Risk Management, PRMIA

August 22, 2007

US and Indian Housing Markets and the Desi tune

In view of the subprime crisis in the US, concerns have been expressed all over the media that Indian markets are also potentially quite vulnerable and huge corrections in Indian real estate markets is a distinct possibility.

The US housing credit scenarion, as noted by the Institutional Risk Analytics ( thanks to chris Whalen for mailing me the article "De-Leveraging America")
" The last time the Fed faced a real credit crisis was the early 1990s, when the very solvency of some of the largest US banks was rightly in doubt. It has been that long since the US banking market worked through a true credit collapse. Today the numbers are bigger, the assets are increasingly opaque and illiquid, and the degree of leverage employed many times higher."

Also, see this generous gesture of the Central Bank:

"As of last week, the Fed was offering 85 percent financing on "AAA" rated collateralized debt obligations or CDOs, paper which changes hands at half that rate over-the-counter, when it trades. This explicit bailout for the Street stands in stark contrast to the Darwinian struggle now underway in the real estate sector, where private loan originators are defaulting in droves. But the Fed may not escape loss itself as it bails out the major prime brokers."
( quoted from the same article)
As for the real estate market in India, loans have risen very fast from its low base since 2004 or so, the Press Note 2 of 2005 of Government of India liberalising FDI in Housing, the pace has accelerated. Housing prices have gone up substantially, due to both real demand and speculation. Due to lack of good data, developers have charged high prices to benefit out of buoyant sentiments.
It is not bailout time in india, at least not yet. The central Bank has already tried its hands in tighteniong the market through rate hikes and higher provisioning plus risk weights for the housing sector.The housing market has cooled down a little and builders are seen doling out(grudgingly) various sops to the buyers.Prices are still high, but moderate correction to the breakneck pace in which the market was growing till last year is evident.

Due to relatively lower levels of development of financial intermediaries and markets, there exists substantial excess demand for credit in this part of the globe. The credit to GDP ratio in India is substantially lower than those in the industrialised countries, and even lower than that in China and Korea. It has improved over time, there has been substantial improvement in the credit-GDP ratio in the country from 44.5 per cent in 1980s to 56.8 per cent in early part of the present decade . Even then there are about 60 countries in the world with a higher credit GDP ratio.

The Indian and US housing markets are two different species altogether. If the US market suffers due to competitive pressures and sophistication in financial engineering, the Indian market suffers due to lack of clean data on Housing prices and the burden of expectations.

The risks at this point are lower in India as Indian borrowers are far less leveraged compared to their US counterparts. The financial saving in India has grown steadily since the 1990s and now shows at respectable 30 plus percentage. Default rates in India are historically low, both due to regulation and caution in Banking.Therefore, the borrowers, benefitting from the high growth economy and saving habits, are less prone to default.

In the banking sector, while extreme risk takers are not absent ( and their total absence may not also be ideal for a growing economy), they are certainly outliers. As a consequence, not only the non-performing loans of the Banking sector remain low in general, thanks to the stress on financial stability as an explicit objective of monetary policy, the capital adequacy of the banks do not pose any major solvency issues in the immediate future.

A fair share of press reportage in India aligns with the possibility of global shocks threatening Indian economy, through the evaporation and reversal of capital flows . To me, this is not a short run possibility . The comfortable forex reserves and many more Indians on flight to different global destinations will certainly do their bit to combat such shocks. The only way a major exodus of capital can happen if we fail ourselves. In other words, if we collectively do not fail ourselves, foreign capital will dance to Desi ( read Indian) tunes.

Posted by sunandoroy at 05:59 AM | Comments (0)

August 21, 2007

Central Banking and Risk Mitigation

The recent financial disturbances in the US and expected ripples in other financial markets across the globe has brought to the fore the role of Central Banks in the present world financial order. Indeed, the swift signalling and action by FED and other central banks indicated that while steering their banking systems towards Basel II, central banks are far more alert today than a decade back. The concern for correcting liquidity mismatches was evident as many central banks talked about their intention to give liquidity support to bail financial institutions out.

As a matter of fact, Fed's inter-meeting move to cut its primary
credit rate (Discount rate) by 50 bps to 5.75% on August 17 and allowing depositories to borrow upto 30 days alongwith its willingness o accept a ‘broad range of collateral’ for the loans,
was an acknowledgement of the liquidity risks in the economy .

What about Inflation Targeting ?

Tellingly, the FOMC omitted any reference to inflation risks from the inter-meeting statement. This signals a welcome respite fronm central banker's obsession with Inflation targeting. Too early to say this very strongly as the subprime saga unfolds, but the last few days shows that the Central Banks do have a broader mandate in financial market and can play an effective role in mitigating adverse market shocks.

Multiple objectives of monetary policy, as practiced in India for instance- growth, price stability and financial stability seems to be the way ahead.

Posted by sunandoroy at 07:16 AM | Comments (0)

August 20, 2007

Revisiting the Jorion-Taleb Debate

My previous blog on Black Swan has ignited a lot of interest about the famous Jorion-Taleb debate on the VaR models in 1997. To those who missed the debate of 1997, here are some links:

Transcript of the VaR debate, 1997, Jorion vs Taleb

http://www.derivativesstrategy.com/magazine/archive/1997/0497fea2.asp

An interview of Taleb published by Derivativestrategy:

http://www.derivativesstrategy.com/magazine/bestof/VAR_Chief.asp

Thanks to David Pappert, a reader of my blog, here is an article of 2005 by Taleb showing his continued distaste for VaR.

http://www.lse.ac.uk/resources/riskAndRegulationMagazine/magazine/summer2007/epistemologyAndRiskManagement.htm

Posted by sunandoroy at 04:41 PM | Comments (0)

August 17, 2007

Subprime Woes- VaR Models in need of Generational shift?

The US, seen through EME lenses, is the Mecca of Risk Management. And yet, the Subprime defaults catch the sophisticated market risk managers by surprise. Why did the market failed to foresee the looming dangers , catch the early signals and take steps to mitigate the risks. The risk managers, who step in at the first stage of the process-namely, identification will have to sort certain things out. There is little doubt that there is something missing in their arsenal that enables the near accurate capture of market risk.

One strange thing with research related to VaR models is that while too much emphasis has been on taming the distributional irregularities, little work took place on integrating market and liquidity risk in a VaR framework.

The responses, in many cases, have been very ad-hoc in nature. For instance, an easy and widely used solution has been to extend the holding period to compensate for illiquidity. Academic research - namely the transaction cost approach or the liquidity discount approach were never really tried out in practice as they needed huge trading data. Even the Wharton model ( Bangia et al, 1999) using bid-ask spreads were not used to mark up VaR with cost of liquidity.

I think we cannot leave out liquidity risk from VaR models calculating market risk. This will leave out a major risk leaving VaR models redundant in times like this. A link here on the topic :
http://www.rbi.org.in/scripts/PublicationsView.aspx?id=7918

Posted by sunandoroy at 08:18 AM | Comments (0)

August 13, 2007

Black Swan and the Bell Curve- An Emerging Market Perspective

Nassim Taleb's book Black Swan is a powerful one. The book is thought provoking as it throws a serious challege to the whole science and art of prediction, looking into the kernel of uncertainty in human existence.

I choose to discuss a single idea from Taleb - the Normal/Gaussian distribution. Even though its decent performance in normal times, it fails to deliver good results in situations with extreme variations. He devotes a complete chapter on " The Bell Curve, that great intellectual fraud" followed by two more discussing similar ideas. His key argument is that statistics that bases analysis on the centrality of data around the average and too few outliers leads to predictions out of touch with reality. To put it mildly, Taleb is not impressed with the estimates of risk analysts precisely due to their love for the bell shaped curve. Surprisingly, he did not mention Value at Risk models in the discussion, and I have no clue as to whether his opinion changed somewhat a decade after the famous Jorion- Taleb debate on VaR.

I read the chapter, however, through the lens of VaR models. Ever since the adption by BIS for market risk measurement in 1996, the central banks throughout the word has propagated this model and the model has been used by majority of financial market practitioners. Tremendous refinements have taken place, including the mandatory Stress testing practice, precisely to catch the black swans. It would be interesting if Taleb agrees to enter into another round of debate with Jorion on this. I, for one, will eagerly await the prospect!

Now coming to real life problems in emerging markets:

My more immediate problem is that in emerging markets, the bell curve not only fails us in abnormal times, it fails us in normal times as well. This part of the world is full of financial markets which are in transition, not deep enough and rarely demonstrate the beauty and certainty promised by the "bell curve". The 'bell curve" specialists from the Western markets routinely fail to produce good models of risk in India, China and others. As a result, even though tried out by MNC banks, risk modeling could not be successfully outsourced to the Tokyo or NY desk. such attempts, which were quite visible in late 1990s and early part of the present decade , slowly died their natural death in competition. The fact remains that the risk manager will have to predict good models that withstands backtesting.The struggle and the search for better models continues and escape routes are being developed from the intellectual dominance and practical failure of the normal distribution in such markets.

To get a glimpse of the ongoing efforts, I give links to few of my papers. I am sure there are many others who face similar problems with the Gaussian distribution and links to the works or comments will be very useful.

Fat tails in Indian Debt Market

http://www.gloriamundi.org/detailpopup.asp?ID=453057606

VaR measure- Comparison of methods and how to overcome non-normality

http://www.gloriamundi.org/detailpopup.asp?ID=453057546

On incorporating Liquidity Risk in Emeging Market VaR estimation

http://www.gloriamundi.org/detailpopup.asp?ID=453057507

Posted by sunandoroy at 05:57 AM | Comments (1)

August 10, 2007

Risks in the Rupee Dollar Rate

In the first five months of 2007, the Indian rupee appreciated significantly , from Rs 46 to a dollar to Rs. 40. The India growth story shining, capital poured in and the market was flooded with dollars. The central bank intervention was to a lower extent, constrained by instruments and inflation worries in the domestic front. But after May, the Central Bank has again become active and the float has stabilised. The VaR figures also came down drastically in June and july pointing towards greater market stability.

Download file

Posted by sunandoroy at 07:49 AM | Comments (0)

India's Market Stabilisation Scheme ( MSS)

The Government of India, in consultation with the Reserve Bank, has further revised the ceiling for the outstandings under the Market Stabilisation Scheme (MSS) for the year 2007-08 to Rs.1,50,000 crore. The threshold at which the ceiling will be reviewed in future will now be Rs.1,35,000 crore. MSS outstanding is at Rs. 98,970 crore now.

MSS involves the issue of special 364 day treasury Bills to mop up excess liquidity in the economy. The primary source of this liquidity has in recent years been capital inflows, both FDI and Portfolio. When foreign capital flows in , the central bank resorted to buying some of them to manage the rupee volatility. When the RBI buys dollars, rupee equivalent gets into the market and causes more money in the domestic economy. MSS sterilises the excess liquidity that overheats the domestic system.

Cost

Obviously MSS has a cost. The cost is the difference between interest you pay on the MSS ( 1 year at the Yield Curve) and the return the central bank earns on its Forex reserves. Calculations point out that the difference is a few thousand crores and currently charged on the Government budget.

The cost is small in relation to the gains you get. The inflation remains under control, the exchange rate managed better and the capital flows are not artificially restricted. The recent increase in the MSS cap will only serve to keep the India story floating, at least for the time being....

Posted by sunandoroy at 07:38 AM | Comments (0)

Corruption and Growth

“The accomplice to the crime of corruption is frequently our own indifference”

An interesting article from Wharton on the linkage of corruption and Growth. It paints a rosy scenario( corruption defeated by growth) and a grim scenario ( corruption takes over and stalls growth). I do not believe either will happen. We shall be somewhere in between the good and the bad. The drive towards transperancy and an alert media have already started changing the face of corruption. But the game is far from over...

Article

In India, Will Corruption Slow Growth or Will Growth Slow Corruption?

Now that India is playing an ever larger role in the world economy, the issue of corruption, in both the private and public sectors, is coming into sharper focus. Two scenarios are possible: As India's multinational corporations develop both economic and political muscle, they may act as a broom, sweeping corruption from the economic sphere. On the other hand, entrenched practices may prove the stronger force and corruption could end up being a significant brake on India's economic rise.

http://knowledge.wharton.upenn.edu/india/article.cfm?articleid=4214

Posted by sunandoroy at 07:18 AM | Comments (0)

August 03, 2007

Creating an International Financial Centre in India : Some action points

The most successful cities for business expansion and investment during the 21st century will be those that give increasing attention to cutting-edge infrastructure that make business operations efficient and allow businesses to operate more effectively in the global economy.
To emerge as an international financial hub, an Indian city will be required to adapt its infrastructure, social amenities , financial markets and institutions in new ways to compete and cooperate at the international level during the 21st century. The efforts of virtually all countries to open their economies to international trade and investment are making the global scenario really competitive.
The most dynamic cities in the new millennium will be those that will put on the platter high quality labor force, modern and efficient infrastructure, and adequate social amenities. They will also be those that foster creative and flexible public and private institutions to help local economies restructure and adapt to rapidly changing international business conditions.

The major features of such integration in the global economy would be :
I. The growing importance of international trade and investment.
II. The increasing global mobility of factors of production.
III. The driving force of technology.
IV. The growing importance of knowledge-based industries.
V. The critical role of market size.
VI. The need to adopt agile business practices.
VII. The necessity of forging international strategic alliances.

To be successful as a city in this new milieu, it is essential to plan effectively, encompassing areas such as land use, infrastructure needs, realistic projection of cost, and implementation.

Thrust Areas for action

Decentralization and Self Financing
Decentralize the instruments of infrastructure provision so that the agencies providing such infrastructure services are able to finance themselves and can respond flexibly to the changing demands of a growing city.

Effective Public-Private participation (PPP)
Private investment in public transport should be allowed to flourish in such a way that high service levels are achieved at low economic and financial cost. This is indeed possible through extensive use of private initiatives within a public regulatory framework. A key problem will be to manage a fast expanding supply of developed urban land for housing and other purposes. Rapid in-migration makes the demand for housing grows much faster than normal population growth. Land development induces investment in infrastructure such as water supply, sewerage, roads and power supply. All this requires substantial front-end investment.

Dismantling Excessive Controls

The Tenth Five Year Plan underscores a growing recognition of the need to dismantle the extensive controls on urban areas, many of which were established during the years 1975-77, at the national level.

Rationalisation of Tax structure

move towards reducing or eliminating octroi, reducing sales tax, road tax and stamp duty rates while increasing user charges.

National Level Co-ordination necessary

At the national level, the ministry of urban development needs to play an effective role in overseeing urban planning and development. Since most the work in urban development planning is envisaged at the state level, the role of the central ministry is mainly as a nodal organization for coordinating action, providing technical advice and working out detailed urban investment implications.

Governance : Making the government machinery work
Need to strengthen city management. city managements will have to manage and cope with large financial requirements for all kinds of investment for infrastructure service provision. Given the overall fiscal constraints at present, resources will have to be raised increasingly at the local level. Thus urban local governments have to be strengthened at all levels, and made creditworthy.

Appraisal Agencies :
The existence of information asymmetries give rise to the reluctance of investors and lenders to invest in urban projects. The government can help in funding professional institutions specialized in such appraisal techniques, who can then build professional credibility and provide project appraisals that are respected, and therefore address information asymmetries effectively.

Making the most of Financial Markets

Building an IFC would require simultaneous development of all segments of financial market i.e., money market, government securities market, corporate debt market, foreign exchange markets and commodities market because the transactions in all these markets are getting highly interlinked. While some segments of the markets have achieved adequate depth, some still lack liquidity and cling to low volume of transactions. To provide a fillip to the development of a vibrant financial market in India, the following changes in institutional and legal framework could prove critical.

In terms of sequencing, forex markets have to be aligned to external sector reforms and development of financial markets as part of overall reform. Further liberalisation in forex markets have to be harmonised with progress in other areas.

The private corporate debt market, in the absence of a well functioning secondary market, remains illiquid and unpopular among the investing population.
we need to look into the following issues:
• Examination of the issues relating to primary issuances as well as growth of secondary market of corporate debt securities in the light of international experience.
• Examination of the regulatory aspects for the development of the market for Asset Backed Securities (ABS) and Mortgage Backed Securities (MBS).
• Analysing the issues relating to trading, settlement and accounting of corporate debt securities including the issue of DvP settlement for corporate debt market.
• Suggesting measures to enhance transparency in pricing and valuation of corporate debt securities.

There are some of the other pre-conditions that still need greater attention. First although there has been some progress in the enforcement of creditors’ rights, the legal and regulatory system still has a long way to go in this area. The implementation of bankruptcy laws is very tardy so bond investors would have to wait a long time to get any compensation from defaulting companies. Second, the interest rate derivatives market is in its infancy and needs greater development for the easy access of hedging instruments to bond investors. Third, brokerage systems for retailing of either government securities or corporate debt instruments have yet to develop. What the retail investor wants is transparency in pricing, confidence regarding repayment, simplicity and convenience of dealing in the market and low cost. There must be adequate liquidity to enable case of entry and exit. This is difficult to achieve without the presence of market makers who can provide buy/sell quotas on a regular basis, and also have the ability to operate in the market with adequate volumes - a role similar to that of primary dealers in the government securities market.
Regarding banking industry, technological intensity is one area where perhaps we need to do significant ‘catching up’, notwithstanding the rapid strides made over the last few years, though data on this score are difficult to come by. It is wise for Indian banks to exploit this globally state-of-art expertise, domestically available, to their fullest advantage.

Developing Educational Infrastructure

The labor-force characteristics of urban areas will fundamentally and pervasively affect the ability of their businesses and industries to produce goods and services for export and to participate effectively in other international economic transactions. One of the most important features of internationally competitive cities in the future will be their capacity to mobilize skilled labor and managerial resources quickly and efficiently for new tasks as global business opportunities change. The most competitive cities recognize that global enterprises must be located near or have access to knowledge centers that can generate or stimulate innovation and provide a reliable source of skilled workers, technically
trained supervisors, scientists, engineers, and managers. At both the secondary and higher education levels they must focus on teaching how to lear and re-invent, because knowledge of the learning process will become far more important to students in a globally competitive world. A strong foundation in fundamentals must be built on a process of teaching that creates the capacity for lifelong learning.
There is a need to foster PPPs in the education sector.

Enhance Civic Leadership and Community Action

To attract and sustain technology-based manufacturing and services activities that are internationally competitive, urban leaders must promote a common civic perspective in the public and private sectors and a positive attitude about a city’s or metropolitan area’s comparative advantages. An urban culture that encourages and supports cooperation among the public, private, and civic sectors to anticipate and adapt to change is crucial for competitiveness in a global economy. In every city that has successfully restructured its economy, changes came through concerted action and civic commitment.

Posted by sunandoroy at 10:11 AM | Comments (0)

Towards a better grip on Financial Statistics of India

To understand emerging market financial risks, one oftignored issue is the data definitions and compilation methods . The latest document by the Reserve Bank of India is an invaluable guide towards a better understanding of macro-economic data in India. This one is a must for economists and financial analysts .

The manual is titled 'Manual on Financial and Banking Statistics'. First of its kind, the Manual is a reference guide and provides a methodological framework for compilation of statistical indicators encompassing various sectors, viz., monetary statistics, banking statistics, external sector statistics, fiscal sector statistics, etc. The manual is prepared on the recommendation of the Steering Committee set up by the Ministry of Statistics and Programme Implementation, Government of India. The manual is mainly devoted to the primary data compiled and disseminated by the Reserve Bank and National Bank for Agriculture and Rural Development in their major publications, following an integrated and uniform approach. This document is expected to facilitate better understanding of conceptual issues on measurement of statistical indicators on the subject.
Find the full Document at:
http://rbi.org.in/scripts/publications.aspx

Posted by sunandoroy at 07:43 AM | Comments (0)