March 29, 2007
Risk Mitigation Techniques in Interbank Market
The interbank market is not an isolated market, it is linked to other segments of the financial sector and macroeconomy. Macroeconomic shocks through their influences on liquidity and asset prices influence the interbank market and change its risk profile. Second, opening up of the external sector may lead to growing cross-border interbank exposures and can increase risks in interbank markets. The level of internationalisation of the interbank market heightens the risks of interbank exposure. Exceptionally high proportions of cross-border interbank loans and deposits highlight a feature of the interbank market in developed countries which potentially transforms the risk of contagion, as well as the way it should be handled. Given that the lion's share of the inter¬bank exposures are situated abroad in advanced countries, banks are more sensitive to international crises than to domestic ones, and any attempt to assess the impact of interbank markets on financial stability must be viewed in that perspective. India is fast integrating with the global economy, and the lessons from the global economy may be instructive.
Mergers reduce risks in Interbank markets
The cross country literature reveals that the interbank market risk reduces when mergers and consolidation takes place. The world over, mergers are taking place in the banking sector at a rapid pace. This is likely to reduce the risk profile of interbank markets.
Tax Policy
Government tax policies in domestic markets often lead to flow of funds towards international interbank markets, with heightened credit and liquidity risks.
Maturity Profile
Maturity structure of inter-bank liabilities bears a close relation to risk. If interbank loans and deposits show a relatively short maturity, banks use interbank markets mainly to manage their short-term liquidity needs, so the risks are limited.
Institutional Mechanisms towards Risk Mitigation
Internationally, several institutional mechanisms were found to be useful in reducing the risks in interbank market.
First, the existence of collateralized interbank market (a well developed and liquid repo market) reduces the risks of contagion. However, the existence of a repo market may lead to the disappearance of the uninsured international interbank market (Freixas and Holthausen, 2001). This can occur as a result of asymmetric information; a bank that attempts to obtain an unsecured cross-border loan may be suspected of having had the loan denied by other domestic banks which have more information about the borrower.
Second, the use of netting contracts among banks is a mechanism for reducing interbank exposures. A problem at one bank is then less likely to initiate a "domino effect" on the interbank market. Emmons (1995), however, shows that netting of interbank claims shifts the bank default risk away from interbank claimants towards non-bank creditors, i.e. the risk is transferred to the banks' creditors who are not included in the netting agreement.
Role of Central Banks
The Central bank has a major role to play in reducing the risks in interbank market. Potential central bank intervention, as well as the presence of safety nets, lowers contagion risk in the interbank markets . There are several forms of central bank intervention to contain interbank exposure risks. They are :
(i) Liquidity Management
Central banks may decide to provide liquidity to the market as a whole when aggregate liquidity is insufficient, or directly to individual banks when the market fails to provide liquidity to sound financial institutions. Moreover, although interbank exposures are not explicitly covered by deposit insurance, issues such as "too-big-to-fail" may introduce implicit deposit insurance for these exposures.
(ii) Containing Market Expectations
Central Banks also play a crucial role in arresting "Spill-overs" of market expectations. Regulatory intervention such as suspension of convertibility or deposit insurance or even active communications policy may alleviate the problem of bank runs and banking panics (Freixas and Rochet, 1997).
(iii) Limits to large counterparty exposures:
Limits imposed by authorities on banks' large exposures and proper monitoring and control of large exposures of credit institutions contribute to reducing contagion risk. Limits are usually formulated in terms of banks' own funds.
(iv) Challenges to Banking Supervision
A regulator entrusted with the mandate of financial stability needs to differentiate between fundamental instability and systemic instability. Banks may default as a direct consequence of shocks (fundamental insolvencies), but also due to a chain reaction, i.e. because other banks defaulted in the first place. The latter cases may be regarded as insolvencies caused by chain reactions (contagious insolvencies). It may be noted that Banking supervision, which focuses on the individual institutions, has no in-built mechanism to arrest systemic insolvencies and thus inadequate to detect such risks. In this context, the need for a separate mechanism to monitor the systemic risks emanating from interbank markets can hardly be underscored.
(v) Effective use of data on Interbank Exposures
Also relevant is to devise a mechanism for optimal use of interbank data, including creation of database, regular monitoring, relevant reporting and assessment of risks. Periodic stress testing by the central banks may be necessary in this regard. In this context, it may be useful to further explore application of a network model in the Indian context by using advanced matrix analysis and entropy optimization.
( Downloadable Paper link : http://sunandoroy.googlepages.com/workingpapers)
Posted by sunandoroy at 11:53 AM
March 26, 2007
Commodity Futures Market and the Indian Farmer
Ever since the go-ahead given by the Forward Markets Commission regarding Commodity futures Trading in emerging markets in 2003, the futures market in commodities has seen vigorous growth. The spectre of Inflation has recently brought the commodity futures market was once again under the scanner. The basic question is- are we witnessing too much speculation going on? The long legacy of treating derivattives as something similar to gambling came back to haunt us.
It is in this context, necessary to examine the benefits accruing to the Indian farmer from the futures market. Those of us, who had the fortune of seeing rural markets from close quarters know that the Indian farmer is far for a representative individual- there are big and small farmers with diverse holding capacity. In many a cases, they contract prices ahead of the harvest . This is often due to working loans needed to cultivate the land. The price typically fall( if not crash) post harvest , and procurement prices are effective only to areas and markets the Government agencies are able to penetrate. Given the poor infrastructure and low awareness, it is not possible for the majority of farmers to dream of trading in organised exchanges.
But the availability of fututes market has emerged as an important source of information to farmers,thanks to the revolution in audio-visual media. Even when the farmers are not exchange users, they are more aware of prices of what they produce, likely prices a few months ahead and related variables. If discussions in village tea shops are any pointer, farmers are using such price information to get better deals in the village marketplaces.Knowledge thus becomes a source of empowerment for farmers. However, the knolegdge penetration among farmers is still pretty low. The road ahead for the State and the exchanges is to facilitate greater sharing of information, more roadshows and interfaces to really make the presence of commodity futures markets beneficial for rural farmers.
For information on the Commodity Futures Market in India
See http://sunandoroy.googlepages.com/workingpapers
Posted by sunandoroy at 12:46 PM
Market Risk Modeling Challenges in Emerging Markets
Market Risk Modeling in emerging markets is beset with a host of difficulties that advanced financial market analysts need not bother about. Managing simple stuff often becomes rather complex. This complexity in the emerging market risk analysis arises from the lack of depth( illiquidity),extreme volatility and more outliers(fat tails), frequent regime changes in transitional markets leading to structural breaks, lack of data and detailed tick-by-tick information gathering mechanisms and so on. While data inadequacies and structural breaks constrain the use of advanced models that are data dependent ( EVT). Often, financial market analysts are left with limited choice of models, known to be error-prone if financial returns are thick tailed. Risks are high in illiquid pockets and very often, there are no proper measurement techniques.
The growing breed of risk managers who depend on emerging market analysis must also take care of country specific macroeconomic specificities and their impact on their model through stress testing. My blog plans to discuss these issues and more from the world of credit risk modeling and operational risk modeling. Comments from the practitioners are most welcome as it will help to thrash out critical issues and help in understanding and improving our practice of emerging market risk management.
Posted by sunandoroy at 12:17 PM
