Perspectives on the Banking Dilemma in India: A Q&A with Vivek Kaul

This interview was first published in Risk Intelligence on March 5, 2021; https://www.garp.org/#!/risk-intelligence/credit/counterparty/a1Z1W000005krEZUAY

Recent projections by the Reserve Bank of India confirm that non-performing loans remain a significant hazard for banks. What are the origins of this risk, what’s the connection to COVID-19, and what are the prospects for India’s economic recovery?

Bad loans and deteriorating asset quality continue to plague banks in India. Last September, the gross non-performing assets ratio (GNPA) at Indian banks stood at 7.5%, but that number potentially could double in just a year’s time.

In its recent financial stability report, the Reserve Bank of India estimated that Indian banks’ GNPA ratio could increase to 13.5% under a baseline stress scenario and 14.8% under a severe stress scenario by September 2021. What’s more, for public-sector banks (PSBs), GNPA may rise to nearly 18%.

Vivek Kaul, the author of Bad Money: Inside the NPA Mess and Hot It Threatens the Indian Banking System, is a well-known commentator and podcaster who has written several books on India’s economy. He talked with Risk Intelligence about the NPA dilemma, the impact of COVID-19, default risk, regulatory flaws, and India’s path to economic recovery.

Risk Intelligence (RI): Can you pinpoint the primary reason for the bad debts and non-performing assets (NPAs) in India? Where does the fault actually lie?

Vivek Kaul (VK): If you look at the current phase of bad loans, which have accumulated over the last five years, I think the main reason for that lies in the period pre-2008. Between 2004 and 2006, the Indian economy grew by greater than 9% annually, resulting in a great deal of optimism among the politicians, bankers, businessmen, entrepreneurs and the public, in general. Suddenly, there was this story going around that India will be the next China, which basically meant that since China was growing in double digit rates, India would follow a similar path.

Entrepreneurs and businesses saw an opportunity. They believed that the growth would fuel demand for goods and services. They started to invest in the infrastructure that would drive this growth and fulfill the demand. The data between 2004 and 2008 shows that the loans to industry given by banks in India went through the roof, and that is where it all started:  the belief that India would continue growing at 9%.

RI: In India, the government uses PSBs to increase the money supply in the market. The latest financial stability report of the RBI, released in January 2021, says that the GNPA ratio of PSBs may increase to 17.6%. That number is frightening.

VK: It needs to be mentioned that if you calculate the numbers properly, they are even worse. What has happened is that the categorization of IDBI Bank - which was by far the worst-performing PSB, with a very high NPA of almost 32% - has been changed to that of a private bank. IDBI has NPLs of close to ₹500 billion, but these are now categorized by the RBI as the bad loans of a private bank, rather than a PSB.

Another well-kept secret of banking in India is that once a bad loan has been on the balance sheet of a bank for four years, it can be written off. After that period of time has elapsed, the loans drop from the balance sheet of the bank, reducing the bad-loan numbers for PSBs.

Moreover, Indian banks have a very low recovery rate of bad loans. Once you take these factors into account, it gives an entirely different dimension to the story.

Here’s what will happen: the bad loans that were recognized, let's say, in 2016, 2017, and 2018, will keep getting dropped off from the balance sheet of banks in the next couple of years. This will lead to the bad loans number coming down in the 2020-2021 financials of the banks. But there will also be fresh bad loans, which we will start to see on account of COVID-19.

RI: You mentioned about the mid-2000s and the optimism that followed. But then the global crisis happened in 2008, which led to the optimism not being there. What do you think the spirit of the times now is with the COVID-19 slump and recession? How will it impact the mess further, and what will recovery look like?

VK: This time around, the issue is a little different. Common sense tells us that this time there will be retail defaults, as well corporate defaults, because salaries have been slashed and people have lost jobs. The entire informal sector has seen huge destruction.

The data for listed Indian corporates for the quarter July to September 2020 actually shows that their profits went up, mainly because they have cut down their costs. But when a corporate cuts costs, someone else's income is being impacted.

For example, if you're a corporate who's making profits, and you've managed to cut down on your raw material costs, some supplier somewhere is seeing reduced business.  As a consequence, that supplier is likely doing the same thing with some of its third-party vendors. The impact is felt across the hierarchy, and that’s problematic.

We haven't yet begun to see the impact of this, because there is a case going on in the Supreme Court about whether the interest on loans during the COVID-19 months should be waived. Until that decision arrives, banks are not allowed to recognize defaults as bad loans. So, will we come to know how bad the defaults situation is at PSBs only after the Supreme Court hands down its decision.

It is also important to remember that more than 50% of all retail loans are home loans, and people will try their best to not default on home loans. So, that is a very good thing going for banks. But the other kinds of loans – e.g., credit card debt, personal loans, consumer durable loans and auto loans - will see an uptick in the defaults.

RI: In this case, culture could also play a big role, right?  In the U.S., the subprime crisis was essentially driven by home-loan defaults, but in India, people probably try to hold on to their homes more dearly, correct?

VK: Yes, the stigma of losing your home is huge in India. People will try selling everything, defaulting on everything else before they default on their home loan.

The other good thing is that even if people default, banks may not lose much. The first reason lies in the loan-to-value ratio (LTV). The LTV of entire home-loan business in India is between 65% and 70%, giving some margin to the banks.

What’s more, over and above the registered price of a house, in many parts of the country, there is a so-called “black portion” in mortgages, which gives a bank the right to recover most of the home loan, if defaulted, by selling the house.

RI: You mentioned in your book that there was an era of easy money in the Indian financial system in the aftermath of the financial crisis of 2009. Do you predict the same will happen after COVID-19?

VK: That is already happening. The amount of money floating around right now is just humongous.

Banks don't know what to do with it. That is clearly visible in the fact that, one, they’re depositing billions of rupees with the RBI to the reverse-repo window, because they don't have any use for that money.

There is indeed a huge amount of liquidity in the system. Some of this has been driven by the RBI printing money, some of it has been driven by the fact that the psychology of a recession is totally in place.

Even though interest rates are falling, people want to save money with banks as deposits because, as of now, they are more worried about return of capital than return on capital.

People are scared. They have lost jobs, and salaries have been cut. Even for those who have not been economically impacted, the psychology of fear is at play, given that everyone wants to be prepared for a situation where, say, jobs are lost, and they are unable to find new positions.

Businesses are not borrowing, too, because with private consumption coming down, there is no need for businesses to borrow and expand. All these factors have come together, and there is consequently a huge amount of liquidity in the financial system.

RI: What can you say about India's path to economic recovery and the current so-called technical recession that we are in? How does it compare to other countries?

VK: The Indian economy contracted by around 15.7% during the half-year from April to September of 2020. In between April and June, we were right at the bottom. Between July and September, we were in the bottom quartile, though not right at the bottom. There were countries, like Chile and UK, which performed worse than India.

Now, to answer your question about when the economy will recover and when growth will go back into positive territory, there are varying opinions. But what most people are not talking about is the fact that India will not return to its 2019-20 GDP level until either late 2021 or early 2022, at the earliest. By the time we see this return, moreover, we will have lost two years of economic growth.

Another point to keep in mind is that a lot of this economic contraction is not simply because of COVID-19. The economy had been slowing down much before the pandemic struck. Indeed, if you look closely at the data between October and December 2019, India grew by just 4%. So, issues which were plaguing the Indian economy, even pre-pandemic, will now only get worse.

For example, the investment-to-GDP ratio has been falling in India since 2012, and that is not going to improve anytime soon. A lot of growth that is happening, or will happen, is basically jobless growth.

The rate of unemployment has been coming down, but how that rate is coming down is very interesting. It is because the labor force participation rate - proportion of the population that is looking for jobs - is also declining.

What that means is that many people who have been unable to find jobs have stopped looking for a job, and, hence, have dropped out of the labor force. This is a very worrying trend, because India anyway has a low labor force participation rate (especially among women), and I think this will only get worse post-pandemic.

The growth will eventually come back. For an economy of India’s size, people will eventually consume and spend money, and we can debate about t when this will happen. But long-term growth prospects of India have now, I think, been hurt, and all the talk of 8%-9% growth is overly optimistic. At this stage, even a 6% growth rate will be brilliant for India.

The Malaxmi Group- An Empowered Team in Action amidst a Global Pandemic

This caselet was first published by STEP on May 14, 2020; Co-Author: Pramodita Sharma, University of Vermont, USA; https://www.stepresearch.org/the-malaxmi-group-an-empowered-team-in-action-amidst-a-global-pandemic/

Headquartered in Hyderabad, a city of 6.8 million and a major technology centre of India, the Malaxmi Group is diversified Group that comprised of several small and medium enterprises (SMEs) in infrastructure, agriculture, irrigation and water management, and construction, with operations spread across India. Since its inception in 2006, founder Harish Chandra Prasad, a mechanical engineer and computer scientist, aspired to build a professional organization and hired his team very carefully to ensure a good fit with his vision of a focus on quality products and services, and values of building a sustainable business on strong ethical foundations. Rapid growth followed. By the end of 2019, the Group’s revenues exceeded $10 million with 300 plus employees. However, there was some catching up to do in terms of internal systems and strengthening relationships internally as well as externally.

Corona Virus in India

By first week of May, India had lost over 1,700 citizens to the virus and another 53,000 had tested positive. The country’s mortality rate of 1.0 per million population and proportion (4.2%) of positive amongst those tested were much lower than in many other countries. Nevertheless, in an attempt to contain the spread of this infectious virus in a populous nation of 1.3 billion with poor health infrastructure, on March 24th the Indian government imposed a complete lock down of the country without giving even one day notice. SMEs feared the devastating effect of the lockdown on them and the economy. Even Malaxmi Group had to stop all works spread across 16 project locations, severely affecting their operations.

Crisis Management at the Malaxmi Group

Malaxmi had invested in a strong team of professionals. They felt that their Group can emerge stronger in the post-covid era, if they utilise the lockdown time to revisit every assumption of the current business practices, set strong systems and processes for the future and pivot the organisation to meet the uncertainties of the future. While providing thought leadership and holding weekly meetings with the top management team, the founder empowered his CEO, Pavan Kumar Bang, to spearhead the exercise. Few proactive measures pre-lockdown and actions post lockdown include:

Vigilance and AgilityWhen stories of the Corona virus epidemic in Wuhan, China reached India in January 2020, Pavan and his team followed it closely as some of their spare part vendors were based in this region. Immediate efforts were made to look for alternative suppliers within India. By the time the borders were closed, and international travel restricted, an alternate supply chain had been established.

Work from Home ProtocolsAnticipating the work from home advisory, Malaxmi decided to implement work from home one week before the Government directives. This helped the team to be equipped with laptops, internet connections and other hardware. When many others were still absorbing the shock of the new work from home reality, a 9:00 am to 7:00 pm ‘work from home’ routine has already been established for the Group and they hit the lockdown running.

Aligning Team Members and StrategyEmployees were encouraged to make a list of routine work-related activities and at least three new activities that were not a part of their routine responsibilities that each of them would take up during the lockdown period. Teams of employees were assigned specific tasks with an overarching aim to rigorously assess, ideate, innovate and consequently update the current systems and processes to help the Group beat the competition and stay ahead in the game. In addition, taking steps to build long-term trust-based relationships with key internal and external stakeholders was stressed upon. Some of the initiatives taken by the Group to achieve these include:

Process Evaluation and improvements:

• A comprehensive list of drawings, do’s and don’ts, mistakes committed and their root cause analysis, and good practices followed at project sites and all projects worked on was prepared, along with pictures. They were catalogued and stored with a semi-automated retrieval system for future reference and learning.
• Every assumption and convention of the businesses was questioned. WHY-WHAT-HOW matrices were prepared for several products and processes.
• Project proposal templates were revamped and standardized for potential customers.
• Financial statements were analysed closely to identify areas of improvement. Long overdue credits and debits were either written-off or cleared. 

Automation and Software upgradation:

• Realising that there will be uncertainty in availability of skilled workers, technologies to semi-automate several activities in construction and project execution such as plastering, tile laying and painting were identified and evaluated. Ten percent of the capital budget for the next year was allocated for procuring such tools and equipment.
• Enterprise Resource Planning software that had been bought 5-6 months earlier, but the implementation was patchy due to lack of time, training and commitment, was now being implemented meticulously.

Vendor relationships:

• Regular calls were made to all vendors, adjusting payment schedules to support those who were in dire need and delayed payments for the better endowed after discussing with them.
• Vendors were requested to conduct e-training for technical team members on issues like site level quality assessment of products, correct installation methods and do’s and don’ts while handling their respective products.
• Pictorial do’s and don’ts manuals were prepared for working with vendors and customers.

Employee training and skill enhancements:

• Senior and skilled technicians were encouraged to make videos on improving quality, increasing speed of execution and standard operating procedures for future training purposes.
• It was decided to reskill and employ existing team members in other departments. Internal job postings were done, interviews conducted, and transfers done. For example, new Quality assurance and Safety department were created with internal transfers and additional training.
• Online training programs were identified for each employee to help them be better prepared for future challenges.
• Employees were encouraged to challenge underlying assumptions and practices embedded in the Group to identify more efficient, environment friendly and sustainable solutions.

Family Governance:

• On his part, Harish started to adapt to working in a paperless virtual environment.
• He undertook peer discussions and consultations with family business experts and lawyers during this period to understand the best ways to govern the family business, steps to be taken for longevity of the enterprise and plan for succession of ownership and wealth transfer.
• He actively started to engage in treasury management and functioning of the family office too.

Key Insights

• Thoughtful visionary leaders can form organizational systems and structures to bring calm and efficiency in the storm of a global pandemic.
• Empowered teams with clear guidance and accountability can find multi-dimensional opportunities to strengthen organizational processes, systems and relationships, in a crisis.
• Paradoxically an obligatory moment of pause is an opportunity for intense activity on important yet ignored projects in the everyday rush of a growing family enterprise.

Sources: http://malaxmi.in/  | http://chiraharit.com/ | First authors’ interview with the CEO

How Velvetcase is Mining India’s Passion for Gold

This interview was published in Management Briefs, Case Spotlight section, ISBInsight, on December 24, 2018

http://isbinsight.isb.edu/how-velvetcase-is-mining-indias-passion-for-gold/

Velvetcase, a made-to-order jewellery company in Mumbai, is disrupting the manner in which India satisfies its voracious appetite for gold. ISBInsight talked to Dr Nupur Pavan Bang about the managerial takeaways and her experience in co-authoring the case with Professor Kurian Vikram.

ISBInsight: What was unique about VelvetCase, a made-to-order fine jewellery company, that got you interested in writing a case on them?

Dr Nupur Pavan Bang: Traditionally, people go to the jewellery store or the local jeweller with whom they are comfortable. They look at the pieces that are available in the store and buy the product. On the other hand, VelvetCase decided to make customised designs for people within their budget. They allowed customers to design the jewellery themselves.

Second, the value of the jewellery is so high, people would not traditionally buy jewellery online. But VelvetCase tried to change that mindset. Finally, in 2013, the Indian Government had raised the import duty on gold from 4% to 10% during the year. Gold prices were very high, contributing to India’s high current account deficit (CAD). VelvetCase promoter Mr. Kapil Hetamsaria had a good proposition where popularising low karat gold would help bring down the CAD to some extent while also catering to the Indian market’s love for jewellery.

VelvetCase, given that their offering was different from traditional jewellery stores, had their task cut out to change consumer mindset about purchasing low karat gold. Could you share some details about their business model?

In jewellery stores, the business model is generally “product forward,” enabling the customers to choose from the pieces already at the store. But in VelvetCase, it is a consumer backed business model. 

VelvetCase wanted customers to wear jewellery that will suit their personal style. VelvetCase also had the first mover advantage in the online jewellery website sector. In India, the closest competitor was Caratlane, a Tanishq partner. But the other online portals did not offer much customisation.

VelvetCase went a step further and had a team speak to the customer to understand the purpose of jewellery purchase. For example, a customer wanted to buy a solitaire but was sceptical about the resale value.

The VelvetCase team advised her to not make the purchase only for resale as a solitaire’s value is derived from wearing it for daily use and not for re-sale purposes. VelvetCase worked closely with the customer to understand the purchase objective.

Customers could not physically try on the inventory in an online store. Therefore, VelvetCase first built mechanisms to evoke strong trust from the customers, such as 100% certified products from internationally reputed third-party labs and a 30-day return policy. Due to this, they not only increased their customer base but also had a 40% return customer base.

They created an augmented reality feature so that buyers could try on high value products. For example, to buy a ring, you could take a picture of your hand and upload it on the online platform, the ring would then come up on the finger with the help of augmented reality.
The use of cutting-edge technology and high imaging made this possible. A product video on the website demonstrated how a customised completed design would look on the customer. And there was great breath of product design, with over 200 designers working with VelvetCase.

A final factor was VelvetCase’s global reach, with English and Hindi interaction options and prices listed in Indian rupee and US dollars. To date, they offer services in US, UK, Singapore and India.

What are the unique features of the demand for gold in India that make it the largest consumer of gold in the world?

In India, gold as an asset class ranks much lower in the reasons why people buy gold. One main reason why people buy gold is for weddings or for religious purposes. Gold is considered an auspicious metal and a symbol of religious purity. In Hindu tradition, it is recommended to wear gold on certain occasions such as Dhanteras. Even if the price of gold goes up, people do not compromise on buying gold jewellery on these festivals.

Second, Indian marriages are great demand drivers for gold jewellery. From as early as the birth of a child, parents start collecting jewellery for the eventual marriage of the child. If it’s a boy, then it will be for the would-be daughter-in-law. Parents hold jewellery as a form of economic security they are giving to the child. It is considered as a last resort in terms of personal financial crisis. Also, it reflects economic status.

What inferences arose from the case with regards to gold as an asset?

Gold is an asset class because it is a global currency. You can buy and sell gold in any part of the world without losing its value. Historically, gold has given good returns to the investors. It is also seen as a good hedge against inflation.

In India, almost 70% of the gold demand is in the rural markets. In these markets, it is very important to have an asset that can be easily sold or mortgaged to take care of urgent needs such as healthcare or buying irrigation equipment. 

In such cases, gold acts as an easily convertible asset into cash. You can find a pawnbroker in any corner of the country, even the remotest of regions. This option gives people an ability to finance their needs in an emergency.

However, VelvetCase is still struggling with the rural market. There are a few challenges here. One, availability of technology: almost everyone in India has a mobile phone, but they may not have access to a smart phone or high-speed Internet which will help them to use the features like augmented reality. Second, the mindset: it is easier to convince an urban buyer to go online and buy jewellery of high-value.

But it is very difficult to convince a rural buyer, who may not even shop on Amazon or Flipkart, to buy a piece of jewellery online. The touch and feel mindset may still exist. Third, the supply chain: while the delivery logistics might be well-developed in the urban areas and Tier 2 or Tier 3 cities, they may not be well developed in remote places. Given that these are very high value transactions, the products cannot be sent by any courier.

One conclusion arising from class discussions was that VelvetCase should tap into the rural market in the future to increase their revenues, as they want to reach their target of USD 100 million (approximately INR 7 billion) in the next couple of years.

Could you discuss this case’s relevance for business practitioners, whether from an online retail, investment or consumer psychology perspective?

There is a huge consumer mindset change already being witnessed. Previously, people would not even buy vegetables without feeling them. Today, they are willing to buy vegetables online apart from books, clothes and electronics. It is just a matter of time before more people start to believe in buying jewellery online too.

VelvetCase offers a reasonable price comparison to brick-and-mortar stores as they do not carry any inventory. They customise jewellery based on orders and import gold, gems and other jewellery components accordingly. They do not have the expenses of a brick-and-mortar store. Hence, they can sell jewellery at a more reasonable price.

Plus, they take care of the trust factor through certification, a lifelong exchange policy and 30-day return policy with no questions asked. With these features, it is just a matter of time before people start exploring and buying higher priced jewellery more frequently on the online marketplace. So, this is a trend worth noting. 

Especially if you look at the segment of working women between the age group of 23-45, they may not have time to go to different stores and try out pieces. They might prefer going online to a portal like a VelvetCase where the piece comes home, and they can return it if they don’t like it.

What were the unexpected takeaways in classroom discussions of this case study?

One common question was about funding. Kapil Hetamsaria is an entrepreneur and the idea that he had in 2012 was very new. The students wanted to know how he funded the startup. Initially Kapil Hetamsaria and Runit Shah, the co-founders, started with their own savings. They were able to get some funding subsequently. They raised about USD 1.1 million (approximately INR 70 million) in November 2014 and later in the second round of funding they got USD 1.5 million (approximately INR 105 million).

Students were also interested to know about high-ticket jewellery sales. It is one thing to buy jewellery worth INR 10,000 or INR 8,000 online. However, it is unheard of that customers would shop for their entire wedding jewellery online. VelvetCase actually made a record of sorts when they received and delivered a single order of ₹1.42 billion. The students found that quite unbelievable.

With innovation and persistence comes recognition. Due to the innovative business model and a laser focused approach towards customer satisfaction, VelvetCase is building a profitable, scalable and capital efficient business for the long term.

The company has been awarded as the “best ecommerce company in jewellery” three years in a row by India’s largest trade body – the Gems & Jewellery Export Promotion Council, Government of India (GJEPC). The large, fragmented jewellery industry is ripe for change with entrepreneurs like Kapil Hetamsaria leading the charge driven by technology.

About the Writer: 

Nikhila Chigurupati is a Content Associate at the Centre for Learning and Management Practice at ISB.

About the Case:  

Bang, N.P., Singh, P., Kuriyan, V, 2014. India’s Passion for Gold: VelvetCase. Indian School of Business case. Harvard Business Publishing. Available at: https://www.isb.edu/research/cases/indias-passion-gold-velvetcase

ETFs and Liquidity Shocks

Professor Vikas Agarwal on the effects of commonality of stocks under varying market conditions

This interview was first published by the Global Association of Risk Professionals on April 13, 2018

http://www.garp.org/#!/risk-intelligence/market/liquidity/a1Z1W000003fORtUAM

Assets under management in exchange-traded funds have grown from $151 billion in 2003 to more than $3.4 trillion in 2017, according to the Investment Company Institute. 

Like stocks, ETFs trade on exchanges and, like mutual funds, represent portfolios rather than individual companies. But unlike mutual funds, they trade continuously and can track the performance of various indices.

Amid the trend toward passive investing, ETFs offer the advantages of low expense ratios and transaction costs, a high degree of diversification, simplicity and transparency, and tax efficiency.

 Due to the burgeoning size of the market, the impact of ETFs on the underlying stocks is significant. Academic research finds that ETFs increase volatility and reduce liquidity of the underlying securities. In addition, it finds that ETFs increase the co-movement in returns and liquidity of the component securities.

Vikas Agarwal, H. Talmage Dobbs Jr. Chair and Professor of Finance, J. Mack Robinson College of Business, Georgia State University, has been studying commonality in liquidity of underlying stocks owned by ETFs. 

A London Business School (University of London) PhD in finance who has served as a distinguished visiting scholar in the Securities and Exchange Commission’s Division of Economic and Risk Analysis (DERA), Agarwal has published extensively on hedge fund and mutual fund subjects. 

In this interview with Dr. Nupur Pavan Bang of the Indian School of Business, Hyderabad, Agarwal discusses the workings of the ETF market and the findings of his research with Paul Hanouna and Rabih Moussawi of Villanova University and Christof Stahel of the Securities and Exchange Commission (SEC). Agarwal says that the commonality in liquidity affects investors’ ability to diversify liquidity risk, and that it comes at a price.

If ETFs are basically derivatives on underlying securities, when and why does an investor prefer to invest in ETFs rather than index futures?

ETFs provide long and short exposure to many more asset classes, styles, and segments that are not all tracked by futures. Additionally, a typical U.S. large cap long exposure through ETFs can be more efficient than the same exposure by index futures.

For example, ETFs, unlike futures, do not involve a rollover of the expiring contract, which can erode performance for investors with holding horizons spanning beyond the maturity of a futures contract.

According to BlackRock, the annualized rollover cost of a long futures position in large-cap stocks (S&P 500, Euro Stoxx 50, FTSE 100) ranges from 0.9% to 1.4%. The total expense ratio for an ETF on the same indexes can be as low as 0.05% (e.g., the Vanguard S&P 500 ETF). Hence, ETFs provide a more cost-efficient way to track an index, especially for investors with longer or uncertain trading horizons.

Additionally, ETFs provide various exposures to styles (e.g. value/growth, industries), asset classes, and geographies that are not tracked by futures or do not have existing liquid future contracts.

How are ETFs managed, and what are their structural features?

Most ETFs are structured as open-end investment companies and are governed by the same regulations as a mutual fund. Similar to index mutual funds, ETFs have fund managers. 

However, ETFs are fundamentally different from other passive or active funds registered under the Investment Company Act of 1940 since they are traded on a secondary exchange. Unlike closed-end funds, ETF shares can be created or redeemed by ETF primary market makers, called authorized participants (APs).

For U.S. equity ETFs, shares trade concurrently with the underlying basket of securities they hold, thereby providing intraday liquidity to their investors. Additionally, unlike open-end mutual funds, ETFs can be sold short.

The concurrent trading of ETFs and the securities they hold presents the challenge to uphold the law of one price. Therefore, continuously throughout the trading day, ETF prices are kept in line with the intrinsic value of the underlying securities through a process of arbitrage in which APs, market makers, as well as hedge funds and other institutional investors, participate.

How does the arbitrage mechanism work?

APs can engage in arbitrage activity by taking advantage of their ability to create and redeem ETF shares. If ETFs are trading at a premium relative to the net asset value (NAV) of their underlying securities, APs will buy the underlying securities while shorting the ETF in the secondary market until the two values equate. 

At the end of the trading day, the APs then deliver the underlying securities they accumulate during the day to the ETF sponsor in exchange for newly created ETF shares in the primary market. They then use these new shares to cover their ETF short positions.

However, ETF arbitrage is not limited to AP primary market activities, as it also takes place continuously throughout the day by hedge funds and high-frequency traders. Secondary market arbitrageurs hold long-short positions on the ETFs and the main underlying basket constituents until prices converge.

What is commonality, and why should an investor worry about commonality in liquidity?

Commonality represents the co-movement of a stock’s liquidity with the rest of the market. Higher co-movements with systematic liquidity factors imply lower ability for investors to diversify liquidity shocks, which can be crucial in market downturns.

Commonality is especially important in market downturns due to systematic liquidity dry-ups. The higher the commonality of a stock, the more likely it will exhibit liquidity withdrawals in times of market stress.

If ETFs exacerbate the commonality of stocks in their basket, then this would translate in a reduction of the possibility to diversify liquidity shocks that these stocks are exposed to, especially in stressful market conditions, which would give rise to an “ETF-specific” liquidity risk factor.

What should be the benchmark against which we measure liquidity going up or down?

We benchmark the stock to itself by including stock and date fixed effects, and thus exploiting changes in the stock commonality that are related to correlated trading by ETFs due to arbitrage. We also benchmark to other stocks with similar characteristics. In particular, we use two experiments to properly identify the causal aspect of the relation between the ETF ownership and commonality in liquidity.

How does the commonality behave during various time periods (crisis versus normal)?

Our evidence illustrates that ETF-driven commonality is not a crisis-only phenomenon but is also significant in normal times.

What are the implications of commonality in liquidity for investors and policymakers?

Our paper contributes to the policy debate of widespread implications of ETFs in security markets. Specifically, we show that as ETFs continue to grow and gain bigger ownership of stocks, it can reduce the ability of investors to diversify liquidity shocks due to an increase in the commonality in liquidity of stocks included in ETF portfolios.

Buying a Used Vehicle? Check your gaadi first!

Co-author- Saumya Rastogi

The used vehicle market in India is growing leaps and bounds – For cars alone the overall market size is close to $15 Billion and is expected to touch $45 Billion in next 4 years. While the growth projections are certainly encouraging, most of this market is still dominated by unorganized players. Consider this – Out of approximately 15000 used-car dealers in India only about 1000 are organized. A whopping 84% of the car transactions happen either between two unknown people (C2C) or through unorganized car dealers. In such a scenario, how does one ensure the quality of the vehicle?

The seller knows everything about the vehicle whereas a buyer has no clue! Information asymmetry between the buyer and seller has been the biggest drawback of used car market or popularly termed as “market for lemons”. With the growing consumer interest in second hand vehicles, players are entering this space to bridge this information gap. CheckGaadi.com is one such startup that aims to reduce asymmetric information between buyers and sellers in the used vehicle transactions with the use of technology. CheckGaadi.com is positioned as a truly independent vehicle inspection startup that avoids any conflict of interest by not getting involved in the buying or selling process.

Founded by Amit Nigam, CheckGaadi.com is an early entrant in this untapped domain. Amit holds MBA from IIM Calcutta prior to which he studied B. Tech at NITK Surathkal. He has an experience of 15 years in software products development. Like many other customers, Amit also suffered from the problem of incomplete information in buying a car for himself and it was then that he felt the need for a solution to this problem. Amit’s experience at Bosch (largest supplier of automotive components) served as a base to equip him with domain expertise for this industry.

Here is the story of CheckGaadi.com from its founder Amit Nigam.

CheckGaadi.com is a very different kind of startup. Would you like to tell us about it? What are the services offered?

CheckGaadi.com is a year-old startup committed to bringing transparency in the purchase/sale of used vehicles. It works as an e-commerce platform; providing on-demand services to customers from the convenience of their homes or offices.  You can call it an online marketplace which provides prospective buyers with expert technical opinion about vehicle quality and advice when purchasing vehicles, thus helping them in making informed decisions at fair prices. The inspection is provided at a nominal fee of Rs 999/- for cars and Rs. 649/- for bikes.

Do you only offer inspection service or you also have collaboration with Repair & Servicing Centers? If not, are there any plans for expanding your network with Service Centers?

We operate via co-branded B2B partnerships as well as direct B2C channels.

We also have quite ambitious plans to serve the customers at every step of vehicle ownership value chain. At present we are conducting a number of pilots and working towards establishing a repeatable model.

How do you incorporate technology in your business?

This space is largely unorganized and has been traditionally served by local garage mechanics. We are trying to bring transparency in multiple dimensions – service quality, pricing, customer interactions, process standardization, predictable output formats etc. Technology takes the center stage in delivering all these promises; everything that can be automated is automated at CheckGaadi.com.

We have developed a proprietary technology called “mini-ERP” which helps us achieve the best in class efficiencies at scale, while making the complete process transparent to all stakeholders. Vehicle inspections are core to our business and we have demonstrated it by investing in this technology. While almost everyone in this business uses “pencil above the ear” approach to vehicle inspections, we have led from the front to deliver the quality and transparency that the customers deserve.

Your website shows Bike Inspection “51 Point Check” and “106 Point Check” for Car Inspection. Can you explain this?

We offer “51 Point Check” for Bikes, that is, 51 point check across all critical areas of 2-wheeler like Engine, Exhaust, Brakes, Suspension, Sprocket, Tires, Bearings, Electricals and all other subsystems. Similarly, for cars we offer 106 point check across all critical areas of a 4-wheeler like Engine, Brakes, Transmission, Suspension, Tires, HVAC, Electricals and all other subsystems.

In which city do you currently offer service? Are there any plans for expansion?

We currently service 6 cities (+5 in NCR) – Bengaluru, Delhi & NCR, Mumbai, Chennai, Pune and Hyderabad. We are looking to add 4 more cities in our list in the short term.

How is CheckGaadi.com different from its competitors? We believe the market is not too penetrated in this area. What is your view on the same?

We are India’s first fully independent vehicle inspection services provider serving both 2-wheelers and 4-wheelers of all brands under a single umbrella. Our “independence” puts us in the position of strength – we don’t get involved in the vehicle buying or selling process and hence can focus on our core offering, i.e., vehicle inspections. Independence and our first-in-class technology led approach is the USP of CheckGaadi.com.

In your business, customers need trust on your inspection service, as their future decision is solely based on your judgment. How do you built that trust and confidence in the customer?

There are enough checks and balances right from the time we recruit the technicians, train them on the do’s and don’ts, continuously taking customer feedback on them and most importantly, incorporating severe disincentives for any deviation from the process.

What are the kinds of employee roles available at CheckGaadi.com?  What is the background preferred for those roles?

We mainly hire for operational roles such as Operations Managers, Operations Executives of varied experiences, BPO executives, automotive domain experts etc. In order to ensure candidates of proven credentials we prefer to hire via referrals; either the candidates should have demonstrable on-the-job experience or should possess relevant technical background (ITI, Diploma, etc.).

How is CheckGaadi.com funded? Are you looking at raising funds in the future?

We are boot-strapped as of now but in advanced stages of closing our first round of funding.

What according to you has been the Eureka! Moment in your journey so far?

We were recently chosen in top 1% of the startups across India amongst those who participated in LetsIgnite – India’s largest Angel conference.

The Magic of Bamboo

Co-Author: Saumya Rastogi

Bamboo, one of the oldest plantations in India is not as well tapped in India as compared to the other countries. This is very strange as it’s a native of India, yet, we do not realize its importance and right usage. Prashant and Aruna set out to revive the bamboo usage in India. Prashant is a Post Graduate in Management from Osmania University and Aruna is a Post Graduate in Science from Nagpur University. During their search for furniture, they realized that the market was dominated by iron, steel, plastic and wooden furniture. Bamboo was nowhere to be seen. Their search for eco-friendly furniture led to the emergence of Bamboo House.

Here is the story of Bamboo House from its founders Prashant and Aruna.

Bamboo House is a social venture focused on incorporating bamboo to provide sustainable livelihood. Would you like to talk about your ‘green’ startup and its emergence?

Bamboo House is a “Social Enterprise” utilizing bamboo as an economic driver for providing sustainable livelihood opportunities through business models designed to work at the base of the economic pyramid and promote bamboo as an eco-friendly substitute to wood, steel, iron and plastic.

On a sunny evening we were shopping around to buy a sofa set for our home but noticed that market was inundated with routine wood, steel, iron and plastic furniture. We searched around and noticed that overseas markets offered numerous bamboo product opportunities but Indian markets offered no simple solution.

Our search for bamboo furniture landed us up in a small village called “Katlamara” in the state of Tripura on the India – Bangladesh International border. “Katlamara” is a sleepy little village, one of the many bamboo and skill rich locations of our country. Village “Katlamara” is politically India but geographically Bangladesh (during Independence, King of Katlamara decided to merge with India). We decided to understand Indian bamboo sector and went for a “study tour” as we sensed Triple bottom-line impact bamboo could create. We had no specific Entrepreneurial motive since we had no idea what bamboo was all about. 

Family and friends were surprised at our decision, we were less than a year into our marriage, and left our respective careers. I was in my established imports business and Aruna dropped her plans of pursuing her Ph.D. We knew it was a big risk but were prepared. I handled half of country's forest and Aruna handled the other half and finally in May 2008 our study tour led to the evolution of our Social Enterprise “Bamboo House” in Hyderabad.

Any particular reason for choosing “Bamboo”? Do you have any expert team for choosing the bamboo appropriate for product development?

We chose Bamboo for Triple Bottom-line Results:

1. Social: Bamboo can help more than 5 million of our population cross the poverty line
2. Environmental: Bamboo minimizes emission of CO₂ gases and generates up to 35% more oxygen than equivalent stand of trees.
3. Financial: Indian Bamboo Market is estimated at Rs. 26,000 Crores by the year 2015 which provides strong growth opportunities

What are the pricing strategy/ methodology adopted at Bamboo House for product pricing?

We have no defined strategy for pricing as we are not operating under fair market conditions.

Bamboo based products are eco-friendly but the fear of termites, pest attacks always prevail. How do you ensure effective monitoring to avoid damage?

Treatment and seasoning of bamboo is done over a period of 12 -15 months and all required technical precautions are taken to ensure products / projects lasts a lifetime, and in any case not less than 30 years.

What are the major challenges faced by you in developing this venture?

We did face several challenges in developing this venture. Bamboo is under Regulatory constraints as per the Forest Act 1927. Harvesting & Transportation of bamboo is not permitted under the Act. Another problem is that Forest Act does not provide any right to choose the bamboo. We have to buy what is sold but while making products we make the right selection from available stock. There are various other challenges like:

·         There is no benchmark to follow in this industry

·         Raw material available through forest auction is not suitable for commercial applications

·         Every state has its own laws on bamboo for forests being in the concurrent list of the constitution

·         Bamboo traps both air and moisture, making it a difficult raw material to work with

·         Most of the tribal forest areas are inhabited by Naxalites

·         Learning the concept and mapping Raw Material species and Resource base is a challenge as well

·         Development of Logistics, supply chain, distribution, operations and Business modeling

·         Scaling and building volumes in this business is not easy

·         Lack of communication and transportation facilities at the production level

All of these make the business quite difficult operationally.

What according to you is the unique selling proposition (USP) for Bamboo House?

Domain expertise, passion and our ability to play well in this sector. We have very high domain knowledge which helps us.

Has bamboo house received any funding in the past? Are you seeking more funds in the future?

We decided to fund/ support our social venture through borrowings from friends and family apart from very little personal savings we had. We knew that no bank/ financial institution would come forward to support us initially.

We raised our first bank loan from Bank of Baroda under PMEGP Scheme under Credit Guarantee Scheme and are now looking to raise funds again to scale our initiative.

What are your future plans? How do you see ‘green architect’ evolving in the future?

We will persist in our endeavor to create sustainable livelihood models and ensure larger involvement at the grass root level. We understood that our country cannot grow and develop if our villages don't grow and we believe that bamboo can serve as one of the growth engines for the country. Some of our new initiatives are: Bamboo Bicycle, Recycled Tyre Furniture, Recycled Tyre Planters, Recycled Tyre Bags, Recycled Tyre Footwear, Bio-Degradable Sanitary Pads, Incinerator for Disposal of Used Sanitary Pads, Recycled Drum Furniture, Street Dust Bins – With Scrap Drums, Low Cost Bamboo Based Toilets for Rural India.

What has been your Eureka! Moments in the journey so far?

Had it not been for the media support, we wouldn’t have travelled this far in our bamboo journey. Nearly 25 of country's leading news channels and 150 newspapers and magazines including BBC helped us in taking our work ahead, as we were very clear from the beginning that community model should be media supported and market driven only then livelihoods can be sustained at the base level.

2013 – March-April: Our Bamboo Initiative received further support, through “International Visitor Leadership Programme (IVLP)” - A 4 week programme of the US State Department.