Call for research proposals on the economics of Indian bankruptcy reform

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Work on building new government institutions at the Macro/Finance Group at NIPFP

The Macro/Finance Group at NIPFP is recruiting.

Background

In March 2011, the Government of India setup the Financial Sector Legislative Reforms Commission to review, rewrite and harmonise financial sector legislations, rules and regulations. In its recommendations, the FSLRC proposed that the draft Indian Financial Code, an umbrella legislation, replace the bulk of existing financial laws and improve the ease of doing business in India. One of the key provisions of the IFC is setting up of various regulatory agencies.

In order to build these regulatory agencies, the Ministry of Finance, Government of India announced a group of Task Forces. These Task Forces are implementation teams which will design and build these institutions. Macro/Finance Group at NIPFP is the `secretariat' doing implementation for the Task Forces. The positions available are in project management, data analysis, procurement of services, and oversight of external contractors towards building these agencies.

Key responsibilities

The key responsibilities of the required personnel are:

1. Formulate and implement strategies for agency development, including modernisation of business processes, developing business plans, capacity building and specifications for information technology systems;
   
2. Design and implement the project plan through which the steady-state agency will be achieved. This includes procuring consulting/IT firms for implementing the plan, and then exercising oversight over them.
   
3. Assist in timely and proper preparation of procurement plans and documents for the concerned agency, ensuring adherence to the deadlines and adherence to applicable procurement guidelines;
   
4. Perform project management activities including: development and management of work plans, schedules, project budgets and monitoring of consultants;
   
5. Participate in other related projects on the implementation of the FSLRC report.
   

Qualification and skills

Graduate or Undergraduate degree from a reputed university with a major in any of the following disciplines - Management, Engineering, or Commerce. Candidates with 3-5 years of experience in the areas of work stated above are preferred.

Duration of Contract

Personnel will be appointed on a contractual basis as per applicable rules and norms followed by NIPFP.

Submission of application

Interested candidates meeting the above criteria may send their applications to anirudh.burman@nipfp.org.in with the following documents attached:

1. Recent curriculum vitae with complete personal and contact details;
2. List of references

Indian Economic Policy Strategy Conference

The program is up.

Opportunities in analytical and policy-oriented finance at IGIDR Finance Research Group

IGIDR Finance Research Group is engaged in analytical and policy-oriented research in finance. See the papers, the fifth of an annual conference series, and systems. IGIDR FRG has the best data centre for doing high frequency finance with Indian data; this involves big data and computational finance.

IGIDR FRG supports the Standing Council on International Competitiveness of the Indian Financial System, and is part of the `Bankruptcy Legislative Reforms Commission' (BLRC), chaired by T. K. Viswanathan. These are policy projects of the Ministry of Finance.

If you are interested in working in analytical, computational or policy-oriented finance, please contact Jyoti Manke <jyotimanke@gmail.com> by 15 January.

Are Indian banks systematically mispricing risk?

by Harsh Vardhan.

The primary objective of a financial system is to efficiently allocate capital. The key step in allocating capital efficiently is to assess and price risk correctly. Correct pricing of risk ensures that it is properly distributed - capital providers get to hold assets that reflect their risk appetite and present them with an efficient risk-reward trade off.

Banks are an important vehicle for linking up the savings and investment of India. It is critical that banks price risk correctly. There are concerns about how Indian banks are pricing risk. The chart below shows the average risk premium charged by the banking system on commercial loans in comparison with the risk spreads on various ratings of bonds.

 
This shows that private sector banks priced their loan book as if it was rated between AA and A whereas public sector banks priced loans as if they were rated between AAA and A. The risk spreads spiked in FY 2009, the year of global financial crisis. The financial years 2006 to 2008 appear to be `carefree' lending years: there was the biggest ever boom in bank credit, and risk premia were the lowest.

This analysis may be challenged on several points:

1. Indian corporate bond markets are not deep enough to provide reliable risk spreads
2. Loan risk spreads cannot be compared with bond risk spreads as loan covenants are generally tighter than bond covenants
3. Bank loan books carry a significant retail lending portfolio, which is generally of much lower risk, and hence the risk of the whole lending book comes down

The first criticism is valid - the bond market is indeed very shallow, and that hampers our ability to read information from it. However, there are two key data points that will throw some more light on this issue. Firstly, in the chart below we show the rating distribution of the top 3 rating agencies in India for the financial year 2009 and 2013. These three agencies account for over 95% of all bonds rated in India. The data shows that the median and mean rating of the bonds was BBB in both the years. The overall rating profile deteriorated over these 4 years. Also, the companies that issue rated bonds are typically larger in size and more established. The firms that banks lend to are, to a greater extent, Small and Medium Enterprises (SME) which are riskier than the large companies that access the bond market. Thus, it is fair to expect that the average rating of the portfolio of banks should be worse than the average bond rating.

Is this an issue of underestimating the risk, or bad pricing? Unfortunately the analysis does not throw much light on the cause of mispricing. But here is another piece of data that may be insightful. In FY 2012, the Indian banking system had ~ 76 Mn commercial loan accounts (i.e. loan accounts for commercial loans excluding Individual loans). Of these about 72,000 were loan accounts of value above 5 crore, and this subset accounted for 80% of the loans of banks. Currently, around 40% of these accounts are rated by rating agencies. (Under Basel II, banks are allowed to use external rating for their loans). This means that about a 3rd of the loan book by value of the banking system is rated by the same rating agencies that rate bonds. It's unlikely that the ratings agencies use radically different (and lower) standards for rating bank loans. This implies that the cause of underpricing may not be misunderstanding risk but mispricing it.

The second criticism, of loan covenants assigning better rights to the lender (i.e. banks) than bond covenants is plausible. It is hard to test empirically unless we get the data on recovery rates of loans vs. bonds. I feel that while this is a factor at work, it cannot explain the significant difference between the loan spreads and bond spreads.

Finally, the criticism about retail loans in the portfolio. It is true that the retail secured lending (eg housing, car loans) has demonstrated a much better risk profile over the last decade or so. However, it is important to note that retail lending constituted about 22% of the overall loan book of Indian banks, and hence the lower risk on retail is unlikely to significantly lower the overall risk.

I hope to have persuaded you that there is evidence in favour of systematic mispricing. This takes us to the next question: Why would there be such systematic mispricing? There are two possible reasons. First, excessive competition, especially in the larger and relatively better rated lending, that drives pricing down.

The other reason is more nuanced. Historically, a significant part of the banks' deposits base (~ 33%) was under interest rate regulation - these are the "CASA" (Current Accounts, Savings Account) resources that all banks chase. The chart below presents some interesting analysis. Consider this: if the banking system as whole did nothing but took CASA deposits and invested in the risk free 10 year government security (we call this Risk Free Margin on CASA) then the margin it would make is more or less the same as the pre-tax profits of the banking system! Over the last decade, the risk free margin on CASA was more than the pretax profits of the system except in a few years when the yields on government securities had fallen precipitously - FY 03, FY04 and FY09. This "lazy profit" has been created by regulations. It is this profit pool that allows banks to underprice loans, effectively creating a system wide wealth transfer from (CASA) depositors to commercial borrowers. Most banks use a cost plus approach to loan pricing where the loans are priced at a margin over the cost of funds, which are kept low by interest rate regulation. Despite lifting the SA interest regulation a couple of years ago, only 3 relatively small banks have changed their SA pricing.

Using sources of funds whose cost has been kept low, because of regulations, to underprice risk in lending, effectively engineers a large scale wealth transfer from depositors to borrowers. This wealth transfer can be interpreted as being an integral part of the system of financial repression which is in operation in India.

Systematically mispriced risk will result in misallocated capital. Is this one of the reasons that the system regularly runs into NPA crises? Is this systematic transfer of wealth the reason why households avoid bank deposits and prefer to hold other kinds of assets?

As the Indian economy grows, our financial system should not just grow in size, but also evolve to become more sophisticated and allocate capital more efficiently. With a monolithic system dominated by public sector banks, we have not seen such evolution. Banks today look and behave the same way they did 10 years ago, they are only a lot bigger. Fundamental change in the framework for financial economic policy will give a banking system that allocates resources better, and is safer.

Policy puzzles of the digital nirvana

by Arjun Rajagopal, Renuka Sane, Somasekhar Sundaresan.

It has been a bad week for Uber. The effect of its automated surge-pricing during the hostage crisis in Sydney and the reaction to this, have exacerbated the publicity surrounding the alleged rape of an Uber customer in Delhi by a driver who was listed on the company's app, and the litigation it faces in San Francisco over not conducting effective background checks on criminal records of drivers. In India, the outrage has been accompanied by bans in New Delhi and calls to ban or suspend Uber in other states.

This is not the first time, or the first geography in which Uber has run into trouble. It has been criticised over its sexism, ethics and bro culture and over its record on passenger safety. The app has been recently banned in Spain and Thailand and has run into trouble with authorities in several other countries, mostly for being at odds with the traditional, regulated taxi companies.

Uber does not have a taxi license in Delhi. It is not a radio taxi service. It does not own the cars or employ the drivers. Fine print on its website suggests that it disclaims the suitability, safety or ability of third-party providers. Uber claims to not be a transportation provider, and only connect riders to drivers through its app. Yet, it claims that its service is a safe and secure one, adopting standards that go way beyond local standards that regulatory authorities may prescribe.

These claims allow one to litigate against Uber with allegations of misleading customers with particular standards of safety when in fact there were none. This is the stuff class action suits are made of. Indian customers could potentially be creative and sue Uber in the US, where control over its operations is headquartered.

However, the furore also raises larger questions on what the appropriate legal or regulatory response should be to such aggregators, and where the liability lies when things go wrong.

Is more required? Liabilities for information aggregators

A defining feature of the early 21st century is businesses becoming powered by software and synonymous with services delivered online. Technology platforms, or aggregators, purely facilitate the sale between buyers and sellers. In this sense, they are neither originators of the product, nor distributors linked to specific manufacturers. Often touted as disruptive innovators, such businesses tread thin on requirements under the licensing and regulatory systems even while competing with similar services provided by the traditional licensed players. This regulatory arbitrage raises important questions on the obligations of such aggregators.

The fundamental question that governments need to ask themselves is what, if any, obligations should be placed on businesses such as Uber. Should a market aggregator be responsible for the quality, or safety of a product that is sold on its technology platform? There are well reasoned views on both sides.

The analogy with a financial exchange

We might make an analogy between Uber and an electronic stock exchange, in which case the exchange aggregates information and enables transactions. The quality of the product being sold (i.e. whether the shares represent a "good" investment) is not guaranteed by the exchange. The transaction is guaranteed. Under this analogy, Uber's job is simply to ensure that double booking of cabs never occurs, and that payment transfers occur reliably and seamlessly.

The analogy with a retailer

We might also make an analogy between Uber and the owner of a neighborhood mall. While a case may be made against regulatory intervention to make the mall owner responsible for quality of the goods and services, there would also be a case for the mall owner being obliged to ensure safety and security in the mall premises, and being liable for a customer injuring themselves on a broken step. Besides, if the mall owner knows that sale of some goods needs a license (for example, alcohol), and turns a blind eye, it would beg the question if the owner can effectively defend against a charge of aiding and abetting a violation of the licensing of sales.

The puzzle

Where does an aggregator fall, on the spectrum? This will determine what aspect of the customer interface the aggregator is held responsible for. For example, companies may make business decisions on where on the safety spectrum they lie, and charge a premium for it. Over time there may emerge expensive aggregator companies and cheap aggregator companies and customers take a call on how much they are willing to pay for what quality of service. Regulators could step in and prescribe minimum standards - in much the same way, product warranties across jurisdictions are spelt out. Rules about information disclosure could help consumers make better decisions.

At the point of entry into the cab, the consumer is held hostage to that cab, and must trust that certain minimum safety and service standards are met. In fact, such requirements were the reasons for entry regulations in the traditional cab industry. The onus for these then lie in the State capacity that gives commercial licenses, and does police verification checks. This requires the State machinery to work, and is independently an issue apart from that of requiring anything of a technology platform that merely brings together buyers and sellers.

Conclusion: Another kind of activism

The problem then, is two-fold. First, there is the tragedy of poor State capacity in preventing and prosecuting crime, which incentivises simply banning certain activities. This is a generic problem that bedevils the working of the Indian economy in numerous contexts. The solution to this issue can only be a long and hard one: of improving the functioning of our public institutions.

The other problem to address is the poor methods for shaping, regulating or nudging commercial conduct. While India is a common law country and action for tort indeed can shape commercial conduct, the problems in delivering timely justice under common law has led to regulators occupying the commercial space in many sectors. However, regulatory interventions with clarity of thought on what can and cannot be done by commercial parties, leaves much to be desired even in sectors that have been regulated for decades. When Uber began its coverage of India, no transport regulator raised as much of a whisper about the status of its regulatory compliance and whether at all intervention was warranted. Now, at the first sight of a crime, the same regulators are quick to consider imposing a complete ban.

Common law remedies coupled with penalties and damages offer recourse to the affected parties, and hit offenders where it hurts: on their balance sheets. Predictable regulations would not only make service providers answerable to society but also would make regulators answerable to the service providers. Is it a substitute for criminal prosecution of heinous crimes? Certainly not. But it is a useful complement. Regulatory activism is not just about ensuring effective prosecution, it also means bringing companies to book if they are lying about what they are providing.

There is an expectation that `software will eat the world', that lightweight businesses like Uber will come to dominate the whole world. Perhaps conditions of State capacity in India will prove to be a bottleneck, both in respect of problems such as obtaining law and order, and in terms of navigating the subtle questions of public economics and coming out with the right answers.

Have Indian banks been underpricing corporate loans?

by Ajay Shah.

In the 1990s, we had large scale defaults on corporate loans, which felled IDBI and IFCI. For some time, we thought that we had learned our lessons, that micro-prudential regulation had improved, so that such failures would not recur. Has this happened? There is cause for concern.

1. After these bailouts of slightly over a decade ago, we haven't had a big banking crisis with a collapse of banks such as IDBI or IFCI. But there is a worrisome scale of regular injections of capital into public sector banks by the Ministry of Finance. If government puts Rs.100,000 crore into an episode of bailing out banks, we say there is a banking crisis. This is not too different from putting Rs.10,000 crore every year for 10 years. Have we had a chronic sub-clinical banking crisis for a long time? Some will argue that all healthy banks raise equity capital as they grow. But there is an unmistakable element of bailout in the equity capital that has gone into PSU banks. On this subject, see Harsh Vardhan and me from October 2012, and this blog post from October 2011.
2. India did not have a big financial crisis in 2008. All we have had was a business cycle downturn that's come after a big credit boom. Yet, we've now got a serious mess in banking on our hands.

These two difficulties suggest that micro-prudential regulation has not improved adequately.

When we open the black box of Indian banking, two problems are visible. Most banks have little skill in credit risk assessment. What passes for `risk management' in Indian banks, too often, is the mechanical adherence with RBI regulations -- regulations that micro-manage and are often wrong. There is low ability in the essence of credit analysis: to understand a firm, and make forward-looking forecasts about default. In addition, all banks suffer from high levels of loss given default owing to the lack of a bankruptcy code.

The objective of micro-prudential regulation of banks is to put down requirements through which the failure probability of banks stays at acceptable and low levels (though not zero). The heart of this is  ensuring that the accounting value of each loan is aligned with market value. This was not done. Banks have systematically failed to recognise and provide for bad loans. I feel a distressing deja vu when I hear stories today about what has gone wrong in Indian banking; we heard those exact same stories in 1999. We did not learn; the problems weren't fixed.

Given these weaknesses of micro-prudential regulation, banks have had a merry time, showing accounting profits while giving out loans at artificially low prices, and building up an ever larger inventory of loans where the book value is in excess of the market value. Better micro-prudential regulation would have created a set of rules through which bad loans were valued at market price. Better micro-prudential regulation would have hindered, and not helped, banks in covering up bad news.

Better micro-prudential regulation would have created incentives for banks to charge higher prices for corporate lending, with interest rates that better reflected their own weaknesses in corporate credit risk assessment, and the high values of loss given default. Mistakes in micro-prudential regulation gave us a systematic under-pricing of risk.

The great credit boom of 2004-2007 has traditionally been interpreted as mistakes of macro policy: This came from the pegged exchange rate. RBI bought dollars in order to prevent INR appreciation, with incomplete sterilisation, which gave low interest rates at a time of a boom in business cycle conditions. This gave us the biggest ever credit boom in India's history. I would add one more ingredient in our understanding of that credit boom: Mistakes in micro-prudential regulation of banks. Mistakes of macro and micro came together to give that party.

Looking forward, improving the thinking in micro-prudential regulation of banks is an important priority. It will take years for India to reverse public sector domination of banking, and the consequential weaknesses of credit risk evaluation. It will take years for India to reduce the loss given default, by enacting an Indian Bankruptcy Code. In the short term, these problems must be treated as given. For the coming two years, the agenda must be to break away from the failures of the last 20 years in banking regulation, while treating the presence of PSU banks and the lack of a bankruptcy code as a given. At present, the landscape of banking regulation is riddled with mistakes  [example, example]. The fair price of a bank loan to a corporation is probably much higher than what we've thought it should be.