and EM, it must be the dharma/mantra of a role model bank management to minimize for maximizing returns to depositors and/or minimizing costs to borrowers . Thus, either way, constrained minimization of the objective function (NIM-ROA) delivers value to all stakeholdergs viz, shareholders, insured & uninsured depositors, borrowers, taxpayers, in particular, and the real economy, in general. To recapitulate,  " the business model of a competitive, efficient, safe and sound bank is one which, while  by minimizing the objective function (NIM-ROA) subject to the constraint of a given ROA, derived, in turn, from a given market-competitive equilibrium ROE, maximizes value for all stakeholders viz, depositors, borrowers, shareholders and public policy institutions, and allows it to grow sustainably by helping the real sector grow consistent with 'financial sector-real sector balance ' where the financial sector is ever a means to the real sector end !! "
           
2.            We  are now ready to unclutter the clutter in bank financial performance analysis and evaluation. As regards the myth of NIM being a key measure of profitability, let it be said that  NIM by, and in, itself conveys nothing more than what it apparently does viz, as we have seen before, it is just the difference between interest earned, and interest expended, as a percentage of a bank’s assets. It is just a means to an end and not an end in itself ! For it,therefore, to make any sense, it needs to be analysed further beyond what it is by considering (NIM-ROA). For if NIM be 6%, and ROA be zero, then automatically ROE will also be zero and it is no brainer to see that this nominally very high NIM only establishes that the bank is neither competitive, efficient, safe nor sound ! Even if  ROA be, say 2%, then ( NIM-ROA) will be (6%-2%) i.e 4%. And this bank will be far less efficient and competitive  than a bank whose NIM  is, say 3%, and ROA , say 1% , and, therefore, (NIM-ROA)  2% ! This is because non-interest cost of intermediation of the higher- NIM bank is twice that of the lower- NIM bank and it is precisely this twice as large (NIM-ROA) and its reasons through its granular analysis and dissection that should engage the attention of bank analysts and investors !  For it is this (NIM – ROA) that subsumes all non- interest expenses such as taxes, salaries /wages /compensation, operational expenses, loan loss provisions, marked-to-market provisions, write-offs etc. And this (NIM –ROA) becomes even more significant, if the reported gross NPAs (non performing assets) are unusually low ! Therefore, in the above example, the bank with lower (NIM-ROA) will be twice as efficient and competitive  as the one with higher (NIM-ROA) because the former maximizes value for all stakeholders viz, depositors by way of higher deposit interest rates, borrowers by way of lower borrowing costs, shareholders by way of given ROA and market - competitive equilibrium ROE ! And significantly, there is no effect on the rigour, applicability and  generality of the above analytical framework even if non-interest income is not insignificant for all that need be done is just add this income, as a percentage of assets , to NIM- ROA , and only refer to this, if you will, as Net Income Margin rather than Net Interest Margin  ! This would, for a given ROA and ROE , only make NIM even  wider and , as stated before , in combination with the unusually low gross NPAs for such banks  , would make NIM- ROA look , if anything, even more questionable in the sense that what is absent in the unusually low Gross NPAs is very likely present in the unusually wide NIM - ROA !
3.                 Finally , coming to too much being made of, say 25% to 35% growth in net profits, this too needs to be regarded with circumspection for these numbers need to be adjusted for the growth in balance sheet / assets and not just considered in isolation and on a stand- alone basis. For if net profit grows at 35%, on a yoy ,or a CAGR, basis and  assets/ balance sheet also grow by, say 35%, then there is really nothing to write home , or to feel gung ho, about for the bank in question has been no more, and no less, efficient and profitable than before ! Another equally insightful way to see this is in terms of change in ROA . For example, if previous ROA be, say 1%, then there is no change in ROA as the ROA also remains unchanged at 1% for 35% growth both in net profits and assets/balance sheet ! On the other hand, if for a 35% growth in net profit, assets/ balance sheet grow by, say 25%, then the bank has been more efficient and profitable only to the extent of (1.35/1.25-1)*100 i.e.+ 8%, and not 35%, as bank analysts would unwittingly have readers and investors believe !! In this case, ROA increases fom 1% to 1*1.08 i.e 1.08% only ! Also, significantly, and equally, if assets/ balance sheet grow by 40%, then the so-called nominal profit growth of 35% will translate into a less efficient and less profitable performance of (1.35/1.40-1)*100 i.e - 3.5% and not 35% as ROA will decline to 0.96% from 1% previously although absolute net profit increased by 35% !!  This then is the conceptually robust and technically rigorous nuts-and-bolts way of  how bank analysts and investors must dissect  bank financial performance and judge true and fair value of banking stocks  for value investing/buying  !

4.              While on the how-and-how-not  of bank financial performance anaysis and evaluation, a tailpiece on banks' reporting of ' total business ' will not be out of place and context. Typically, in India, it is routine for banks to report total business as the sum of deposits and loans to give analysts and investors a sense of growth in banks' business. But this is not only at variance with the international practice but also intellectually and conceptually flawed and vitiated for  all  ' business ' is about generating revenues and returns for shareholders and it is ' total assets'  that precisely do that and it is tautological and axiomatic that there is no way revenue generating assets can exist and grow without corresponding  expense contributing liabilities ! That is also precisely why, as sources and uses of funds, liabilities and assets appear opposite each other on a balance sheet . Significantly, the so called total business of banks has typically exceeded total assets/ balance sheet size by about 50% !
5.              Therefore, while bank analyts and investors will do well to go that extra mile to have a true and fair sense of banks' business growth, with a view to aligning with the international practice , RBI may also consider mandating banks  reporting total assets/ balance sheet size rather than the so called ' total business ' adding deposit liabilities and loan assets.
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