Preventing shocks or becoming resilient to them?

My previous blog post, on not cancelling trades after a fat finger trade, elicited some interesting email conversations. In a nutshell, there are two views of the world. One camp argues that it is important to prevent fat finger trades and other such weird episodes. This requires building an array of preventive measures. The other side argues that the costs of prevention are high, and what's really important is to make a resilient market that is able to absorb shocks.

Prevention is difficult for two reasons:

1. NSE and BSE are some of the biggest exchanges of the world. We should be pleased that India has two of the great factories of the world doing order matching. But as a side effect, NSE and BSE are at the limits of what today's CPUs can do. Many, many orders are placed, compared with the number of trades. Pre-trade checks are expensive because the number of orders is high. Fairly trivial notions of pre-trade checks can triple the hardware requirements or worse. We have to ask ourselves: Is it worth driving up the cost of transacting by 3x or 5x or 10x in order to do those checks? In addition, pre-trade checks introduce delays ("latency") which are not good for the trading process. When an order is placed, the person wants an instant confirmation that it was placed into the order book and ideally matched. More work in screening orders before the trade increases the latency suffered by traders. This, in turn, increases the risk faced by various trading strategies, which has adverse implications for market liquidity and market efficiency.
2. What validation rules would you write, pre-trade? There is a danger of fighting the last war. New kinds of problems will inevitably surface in the future. Will we keep on increasing the burden of pre-trade computation, over the years, as the list of potential difficulties goes up through time?

There is a shades-of-gray dimension here. It appears obvious to us that if a computer program is buggy, and puts in a wrong order, this should be blocked. But what when a man-machine hybrid (the typical human trader that operates a computer) makes a mistake? What about a pure human trader that makes a mistake (e.g. saying on the phone "buy me 25 million shares of Infosys" when he meant "buy me 25 million rupees of Infosys")? Where do you draw the line?

It is better, instead, to see that mistakes are an inevitable part of financial markets. I would argue that pre-trade computation should be kept to the bare minimum, and that it is instead important to focus on deeper initiatives that will make the market more resilient. We need more eyeballs, more capital, more limit orders, more arbitrageurs, more algorithmic trading, more short selling. This is what will make the market resilient. A resilient market is one that is ready to accept a diverse array of unpredictable shocks in the future. Until a few weeks ago, we never imagined an order for 17 lakh nifties could be placed. The market did well in absorbing this completely unanticipated shock. The market should be a flexible, intelligent, resilient construct that is ready for all sorts of unexpected events of the future.

Some people say: "We should put in infinite expenses in order to screen orders". This reflects a lack of  economic thinking. The strategies of prevention and cure need to be evaluated from a cost/benefit perspective. Each features tradeoffs. Driving up the charges of an exchange by 3x to 10x, and increasing the latency suffered by every market participant, is a big cost. This should be weighed against the benefits.

I am reminded of a great story told by the Chilean economist Raimundo Soto at a NIPFP/DEA Conference in 2009. He started by describing a cautious 80-year old person, who is very careful about what he eats, who avoids stepping out of the house, and so on. He stays alive, but is perennially afraid that a small sickness will bring him down. And, indeed, when one small common cold comes along, it can have catastrophic consequences for him. Compare this with a 15-year old prancing around the world, tumbling in the dirt, taking risks, and living a great life. He is exposed to many illnesses, but rapidly bounces back from each of them.

Raimundo Soto said that the analysis of capital account convertibility should be rooted in the desire to become this 15 year old rather than this 80 year old. We should be asking: How can the system be made more resilient to shocks? We should not aspire for a Chinese Wall of capital controls that cuts India off from the global financial system; instead we should be doing the things that make India resilient to international shocks - such as develop a sophisticated Bond-Currency-Derivatives Nexus.

In similar fashion, too much of the conversation in India, after the Emkay fat finger trade, is about asking How can such shocks be prevented? I think we should aspire to be like the 15 year old and not like the 80 year old. The really important question is: How can the system be made more resilient to such shocks?

Cancelling trades on an exchange: When is it a good idea?

When inexplicable things happen on an exchange, many people argue that those trades should be cancelled. I think it is useful to be clear about the test to apply for this.

The key question should be: Did something foul up in the order matching software? If order matching went wrong, or if there was a systematic breakdown of connectivity to the exchange, then there is a case for cancelling trades. We'd say that persons placed certain orders, but the exchange mis-handled the orders, hence the observed series of matched trades and prices is unfair.

If the exchange and its rules worked as advertised, this reason peels away. In fact, I would argue that particularly when there is a fat finger trade or something like the US `flash crash', it is important to not cancel trades, to cement faith in the trading process.

The recent events surrounding the fat finger trade by Emkay are a good example of this line of thought. Owing to a human error,  a basket trade to sell Rs.17 lakh of Nifty was instead placed as an order  to sell 17 lakh nifties (where one `nifty' is a basket of 50 shares adding up to the present level of the Nifty index expressed in rupees). If Nifty is at 5000, then an order for "100 nifties" is an order for Rs.500,000.

Through this human error, a very large sell order appeared on the market. At that instant, everyone looking at the market would have been taken aback. What was going on? Has a huge event unfolded which some informed speculator knows about, but I do not know about? It takes nerve in that moment to be on the other side of the order. We must reward the people who did not lose their head when everyone around them was losing theirs.

When the big Emkay order came in, many of the orders which were matched were limit orders which had been patiently waiting there. This does not, in any way, change the analysis. Waiting with `deep out of the money' limit orders is a hazardous business. As an example, consider the persons waiting with deep out of the money limit orders, standing ready to buy at very cheap prices (e.g. 10% below the current market price) when the Satyam scandal unfolded. They lost money big time because the informed speculators, who understood the Satyam announcement and placed massive market sell orders, knew more than them. Waiting patiently with limit buy orders, 10% away from the touch, is not free money. ("The touch" is finance parlance for the bid and the offer price). It is a risky trading strategy.

Two trading strategies matter most in stabilising a market when crazy things have happened. Traders  have to be there ahead of time, with limit buy orders far away from the touch. The limit order book should be thick with orders; i.e. the impact cost associated with a giant market order should be low. And there have to be traders who see that the market has crashed, are able to work the phone and gain confidence that this is an idiosyncratic shock, and come into the market and buy. The more the capital and intelligence behind such trading strategies, the more stable the market will be.

If trades are now cancelled, these two trading strategies will have suffered the risk and got nothing in return. In the future, they will be more circumspect about stabilising the market. Similar considerations apply on the other side. When there are strange and large upward moves of the market, we want rational speculators who short sell and bring the price back to fundamentals. The market must be designed in a way that supports and enables this. At present, it is not [link, link].

Fat finger trades will happen. There will occasionally be strange rumours and other odd things that will make markets fluctuate away from fair price. In those situations, what we want most is for clear-headed rational speculators to put large scale capital into making money by stabilising the market. The rules of the market should reward the people who perform these roles. Trades from their orders should not be cancelled.

The Emkay story has gone well for the Indian securities markets. The market design worked as it should have. A human error was made, there was a brief market-wide suspension on the equity spot market (but the futures market continued to work). A call auction took place to discover the price, and within minutes everything came back to normal. Emkay took full responsibility for their trades and came through with the money. We shouldn't stumble in the policy analysis that follows this story.

Government equity infusions into PSU banks

Harsh Vardhan's excellent blog post on this subject made me think further about the questions.

Finance policy makers in India are often proud of the fact that India has avoided a large systemic crisis in which substantial fiscal resources have been put into rescuing financial firms. I think this optimism is overstated. If we look back into the last 20 years, there has been a steady process of government money going into financial firms. On one hand, we have big events like UTI or IFCI or Indian Bank where large sums of public money were put into financial firms. Equally important is the regular flow of government money into PS Banks.

India is in the midst of a business cycle slowdown. This has come after the biggest-ever credit boom in India's history: in 2007, year-on-year growth of non-food credit was nudging 35%. As we know well, a boom in credit is followed by a boom in NPAs when a downturn comes about. We may well be at the cusp of an upsurge of NPAs. In this case, the pressure on capital in PS banks is going to be acute. If government thoughtlessly continues on the path of putting public money into PS banks then it would involve large sums of money.

As Harsh remarks, the striking feature of this annual resource flow is the way it has become commonplace. Nobody even notices this any more. In a time where government does not put equity capital into any other PSUs, the scale at which this is taking place is quite remarkable.

When the government builds a highway, the cost-benefit analysis is straightforward. Do we want to spend Rs.5000 crore in order to get a 1000 kilometre highway? A tangible result -- the highway -- is the fruit of the fiscal labour. In contrast, capital infusions into PS banks are not animated by a clear goal. What are we doing? Why is this wise? What is the cost benefit analysis? Are there other mechanisms through which the same objectives can be obtained at a lower cost? As the approach paper of the FSLRC has emphasised, perhaps the most important element of the public policy process that we require in India is clarity on objectives, and a clear demonstration that the proposed policy initiative is the best way to achieve the objective. I would classify the annual fiscal transfers to PS banks as part of the larger problem, that the edifice of Indian financial economic policy has been grounded in inadequate analysis. I am almost certain that 1000 kilometres of highway is a better use of public money than putting it into the equity capital of a PSU.

Once objectives are articulated, it becomes possible to measure the extent to which those objectives are being achieved. Evidence can be brought to bear about the extent to which the claimed objectives are being pursued. As an example, Shawn Cole did a beautiful paper which demonstrates the extent to which PS banks are a tool for rigging elections in India [journal link, ungated pdf]. If this is what PS banks do, are we better off if PS bank assets would decline, as a fraction of GDP?

Harsh's calculations treat one key number -- 1.1% return on assets for Indian banks as a whole -- as a given. If this number is given, the average Indian bank is not generating enough retained earnings to support growth, and then there is an inexorable need for fresh equity capital. I would attenuate this discussion in two dimensions:

• A key feature of a world where banks are required to have equity capital is that not all banks get this equity capital. Some banks do well, they build up their balance sheets, they have good prospects and are able to raise equity capital, and they are able to grow. Alongside them, weaker banks fail to grow. This is perfectly appropriate and a desirable feature of the system: a healthy banking system must be one where only some banks are able to grow. The fact that a bank with the average ROA requires capital for growth does not mean that we should be putting public money into all banks that require capital for growth. Many, many banks in India do not deserve to grow and hanging tough is the right way to deal with them. Growth is not a birthright: a bank must do well, and pass the market test, and thus earn the right to grow.
• There are many elements of banking policy which are driving down the return on assets. Easing these constraints is a better path for policy rather than putting in public money.

Banks in India are facing a combination of swelling NPAs, and difficulties in finding capital to grow. It is not fair for private banks to face competition from PS banks that get equity capital for free. I am reminded of Kingfisher. As long as Kingfisher was around, with an artificially low cost of capital, this exerted downward pressure on air fares, and hurt all healthy airlines. The exit of Kingfisher was of essence in bringing the rest of the industry back to health. This is the story of Japan's `zombie firms': when failed firms were kept alive using public money for capital infusions, this infected healthy firms. Percy Mistry famously pointed out that Indian finance suffers from the presence of `zombie banks', who only walk the world on the life support of public money. This is a deeper consequence of easy access to capital for public sector companies that we in India should be worrying about.

Harsh is undoubtedly right in suggesting that government should be willing to accept a reduced shareholding in PS banks while retaining control under the Bank Nationalisation Acts. But this leaves the residual question: if PS banks have a low ROA, the share price that this can support is low, if investors see no possibility of true privatisation in the years to come. The amount of equity capital which will come by going down this route is limited. The real story has got to be to ask PS banks to demonstrate that their claim on public money is backed by a good possibility of using capital better than NHAI.

Suppose we suggest that the government should be stingy in giving equity capital to PS banks. In the short term, the partial equilibrium analysis suggests that this will hold back the growth of banks and thus the size of Indian banking. We should bring two different perspectives to this. First, the very absence of free capital for PS banks will increase the profitability and thus equity capital access for private and foreign banks. The overall impact for India will thus be attenuated. In addition, it's easy for government to have entry of 20 new private banks. Suppose each is asked to bring in Rs.500 crore as equity capital. Using the rough 20x leverage that's found in Indian banking, this gives us new bank assets of 2% of GDP or Rs.2 trillion.

Should government capitalise public sector banks?

by Harsh Vardhan.

What would you say if someone was borrowing money at 8% and investing it to earn around 3%? "Uninformed!", "financially illiterate!" or even outright "foolish"! And yet this is what our government has been doing with trillions of rupees over the last many years and has committed to continue to do so in the future. The process by which this is done is called capitalisation of public sector (PS) banks. Such capitalization is not only a bad idea economically as it puts enormous stress on the government resources, but also one which affects that behavior of banks and hence the robustness of the whole banking sector.

Commercial banks need capital to grow. Capital adequacy requirements ask all banks to keep a minimum amount of shareholder capital in proportion to their balance sheet size. Currently, in India this requirement is 9% of "risk weighted assets" of banks. Roughly, it means that banks are expected to have equity capital which is 9% of their commercial loans.

As banks grow their business, their risk weighted assets also grow. This means that banks has to increase their capital base in line with the growth of their loan book. Such increase in capital can come from exactly two sources - retained profits that are added to the capital base, or fresh infusion of capital from shareholders (old or new). In India, given the overall profitability of the banks (~1.1% return on assets) and the amount of dividend that they pay (~20%) of post-tax profits, banks do not have enough retained profits to support their business growth. Therefore, every now and then, they go to shareholders to raise fresh capital.

PS banks pose a peculiar challenge for the government. Being the majority owner of these banks and having committed to stay the majority owner, government has to infuse capital into these banks proportional to its ownership stake. Since the government wants to maintain its ownership at 51%, it has to supply atleast 51% of the fresh capital that PS banks need. RBI governor Dr. Subbarao, in a recent speech, said that the capital infusion by government into PS banks over the next decade will be of the order of Rs.0.9 trillion. I have read estimates of other analysts where this number is as high as Rs.2.50 trillion. These estimates depend on the assumptions one makes about a number of factors - the rate of growth of banks (which in turn depends on the growth of the overall economy), the profitability of banks, their dividend policy, their ability to raise other forms of capital (especially tier II capital), regulatory requirements on capital, etc. No matter how you estimate it, the number is very large. In other words, the government will be compelled to invest a very large amount of capital into PS banks over coming years.

Why is this a problem? Let’s look at the some simple public finance issues. India is in a deep fiscal crisis, and it is not easy to find trillions of rupees to put into PS banks. If such resources were injected into PS banks, it is not conducive to healthy public finance, since these injections are not a good deal for the government. The Indian government currently borrows long term money at over 8%. The dividend yield on PS banks shares has been between 2% and 3% over the last decade. This means that the government earns between 2% and 3% on its investments in PS banks. There is a 5% “negative carry” or loss that government bears on these investments.

A private investor also earns a low dividend yield from investing in PS banks, but can benefit from capital gains - a potential increase in the value of shares which the investor can obtain when she sells the shares. Government has never sold shares of PS banks (except when it initially listed some banks) and will not do so if it has to maintain majority ownership which is its stated policy. Hence, for the government, the financial analysis of a proposal to put money into PS banks should hinge on a comparison between the flow of dividends versus the cost of borrowing.

Capitalisation of PS banks is, thus, bad for government finances. It's a double whammy! On the one had government has to raise vast resources to be invested into banks and then carries a loss of around ~5% on these investments year after year.

Ownership and behavior of banks

Government capitalisation of PS banks is not just a fiscal challenge. It also impacts the competitive dynamics of the banking industry. Most privately owned banks are under constant scrutiny of investors and analysts. When they go to external investors for raising capital, they have to satisfy these investors on number of critical aspects of the business - profitability and its sustainability, efficiency of capital use, quality of management team, cost efficiency, etc. In other words, private banks face a market test; they do not get capital for free. Only well run private banks get equity capital that is required for growth.

None of these questions get asked when government puts capital into a PS bank. One has never heard a senior government official commenting on the Return on Asset (RoA) or Return on Equity( RoE) of PS banks. The decision to put capital into PS banks is treated as a mechanical and administrative decision. This absence of a market test has systemic consequences. PS banks have ~70% share of the Indian market. When the majority owner is asking no or very few questions on performance, and is assuring an almost unlimited supply of capital, these banks have little incentive to improve financial metrics such RoA and RoE. This hurts the overall banking industry. For example, PS banks can underprice loans compared to their private sector peers. Such behavior would migrate the whole business to lower returns. It is hard for a private bank to be profitable when facing rivals that are not concerned about return on capital.

Misplaced obsession with majority ownership

The source of this whole capitalisation issue is the government's obsession with retaining majority (over 51%) ownership of PS banks. This is often explained in terms of the need to maintain the "public sector character" of these banks. While there may be a separate debate on whether we need to maintain public sector character for all the 25 plus PS banks, the fact is that the government does not need majority ownership to achieve this objective.

  All PS banks are not companies under the Companies Act. The notion of 51% giving majority control is enshrined in the Companies Act. PS banks were created under the Nationalisation Act (SBI has its own SBI Act). The Nationalisation Act provides the government untrammelled control over these bank. While it does prescribe 51% government ownership in the PS banks, the control of government is independent of the level of its ownership. Furthermore, there is a limit of a 5% (10% with prior approval of the RBI) stake owned by any single shareholder in all banks. There is no chance, therefore, of any external shareholder acquiring control in these banks. Even relatively minor changes to the functioning of PS banks require approval of the parliament. Where is then the question of diluting the public sector character if the government ownership were to drop to, let's say 26%, which is the threshold for "significant" minority stake in a company?

In the long run, therefore, it makes no sense for the government to commit itself to the capitalisation of PS banks. Precious government resources can be better deployed in critical areas (such as power transmission and distribution) where private capital on large scale is hard to come by. In the medium term, it can use tactical measures such as merging banks where it has significantly high ownership with those where the ownership is already down to 51%. But these tactics will not solve the issue structurally. The only long term solution is to give up the majority obsession, explain to all the stakeholders the fallacy of this obsession and the resulting pressure on public finance, build a political consensus to enact necessary legislative changes and then dilute down to a reasonable level.

Interesting readings

The price of half-truths by Pratap Bhanu Mehta in the Indian Express.

Rise of crony journalism and tainted money in media by R. Jagannathan on Firstpost.

Telecom, power, oil: Guide to crony capitalism, Indian style by R. Jagannathan on Firstpost.

Trampling on the individual in India:
- Gagged and Bound: Why India's `free internet' is a big, fat lie by Danish Raza on Firstpost.
- Why we need more blasphemy, not less by R. Jagannathan on Firstpost
- Aakar Patel on FirstPost on the problems of free speech in the Indian Penal Code.
- Lakshmi Chaudhry on Firstpost about Aseem Trivedi's arrest.
- Salil Tripathi in Mint on Aseem Trivedi.
- Kian Ganz describes the problems with freedom of speech in Indian law in Mint.

In India, the music fest comes of age by Isha Singh Sawhney in the New York Times.

Matthew Yglesias reminds us of the elementary logic in favour of low taxation of capital income.

Fear grips public sector banks by Dinesh Unnikrishnan, Anup Roy and Joel Rebello in Mint.

What drives volumes on BSE and Why lower trading fees may not be a game-changer by Mobis Philipose in Mint.

Materials from Ila Patnaik's blog: Sovereign warning, RBI is fighting the right battle, The emerging slowdown and Chidambaram's challenge.

Kayezad E. Adajania on recent developments at SEBI on moving towards principles-based regulation (link).

Vikram Doctor tells a story of coal mining in India that goes back to Dwarkanath Tagore.

Golden Dawn -- a far-right party where goons hang out in the streets and kill immigrants in daylight in Greece. 1936? No, 2012.

The Apple/Samsung case has set off shock waves across the world, about the threats to innovation that the patent system, particularly the US patent system, poses. I have always been skeptical about how the sanctity of property rights was invoked in the phrase `intellectual property rights', even though knowledge is the ultimate public good: non-rival and non-excludable. On this subject, read: Timothy B. Lee on arstechnica. Gary Becker / Richard Posner on the Becker-Posner blog; Jordan Weissmann on qz.com writing about a new working paper by Boldrin and Levine. I have to confess, though, that the one thing in this landscape that I dislike more than Apple is Intellectual Ventures.

Poul-Henning Kamp in ACM Queue on the great crisis facing the world of software today. Perhaps more poignant in India than elsewhere.

It all began with an email by Yanis Varoufakis: The unexpected twists and turns of economics as a profession.

Offtopic: Read a great short story Enoch Soames: a memory of the eighteen-nineties by Sir Max Beerbohm, written in 1916, and after that read a story A memory of the nineteen-nineties in the Atlantic magazine, November 1997, by Teller, and after that read a great article The honor system about Teller, by Chris Jones in Esquire magazine.

An entry level 3-d printer at $400! I can remember buying printers that print on paper for more than that.

Comments on FSLRC approach paper

• Embrace FSLRC's approach towards financial reforms, by the editorial team on taxindiaonline.
• Dhirendra Kumar on valueresearchonline.
• N. Sundaresha Subramanian in the Business Standard.
• George Mathew in the Indian Express.
• Shaji Vikraman in the Economic Times. Editorial there.
• What is regulation for? by Ila Patnaik in the Indian Express.
• Buyer beware to seller be responsible, by Monika Halan in Mint.
• Editorial, Monika Halan (+video), Asit Ranjan Mishra, Mobis Philipose in Mint.
• Editorial, Ila Patnaik in the Financial Express.

Approach paper released by the Financial Sector Legislative Reforms Commission

The Financial Sector Legislative Reforms Commission (FSLRC) is rethinking the legislative foundations of the Indian financial system. FSLRC was setup by a notification on 24 March 2011 and asked to submit its findings on 24 March 2013. FSLRC constitutes the first time in Indian history that a large-scale re-examination of multiple laws in a sector is being undertaken.

FSLRC has released a compact approach paper showing preliminary findings about the strategy that will be adopted. The release of this report is part of the consultative mechanisms that have been followed within the Commission. The Commission has invited feedback from experts and interested parties on this document.