Should Central Banks Be Generous?

These posts have spoken earlier about the Sub Prime Crisis and how bearish Central Bank made sure we remained insulated from the Crisis. ( how far the De Coupling theory stays true is anyone's guess however!). the Sub Prime Crisis is a Black Swan event and like all Black Swan events, it has brought winds of change in public policy in general and banking regulation in particular. it is time that we reflect on these winds of change and so this post I revisit a related issue;
Should Central Banks act pro-actively to save banks and other Financial instiutions from goin down under? Are there good reasons to intervene and inject liquidity in a failing bank? The answer to the first question till last year would have been a straight No, but after the battering systems received last year, the present system seems to be leaning towards interventionism.

So should we have a system where the Bank Of England or the Reserve Bank intervene and inject liquidity, the moment it sees a bank is in the red? or should we have a system where decisions are taken by Central banks on a case to case basis, intervening only when it foresees that failure of banks has systemic effects. It is interesting to note that the Central Banks Of England and United States till very recently followed a " systemic effect" intervention policy in keeping with the laissez faire nature of the economy in those states while bank regulation in our Country has been based on a multi factor test, inter alia including Depositor interest and public interest and stability of banking system.( These factors cannot be simulataneously balanced; indeed some are antithetical to each other. for example, a particular bank might not be systemically important and so it might not be in public interest to bail it out; however acting in public interest here is directly prejudicial to depositor interest as they stand to fail if the bank is not protected).
the recent Crisis has however as i earlier pointed out brought out interventionist thought in laissez faire thinking.( See how Mervyn King did a volte face and decided to bail out Northern Rock; his early speeches were an eulogy to " systemic effect intervention").

My understanding however is that this change in policy does not augur too well for the Economy. the Economics of bail out suggests that the tax payer pays for share holder apathy. and a sustained policy therefore subsidises risk taking by unscrouplous bank Boards and incentivises further apathy by the share holders. In the long run , market discipline suffers and no one is happier. Rather all Central Banks should return to the " systemic intervention" plank and restrict their altruism to that factor alone. that way owners will monitor banks effectively, agents will have less incentives to self deal substantially reducing agency costs.

It is not my case that the intervention policy is wrong; it is however emphatically my case that it must only be followed this one time; till the crisis is over.

Darwin was not a evil man was he?

Should Banks be Held Liable For Excesses Of Recovery Agents?

These posts have hitherto been talkin about the macroeconomic policies that India ought to follow. So, this post I take a break and talk about a problematic issue in microeconomic area.the problem of recovery agents and the excesses they commit in the course of recovery of loans from retail borrowers has been in news of late. Recently, the National Consumer Commission delivered a verdict that held a reputed private bank responsible for the excesses committed by its recovery agents. the Bank was held responsible for "deficiency in service". the media generally welcomed the judgment and the general consensus was that it was a welcome step that struck a blow for consumer movement in the Country.

this post I look at whether banks should be so held responsible for the excesses committed by its recovery agents. Of Course, if we take a " law as principle" approach inspired by worthy notions like justice, there are no two ways about it. the judgment puts the onus on the banks to ensure that recovery practises are fair; and indeed the liability is rightly , a few would argue, upon the person who has the resources to avoid the damage.
Scratch the surface however and a different pixture would emerge. here's how!

Banks and other financial Institutions forever grapple with the Problem of "sticky assets". Loans that go bad and do not pay returns. The problem is compunded by the fact that the country has no proper restructuring mechanisms and there is government intervention by way of compulsary priority Sector lending. Couple that with the fact that the CRAR ratio-the Capital Adaquecy ratio that they have to maintain is 9%- 1 % higher than the Basel standards that are globally accepted.

let us look at the fall out of this judgment-
banks will be ultra conservative in lending practices. Credit would not be cheap; so,if you are a 20-sth. looking to buy that first house, you buy credit at a higher rate. and you need collaterals and guarantors. The Sub Prime class in India that currently buys credit with the interest rates that range from 25-60% would be the worst hit. I have a belief that these borrowers would be denied credit absolutely. Already poor in terms of income, they would have no recourse to capital.

Additionally, holding banks responsible for the excesses of their agents has reputation costs. Retail borrowers would be less inclined to approach banks for fear of recovery agents; and also because, they are any way not entertained there. They would then look to specialised loan providers like say housing finance Companies and other less prudent entities to finance their needs. these institutions are not diversified (hence risky) and rely on specific sectors for asset creation. Increased sub prime load on their balance sheets mean they become prone to failures themselves.

Thus, while banks have responsibility in ensuring that fair recovery practices are followed, the problems compound when they are held liable. the problem needs policy instruments like Securitisation and more leeway to banks in terms of managing their port folios. Hap hazard innovations by the judiciary will only stall the momentum of the India growth story!

SWF II - Answering the Naysayers

Last week, through these posts I suggested how the surplus reserves that India possesses could be harnessed to further strategic and commercial objectives. this week we will have a look at the likely problems that might arise in the establishment of such SWF in our country. The following are the principal issues that we have to address before the establishment of a SWF.

Administration and Management of the Fund
Going by the precedent, each State has an independent fund manager for the SWF that takes decisions based on policies formulated by the Board. In India, we can have an independent vehicle ( Corporation) with the Board taking policy decisions. In my opinion, the Board ought to be as follows:

(a)The Governor of the Reserve Bank or his nominee; will make sure that the invesment is consistent with Forex policies,
(b)the Finance Minister or the Secretary of Finance; to ensure political costs in the event of mismanagement,
(c)Representative of the MEA; to leverage the stretegic potential,
(d)CAG, the Comptroller And the Auditor General; to ensure transparency.

The Current Account Deficit.
This bit is standard. All the States that are investing through the SWFs have a current Account Surplus. We have a Current Account Deficit. So, the argument goes, we do not have the liquidity that other funds enjoy. I agree that this is one of the principal diffrences between us and the rest; and yet this ought not to hinder or freeze our investment options. the solution lies in investing in a relatively diversified portfolio and relatively liquid assets that can be summoned as demand for the dollars increases here. Also, as the Chinese have shown even one-fifth of foreign reserves are enough for the SWF. It is not my case that chunk of the foreign reserves are to be locked-in. this solution clearly implies that the Current Account deficit argument does not pan out.

Corporate Governance
hmm, this seems to be the buzzword these days. And much of the issues sorrounding SWFs stems from the fact that barring Norway, none of the funds have had transparency in its operations. However Capital in the hands of Government that are Democratically chosen have inherent " checks and balances". the Board Composition that I suggested above has the Comptroller as a watchdog and the Finance minister as its members; that would ensure a Parliamentary check on the Fund. As I pointed out above, this Composition would ensure that there are political costs of mis management and the knowledge thereof would make the Fund transparent ex ante. we may follow the Norwegian lead in this regard.
As we usher in the New Year and celebrate India Inc.by cutting the Cake for Tata Motors acquring Jaguar-Rover, A New Year resolution of SWF by the North Block may just be the icing!

Does India Need a Sovereign Wealth Fund?

The last piece i spoke about how we must raise a toast to socialists and bearish Regulators for insulating us from the Sub Prime crisis. This piece i speak of a related dvelopment and another one that regulators in India mght have to mull about- that of using the huge forex reserves that India is currently sitting on and the best way to utlise them.

From a country that had balance of payment issues in the 1990s, we have indeed come a long way in terms of forex reserves! in fact we have reached the other extreme end of the continuum and the bank regulator is tryin to suck up the excess dollars in the system by such measures as market stabilisation bonds. but we have not seriously at any rate, tried to reap out of the surplus reserves that we possess.

In other words, does India need a Sovereign Wealth Fund( SWF)?In my opinion seems a very lucrative and strategic solution to the surplus reserves problem.

The gulf nations sitting on their " Oil Dollars"have shown how to use an invesment vehicle strategically as well. it may be noted that CITI was bailed out by the Abu Dhabi fund and chances are that the Gulf states would make more hay in the recession hit US market. the Chinese with their Chinese Investment Corporation that has a 30% stake in Blackstone would also try and place themselves as investors in strategic areas of key competing states- as we speak Temasek- the Singapore Government fund is in talks with Merill Lynch for fund injection in the latter. and it already has stakes in Barclays and StanChart. The Fund has invesments in everything to biotechnology to port operations- port operations! there you have a whiff of huge strategic potential of the SWFs!

The macro? more and more government are using reserves to build up strategic positions in key areas of other states. And i suspect it is time for India to follow suit. The Surplus reserve Problem would be solved and Economics of the SWF will inform Politics going by the aforementioned data.

That is not to say we want to have an absolute " Laissez Faire"; obviously the hunters all stand the risk of becoming the hunted in the current scanario. So, India stands the risk of " exposing" its key sectors to Foreign governments. there are transparency issues as well. Apart from the Norwegian SWF, the most transparent of SWFs, ( it debarred "Vedanta Technologies" from being part of it because of the latter's shady Environmental rights record), no one knows where the money in the SWFs of States is coming from.

So, obviously some key issues have to be regulated. A best Practises code needs to be hammered out - by a " basel-like" system. Certain sectors, key to each state would have to be protected and multilateral reciprocal arrangements would have to be put in to place to keep those areas "beyond bounds", but i suspect, as the old brokers say, 'Capital would find its way!'

Are the Mint Street and the North Block listenin?

the Next Time You make A killing On the Stock Exchange, think Of Marx!

Socialists are a sorry lot these days. with the inflows and the Projected growth of the indian Economy pegged at around 10 per cent, i would be called a fool if a i were to say that Socialists are partly responsible for the Economic growth. Sounds Silly ? read on then !

Any one keen on financial scene will tell you that the Northern Rock going down in the Sub Prime crisis was one of the most disturbing news of 2007. (Citibank was only recently bailed out by the cash rich Abu Dhabi SWF and DSP Merill Lynch had to "pink Slip" a few of its top execs)

Of Course the depth of the Sub Prime Crisis is still not known but its pretty much clear that the Banks granting loans reposing faith on easy interest rate regime ( not for nothing is Ben Bernanke called " the big Bull") were one of the factors responsible for the Sub Prime Crisis; in other words, cheap availability of Credit and excessive liquidity in the markets lulled the lenders in underestimating the Credit Histories of their borowers precipating the Crisis. So when the Fed or the Bank Of Japan suddenly upped the interest rates, there was relative credit Squeeze and the banks and other lenders tripped because suddenly the assets were not yielding like before. the macro? less regulation was responsible for the Sub Prime Crisis.

And what was the scene in India ? Compared to say the UK where interest rates fluctuate between 5-5 and a half, we are a nation consistently ranked highest in terms of high interest rates,Cash reserve ratio and the statutory liquidity ratio ( in a nutshell these instruments are a like a banking tax) that translated in less liquidity in the market and a conservative lending approach. the Macro? more regulation saved the India Growth Story from being stalled.

the next time you make a killing on the Stocks, remember marx!

the Global Warming Conundrum part II- is risk based system, the best system of Premium levy?

Hi people, the last time i was on, i spoke about the likely solutions to collective action problems like Global Warming. the idea that an insurance fund on the lines that the banking business has to curb a similarly collective action problem of bank runs was mooted. the last time the question that i posed was what is the system of levy that this insurance fund should follow. this post would try and see if the risk based system is the best suited for this insurance fund.

but first things first, the question still remains if we are to prepare risk profiles of all the states in the Global Economy, what would be the parameters on which these risk Profiles would be based? i have tried and hammered a few of those;

Carbon Foot Print Per Capita

Technological Ability

Consumer Preferences

Political Climate

(A couple of more could be added to those and interested readers may post those)

Once we have a set of parameters to have a database of risk profiles, asking States to contribute based on their risk Profile is the next step. So, if China has a risk Profile of 7 on a scale of 10, it would have to shell out more per tonne of Carbon than say Nauru that would have a risk Profile of say 2 ( by specifyin a floor, we could also exempt Nauru from paying any premium, For Example, only Countries having risk Profiles above 3 may be required to contribute)

the last time i mentioned the moral hazard issue that is almost always cited when an insurance fund idea is floated; the moral hazard problem shortly stated is a bit like this ; if Godva has an insured vehicle, she would have at least some incentive to drive rashly,( the risk of the vehicle getting damaged or posing third party risks is hedged) is it not? thus if States know that they can get away by paying a minimum flat levy in the fund, which would be utlised to bail out States and Communities in the red, they would have incentives to pollute more. the beauty of having a Risk Based system is that you do not encounter moral hazard issues to the extent they arise in " Flat rate" system coz States pay in proportion to the risk they pose in causing "the red"; this makes them take Ex Ante measures to curb Carbon Emissions.

But we need to have a " carrots and sticks" approach to this process. China should have incentives for Example to climb up a place or two on the risk profile. the next post we will try and figure out how that approach may be beneficially employed?

Post-Kyoto and beyond- Do we have a solution to the Global warming

As I write this friends, representatives from around the world are in conference at Bali, Indonesia tryin to hammer out the next in what could possibly be a series of accords on global warming.

In this piece I am going to do some loud thinking and tryin to figure out whats the best way to deal with the global warming issue. In my opinion, to understand the nature of the problem would be the first step; and the defining characteristic of the global warming issue is that its a collective action problem.

A collective action problem is one when stakeholders collectively stand to benefit from acting in a particular way; however individually each stands to lose acting in that way. The global warming issue is a Collective Action Problem. Collectively humanity stands to benefit by going easy on carbon emissions; individually since lowering carbon emissions translates in to going easy on resource allocation to " development", each state will try and not act in a way that is collectively beneficient. So, China and India are not acting enough to curb carbon emissions unless the " developed west" takes to that way in a robust way. And since no one State knows how the other is goin to react, it acts in a way that it the best perceived course for itself ( and that of course as we saw earlier, is not the " Socially beneficient" course to take).

Collective Action Problems are seen in other spheres too; most notably in Depositor behaviour when there is a buzz that a bank is goin to fail. Collectively the Depositors stand to gain if there is no run on the bank; individually they stand to lose if they do not withdraw; and since none knows how the other is goin to react, they take the best course for themselves. The result: massive runs that translate in to asset liability mismatches and the bank fails.

So what is the solution to Collective Action Problems ; insurance is a solution that comes readily to mind. And indeed that is the one employed by bank regulators to curb bank runs and influence depositor behaviour when buzz of a bank failing is doing rounds!

Can a similar ex ante insurance fund be one of the solutions for the global warming conundrum? The fund thus created could be utilised for states and communities that say are " significantly affected" owing to global warming ( much like distressed banks utilise the insurance Fund)

Admittedly this insurance fund idea is not without its own set of issues; for instance, what would be the basis of Premium? Would it be Flat rate for all the states or risk based? While a flat rate system appears attractive in that it is easy to calculate and collect, it is a bit problematic because what that means is that powerful states incur some costs for the global warming that developing states cause. The developing States are not likely to consent to a risk based premium pattern because most likely if we were to have a "Dunn And Bradsheet" rating of risk profiles of all the states, developing States would most likely have riskier profiles than the developed West translating in to more premium for each of them.

There is also that familiar "bete noire" of all insurance-exponents- the Moral Hazard problem. But more of that later!

Interested readers may comment on this. Lets see if we can come up with somthing.