Banks’ NPA and RBI: Are regulators responsible for the (non) performance of the regulated? Financial Express 13th November 2018

It cannot be argued that the regulator should dictate the activities of the regulated. If that happens, then the regulator becomes responsible for the performance of the regulated, which should not be the case. No regulator ever tells the regulated to be indiscriminate while lending or investing

The high-pitched proxy debate between the government and the Reserve Bank of India (RBI) has touched on one unrelated, but very important issue—it is the contention that RBI allowed banks to lend indiscriminately during 2008-14, which sowed the seeds for the non-performing asset (NPA) problem. As is the case in any crisis-like situation, one has the advantage of hindsight when making such an evaluation.
The fundamental question is, whether or not it is the duty of the regulator of any market to get involved in commercial decisions of the regulated? It is necessary to address this issue because once this responsibility is taken on, then it would also be responsible for the performance of the entity and its shareholders. This does not sound right.

A banking regulator lays down the rules of the game, and ensures that everyone follows them. There is an ongoing supervisory process that is topped with periodic audits. There are, hence, stringent norms on capital adequacy where RBI has always clearly been ahead of the curve of both Basel II and Basel III. Similarly, the norms for recognising income and asset quality are clearly spelt out, and the compliance ensured. Within this framework, banks have to take their decisions. There are several rules in place on lending practices, such as concentration, groups, etc. If one plays within these rules, the regulator should be agnostic to how the regulated function.

The same holds in the capital markets, where the rules are laid down on how business should proceed. But, at the end of the day, if the market crashes for some reason and players make losses, the regulator is not responsible as every player is supposed to take their own calls on stock price movements. The regulator only ensures compliance with rules and fair play, and also spreads awareness as individuals are involved.

In 2008, when the crisis struck, all of us wanted an economic stimulus, which was provided through both the fiscal and monetary routes. The government spent more money, while RBI became accommodative. Ironically, even today, with the so-called liquidity conundrum, the call is on RBI to provide liquidity! The decibel levels at the time of the Lehman crisis were even higher as there was a fear of the economy slipping into a recession. When the central bank intervenes, it announces measures to provide liquidity to banks or makes loans cheaper by changing the policy rate, hoping that the pass-through channel is efficient. But it does not force banks to lend and ‘nudging’ is often the tone assumed. Banks ultimately take their call on lending to their customers based on their individual risk appetite.
Now, in this phase, everyone assumed with hubris that India was the second-fastest growing major economy in the world, and that the way was only forward. Every investment bank, economist, stock analyst, etc, assumed with confidence that India would grow at over 10% per annum, which became the groupthink. At that stage, there were no naysayers. All white papers of the government and reports from the western world painted the same picture as growth prospects for India were decoupled from the rest of the world. The same confidence level permeated the banking sector, where it was assumed that all sectors would grow—especially infrastructure—which led to over-lending in a way. And, interestingly, no one objected to this futuristic vision.

It was the same story about the Lehman saga. When securitisation caught on in the United States, it was considered by all to be a marvel in financial engineering, when one dollar lent could be churned multiple times and the holders of debt instruments were different from the originator. No one expected this edifice to collapse. The absence of regulation was noteworthy out here, which was followed by a more coherent framework. But, in our case, the regulatory framework was always in place.

The problem really was that there were unusual circumstances that were triggered by a series of irregularities in the earlier political regime, and which brought projects to a standstill, leading to the creation of NPAs. At this time, in the collective wisdom, it was argued that these assets were not NPAs, but viable, as they were affected by extraneous factors such as non-availability of coal or power, etc, and were rechristened as restructured assets. As the corporate debt restructuring cell consisted of bankers, there was a perverse incentive to classify more NPAs under this heading. Few criticised this move at that time. This carried on for almost five years, before the asset quality recognition norms came in.

While the camouflage of restructured assets could be a debatable issue in terms of the central bank permitting the same, a question that can posed is, what would have been the reaction if this was not allowed? Probably the same as is being witnessed today of unnecessarily penalising banks—which is being said about the prompt corrective action (PCA) framework. At that time, emotions were high that the so-called scams were responsible for this malaise. The same kind of umbrage would have been expressed in case such a drastic step was taken, as is being done today for curbing the lending activity of the 11 banks under PCA.
Therefore, it would be necessary to frame the rules for the regulator of any market. It has to be separated from the commercial considerations of the regulated entities. Banks take decisions based on their perceptions of the real sector. The real sector, i.e. industry, behaves in a whimsical way, which is often cyclical. But there is a difference between failure in the real sector and the financial sector. If a steel company fails in terms of losses, then the shareholders bear the cost.

However, this failure spills over to the financial sector, which is the intermediary, and which cannot fail as it receives sustenance from the public—like deposit holders or insurance policy holders—and not the shareholders. This is why it becomes a serious issue.
It cannot be argued that the regulator should dictate the activities of the regulated. If that is done, then it becomes responsible for the performance of the regulated, which should not be the case. No regulator ever tells the regulated to be indiscriminate while lending or investing. The so-called incorrect decisions are based on subjective judgements of bankers, which will always get exposed in these episodes of downturns.
In addition, it must be accepted that economic cycles are a reality and there will be even sharper amplitudes in the future. Any failure or collapse will hurt, and cannot be painless.

Book Review: India Ahead: 2025 and Beyond by Bimal Jalan: Financial Express 11th November 2018

Bimal Jalan is probably one of the best-known names in Indian economics and has had varied experience in the central bank, financial institutions, multilateral institutions, as well as the government. He brings along a lot of knowledge and wisdom not just as an economist, but also as a practitioner in his new book, India Ahead: 2025 and Beyond.

Any book with a title that projects a future date can be cliched, but this is where Jalan makes a difference. This book is quite an erudite presentation of his views of what needs to be done in the next few years to make the country better. He gets to the point directly, which is important, and does not talk of superficial generalisations that have now become a habit with several authors who draw futuristic scenarios.

Jalan’s main focus is on the political set-up, which is in need of quick reforms. This is a good starting point and holds irrespective of the party in power. Good politics makes good economics, and this is why reforms are essential here.

It is not just a case of electoral funding, but also the way in which the administration functions. Politicians draw an awesome amount of power because they are not just involved in framing policies, but also carrying those out, which ideally should be the preserve of the bureaucracy.

He has drawn up a 10-point agenda that the reader can relate to, like the role of council of states, state funding of elections, role of small parties, Parliament, etc. On the role of small parties, he has an interesting suggestion that just like there is an anti-defection rule for MPs, the same must hold for parties in a coalition. This is because it has become fashionable to start small parties with probably four-five seats, which support a coalition and then become opportunistic.

On reforms in the conduct of Parliamentary business, Jalan is critical of the large number of disruptions brought in by the opposition and voices more power for the chairman or speaker to expel members responsible for such chaos. He also points to instances where several bills were passed in the houses without any debate in just a matter of minutes and which should have taken days given their importance.

The author has an important section on criminals in politics, where he argues for quick reforms. This is possibly the only sphere in government where a person charged with criminal offences can stand for elections and win on the strength of the people voting for the candidature. Jalan uses statistics to show how there can be as many as 20% of our MPs and MLAs across the country who have such cases against them. The advantage of getting elected, especially on behalf of the winning party, is that there is immunity for the candidate, as the system works to ensure that no action is taken against the person. Therefore, there is a perverse incentive for criminals to stand for elections.

From criminality, Jalan moves over to corruption, using some interesting research to show that Re 1 of corruption can cost the country Rs 3-Rs 4. This is because such corruption works through a multiplier process, which can be in terms of sale of natural resources, giving licences to the undeserving, purchases by government of inferior equipment, and so on.

To check this, we need to tackle both the supply and demand sides of the story. If things are transparent and do not require human interface, then the demand for paying bribes comes down. If rules are well-structured, then the power given to politicians or officials comes down to bestowing favours. Here, while the author has stayed apolitical, it can be said that in the present NDA government, both the aspects have been addressed to reduce the scope for corruption at least at the central level.

After taking us through the political reforms required and the deeper malaise of corruption and criminality in politics, the author steers the discussion to the economic arena and highlights two issues. The first relates to the quality of life, where he uses the human development index (HDI) and reforms in the financial sector. Both of them are perfect touch points to address with a new approach. On the issue of quality of life, Jalan bats for education, health and food security. On the financial sector, the argument is on the now-familiar story of capital and quality of assets. There is also some customary talk on the role of IT and a useful debate on how the exchange rate management process should be.

Towards the end, Jalan provides his take on the public sector in the context of administrative reforms that are needed in the country. He also feels that there could be too many ministries and ministers, which, in turn, inflate the accompanying bureaucracy, which becomes an administrative challenge for coordination. In his opinion, a large number of offices and sub-offices are non-functional and end up only enlarging the size of the government. Therefore, it is not just a case of closing down the PSUs that do not perform—and depending on public money to operate—but also the departments that do not serve any purpose.

After reading this discourse, the reader may ask, what next? The problem with the entire political and administrative framework is that these deficiencies are well known and hard to dilute. Changes take place only gradually, which is why, practically speaking, it would take decades to completely address these fundamental problems.

Curiously, Jalan points out that while a lot has been attempted to check the flow of money for elections, even today, the checks are dodged through cash payments and free services provided, which are hard to detect! There always are ways to game the system.

A closer look at FinMin, RBI stand-off Business Line 8th November 2018

The scales tilt more in favour of the RBI standpoint over the five issues that are being hotly debated

The perceived difference of opinion between the RBI and the Finance Ministry would take its course and few know the powers of each entity when it comes to imposing its view on the other at the practical level. Given the way the arguments have been put forward by the government, it would be interesting to debate both sides of the issue.

There are essentially five issues that have come up in the debate. These can be found in the RBI circular of February 12, and they relate to NPAs (non-performing assets), tweaking PCA (prompt corrective action) norms which put some restraints on the banks concerned, providing liquidity to NBFCs, furthering lending to the SME segment, and deploying the reserves of the RBI to fund the Budget.

From a purely economic standpoint, all these issues are quite fundamental in nature and can provide solutions if there is acquiescence.

Let us first look at the IBC (Insolvency and Bankruptcy Code) related issue. The IBC was a major path-breaking reform brought in by the government to address the issue of NPAs when all else failed. The RBI, in its February circular, only cemented the rules by mandating that if a loan is in default even for a day, the resolution process has to be set in motion for 180 days, after which the the IBC would take over.

This action was applauded as it gave teeth to the IBC for solving the NPA problem. There could have been arguments on the number of days involved, but the contrary view came in when the power sector pleaded for exclusion, as given the specific problems they faced, most companies would come under the IBC. Can an exception be made?

There are two arguments against making exceptions. The first is that when exceptions were made under corporate debt restructuring, that proportion bloated to almost the size of the NPAs.

Second, if allowed for power, why not for steel, telecom or textiles? The arguments could go on and it would be back to square one and the IBC resolution process would lose its effect. The question to ask is whether we are serious about solving the NPA problem or not? If we are not, then we should not be complaining about NPAs building up.

SME lending

Related to this issue is the one on SMEs. When demonetisation happened, the RBI made an allowance for NPA recognition for this segment. The RBI does not lend to SMEs but creates an enabling framework for them, and this already exists. The priority sector lending guidelines, howsoever restrictive they may be for banks, defines how SMEs get their share.

Should banks be pushed to lend more to this sector just because it is important for the economy and cannot get finance elsewhere? This needs to be answered because if credit appraisal processes are relaxed and an unfavourable NPA portfolio results, then who would be held responsible? Infra lending is a case in point and banks have been struggling with the consequences for over two years now. By relaxing the IBC norms and forcing lending to SMEs we would be merely kicking the can again.

Third, let us look at the PCA rules. Banks which have been defined to be weak have lending restrictions placed on them until they turn the corner. In the present environment, where liquidity is an issue, there is an argument to allow the 11 banks under PCA to get some exemptions. This is analogous to a student who has failed class 9 exam but is allowed to go to class 10. The irony is that the net worth of these banks ís in jeopardy, with the main shareholder, the government, not willing to provide capital (as the approach has been to give capital to the more productive banks).

Now if these banks are not well capitalised and are struggling with NPA recognition and provisioning, letting them enter the mainstream can exacerbate the situation. This again does not look agreeable. The only compromise possible is that they lend only to top-rated PSUs so that the funds remain within the government.

Funding NBFCs

Fourth is the issue on liquidity to NBFCs. The RBI provides funds to banks which are on-lent to others, which include NBFCs. The RBI’s role can be to the extent of ensuring liquidity in banks through repo, OMO (open market operations) and possibly CRR cuts. This is being done on a continuous basis.

Opening a window for NBFCs is an option, but if this is done, similar allowances may be sought for other sectors too.

It would become like the QE (quantitative easing) programmes of the West, where the banking system had all but collapsed and the central banks had to intervene and buy commercial bonds from entities. This again may not sound right to the conventional minded economist.

Today, banks have funds and are selective while lending based on credit perception. So it is more a case of liquidity being there but judgment coming in the way of the flow of funds.

Last is the question of whether the government should take the reserves of the RBI and use them to fund the Budget. In legislative terms they may have the right but this is not a good idea as it is a one-time transfer like disinvestment, once exhausted the problems resurface.

Using reserves can be for specific purposes but not for balancing the Budget. Using this theme, one can also then ask whether the government can take the reserves of PSUs proportionate to its holdings in the entities for the same purpose? The government already makes some PSUs pay larger dividend at times when the Budget is stressed.

The present situation definitely calls for introspection and the need to reformulate our premises. One can quote Ayn Rand’s famous words, “Contradictions do not exist. Whenever you think you are facing a contradiction, check your premises. You will find that one of them is wrong.”

As a corollary, are we really committed to cleaning up the system? In this context, it would be apt to mention Shakespeare’s well-known saying, “This above all: to thine own self be true.”

Lower interest rate encouraging investments may not always hold true Economic Times 7th November 2018

An independent study of RBI argues that over a longer time period, higher interest rates and fiscal deficit drive down investments, which is in consonance with the view held by successive governments. But is this really so? This question is important because the argument is more from the supply side where it makes sense theoretically. But if one examines say the last 7 years or so post 2011-12, the picture obtained is different. 

Let’s look at hard data. The average interest rate paid on outstanding debt, which is the metric for potential investors as this is the cost incurred by them, has come down continuously from 12.56% in 2012-13 to 10.39% in 2017-18, which is more than 200 bps. This means the policy has supported the lowering of rates in a gradual manner and the response of banks though sticky has been in the right direction. Yet, the investment rate defined as the gross-fixed capital formation rate has declined fr .. 

There are two parts of the story. The first is that investment has not been forthcoming from manufacturing as the capacity utilisation rate has been declining. RBI data show that the average rate was 77.8% in 2011-12 and came down to 72.3% in 2016-17 and improved to 73% in 2017-18. If this rise is sustained, there will be a good chance of investment picking up. The important thing is that until capacity utilisation (CU) rates improve in the region of 78-80%, fresh investment won’t be undertaken  .. 

Second, investment in infrastructureNSE -0.31 % is the other source of demand for funds. Here, given limited investment coming from the government which drives private investment, and stagnation in new opportunities, investment demand is restrained. CMIE data reveal that the quantum of investment dropped (shelved, stalled and abandoned) has been rising progressively in the last five years post 2011-12. To top it all, the NPA issue has added to the pressure on banks on the lending side as well as .. 

Therefore, the argument linking interest rates to investment can be debated. How about fiscal deficit? The theoretical reasoning is that when the deficit is high, borrowings tend to increase which, in turn, crowds out private investment. This sounds good. But does this really happen in India? The metric to use here is the net borrowings of the government, which has shown a downward tendency. The net borrowings of the government came down from Rs 4.67 lakh crore in 2012-13 (being higher than Rs 4 .. 

Curiously, the mandated SLR is 19.5%, but on an average basis, banks hold excess SLR of almost 7-8%. Holding these securities has been attractive for banks (besides the advantage of using a part for LCR requirement), as it helps them stave off NPAs – the PCA banks will be attracted to this option. The difference between return on advances and investment could be around 150 bps besides the MTM losses that have to be reckoned in a rising interest rate scenario which would be acceptable as there is .. 

For investment to revive, we need to look at both the demand and supply sides of the picture. Interest rate is one factor, which curiously did not hinder investment during 2009-12, when they had peaked along with investment! 

Getting the MSP to work Free Press Journal 2nd November 2018

One of the more aggressive steps taken by the government to enhance the income levels of farmers was to announce higher MSPs for the kharif and rabi crops this season. But a question often posed is as to how effective are these announcements in terms of delivering the price to the farmer? For the MSP to work, there have to be buyers at this announced price or else the farmer will never be able to sell the crop. This issue becomes acute when there are oversupply conditions in the market and prices tend to go down.

While this was accepted in the past, today it has become controversial since lower incomes of farmers has had negative effects of debt servicing, suicides and loan waivers. Also the ‘rural demand’ story has been dented sharply even when the harvest is good on account of lower remuneration. Therefore, the MSP has been projected as being a panacea. The challenge is how does one get the buyer in the market to buy at a price which is higher than what the demand-supply conditions warrant? Presently there is an active procurement scheme in case of rice and wheat.

This means that with the MSPs being announced, farmers can walk up to any procurement centre identified by the government and sell the crop at this price. But it has been seen that even for rice and wheat, the machinery exists for a handful of states which include UP, Punjab, Haryana, Odisha, AP, Telangana, TN, WB, and Uttarakhand. This means that a farmer producing rice, in say Maharashtra, may not have easy access to the FCI agency. Farmers, then, perforce have to sell to the private parties which will be driven by the market forces.

It is only when the private buyer sees that the farmer has alternatives that the willingness to pay a higher price increases. Therefore, for MSP to work, procurement is essential. Interestingly today, if one were to look at the highest price in any market for Tur in Maharashtra for October, it is around Rs 3300-3400/qtl as against a MSP of Rs 5,675/qtl (AGMARKNET). In case of moong and urad, with MSP of Rs 6,925/qtl and 5,600/qtl respectively, the modal value is lower at Rs 4600-5100/qtl and Rs 4000-4400/quintal respectively. Even for soybean while the MSP is around Rs 3,399 the average modal price across markets during the month was at Rs 2900-3100/qtl.

The government does not have the machinery to buy these stocks and even in case it does, warehousing and disposal is a challenge. This involves a carrying cost and would become difficult to dispose of as it is not part of the PDS system. In fact, with Aadhaar coming in for implementing PDS, procurement becomes a contradiction. Logically, if households are being given a cash equivalent for buying foodgrains, then there is no need for having ration shops. And in this scenario of getting the MSP to be effective, procurement is necessary! Now disposing off pulses in the market becomes relevant only in case the crop falls short in the immediate subsequent year.

If the crop is good this time, then it would be a challenge to sell old stock. In fact any sale undertaken by the government will only depress prices further. At the same time unlike say sugar where there can be a policy for exporting surpluses, it is not possible for pulses as there are no large consuming countries in the world which rely on imports. An idea here is to compensate farmers for the difference between the price received in the market and MSP without there being procurement. This scheme called the Price Deficiency Payment has being proposed for soybean with a limit of 25% being set for this season. This makes sense though implementation will always pose challenges.

This is a very interesting proposition and could be linked directly with Aadhaar to ensure that the beneficiary is well identified. Further, the mandis that are to be covered should be known to all so that the price collection systems can be monitored in these selected markets. There will however be the challenge of identifying the actual price received by the farmer as there would be a ‘tendency to cheat’ wherein the farmer says that a lower price has been received. Alternatively the buyer may pay even lower rates knowing fully well that the government is providing the compensation.

As both parties may game the system, to prevent such adverse selection the mandis chosen for this purpose must be well regulated and transparent in operations. A way out would be to link all such compensations with the eNAM where there is a transparent system and as this concept catches up and all transactions are captured on this platform, providing this compensation will become a smoother and more effective operation. Otherwise, choosing a fair price in the market will be difficult given that the mandis are very opaque in operations.

Will NBFC liquidity squeeze snowball into a crisis? Financial Express 30th October 2018

NBFCs carrying higher risk perception and 11 banks under PCA; Will NBFC liquidity squeeze snowball into a crisis?

By: Madan Sabnavis | Updated: October 30, 2018 4:19 AM

A liquidity issue has surfaced in the financial market given the challenge faced by NBFCs in raising funds.

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The question, however, is whether or not banks are willing to lend to specific NBFCs? Besides, this will hold only till December and isn’t a permanent measure.

A liquidity issue has surfaced in the financial market given the challenge faced by NBFCs in raising funds. There are three questions here. Firstly, whether or not it is serious. Secondly, whether this can be addressed by the system. Thirdly, whether this will affect the growth path.

It is necessary to understand the concept of liquidity which is being talking about. There is one path endogenous to the system where money flows to various financial intermediaries in the normal course of activity. The flow of funds comes in the form of bank deposits, mutual funds, insurance, provident and pension funds at the retail end.

At the wholesale side, it is money put in bonds and some money market instruments. The latter is limited as it is more a channelling of funds in the secondary stage as investments in bonds and CPs is done from the funds collected at the retail end which can also have some bulk deposits.

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Here it can be seen that growth in bank deposits for the first half of the year at `3.7 lakh crore is more than double that of what was there last year at `1.6 lakh crore. Bank credit increment this year is, however, at `3.6 lakh crore and investments are at `1.3 lakh crore, leading to a liquidity issue with banks which has been supported through the LAF window where there are around `1.3-1.5 lakh crore in net repos (overnight and term). Add to this the exogenous impact of RBI coming in with periodic OMOs and liquidity to the banking system is well balanced.

Bond issuances have been lower, but it is hard to find out whether it is a supply issue or demand one. Mutual funds flows have increased, while small savings could have gone up given the higher rates being offered. The listed insurance companies and EPFOs show higher inflows.

Put together, this indicates that flows are steady. It looks like investors and lenders have become more discerning.
Now, when it comes to NBFCs, sentiment has changed. Funds normally flow from banks and bonds for long-term purposes and banks, CBLO and CPs for short-term requirements. If there is a slower flow of funds then it is more a case of willingness to lend by the concerned lenders/investors in these instruments. The problem as stated by RBI is actually not acute across the industry but more specific to a handful of these entities.

Institutions like insurance companies or provident and pension funds do have funds to invest as there is data to suggest that the investible corpus has increased for insurance companies as well as EPFO. While it is possible that any increase in small savings would have gone to GSecs, the others have the option of investing in bonds issued by these NBFCs. How about banks? RBI data on sectoral distribution of credit suggests that, up to August, there was a fall in outstanding loans to NBFCs.

Here, it may be conjectured that this component could have come down further in the following two months. There are two issues here. Firstly, banks have been eager to expand on their retail loan book and hence may choose not to lend to NBFCs as there is a higher risk perception. Secondly, with 11 banks under PCA, the overall ability of banks to lend has come down. Hence, while these banks continue to receive deposits, they tend to get invested in GSecs as narrow banking takes over.

Two announcements have been made which can alleviate the situation to an extent. The first is by RBI, where it has allowed another 0.5% of NDTL, which is held under SLR of 19.5%, to be permitted for calculation of high quality liquidity assets under LCR within the category of FALL (facility to avail liquidity for LCR) to the extent of incremental lending to NBFCs.

The question, however, is whether or not banks are willing to lend to specific NBFCs? Besides, this will hold only till December and isn’t a permanent measure. Therefore, banks may be cautious to extend lending.

The second is statements made by some banks that are willing to buy some of the loans of NBFCs. But this will only mean the churning of existing funds as a purchase of, say, an auto loan book from a NBFC will result in banks probably lending less directly to customers on their own account. For the financial system as a whole, this may not matter.

A way out could be to do what the Fed did with QE wherein it purchased commercial loans and generated liquidity. This is an option which has been vetoed by RBI which does not believe this problem is pervasive to opening a window for NBFCs, although the reference is more like allowing NBFCs to join the repo window and offer their holdings of GSecs (which they are already using at the CBLO market). Therefore, there would be no assistance coming from RBI as of now.

It has been suggested that RBI should dilute the PCA principles so that these banks can lend more, but this would mean going back to the old days of compromise which should be eschewed. Therefore, this does not make too much sense. Another piece of advice has been to make RBI announce the lowering of risk-weighted norms for reckoning capital on loans to NBFCs. This will be imprudent and is not something which one can recommend to enable easier flow of credit to this sector.

Will the ongoing problems come in the way of growth? If the supply of funds to NBFCs has been hindered on account of unwillingness of banks to lend due to risk-profile issues, then there would be a movement for those borrowers of NBFCs to the banking system. Here, the SMEs, automobiles, tractors, real estate and housing industries would be the affected parties. They would have to either look for better funded NBFCs to source loans or the banking sector. Such a transition would be visible when data on bank lending is released for the months of September and October.

However, to the extent that lending is hindered because of the inability of the financial system, RBI has been proactive with OMOs as well as relaxing of the norms for reckoning the liquidity coverage ratio under Basel III to ensure that the funding power of banks is enhanced.
Therefore, while there definitely is an issue on the liquidity front, it is localised to a specific segment and not pervasive. To the extent that there is a shortfall, it is being addressed by RBI through some fine tuning. But, if liquidity is not forthcoming due to risk perception issues, then the specific segment would be impacted.

However, it is not expected that this will snowball into a crisis-like situation as substitutions in funding can take place over time. Presently, one can confidently be agnostic in the view of the situation’s impact on economic growth, but monitoring the developments would still be advisable.

Book review: The Aadhaar Effect by NS Ramnath, Charles Assisi Financial Express October 28 2018

it is quite appropriate for a book on Aadhaar to come out at a time when the courts also have taken a view on its authenticity with the accompanying caveats. What started off as giving an identity to every individual has now become an integral part of policy formulation and implementation at various levels, which, in turn, has also raised security issues, as well as concerns on violation of privacy.

NS Ramnath and Charles Assisi, in their book The Aadhaar Effect, have done a fairly good job in giving us a glimpse of the history of the concept, from how it all started to where it is today. In fact, the original idea was to have a smart card that finally got diluted to a strip of glazed paper. There were several people involved in bringing this scheme to fruition, and while the name associated with it is Nandan Nilekani, the success was due to a team effort. The authors take us through the thought processes behind this scheme and how the two governments supported the concept with the usual hiccups. The conflicts between the home ministry and Planning Commission, followed by Niti Aayog, are quite interesting.

Aadhaar has been a clear case of PPP, where governments have supported the concept being driven essentially by private enterprise. The team, set up by Nilekani, had elements of both the sectors and, hence, the characteristics were a blend of advantages and disadvantages that come with such a combo. Evidently, the authors have had detailed discussions with several of those involved in this enterprise, which created this winning combination.

The project had its critics from the day of inception and which had to be addressed by Nilekani and company. In the process, Nilekani may have gotten carried away, as he changed track depending on the audience. It, hence, was made to look like a cure for everything, which was not the case. Giving an identity to every citizen is one thing, which is similar to a passport, ration card or voter card—there could be no argument against such identification—but the use of Aadhaar was projected as a policy panacea, which attracted its share of naysayers. If one looks at an Aadhaar card, it just tells the person of his or her existence and does not reveal anything more. There is no mention of background or income and, hence, from a policy perspective, can’t go beyond identification. As Aadhaar has gotten linked to bank accounts, it does serve the purpose of better targeting of benefits in the form of cash transfers. But it does not solve the problem of whether the person deserves the benefit, especially when a distinction has to be made between the poor and not-so-poor.

Here, the authors also present the story of how well it has worked in terms of the schemes that were linked with Aadhaar. The reader can’t be blamed if she feels that the book is sponsored by the creators of the concept, as it reads like positive propaganda. However, towards the end, they have separate sections on the critiques of the concept spread over various dimensions. This, sort of, balances the presentation, which otherwise reads too one-sided.

The authors treat the implementation of Aadhaar as a game consisting of Lego blocks being put together. These include UPI, eSign, eKYC, DigiLocker, etc, together with the other infrastructure that the country has built, especially GSTN, which, the authors feel, has far-reaching effects. Therefore, in their opinion, one should view the story as the creation of a new superstructure that will put the blocks together to improve interconnectivity between different economic programmes, government expenditure and income, thus leading to a superior solution.

While the larger part of the presentation is in praise of Aadhaar, let us look at the opposite view, which is also presented. There have been cases of fraud (which has come in terms of incorrect identities), as well as manipulation of the biometrics. Once given and linked to government programmes, Aadhaar has meant exclusion of the millions who do not have this identification. Also, the fact that delivery of services is linked to this number means that in the absence of biometric matching or absence of electricity or internet connection, benefits are not received. Creating a superstructure without infrastructure in place is a valid criticism, which, however, does not diminish the power of using this system for delivery of benefits. Another criticism is that the government claims to have saved a lot of money, which is not substantiated. But again, this can’t be made out as a case against Aadhaar.

Aadhaar was supposed to also identify fake PAN cards and duplicates by presenting a unique identity to everyone. However, it was found that the proportion of fake PAN cards taken out of the system was just 0.47%. Further, duplicates removed from the system were even more minuscule than the fake ones. This then begs the question of whether the exercise was worth the cost given the existence of several alternative identity documents in the system. The question of security is probably more serious, and the fact that there has been no breach so far is not assurance that it will not happen in the future.

On the whole, it is a fair presentation of the scheme with a tilt towards eulogising it. As the book gets into details of the building of the team and creating a structure, there are several names involved and their views presented. This could be a drag when reading, as is the case with any biography of a concept, where only those in the job would identify with the characters. The book could have been better knit by reducing the noise on personalities and focusing on the issues, as this results in some bit of meandering that can distract the reader.

s there space for more commodity exchanges? Financial Express 20th October 2018

Traders would prefer to trade on a single exchange as this lowers the bid-ask spread and impact costs, making the existence of another exchange unviable.

Is there space for more commodity exchanges? This is a pertinent question because it is accepted theoretically that more competition can bring about better solutions in any market. But in case of commodity derivatives trading in India, the story has been one of diminishing number of exchanges over the last decade and a half ever since commodity futures trading was resurrected. In fact, even traded volumes have come down from previous peaks and, presently, the impression is that they are just about stable.

The two leading stock exchanges, NSE and BSE, have now also brought commodity derivatives onto their trading platform and this adds an interesting dimension to the market. It has been observed across the globe that liquidity tends to get concentrated in trading in specific commodities on specific exchanges and it is here the early mover advantage lies. Intuitively, trading members would like to trade on the exchange which has the largest volumes and number of trades as this lowers the bid-ask spread or the impact cost. The adage ‘liquidity begets liquidity’ very much holds here. Hence, for traders who are not hedgers but more of day traders or speculators, it may not make sense to trade on different exchanges. They would prefer to concentrate their business on a single exchange. And wherever a second platform is an option, it is used for arbitraging to the extent that there are micro price differences.

In India, if one looks at vibrant trading in commodity derivatives, NCDEX has advantage in cotton, sugar, soybean, mustard, chana, guar and spices. While it started off with a wider array of products, today it is recognised more as an efficient exchange for farm products. MCX is a clear leader in gold, silver, energy products, metals and mentha. MCX has, over time, evolved to hold some can of a monopolistic position in these commodities. In a way, things have gotten compartmentalised over time. The third force in the form of a merged ICEX-NMCE would have some advantage in rubber from the latter and diamonds for the former. Total volumes traded on these exchanges have been stable in the last two years. For MCX, it was about Rs 54 lakh crore in FY18 and about Rs 6 lakh crore for NCDEX. The merged ICEX had volumes of Rs 0.36 lakh crore.

The new entrants will be looking more at bullion as they are easier to launch compared with farm products. This is where the challenge lies. Bullion trading is already concentrated in MCX and weaning away members to a new platform is difficult. Three points need to be made here. Firstly, anecdotally, it should be pointed out that when futures trading was in its infancy, NCDEX was dominant in silver and MCX in gold. But over time, MCX had taken over as the dominant player and today all trading takes place here. NCDEX has not been able to make inroads notwithstanding several products being launched to gain market interest. Secondly, today, arbitraging takes place across exchanges in different countries and therefore existing players would have to be open to a new opportunity of arbitraging across two domestic exchanges which they have chosen not to do so far. It is not certain whether they would be up to it in the absence of any incentive.

Thirdly, in the days when commodity markets had a separate regulator, FMC, equity brokers perforce had to open a subsidiary to do commodity trading to separate the risk of equity trading from this arm. Today, this is no longer an issue with SEBI being the unified regulator and hence there will be few players who have been held back on this score.

The new comexes have to, hence, address the requirements of a new set of traders who have not been active in this segment. Therefore, for the new exchanges to be successful, the approach has to be different. Brokers operating on the equity platform must be encouraged to trade in commodity exchanges too. BSE and NSE, hence, have an advantage of a committed member group. But still, moving members from MCX to NSE or NCDEX will be difficult just as it has been seen that the differentials in volumes of trading between BSE and NSE have been maintained over the years.

Gold and silver are definitely easier commodities to understand as they do not get messy like agricultural commodities which have delivery, quality and accompanying penalty issues. To begin with, some kind of incentives can be given to get equity traders to deal with commodity derivatives. This is not easy as it requires a different kind of understanding of the subject which may be a deterrent for newcomers. Besides, in order to ensure an even playing field, the regulator has to permit the same for other existing exchanges too.

Also, the sheen in commodity markets has worn off to some extent in the last few years. This is on account of a limited basket of commodities being traded and the fear of bans still being present. Alternatively, some kind of market making should be permitted here, but then it has to apply to other exchanges too and if this is done, it may negate this effect.

Interestingly, commodity derivative trading has a fairly unique history with there being several regional exchanges when futures trading was revived in 2002. But all the existing exchanges have closed down. Further attempts have been made by new entrants, too, which have not been sustainable. ACE and Universal Commodity Exchange were two new exchanges that were operational but had to close down due to non-viability.

Against this background, the new platforms could be starting from a position of disadvantage, though the existing support of the equity platform and the franchise built by BSE and NSE would be the main driving factor for this business.

A curious question that can be raised here is that, if stock exchanges have been allowed to have separate trading platforms for commodities, by the same logic, the existing commodity exchanges, like NCDEX, should be allowed to deal with shares. MCX already has this through the Metropolitan Exchange route. For an exchange like NCDEX, or even the merged ICEX, this will make sense given the barriers in commodity trading where a modicum of stagnation has set. Allowing equities, and also currency derivatives and interest rate futures, could open new lines of business. And, curiously, NSE has a stake in NCDEX and is now operating its trading platform. By similar logic, NCDEX offering the same products as NSE would be an interesting regulatory proposition even though the probability of success would be uncertain.

Why banks don’t need to worry about deposits despite ostensibly higher post office small saving rates: Financial Express 16th October 2018

With digitisation catching on and the India Post possibly becoming a successful payments bank, the concept of small savings may narrow down to those which exclude deposits.

The increase in interest rates in some small savings schemes has expectedly raised the question on whether or not the demand for bank deposits would come down in case banks do not increase their interest rates. The recent hikes in interest rates, which are based on the movements in market rates of GSecs, have ostensibly made such deposits more attractive. In this regard, it is interesting to gauge the importance of this category of savings.

Small savings come in three forms: Deposits with post offices, certificates and PPF. There are different motivations for going to a post office for opening such accounts. Deposits with post offices are similar to those offered by banks and appeal more to the lower income groups. Certificates are virtually discounted bonds which give a fixed return on maturity and are similar to bearer bonds with certain KYC caveats attached. PPF are long-term deposits with tax benefits which have very rigid rules when it comes to withdrawal. It is a niche product as people use it for tax savings where one gets tax benefits on the deposits made as well as on the returns. However, there is an upper limit on such deposits which is Rs 1.5 lakh per annum. Bank deposits, on the other hand, are quite singular in scope but offer a basket of other facilities once an account is opened that are not available with post office deposits.

Presently, the interest rate disparity is significant in some buckets when returns on bank deposits and post office deposits are juxtaposed. A savings account with a post office gives 4% against 3.5% for most banks, while some offer higher rates of 6%. The difference in interest rates between term deposits in the two schemes could be as much as 50 bps for 1 year, 30 bps for 2 years, 50-55 bps for 3 years and 45-50 bps for 5 years (a sample of five leading banks in terms of size has been used here). Hence, broadly, the difference can be in the range of 50 bps.

Interestingly, within commercial banks, too, there is a similar disparity in interest rates which does not cause customers to switch from one bank to another as these rates are dynamic and the differential can change at various points of time. Besides, once a relationship is built with a bank branch, rarely does one change the destination for deposits on this score. This explains why customers do not move from one bank to another even when new branches of other banks are opened.

This can also explain why the small savings avenues have never been too attractive for customers even though, on an average basis, the returns have been better here. The attached graphic provides information on outstanding small savings and bank deposits for the last 6 years ending FY17.

The graphic shows that the share of small savings in the deposits pool of the public has been coming down and is in the range of 6.5-7%. Therefore, there does not really appear to be a significant threat to bank deposits per se. This can be due to several factors.

Firstly, post office deposits are always considered to be more distant and hence less accessible. Secondly, these deposits have been more popular amongst the lower income groups where the savings power is limited. The users of small savings hence tend to be quite niche. Thirdly, banks offer other facilities like cards, remittance facilities, loans, transfers, and third party products, etc, which make it a one-stop shop for all financial requirements. This is not possible when it comes to post offices. And lastly, as said earlier, funds do not move from one structure to another merely because of rate differentials. This is because of inertia on the part of the customer as well as the fact that, given the changes in interest rates by banks, it is not possible to keep switching deposits across these alternatives. The most glaring case is of the savings deposit rate offered by some private banks which is substantially more than that given by the rest of the banks. Yet, every bank has its own clientele and there is rarely a diversion of deposits.

Also, within small savings, interestingly, the share of certificates has come down over the years from around 35% to 27% between 2011-12 and 2016-17. The share of all deposits has increased from 59-60% to 64% while PPF has gone up from 5-6% to 9%. Within small savings, the schemes oriented towards senior citizens and girl children have become popular and have contributed to the growth in such savings.

Prima facie, it does not appear that banks have to worry much about interest rates of small savings being increased as it is unlikely to affect the flow except at the margin. The bigger challenge will be the competition from within i.e., the payments bank of India Post. It offers a savings deposit account with all the frills of a normal bank account and pays an interest rate of 4%. This holds for individuals, merchants and postmen. Add to this the availability of the DBT facility and it would directly impact the business of small savings as whole. Savings accounts of post offices will now compete with those offered by India Post Payments Bank and there can be some cannibalisation. Here, there is a possibility of savers moving their accounts over to the new platform.

With digitisation catching on, commercial banks having Jan Dhan accounts firmly entrenched and the India Post possibly becoming a successful payments bank, the concept of small savings may narrow down to those which exclude deposits. This is something which the system must be prepared for and just like how several postal services are less important in the age of mobile phones and WhatsApp, the same would be the case with this avenue of services of post offices. This would be good for the government which, today, has to pay a higher cost of small savings compared to that of regular market borrowings. The future surely will be interesting for this range of small savings schemes.