Regulatory Issues In Derivatives Markets In India: Doing The ‘Right’ , and Not The ‘Easy’, Thing

V K Sharma, Former Executive Director, Reserve Bank of India

    

1.   I deem it an honour and privilege to be addressing this very distinguished and august audience.  Right at the outset, I would like to impress upon this very learned and discerning audience the proposition that the ‘financial sector’ is not an end in itself, but instead, it is a means to the end of sub-serving the ‘real sector’ and, in that sense, it is consistent with, and a natural fit to, the public policy imperative of “financial sector-real sector balance”.  As this distinguished audience is aware, there is now  a broad consensus and unanimity  among all the key stakeholders that, in the run up to the the apocalyptic and cataclysmic global financial crisis of 2008 , the “financial sector”, what with the  total notional amount of outstanding derivatives worldwide at US$ 675 trillion being 11 times the total world GDP of US$ 60 trillion,   got to the point where, to all intents and purposes, instead of being a means to the end of sub-serving the “real sector”, it  came to exist, almost entirely for its own sake, to the almost complete exclusion of the needs of the “ real sector”, resulting in the massive and unsustainable “financial sector-real sector imbalance” and the worst financial crisis and economic recession since the Great Depression! And, therefore, the Conference theme “Strategising India to be a $ 20 trillion Economy: Issues and Challenges In Accounting, Finance, Economics and Banking” provides the perfect backdrop, and contextual topicality, to the challenge of credible, effective, preemptive  and proactive, as opposed to the reactive, regulation of the Indian derivatives markets in delivering on the public policy imperative of “financial sector-real sector balance” by doing the ‘Right’, and not, the ‘Easy’ thing, and which precisely is the central and key message of my today’s Keynote Address! 

2.   In India, we have a host of exchange-traded cash-settled derivatives contracts like currency futures and options, Government bond (Interest Rate) futures, index futures and options and single stock futures and options which all settle in cash rather than by physical delivery on their expiration.  In contrast, in the US, these very same derivatives contracts, except index derivatives , are required to be settled by physical delivery on their expiration. And, the reason why derivatives  must settle not in cash, but by physical delivery, on expiration of the contracts is that this discipline ensures almost real-time "organic connect", coupling, alignment and lockstep convergence between the derivatives price and the underlying cash market asset price much like the "organic connect" of the umbilical cord between the foetus and the mother until the physical delivery!

3 .  Significantly, regardless of whether the derivatives are over-the-counter (OTC),  or exchange-traded,  the underlying  theory and practice has been the so-called "law of one price" or, what is the  same thing as, the "no-arbitrage argument", involving the replication of the derivatives cash flows in the underlying cash markets.  In other words, a derivative of an underlying cash market asset which derives its value from that of the underlying cash market asset, will be so priced/valued that it is not possible to arbitrage between the cash market price and the derivative price because the derivative is correctly priced relative to the underlying asset in the cash market. For, if a derivative were priced expensive relative to the underlying asset in the cash market, an arbitrageur will engage in risk-free/risk-less arbitrage by selling the expensively priced derivative and simultaneously buying the asset in the cash market by financing it at the lower (than the repo rate implied by the expensively priced derivative contract) actual repo rate and physically delivering  the asset on expiration and thus realising the targeted risk-free/risk-less arbitrage profit! In the opposite case, where the derivative is priced cheap relative to the underlying asset, an arbitrageur will engage in risk-free/risk-less arbitrage by shorting the asset in the cash market, investing the proceeds of short sale at the higher actual repo rate and buying the relatively cheap derivative (lower implied repo rate) and taking physical delivery of the asset on expiration of the contract , using the asset so acquired through physical delivery to return the asset borrowed for delivery into the short sale and, thus, again realising the targeted risk-free/risk-less arbitrage profit! This seamless and frictionless risk-free arbitrage, made possible by the discipline of physical settlement on expiration, will continue apace until, in equilibrium, the derivative was correctly priced/valued relative to the underlying asset in the cash market, "so much so that this very near perfect arbitrage-free pricing of derivatives itself will result in negligible actual physical delivery on expiration with the participants closing out their open derivatives positions with offsetting trades before expiration!" In a physically-settled derivative contract, the only open positions that go into actual delivery at expiration are only the arbitrage positions and not even those of hedgers who close out their positions just before expiration, achieving the objective of a true basis-risk-free hedge! The anecdotal evidence from the derivatives exchanges around the world is that in the physically-settled derivatives contracts, actual delivery is almost absent if not exactly zero! And it is precisely this feature of a physically-settled derivative contract of almost "no actual delivery" on expiration , due to the discipline of risk-free/risk-less cash-derivative arbitrage, that is the incontrovertible touchstone and hallmark of an efficient, deep and liquid derivatives market which fully delivers on its public policy purpose of real time efficient lockstep price discovery and basis-risk-free hedging in the underlying cash market assets! So, paradoxically, in the case of physically-settled derivatives, actual physical delivery on expiration "doesn't happen precisely because it can happen" were the prices of the derivatives and the underlying assets in the cash market to diverge, decouple, disconnect and not move in lockstep!

4. But in the case of the cash-settled derivatives contracts, because of the absence of risk-free/risk-less cash-derivatives arbitrage, and the leverage typical of the derivatives , there is considerable scope for a derivative to derive its  price from itself, rather from its underlying asset in the cash market, and for speculators/manipulators to make derivative price go way too out of sync and  lockstep alignment with that of the underlying asset, which, in turn, has the effect of making the derivative a "non-derivative", exposing, both arbitrageurs and hedgers, to not inconsiderable "basis-risk", and defeating, in the process, the very public policy purpose of a derivative acting as an effective true hedge for the “real sector”! It is noteworthy that ‘risk-free/risk-less’ cash-derivatives arbitrage in physically-settled derivatives becomes a ‘risky arbitrage’ in cash-settled derivatives because on the settlement day, arbitrageurs may either make a profit , or equally, a loss, because of the cash settlement price being different from the actual cash market price on the day of the settlement. This is so because on the cash settlement day, an arbitrageur ,who is short the cash market asset, may end up having to buy back his short position at a loss, or profit, or an arbitrageur, who is long the cash market, may end up having to sell his long position at a loss, or profit, except in the fortuitous event of the cash settlement price being exactly equal to the actual cash market price, in which case, of course, the targeted, but no way risk-less/ risk-free, arbitrage profit will be realised! 

5.  The foregoing cannot happen in the physical settlement version because, if a speculator manipulates the derivative price to be higher relative to that of the underlying, he will be punished by arbitrageurs who will buy the underlying asset cheap in the cash market and deliver it to the price manipulator at his higher price, making, as we have seen above, a risk free/risk-less arbitrage profit entirely at the expense of the manipulator! In the opposite case, risk-free/risk-less arbitrageurs will punish the manipulator by making him deliver an otherwise expensive asset at a lower derivatives price, again, as we have seen above, earning the targeted risk-free/risk-less arbitrage profit entirely at the expense of the manipulator! Thus, in cash-settled derivatives, both arbitrageurs and, therefore, hedgers, lose out to manipulators/speculators due to ‘basis risk’ but, in a sharp contrast, in physically-settled derivatives, arbitrageurs actually profit at the expense of price manipulators/speculators through ‘risk-free/risk-less arbitrage until the ‘basis risk’ to hedgers is completely eliminated, thus, sub-serving the public policy purpose of providing the true and effective hedge to the ‘real sector’!

6.  While the underlying assets in the case of the single stock futures/options and currency futures/options are homogeneous, this is not the case with Government bonds underlying the Interest Rate Futures (IRF) . This is because a standard 10 year Government bond futures contract will cover a deliverable basket of comparable maturity bonds with widely differing coupons. They are made comparable through what is known as conversion factor which is unique to each deliverable bond. To arrive at the conversion factors of the individual deliverable bonds, they are all priced to give the yield of the notional/ hypothetical par bond underlying the IRF. These prices are then divided by the par price to give the respective conversion factors.

7.     It will be instructive to review the evolution of the physically-settled IRF since its launch in August 2009. After their second launch in August 2009, the Interest Rate Futures on 10-year notional government bond had seen two settlements, viz., the December 2009 contract and March 2010 contract.  Significantly, both traded volumes and Open Interest (OI), witnessed decline over the two settlements, eventually decaying very quickly to zero permanently.  In particular, the December 2009 contract, which had a peak Open Interest of ₹ 980 million declined to a pre-settlement Open Interest of ₹ 610 million and settled “entirely” by physical delivery, representing physical settlement of 62% of the peak Open Interest!  In contrast, the March 2010 contract, which witnessed a peak Open Interest of ₹ 570 million declined to a pre-settlement Open Interest of ₹ 420 million and also settled entirely by physical delivery, representing physical settlement of 74%!  Both these settlements were a far cry from the hall-mark and touch-stone of an efficient, frictionless, seamlessly coupled, and organically connected, physically-settled futures market even where physical delivery typically does not exceed 1% of the peak Open Interest!  In fact, on Chicago Mercantile Exchange and New York Mercantile Exchange, settlement by physical delivery is as low as 0.4% even though the contracts are physically settled types. This happened because of the inefficient ‘disconnect’ and ‘friction’ in the IRF market due to only one way arbitrage, viz., buying the cheapest-to-deliver (CTD), with the highest implied repo rate (IRR), by financing the same at the lower actual repo rate and simultaneously selling futures.  In fact, for one market participant, who accounted for almost the entire ₹ 600 million worth of physical delivery into the December 2009 contract, the implied repo rate of the CTD was 6.75% as against the actual repo rate of 3.4%, representing a risk-less/risk-free arbitrage profit of 3.35%!  But unlike this, on the other side, for the so-called benchmark, and most expensive-to-deliver, Government bond, the IRR was almost zero to negative, suggesting a risk-free arbitrage profit opportunity of short-selling this bond and investing the proceeds of short sale at much higher actual repo rate and buying the futures contract!  "But, alas, this arbitrage could not be engaged in for want of short selling for a period co-terminus with that of the futures contract!"  It is the possibility of this two-way arbitrage, working in the opposite directions, that, like a “good conductor” of ‘heat’ and ‘electricity’ in physics, will seamlessly conduct/transmit/permeate/impart liquidity and homogeneity, as it were, from the relatively more liquid (the most-expensive-to-deliver) benchmark government bond to the so-called illiquid (the cheapest-to-deliver) and heterogeneous bonds in the deliverable basket !

8.   As we can easily see above, the physically-settled IRF failed not because of any design defect but because of the absence of the necessary and sufficient conditions for efficient, seamless and frictionless cash-derivatives arbitrage between the deliverable bonds and the futures contract. So, it might just as well be to list out the necessary and sufficient conditions for physically-settled IRF to succeed as indeed it has in all the developed and mature markets across the world. And the necessary and sufficient conditions are as under:

i)   Symmetrical and uniform accounting treatment of both cash and derivatives markets.

ii)  Removal of the ‘hedge effectiveness’ criterion of 80% to 125% which militates against the use of derivatives for hedging purposes for it is better to have ‘ineffective’ hedge than to have no hedge at all!

iii) Roll-back of the Held-to-Maturity (HTM) protection, that is, substituting the current “accounting hedge” with “derivative hedge”.  This is because with HTM, there is no incentive/compulsion whatsoever for the use of market-based solutions like IRF which also require constant monitoring, infrastructure, transaction costs like brokerage and margins, etc.  

iv)  Delivery-based short-selling in the cash market for a term co-terminus with that of the futures contract and introduction of term repo, and reverse repo, markets, co-terminus again with the tenure of the futures contract for borrowing and lending of cash and G-Secs. 

v )   Both for IRS (Interest Rate Swaps) and IRF, actual notional/nominal amount of IRS/IRF must be allowed on duration-weighted basis unlike the current regulation which restricts the maximum notional/nominal amount of hedging instrument to no more than the notional/principal amount of the exposure being hedged resulting in under-hedging of risk .

9. What should certainly not have been done was even to contemplate, much less permit, the most-liquid-single-bond IRF for the very simple ​reason that this benchmark security represents less than 20% of the current 10-year IRF deliverable basket and would, therefore, at a time, when we are talking about ‘inclusion’, this would amount to veritable ‘exclusion’ of 80% of the 10-year Government securities from the benefit of the liquidity of the most liquid benchmark 10 year bond which arguably is incompatible with the larger public policy purpose of IRF providing liquidity, depth and basis-risk-free hedge to as wide a universe of government securities as possible. But rather than establish and continuously  ensure the above necessary and sufficient conditions on the ground for a successful  physically-settled IRF , a cash-settled most-liquid-single-bond IRF was launched, instead, which would, to all intents and purposes, exist and trade as “an end in itself”, rather than serve  “as a means” to the larger public policy purpose of real-time efficient lockstep price discovery, liquidity, depth and basis-risk free hedging in the stock of the heterogeneous government bonds.  

10. In particular, the necessary condition for physically-settled derivatives in paragraph 8(iv) above holds just as much for all other derivatives such as those on foreign exchange, single stocks, indices and commodities and is , therefore, a ‘sine qua non’ for risk-free/risk-less cash-derivatives arbitrage as I have  articulated in great detail.

11. In this background, it is indeed very heartening , and reassuring , to note that, in a first for the 25-year old Sebi, the Tyagi Sebi has very recently already made commodity derivatives mandatorily physically-settled and has also proposed physical settlement of equity derivatives noting that the trading turnover in these products has seen a sharp surge of over ten-fold over the past decade and the ratio of the trades in the equity derivatives to that of the equity cash market has risen to over 15-times. Curiously, reacting  to the Sebi proposal, the Association of National Exchanges Members of India (ANMI), a pan-India body of trading members across the leading exchanges, including NSE and BSE, has submitted that "the NSE publishes options data by stating 'notional' turnover (as opposed to premium turnover), thus grossly overstating the total turnover in the futures and options segment". Specifically, it has argued that while the turnover in the equity derivatives is 15.59 times of that in the cash market, this ratio after taking only the premium value is only 2.53 times! 

12.  But these arguments of ANMI are specious and fallacious and do not hold water simply because what they are saying about the inflated volumes of the options because of counting notional value, as opposed to premium value, is not applicable to futures  because the hedge ratio for futures is always either -1 or +1 and, therefore, both the cash market and the futures turnovers  have to be exactly equal! Besides, significantly, in the case of the options, the notional value must necessarily be adjusted by the hedge ratio (delta) which varies between 0 and 1 for  call options and -1 to 0 for  put options. So, in the case of options with +1 and -1 delta, the options and the futures become identical where the notional value alone can, and must, be taken as is being done now. And, even if the delta is not 1, but, say 0.75, that is, 75%, the cash-market-equivalent delta-neutral options turnover will be equal to 75% of the notional amount and no way equal to the premium value, as contended by ANMI! So, in this framework, given that most active options positions will be at-the-money, in-the-money and deep-in-the-money, it will be  reasonable to assume an overall delta/hedge ratio of 75% which will deflate the notional derivatives  turnover to cash market turnover ratio from 15.59 to 15.59*0.75, that is, 11.70 times, which will still be 4.63 times the ANMI ratio of 2.53!

13. Contextually, I chaired a Working Group on Interest Rate Futures back in 2007, which very strongly  recommended Physical Settlement! Besides, in several of my speeches and papers during the past decade, I have cogently  articulated the public policy imperative of physical settlement of derivatives, with the key message that “the trouble with  doing the “easy” (cash settlement), but not the “right” (Physical Settlement), thing is that undoing the “easy” (cash settlement) thing becomes a very “difficult” thing! I , therefore, take the present opportunity, what with the physical settlement of commodity derivatives behind it, to wish the Tyagi Sebi Godspeed in undoing the “easy” (cash settlement) thing and doing the “right” (physical settlement) thing not only in the equity but also in other exchange-traded derivatives like currency and interest rate derivatives in consultation with the Reserve Bank of India! 

14. With these remarks, I conclude my keynote address and wish the Conference all the success that it so very much deserves!

The Risk Management Imperative

by
Mr.  V.K. Sharma¹
Executive Director
Reserve Bank of India
1. What with the cataclysmic and apocalyptic events like the US downgrade and Eurozone sovereign debt crisis overwhelming the world and India, the last two years have been characterized by unprecedented and excessive volatility in asset prices and currency values, catapulting the critical imperative of Risk Management to the centre-stage like never before.  Against a financial backdrop as somber, traumatic, portentous and sobering as this, FICCI’s initiative in focusing attention on the risk management imperative has come not a day too soon !
2.   However, if only to reinforce the context of this initiative, I cannot stress more the commonalities between the crisis of 2008-09 and the current one.  Specifically, 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 current crisis, the rupee depreciated by almost 18% in less than 6 months between August 5 and December 15, 2011, with the volatility almost doubling from about 5% to 12%.  Equally deserving of the attention is the fact that since March 2010 to date, the Reserve Bank hiked key policy rates 13 times, raising the effective policy rate from 3.25%, (the k8.5% (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 !  Equally significantly, global commodity prices have been just as volatile since the crisis of 2008; crude prices, after rising steeply to US $ 147 per barrel in July 2008 and then falling precipitously to $ 32 per barrel in December 2008, have risen from US $ 32 to around US $100 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 !                                      
3. 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 the target audience of this article 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 this article, 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.
4. 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 a market-competitive stable return on equity to shareholders.
5. 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.  Indeed, in the background of the measures announced by the Reserve Bank of India on December 15, 2011, withdrawal of the facility of cancelling and rebooking of forward contracts leaves no other option but to follow the base-case strategy.  But as learned, and discerning, readers of this article 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 !
6.   As regards forex risk exposure of business and industry, I would like to take readers of this article 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. I am sure the readers would recall that such un-hedged and floating-rate-based foreign currency exposures culminated eventually into the now-all-too-familiar apocalyptic denouement, entailing 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 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 readers of this article 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.
7.   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 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 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 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 !  
8. 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 5.25% 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 have 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 is around Rs.9 trillion (US $ 170 bn).    In this background, it is noteworthy that the Planning Commission have recently 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 aggregate 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 bank 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 trades about 140 to 150 basis points below sovereign yield, 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 8.40%).  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) have traded about  1% to 1.5% 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 3.5% in March 2010 to 8.5% in October 2011 i.e., effective cumulative rise in overnight interest rates of 5% !  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 are exposed to interest rate risk because of 5% increase in interest rates.  On the other hand, if they speculate in IRS market without any underlying exposure in the fixed rate long-term loans, then they will 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 have speculated in interest rate markets, rather than hedge, they have 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 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, is a whopping Rs. 60 trillion (about 82% of total banking assets) (USD 1.14 trillion) and of which, disturbingly, only less than 2% is accounted for by the real sector i.e. business customers and the rest is 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 represents 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 and, therefore, if corporates, as natural fixed-rate payers, as I said before, come in, that will only make the fixed-rate receivers too happy as the additional demand for paying fixed will only increase returns for fixed interest rate receivers in the IRS market.  That this represents potentially a veritable systemic financial risk is another matter to which I have separately, more than once, cogently alluded, to no avail and, do again, in the following paragraph, hopefully, to some avail.  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.  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’ !
Besides, the IRS market is fairly liquid, deep and efficient up to 5 year 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.  As regards mobilizing long-term players, like pension and insurance funds, into IRS market, they being “real money” investors, would not be a natural fit to the IRS market.  Even if they do, to convert their short-term assets (of which they will have hardly any), into long-term ones, they will not take recourse to the IRS market for the simple reason that, as I also said before, they will be earning ‘more’ than 100 basis points ‘less’ than the corresponding maturity G-Secs.  The stock refrain explaining this almost a permanent structural, though quirky, counter-intuitive, perverse and preposterous feature of the Indian IRS market is that arbitrage, involving receiving fixed on G-Secs, and paying fixed in IRS, is not possible because of the so-called ‘basis risk’.  But this is totally untenable for the simple reason that ‘basis risk’ applies just as much to ‘hedging’ as it does to arbitrage.  In other words, ‘basis risk’ is “arbitrage-hedging” agnostic and, therefore, it inevitably follows that IRS market, unlike OTC forward exchange market, is being used out and out for speculation and not at all even for hedging and, therefore, incontrovertibly explains why less than 2% of the outstanding notional principal amount of the IRS alone is accounted for by the real sector i.e. business customers !   Besides, significantly, this preposterous feature of the Indian IRS market is anti-thetical to the “law of one price, OR, which is the same thing as no-arbitrage argument” !  This underlies the theory and practice of any derivatives pricing valuation.  But in the case of the Indian IRS market, what holds instead is the “law of two prices, AND no-arbitrage argument” !!  On this touch stone, the IRS market in India is then a ‘non-derivative’ !!Another dramatic, but realistic, interpretation of this phenomenon is that there is a super bubble inflating in the IRS market because typically zero to very tight/narrow, but still positive, spreads to risk free G-Secs imply a bubble and, therefore, huge negative spreads of riskier IRS bank dealers to risk free G-Secs imply a super bubble !!  However, if banks and corporate practise what I have suggested, the Indian IRS market will turn into a ‘derivative’ !!
9. 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.
10. By now, I am sure readers 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 Warren Buffett who famously described derivatives ‘as probably the most dangerous financial products ever invented’ and ‘financial weapons of mass destruction’, respectively.  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 most readers are well aware, 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, are 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.
11. 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 bank 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 Speech, 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 the 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.
12. Significantly, businesses not practising the nuts-bolts-what-why-how-when regimen, commended in this article, 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 article, 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.  Just as in the case of a patient, close relations and friends may try, and secure, regimen 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 article.  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).  (The latter is indeed enjoined upon banks by paragraphs 102 and 103 of the RBI’s Second Quarter Review of Monetary Policy of October 2011.  These decade old instructions/guidelines, originally issued in 2001, were, more or less, reiterated in 2003 and 2008 and, of course, again, in the Second Quarter Review of Monetary Policy, in October, 2011).  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.
13. To sum up, such is the insidiousness of risk that its under-pricing 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.  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 hedging 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 the learned and discerning readers to the Financial Risk Management imperative enough, I will feel vindicated that I have delivered on my dharma !  And, I have no doubt, if business 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 article and going forward wish business and industry a truly blissful Risk Management nirvana !

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Getting Credit Default Swap Market  In India Up and Running 

I propose to discuss in my column today the long overdue imperative of developing a vibrant Credit Default Swap market in India . 

In the inflating of the credit bubble in the run up to the Global Financial Crisis , and its inevitable concomitant, the Great Recession from which the global economy is yet to recover , inflated ratings to sub-prime mortgage backed Collateralised Debt Obligations by global rating agencies played a significant role. Given,therefore, the question mark over the infallibility of rating agencies, the Basel Committee needs to revisit the primacy of role assigned to ratings of such agencies for assigning capital charge for credit risk by banks . In fact, credit appraisal and measurement are the most basic functions of intermediation performed by banks traditionally. In the light of this, ratings may be meant for, and be relied upon by, the unsophisticated and uninitiated retail and small investors, but certainly not banks. Besides, given the fact that pre-crisis rating agencies generated almost 40 per cent of their revenues from assigning the so-called inflated ratings to CDOs (Collateralised Debt Obligations) tranches, backed by sub-prime mortgages and the obvious inherent conflict of interest involved, the US Congress and regulators investigated the role and function of rating agencies in the aftermath of the Global Financial Crisis. In view of this, Basel Committee needs to de-emphasise ratings assigned by Rating Agencies for assigning capital charge for credit risk by banks. Indeed, if anything, given the tremendous volumes and liquidity of Credit Default Swaps (CDSs), both single-names and indices-based, it would be far more market-price discovery-driven for banks and regulators alike to rely on prices backed out from these credit derivatives . Indeed, CDSs price credit risks almost on real-time basis as much as Government bonds , foreign exchange, stock and commodities, markets do. Credit rating agencies, in comparison, are inertial and lagged. In the way of example, in the USA, the traditionally very healthy AAA rated mono-line municipal bond insurers MBIA and Ambac changed their business model from insuring only their staple municipal bonds to insuring CDOs and ABS (Asset Backed Securities) . While this went unnoticed by insurance regulators, Pershing Square, a hedge fund, spotted trouble and started shorting both equity and credit risk of these two companies by buying their CDSs. But even after sharp increase in real time CDS spreads of these two insurers , regulators failed to take notice of these early warning signals and any timely preemptive corrective action with the two companies being eventually downgraded several notches by Credit Rating Agencies but only much afterwards ! Significantly, as if to redeem their lost infallibility and reputation, these Rating Agencies , almost immediately after the financial crisis, started a new service which provided implied credit ratings backed out/derived from CDS spreads ! There is thus a very strong case for kick-starting a full-fledged CDS market in India. 

The popular refrain that the last global financial crisis was caused, or exacerbated,  by CDSs is again a myth in that CDSs which are simple plain-vanilla off-balance-sheet/non-fund based credit derivatives, were confused with the CDOs (collateralised debt obligations) which are on-balance-sheet and funded securitised structured credit products. It was securitisation/re-senuritization, involving CDOs that played a seminal role in the crisis and no way the CDSs ! In fact, it is also a myth that securitisation through CDOs was an originate-to-distribute model; rather, really speaking, it was an originate-to-distribute-back-to-originators model! This is because almost all CDOs originated came back to sit on the SIVs (Structured Investment Vehicles)/ conduits sponsored by originating banks themselves. Besides, for all the overdone and totally uninformed fears about systemic risks from the so-called unregulated Over the Counter (OTC) CDS markets, remarkably orderly and non-disruptive auction-based settlement of CDS claims in respect of CDSs written on Lehman Bros., Icelandic Banks, Fannie Mae, and Freddie Mac, incontrovertibly attested to the resilience of CDS markets. Indeed, if anything, CDSs can be an effective and neat answer ,and substitute,for lagged and inertial ratings of credit rating agencies ! And indeed precisely for this reason , RBI should not insist on CDSs being allowed only on listed and rated corporate bonds as what listing and rating purport to deliver is actually delivered far more efficiently on real time basis by CDSs , as typically, CDS markets sniff out financial mess much faster than even equity markets ! 

Interestingly, the New York Fed-led initiative to improve the OTC CDS markets sought to replicate India's CCIL ( Clearing Corporation of India Ltd) -model, where although OTC foreign exchange transactions are bilaterally negotiated, they are cleared and settled through RBI -sponsored Clearing Corporation of India Ltd. (CCIL). Today CDS prices/spreads are by far the most closely tracked early warning signals for real time changes in credit risk profile of an entity, whether private or sovereign. This is because CDSs make it possible to back out an implied credit price even when one is not being discovered in the underlying cash market instruments like bonds or loans as indeed in the latest instance of Deutsche Bank where its CDS spread widened real time from 100 basis points to 245 basis points in a matter of a week !   Thus, CDS market has tremendous practical application as a reliable diagnostic tool in stress-testing for supervisors and regulators. Besides, a CDS market will also enable efficient trading and hedging of credit risk and synergise development of active and liquid corporate bond and Repo markets. Like equity, credit risk subsumes all other risks as it is a function of forex risk, interest rate risk, leverage risk, liquidity risk, human resources and governance risks and that is why CDSs and equity prices have been , in equilibrium, almost perfectly negatively correlated, that is, as CDSs spreads widen, equity prices fall almost one for one !


Credit Default Swap, like Interest Rate Swap (IRS), or for that matter any other derivative, is no exception to the so-called law-of-one-price/ no-arbitrage-argument based cash market replication principle of derivatives pricing. Without going into mathematical gymnastic proper, price of a CDS, in spread terms, is reasonably approximated by the difference between the spread of a reference bond/loan to corresponding maturity G-Sec ( Government Security) yield and the spread of IRS to the same maturity G-Sec yield. Thus, if Sc be corporate bond spread and Ss be IRS spread to risk-free G-Sec yield of corresponding maturity, then the fair/theoretical/model value/price of a CDS is approximately equal to Sc minus Ss. Tautologically, since G-Sec yield is common to both spreads, another way to approximate CDS price is simply to take the difference between the yield of the reference bond/loan and the same maturity IRS yield. As is well known , finally when the product was launched in India on 7th December, 2011, it was a stillborn and remains so even after RBI’s revised Guidelines issued on 7 January 2013 . In fact, its epitaph was written in the warped, anomalous, quirky and preposterous feature of hugely negative IRS yield spreads to corresponding maturity G-Sec yields and which,alas, exist even today !  For, as one will readily see from the above formula, because of the hugely negative IRS spreads, fair price of a CDS would be so high as to make it both pointless, and useless, to buy a reference bond and also hedge it with a CDS! In other words, one is much better off straightaway buying a corresponding maturity risk-free G-Sec itself because hedged reference bond would have CDS-cost adjusted yield of G-Sec yield minus the IRS spread rather than the normal G-Sec yield plus the IRS spread ! Significantly, if actual CDS premium/price/spread is higher than the above theoretical/model price, then an arbitrageur will sell a CDS (which is equivalent to going long the reference corporate bond) and receive this actual spread and short the reference bond and invest the proceeds of short sale at the going corporate bond repo rate and receive fixed, and pay overnight, in an IRS, and do the opposite arbitrage if the actual CDS spread is lower than the theoretical/model spread/price until the arbitrage opportunity disappears and theoretical/model and actual market prices align again. But sadly, like in a classical catch-22, this arbitrage is just not possible simply because of its complete absence in the IRS market and, therefore, alas, much as we would all wish, a happening corporate bond market cannot happen, inter alia, to supplement huge infrastructure financing needs of the Indian economy!        

REWARD – RISK  TRADE OFF IN LEVERAGING BANKING TECHNOLOGY
                                                                                       By
                                                                         V. K. Sharma 1
                                     
     I deem it a privilege and an honor to be addressing today this very learned and discerning audience comprising representatives from public, private, co- operative, foreign banks and technology companies. To be frank, I am no authority on, or expert in, Banking Technology and, therefore, if anything, I feel humbled to have been invited to deliver this Keynote Address today. I must heartily compliment and congratulate Ernst and Young on conceiving,designing and organizing this contextually and topically very appropriate and relevant Summit.  I am also very pleased to note that the Banking Technology Summit 2013 today has a very comprehensive agenda featuring contemporary and futuristic business and technology challenges in such critical areas as Technology Adoption, Business Continuity Plan (BCP) and Disaster Recovery (DR), Risks, Regulation, Mobile Banking, Cloud Computing etc. I shall, therefore, confine my address to shining light on, and sensitizing, and alerting, this discerning audience to, rewards, downside risks and costs of leveraging banking technology. Significantly, if this discerning audience has not
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1 The Keynote Address delivered by Mr. V. K. Sharma, Advisor, Edelweiss Financial Services Ltd  and former Executive Director, Reserve Bank of India , at the Banking Technology Summit 2013, organized by Ernst & Young,  at Mumbai, on 17th April 2013.  The views expressed are those of the author only.
already noticed the reverse sequence viz ‘Reward – Risk’ as against the more standard  ‘Risk- Reward’, customary in finance theory and practice , I have a very cogent reason for why I have chosen to do so. And this is that in finance theory and practice, it is financial risks that are deliberately, and consciously, assumed for earning financial rewards/ returns whereas, when it comes to leveraging technology it is  exactly the opposite i.e. it is ‘Reward’ that is chosen almost entirely for its own sake and ‘ Risk’ follows ! I do hope to illuminate this presently as I proceed with my keynote address.
2. Given the extensive, and widespread, financial exclusion in the country, both the Government of India and the Reserve Bank, decided to put financial inclusion,including as its key component, the recent roll out of Direct Benefit Transfer (DBT) in select districts, on the top of their policy and strategy agenda. As part of this veritable watershed policy and strategy initiative, the Government  and Reserve Bank enjoined upon Scheduled Commercial Banks and Regional Rural Banks to roll out, in a time- bound manner, Board – approved, Top – Management- owned, business- plan- integrated, mission – mode- driven and Government & RBI- monitored , BC-ICT-CBS (Business Correspondent- Information & Communication Technology- Core Banking Solution) – leveraged Financial Inclusion Plans for last mile access to, and delivery of, a bouquet of basic financial services in the hitherto financially – excluded rural areas. But I must hasten here to add that the idea is not to compete with, but complement, rural and agricultural cooperatives in their ever critical and central ‘niche’ role in delivering on financial inclusion !
But having said that, as regards the national challenge of delivering, credibly and effectively, on financial inclusion agenda, it would be very instructive to put in perspective the relative potential of the rural co- operative credit structure. Specifically, considering that compared to Commercial Banks and Regional Rural Banks (RRBs), which, between them, currently account for 33,000 rural branches, 31 State Co-operative Banks with 953 branches, 371 District Central Co-operative Banks (DCCBs) with 12,858 branches and 109,000 Primary Agricultural Credit Societies (PACS) between them, account for a total of 122,590 service outlets , the penetrative outreach of the command area of the rural co-operative structure is simply formidable !  Indeed, it is precisely because of this formidable penetrative outreach of the rural co-operative structure that the Reserve Bank of India has not only allowed PACs to act as Business Correspondents of Commercial Banks but also allowed treatment of loans by Commercial Banks to farmers through PACS, Farmers’ Service Societies (FSS) and Large – sized Adivasi Multipurpose Societies (LAMPS) as priority sector lending in indirect finance category. Although under the Financial Inclusion Plan initiatives, Commercial Banks and RRBs will, through both brick and mortar branches, and business correspondents, provide banking outlets in around 350,000 out of 600,000 odd villages by 2013, it is because of the huge potential  and promise that the rural co-operative credit structure represents for financial inclusion that the Government and Reserve Bank of India thought it fit to revive the financially hemorrhaged Short- Term Co-operative Credit Structure (STCCS) by setting up the Vaidyanathan Committee and accepting its comprehensive recommendations for implementation in a business-like manner. Between them, these mission- critical, watershed and game changing epochal policy superventions hold the veritable promise and potential to upscale the reach and penetration of the banking system to the next level in a never - before manner, paving the way for a viable, profitable yet fair, sustainable, credible and above all, inclusive credit delivery architecture for last- mile access to, and delivery of, basic financial services in the hitherto unbanked/ under – banked rural and semi urban areas of the country. Based on the recommendations of the Vaidyanathan Committee and after reaching consensus with Chief Ministers, Finance Ministers and Cooperation  Ministers of States, Government of India decided to provide massive financial assistance (since revised to Rs. 19,330 crores( Rs. 193 Billion) from the originally estimated Rs. 13,596 crores ( Rs. 136 Billion)) to the financially hemorrhaged Short Term Co-operative Credit Structure but also, only appropriately , made it conditional upon rigorous, and stringent, compliance with, and progress on, pre- specified  critical parameters like, inter alia, computerization. Indeed, if only to take this forward, rural cooperative institutions have been enjoined upon to be fully CBS (Core Banking Solution)-compliant by 30th September 2013 !
3. In delivering credibly, and effectively, on a national agenda as challenging, formidable and onerous as the foregoing, you will readily agree with me that leveraging technology is a sine qua non  and this, therefore, provides the most appropriate and fitting backdrop, and context, to today’s Summit which has been organized not a day too soon.
4. Having seen the imperative and inevitability of this seminally critical role of leveraging technology in banking, it would only be instructive and value -adding to consider the business model of a typical 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, safe and sound, banks have had historically an average ROA of about 1% and a reasonably safe EM of about  15, implying an average equilibrium ROE of about 15%. In the recent period, the Indian Banking System has had leverage of about 13 to 14 times. 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. For Indian Banks, NIM has varied between 2.5% to 3.5%. If we deduct ROA from NIM, we get what can be called Non Interest Cost of Intermediation. In fact, it is this critical parameter viz (NIM-ROA) which can be controlled by leveraging technology. All else being equal, technology leverage in a bank can typically significantly reduce this non interest cost by delivering humanly impossible exceptional speed, efficiency and volumes in banking transactions and, therefore, for a given NIM, increase ROA, or for a given ROA, ROE and EM, significantly reduce NIM and thus borrowing costs for bank customers. In the first case, higher ROA  and hence ROE enhance shareholder value, making the bank less risky and thus reducing equity risk and deposit insurance premia and potentially keeping taxpayers out of harm’s way. Thus, either way, Technology Leverage (TM) delivers value to all stakeholders viz, shareholders, uninsured depositors, borrowers, taxpayers,  in particular, and the real economy, in general. As this discerning audience will readily see, this is where leveraging banking technology can, and does, make a significant difference in terms of costs and time savings by providing speed, efficiency and huge volumes. It is also interesting to note that banks are special because of their intermediation role in the real economy and that is why they are allowed by public policy and regulators higher leverage. More specifically, higher leverage for banks is critical to efficient and effective monetary transmission because higher leverage means banks’ relatively higher reliance for their lending to the real economy on non- equity interest rate sensitive deposit liabilities  which is typically the key target variable of monetary policy. To have an incontrovertible, and conclusive, sense of this proposition, this learned audience only needs to consider the extreme hypothetical case of banks having an Equity Multiplier (EM) of 1. This, as the discerning audience will readily see, will mean ROE = ROAx1 and if this be, say 15%, the borrowing costs to the real economy will be 15% + even if the applicable policy rate is 1% as banks’ lending will be entirely funded  by interest insensitive equity !  In other words, monetary transmission will be completely clogged. But since higher leverage is a double edged sword, it increases, through leverage multiplier, both profits and losses and, therefore, needs to be handled with care. This, in turn, is ensured by effective regulation and supervision of banks for uninsured depositors and deposit insurance for small depositors. In particular, as this learned audience is aware, in delivering equilibrium market competitive return on equity, banks assume financial risks such as credit, interest rate, foreign exchange risks etc. While assuming financial risks directly contributes to financial returns, technology risks do not contribute incremental returns directly but only indirectly by, as I have observed above, cutting non interest costs/ expenses through cost and time savings and very high speed, efficiency and volumes, although risk of loss is contributed exactly in the same manner as financial risks (i. e. loan and marked to market loss provisions). By now, to my mind, we are ready to reckon with what I would call the Technology Multiplier (TM) or Technology Leverage.  Almost exactly like financial leverage in a bank, Technology Leverage also signifies potential downside risks to ROA and, therefore, ROE. But in combination with the already inherent financial leverage, Technology Multiplier (TM) and Equity Multiplier (EM) make for what I would call ‘leverage on leverage’ or ‘super leverage’ like options on futures and derivatives on derivatives !  This is attested to by recent infamous technology glitches/snags at Royal Bank of Scotland (RBS) and Lloyds Banking Group. As this learned audience might be aware, RBS is paying about USD 200 million in compensation to its 17 million technology - disenabled customers due to a massive technology meltdown which locked them (customers) out of their accounts for three weeks !  This has also made the recently established Financial Conduct Authority (FCA) – successor to Financial Services Authority- take the unusual step of announcing an enforcement investigation which may likely result in huge fines in addition. Another example of a technology glitch is that of Lloyds Banking Group’s  ‘Faster Payments’ designed to ‘speed up’ cash transfers going slow after it was hit by a glitch delaying wage and bill payments and as regards the relatively recent but mushrooming credit card frauds , less said, the better. If only to complete the Technology Leverage/ Multiplier backlash story, one cannot but refer to the recent case of Knight Capital which went belly up due to a USD 440 million loss in a matter of less than 45 minutes - literally USD 10 million per minute, and that too ‘involuntarily’ -because of a technology glitch in its High Frequency Trading (HFT) algorithm system. This simply meant that it was not humans but ‘Technology’ that was in complete control and command for it is humanly impossible to lose $440 million in 45 minutes through what was a preposterous ‘buy high- sell low’ algo- trading !  The sheer speed of Algo-trading left just no response time for just- in time human intervention. This is simply because Technology Leverage/Multiplier being symmetrical also ‘saves’ time in reverse during a backlash, delivering losses in multiples as it delivers benefits/ cost savings in multiples of speed and volumes !! In other words, while technology is not infallible as humans are not, because Technology Multiplier/ Leverage is multiple of that of humans, losses due to its fallibility are multiples of humans’ failure. However, here I must hasten to caution that even if humans, unlike Technology Multiplier/ Leverage, do not have leverage, unethical and rogue traders/ executives in banks can, and do, piggyback ride Technology Leverage as indeed illustrated umpteen times in the past by the egregiously unedifying cases of the Nick Leesons and Jerome Kerviels !  Be that as it may, high frequency trading, based on complex algorithms, is trading by computers and not by humans. The long and short of this very elaborate overview of the downside risks of technology is to alert, and sensitize, this discerning audience to the very real and extreme risks which leveraging technology can expose banks to and, therefore, the ‘Technology Leverage’ can make a huge difference to Return on Assets (ROA) and, therefore, Return on Equity (ROE), thus having adverse consequences not only for the shareholders of banks but also other stakeholders such as uninsured depositors, deposit insurers, borrowers and unsecured creditors by significantly raising equity , credit and deposit insurance premia and in the extreme case, threatening systemic financial stability with potential implications of taxpayer - funded bailouts.
5. To conclude, my purpose was to alert, and sensitize, this learned and discerning audience to the upside potential and downside risks of the so -called Technology Multiplier (TM), a close cousin of the well known Equity Multiplier (EM) and no more, no less.  If only to recapitulate, since Leverage is just as profit/ upside agnostic as indeed it is loss/ downside agnostic when it comes to multiplying them both, it is imperative to vertically integrate fail- safe technology systems with robust, credible and reliable BCP and DR backstops. To paraphrase Einstein, “Technology is a good servant, but a bad master.”  Therefore, the key in leveraging technology in banking is humans being in control, command and on top of technology and not the other way around. My message today is that we need to resist the temptation of cutting corners when it comes to investing in technology in- house as opposed to mindless, indiscriminate and injudicious outsourcing driven and motivated only by considerations of cutting costs to the bone at any cost ! In conclusion, having hopefully done a good job of the easier part of ‘why’ it must be done , I leave the not -so- easy- part of  ‘what’, and ‘ how’ it, must be done to the very redoubtable Technology Experts, Practice Leaders, Operations Heads and Senior Technology Process and Solutions Experts assembled here !  With these words, I close my keynote and wish the Summit all success it so very much deserves !  Thank you all so very much indeed.

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