What ails credit infrastructure in India?

With higher disposable income and a subsequent increase in consumption, Indians are borrowing more and more. The life-styles of families have improved and they do not mind going to a bank anymore to maintain this high standards. While banks are very excited at the prospect that this new development offers, they are still not sure of the quality of credit information they have. The best information that lenders have is the statement of earnings of the head of the family member, and a metric loan amount/value is used to determine the credit worthiness of the customer. This creates a lot of information asymmetry and causes the problem of adverse selection as it is assumed that only people with bad credit worthiness approach the bank in the first place. There is no way for the bank to determine whether the individual approaching it has taken loans from other banks as well, whether he has defaulted on those payments, whether he has declared bankruptcy in the past few years and other important issues. This increases the chances of default and malpractices like recovery agent. With stricter laws on recovery, banks become circumspect in giving the loans and if at all they do, they do it at higher rates, justifying the risk, leading to the problem of lemons, where only people with a bad credit history take loans at such high rates, whereas individual with high credit worthiness just step out of the market, further escalating the risk of defaults for the banks.
Is increasing CIBIL’s coverage the answer?
For most part ‘yes’, but with a catch. Increase in CIBIL’s coverage in terms of depth and reach would solve many problems for the banks and other lending institutes:
a) Increased reach would provide the banks access to a larger portion of the population, without any additional risk. The banks can now significantly increase the asset side of their balance sheet, leading to higher interest income and profits.
b) Increased depth would remove the information asymmetry resulting in faster loan approvals for individuals and better risk management for the banks. Additionally this would remove certain socio-political biases that emanate from such a lack of information, where bank managers use demographic variable like caste, color and race, among others to determine the credit worthiness of an individual, depriving many people of their dreams of an improved life-style.
c) The banks can now use objective financial metrics and with reasonable level of accuracy determine the credit worthiness of an individual. This would be a great tool for active risk management.
d) The banks can ask for more innovative collaterals, as it would now have access to full investments of the individual.
One question to ask is that why did the US banks fail in the presence of such information. And the short answer here is greed. The banks can use this information to draw fancy models and indulge in dangerous practices like sub-prime lending, among others. The key here would be regulation and self-regulation. Whether that would happen: my guess is as good as yours!

Are Indian markets liquid?

Let us first understand the liquidity and the efficiency aspect of the Indian Financial Markets. When we look at liquidity (the ability to transact at low costs), there are three aspects to it Immediacy, Depth and Resilience. Immediacy as in ability to trade without moving the prices, depth as in the amount that can be traded without taking shocks, and resilience as in speed to recovery after a large shock. When we look at the current market scenario only large cap stocks and futures and index futures meet these three criteria of liquidity. Among other markets only government bonds and interest rate swaps to an extent are liquid. On the other hand there is no market for corporate bonds, commercial papers and commodity futures.
This lack of liquidity in the market translates into low efficiency. This is due to the high interconnectedness of the two concepts. Efficiency relates to how quickly and to what extent are information and forecast priced in. For markets to be efficient, the investors need to have an incentive to share the information, and for them to have an incentive the markets should be liquid, otherwise their profits will vanish due to high transaction costs.

Are more markets and liberalization the answer?
The two biggest reasons for the lack of liquidity as mentioned in the Raghuram Rajan Report are “Banning of products and markets” and having “Rules that impede participation of firms and individuals in certain markets for reasons other than sophistication”. The banning of markets is an obvious cause of illiquidity. Furthermore the absence of one market might lead to illiquidity and inefficiencies in other markets as well. The argument around some markets being manipulated does not have much meat, as a market becomes efficient and thus less prone to manipulation only when there is broad participation. Thus adding more markets would not only improve the liquidity but also add to the efficiency of the financial markets.
The other key reason involving restricted participation is also hampering the liquidity of the markets. Accessibility is a key element in improving the liquidity of the markets. Currently only equities and derivatives markets are accessible to all kinds of participants. Otherwise markets like Government Bonds, Credit Derivatives, Commodity Futures and Options are fairly restricted. Especially interesting to note is the debt market where government’s share in the public debt is a mindboggling 91%. This is much higher than the world average of 47% or even China’s share at 68%. We need to take a cue from the most unrestricted market i.e. equities which has achieved high liquidity and efficiency. As a result of liberalization in terms of who all are allowed to participate, the equity market reaches global investors, and hence no investor becomes large enough to distort the prices, leading to high efficiency levels.

Is FSDC the solution to India's regulatory woes?

Status Quo
The current regulatory framework does not allow for innovation and has excessive micro-management. Also the objectives of the regulators are not clear and there is a lack of communication between different regulators. Additionally there are overlaps between different regulators and there is no clear overriding regulator in such cases. For instance there are products that overlap between two markets such as ULIPs which cause a huge dispute between mutual funds and insurance companies due to the disparate nature of regulation by SEBI and IRDA
But the biggest draw-back of a fragmented regulator is the underestimation of conglomerate wide risk. Today financial conglomerates manage different but highly inter-related business. While individual regulators assess the risk of individual businesses, there is a need for a regulator that can assess the total systemic risk of such financial giants. Currently HLCC (High Level Co-ordination Committee) is expected to resolve regulatory issues. The problem with HLCC is that there is no mandate or objective because of which the meetings are meaningless with clear communication and coordination gaps. Additionally committees by nature are not effective as power centers, as they have no statutory powers.
What is required?
What’s required is coordination among regulators, integrated regulation of financial conglomerates and overall monitoring of entire financial system.
Is FSDC the answer?
Financial Stability and Development Council is expected to coordinate and preside over regulators including RBI, SEBI, IRDA and PFRDA. This corrects one big flaw in case of HLCC; the fact that HLCC was chaired by RBI, which itself was a regulator. Also assuming the sectoral regulators continue to regulate their respective activities, FSDC can step in cases of systemic risk in the financial market. It would also better assess the risk of a financial conglomerate. Currently financial institutes operate in such diverse domains, that some of the fields go completely unregulated. The presence of FSDC would create an agency which would be able to regulate the activities of such conglomerates. This would be particularly useful in case of products that straddle different markets. FSDC can set up consistent regulatory norms for such products. While we cannot deny the need of a super regulator there are certain pressing concerns. There is some lack of clarity regarding the role of FSDC whether it would have the overriding powers or not, also finance minister chairing the FSDC would bring political interference in financial regulation, which is seemingly a bad idea. Another problem might be the loss of accountability and reduced efficiency due to the introduction of an additional layer of approval. Additionally the unified regulator, which would essentially result from merging the existing regulatory agency, would create a regulatory behemoth; this might create huge bureaucracy issues in the system.
The implementation is the key here. The role of FSDC, its powers, the change if any in HLCC are factors that would change the way we would view FSDC and its efficacy. The devil here as they say lies in the details!

Paradox of choice

While in Standard 12th there was only one thing I wanted to do, that was to get into IIT, so I studied day and night and was thrilled when I got through. At IIT I used to live with three people in a room with sub standard infrastructure and attended classes of professors who taught in Greek. But I was very happy; IIT was a vindication of my belief in my talent and myself. But while I was applying for an MBA, I had choices. I got through 3 MBA schools and chose ISB over all others. Now whenever anything went wrong at ISB I used to ask myself if I made the right choice. It was much easier for me to regret my disappointing choice. My mind used to mentally calculate the opportunity cost of my decision and this led to the escalation of expectation that I had from a perfect choice. Thus the extra choice did no good to me, in fact it made me miserable whenever something bad happened as a consequence of the choice I made; say when I didn’t get placed on Day 1, I wondered what would have happened if I had gone to the US. Even though at IIT I didn’t get placed till into the second week of placement I was fine, as I had no choice but this institute. And worse with no choice I could blame the world for my predicament, but here I had all the choices and I was the one who was responsible.