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!
Showing posts with label Knowledge_ISB. Show all posts
Showing posts with label Knowledge_ISB. Show all posts
Wednesday, March 31, 2010
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.
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!
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!
Saturday, February 27, 2010
Budget 2010:Effective Social Sector Spending Needed
Here's the text of my article published in WSJ on the Need for Effective Social Sector Spending in India. The link to the article is given below:
Article
-------------------------------------------------------------------------------------
By SHASHWAT RAJ BADONI and PRIYA NADKARNI
This article focuses on the proposals for the social sector expected from Budget 2010.
With the burgeoning fiscal deficit of 6.8 % of GDP on one hand and the growing inflationary monster on the other, the finance minister will have his hands full this budget day. The third part of this three-part conundrum that Pranab Mukherjee can hardly afford to ignore is reaching GDP growth of 10 %.
We attempt to make a case for an efficient and convergent implementation of major government programs instead of the allocation of additional resources for each program. We also analyze the major themes that we observed in the government's social sector programs and whether this year's budget will continue from where the last one left off.
An Indian village woman gathers dried cow dung cakes in the Teliarganj area on the outskirts of Allahabad on December 21, 2009.
The National Rural Employment Guarantee Act, now renamed Mahatma Gandhi National Rural Employment Guarantee Scheme, guarantees 100 days of employment at the state's minimum wage. It has provided employment opportunities for more than 44.7 million households during 2008-09. The aam admi cheered as the government increased its allocation to NREGA by 144% to 39,100 crore rupees last year but questions about its efficient implementation remain unanswered. While we welcome the government's spending on socially beneficial programs, we are concerned whether these programs actually benefit the targeted segment.
We believe that funds should be set aside in the budget for support functions that improve the implementation of such programs. MGNREGS, for instance, has been marred by patchy implementation with different efficacy levels in states. In states like Jharkhand, money is being siphoned off in the names of non-existent workers. Additionally, a new breed of brokers has sprung up that charges money to arrange jobs. On the other hand, states like Rajasthan and Andhra Pradesh have higher success rates due to transparency and the use of support functions like IT.
The government has begun to make changes to its existing policies to facilitate institutional improvements within these programs but certain fundamental problems still remain.
The outcomes budget for 2008-09 states that about 51% of the total outlay for Sarva Shiksha Abhiyan (an educational program started in 2001) was committed to improving the quality of learning and ensuring access to upper primary classes.
Despite this, the centre-state tussle over the devolution of funds continues to delay programs. The Right to Education Act passed last year will only be implemented from April this year because the states and the central government could not reach a consensus about their share of monetary participation in the Act's implementation.
Similarly, even though the Finance Minister increased the allocation for National Rural Health Mission (started in 2005) to 12,050 crore rupees last year, the problem lies in the shared responsibility between states and the central government. The central government contributes 85% of the total fund requirements while the states contribute about 15% in the case of the NRHM.
However, the central government has not been successful in holding the states accountable. The Comptroller and Auditor General's report on NRHM highlights the fact that the actual release of funds has been higher for non-focus states because of high unspent amounts in the focus states.
This reveals the ineffectiveness of budgetary allocations in the presence of indecision over centre-state participation in program implementation. The report of the 13th Finance Commission under Vijay Kelkar will provide the roadmap that will define the centre-state equation as the Finance Minister has already stated that the Commission's proposals would find a place in the budget.
The government is increasingly inviting private players to work alongside the state machinery. The interest among private enterprises and NGOs to partner with the government is high as evidenced by the National Rural Livelihood Mission that currently has 15 private partners providing vocational training to the rural youth. The government bears the cost of the training on the condition that the private parties will provide jobs to the trained workers.
We expect that the government will identify more such areas where private sector participation can be leveraged in development. The government can suitably incentivize private participants to set up healthcare infrastructure through the extension of existing tax holidays and, at the same time, institute an assessment mechanism in the public sector to improve quality, access and delivery of care.
The government is trying to streamline most major welfare programs that it has running currently. It is planning to implement the Right to Education Act passed in 2009 through the Sarva Shiksha Abhiyan. The Human Resources Development Ministry has projected 1.71 lakh crore rupees as the total cost of RTE, for both the centre and the states, for five years. More than 20,000 crore rupees has been given to the states for SSA, according to a news report. Allocating funds for the joint implementation of these welfare programs would plug the wastage of taxpayers' money.
In a circular issued before last year's budget, the government sought to implement the Integrated Watershed Management Program along with the NREGA as more than 50% of NREGA works relate to soil and water conservation. This will increase the productivity of assets and prevent duplication of effort in each of these programs. The state is already talking about the convergence of programs as a way of bringing in more effective governance but this would also require a tremendous co-ordination effort across ministries.
ABOUT THE AUTHORS:
Priya Nadkarni is currently pursuing a post graduate program in management at ISB. She was previously a business journalist with a financial daily in India, based out of Mumbai. She covered capital markets and the Securities and Exchange Board of India. She has a keen interest in public policy and regulation in the financial markets.
Shashwat Badoni is currently pursuing a post graduate program in management at ISB. Prior to ISB, he was working as an equity research analyst focusing on technology and commercial services companies. He is keen to develop cross-functional expertise in the consumer goods industry.
Article
-------------------------------------------------------------------------------------
By SHASHWAT RAJ BADONI and PRIYA NADKARNI
This article focuses on the proposals for the social sector expected from Budget 2010.
With the burgeoning fiscal deficit of 6.8 % of GDP on one hand and the growing inflationary monster on the other, the finance minister will have his hands full this budget day. The third part of this three-part conundrum that Pranab Mukherjee can hardly afford to ignore is reaching GDP growth of 10 %.
We attempt to make a case for an efficient and convergent implementation of major government programs instead of the allocation of additional resources for each program. We also analyze the major themes that we observed in the government's social sector programs and whether this year's budget will continue from where the last one left off.
An Indian village woman gathers dried cow dung cakes in the Teliarganj area on the outskirts of Allahabad on December 21, 2009.
The National Rural Employment Guarantee Act, now renamed Mahatma Gandhi National Rural Employment Guarantee Scheme, guarantees 100 days of employment at the state's minimum wage. It has provided employment opportunities for more than 44.7 million households during 2008-09. The aam admi cheered as the government increased its allocation to NREGA by 144% to 39,100 crore rupees last year but questions about its efficient implementation remain unanswered. While we welcome the government's spending on socially beneficial programs, we are concerned whether these programs actually benefit the targeted segment.
We believe that funds should be set aside in the budget for support functions that improve the implementation of such programs. MGNREGS, for instance, has been marred by patchy implementation with different efficacy levels in states. In states like Jharkhand, money is being siphoned off in the names of non-existent workers. Additionally, a new breed of brokers has sprung up that charges money to arrange jobs. On the other hand, states like Rajasthan and Andhra Pradesh have higher success rates due to transparency and the use of support functions like IT.
The government has begun to make changes to its existing policies to facilitate institutional improvements within these programs but certain fundamental problems still remain.
The outcomes budget for 2008-09 states that about 51% of the total outlay for Sarva Shiksha Abhiyan (an educational program started in 2001) was committed to improving the quality of learning and ensuring access to upper primary classes.
Despite this, the centre-state tussle over the devolution of funds continues to delay programs. The Right to Education Act passed last year will only be implemented from April this year because the states and the central government could not reach a consensus about their share of monetary participation in the Act's implementation.
Similarly, even though the Finance Minister increased the allocation for National Rural Health Mission (started in 2005) to 12,050 crore rupees last year, the problem lies in the shared responsibility between states and the central government. The central government contributes 85% of the total fund requirements while the states contribute about 15% in the case of the NRHM.
However, the central government has not been successful in holding the states accountable. The Comptroller and Auditor General's report on NRHM highlights the fact that the actual release of funds has been higher for non-focus states because of high unspent amounts in the focus states.
This reveals the ineffectiveness of budgetary allocations in the presence of indecision over centre-state participation in program implementation. The report of the 13th Finance Commission under Vijay Kelkar will provide the roadmap that will define the centre-state equation as the Finance Minister has already stated that the Commission's proposals would find a place in the budget.
The government is increasingly inviting private players to work alongside the state machinery. The interest among private enterprises and NGOs to partner with the government is high as evidenced by the National Rural Livelihood Mission that currently has 15 private partners providing vocational training to the rural youth. The government bears the cost of the training on the condition that the private parties will provide jobs to the trained workers.
We expect that the government will identify more such areas where private sector participation can be leveraged in development. The government can suitably incentivize private participants to set up healthcare infrastructure through the extension of existing tax holidays and, at the same time, institute an assessment mechanism in the public sector to improve quality, access and delivery of care.
The government is trying to streamline most major welfare programs that it has running currently. It is planning to implement the Right to Education Act passed in 2009 through the Sarva Shiksha Abhiyan. The Human Resources Development Ministry has projected 1.71 lakh crore rupees as the total cost of RTE, for both the centre and the states, for five years. More than 20,000 crore rupees has been given to the states for SSA, according to a news report. Allocating funds for the joint implementation of these welfare programs would plug the wastage of taxpayers' money.
In a circular issued before last year's budget, the government sought to implement the Integrated Watershed Management Program along with the NREGA as more than 50% of NREGA works relate to soil and water conservation. This will increase the productivity of assets and prevent duplication of effort in each of these programs. The state is already talking about the convergence of programs as a way of bringing in more effective governance but this would also require a tremendous co-ordination effort across ministries.
ABOUT THE AUTHORS:
Priya Nadkarni is currently pursuing a post graduate program in management at ISB. She was previously a business journalist with a financial daily in India, based out of Mumbai. She covered capital markets and the Securities and Exchange Board of India. She has a keen interest in public policy and regulation in the financial markets.
Shashwat Badoni is currently pursuing a post graduate program in management at ISB. Prior to ISB, he was working as an equity research analyst focusing on technology and commercial services companies. He is keen to develop cross-functional expertise in the consumer goods industry.
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