Make best of deft NEFT

This article was originally published in Postnoon on October 26th, 2012, Co-Author: Anuj Hetamsaria


http://postnoon.com/2012/10/26/make-best-of-deft-neft/82944

A few days back, I had counseled Mr. Mukherjee about mobile banking, in the context of transferring funds from one account to the other. Today he came to me with further questions with regards to funds transfer.

Mukherjee: Professor, the relationship manager at the bank told me that funds could be transferred via NEFT. What is this NEFT?

Nicky: NEFT stands for National Electronic Funds Transfer and it facilitates the transfer of funds across different branches of the same bank or different banks. It is easy, cheap, safe and fast.

Mukherjee: I am sure it comes with its own set of requirements!

Nicky (smiling at the cynicism): Oh yeah! You will need to provide to your bank, the Account Number and name of the beneficiary, the name, address and IFSC (Indian Financial System Code) of the beneficiary's branch.

Mukherjee: Where do I get all these details from?

Nicky: The person to whom you want to transfer the money to, that is, the beneficiary, should be able to help you with this. All these details will be found on the cheque book of the beneficiary. IFSC code can also be found out on RBI website and from the bank branch. Care must be taken to ensure that these details are provided to your bank correctly, to avoid transaction errors.

Mukherjee: What is this IFSC? I have never heard of it before?

Nicky: According to wikipedia.com, IFSC is an alphanumeric code that uniquely identifies a bank branch for participating in NEFT system. It is an 11-character code with the first 4 alphabetic characters representing the bank and the last 6 characters (usually numeric, but can be alphabetic) representing the branch. The 5th character is 0 (zero). IFSC is used by the NEFT system to route the messages to the destination banks / branches.

Mukherjee: So I can transfer funds using NEFT at any time of the day or night and any day of the week?

Nicky: Not really. You cannot transfer funds on bank holidays, like public holidays and Sundays. From Monday to Friday, the facility is available between 9 AM and 7 PM and on Saturdays, between 9 AM and 1 PM. There are eleven hourly settlements between 9 AM and 7 PM on all weekdays and five hourly settlements between 9 AM and 1 PM on Saturdays.

The money will be credited to the beneficiary’s account on the same day or at the most next day in case the message is sent during the last batch of settlement. If the amount is not credited within the specified time then the same must be reported to the banking authorities and proper follow up of the same to be done.

Mukherjee: You did tell me that it is cheap. But can you offer some specifics on charges?

Nicky: Well...My bank changes Rs5/- per transaction if the amount is less that Rs 1 lakh and Rs 25/- if the transaction amount is more than Rs. 1 lakh.

Mukherjee: Hmmm, that's really not much. Thank you Prof.

A Simple Solution for Tail Risk

FFTW’s Thomas Philips on an enhancement to mean-variance optimization


The interview was first published by the Global Association for Risk Professionals on October 16th 2012

http://www.garp.org/risk-news-and-resources/2012/october/a-simple-solution-for-tail-risk.aspx?altTemplate=PrintStory


In scenarios that are simply not accounted for in classical theories of finance, how will most investment portfolios perform? "Poorly!" asserts Thomas Philips of asset manager Fischer Francis Trees and Watts. "Classical risk budgeting solutions are based on Harry Markowitz's mean-variance optimization paradigm," he says, "and are ill-suited to assets and strategies with significant amounts of tail risk."

Philips is not alone in having to face this conundrum, but he has been original and innovative in doing so in his role as global head of investment risk and performance at FFTW, a New York-based, fixed-income-focused firm that manages $56 billion on behalf of clients around the world.

"While algorithms to optimize tail risk are known," he notes, "they tend to be complex and are not easily implemented. In addition, they tend to rely on historical data for their inputs, as they are not readily adapted to include forecasts of risks."

In the interview that follows with Nupur Pavan Bang (Nupur_Bang@isb.edu), senior researcher at the Centre for Investment at the Indian School of Business in Hyderabad, Philips discusses a simple enhancement to the mean-variance paradigm that allows for the inclusion of tail risk.

According to Philips, this approach is easily implemented and has proven itself in the management of a wide range of fixed-income portfolios. It can be solved in closed form and typically results in a 15% to 20% reduction in tail risk relative to a classical mean-variance solution, with no change in volatility.

Philips, who has a PhD in electronic and computer engineering from the University of Massachusetts, is also BNP Paribas Investment Partners' regional head of investment risk and performance for North America. (Fischer Francis Trees and Watts has been an affiliate of BNP Paribas since 1999 and wholly owned by the Paris-based bank since 2006.) Philips has also worked at the IBM Thomas J. Watson Research Center, the IBM Retirement Fund, Rogers Casey and Associates, Paradigm Asset Management and OTA Asset Management. He has published more than 30 research papers and is credited with two patents. He won the first Bernstein/Fabozzi/Jacobs-Levy prize for his paper "Why do Valuation Ratios Forecast Long Run Equity Returns?" and the Graham and Dodd award for "Saving Social Security: A Better Approach."

Philips elaborated on his methods, their academic grounding and practical implementation during an August visit to the Indian School of Business.

NUPUR BANG: Markowitz's mean-variance optimization model is one of the most widely used models in the investment industry. How does your model differ from his?

THOMAS PHILIPS: To understand that, you have to understand what mean-variance optimization addresses and what it does not. Mean-variance optimization allows us to build portfolios which appeal to us in two dimensions. In particular, it gives us a simple and computationally tractable way to relate the expected return and the risk of a portfolio to the risk and returns of its underlying assets, and a reasonable way in which to think about a trade-off between the two.

The last step involves utility theory, but even without the use of utility theory, mean-variance optimization is very useful. Before Harry Markowitz developed it, there wasn't such a clear-cut focus on risk and return. A great deal of work, particularly on risk, had been done by gamblers and insurers, but their work was disjointed from the investment literature. The notion of a common person trading off risk and return came to the forefront because of Markowitz. And he made it accessible to a wide range of people because he used simple, computable measures of return and risk.

If you look at assets whose returns are largely a function of their mean and their variance, such as stocks, mean-variance optimization is a pretty good way to think about the problem of portfolio construction. But for assets such as bonds and options, it is a poorer approximation. Our model addresses the issue of how one ought to trade off risk and return when the distribution of asset returns is more complex.

Can you explain this further? Why is it a poor approximation for bonds and options?

Largely because their returns tend to be very skewed.

Let's think about how corporate bonds are created. Risky corporate cash flows are split between two classes of investors: bondholders and stockholders. Bondholders are offered a relatively low, but correspondingly safe, rate of return. Equity holders are residual claimants to corporate cash flows -- they get paid a higher (but risky) return. In particular, they get paid only if there is money left over after bondholders have been paid.

As a consequence, stockholders pick up almost all the variability in the company's earnings, while bondholders experience little variability in their cash flows. But if a company gets deeply distressed (think of Enron) and then is unable to pay its bondholders, they take a huge hit. So, most of the time, bonds have a steady return, but once in a while they suffer huge losses. In other words, the distribution of bond returns cannot be normal.

It is worth pointing out that bonds typically come with protective covenants which give bondholders possession of the machines in the factory or the desks in the office in the event that the corporation cannot pay them what they were promised. In principle, at least, the bondholder can take those machines and desks and sell them at an auction to recover some, but likely not all, of their investment. It is commonly assumed that the recovery rate is about 40%.

How do you deal with this in practice?

One approach is to simulate the behavior of bonds and options, or to sample their historical returns and then build a complex optimization around these samples. Unfortunately, if the simulation model is not good, or if the historical returns don't cover bad times as well as good times, one can get silly results. Another approach is to model the distribution of returns more accurately using a mixture of stable distributions.

Regardless of which approach one chooses, the level of mathematical sophistication rapidly escalates, and one has to be careful not to get trapped in a mathematical quagmire. Typically, when thinking about investments, simple math works best.

We address this problem by modeling risk in a simple, sensible way that is intuitive for fixed-income investors. We are happy to settle for a model that isn't exact but points us in the right direction and is analytically tractable. In the special case when all returns are Gaussian, our model returns the same results as a classic mean-variance optimization. In other words, it is a good approximation in difficult cases, and exact in easy cases.;;

How is it different from some of the other efforts by, say, Black and Litterman?

There actually is a point of connection between our model and the Black-Litterman model. The key insight that underlies Black-Litterman is that one can use results from general equilibrium to get a basic solution in closed form, and can then modify this basic solution in accordance with some further insights on the relative expected returns of a few assets.

Our model is similar in spirit. We start by solving a simple mean-variance optimization problem in closed form, and then gently modify this solution in accordance with some insights that we have about the tail risk of each asset or strategy. Basically, if an asset or a strategy has a lot of tail risk, we decrease its allocation, and if an asset has very little tail risk, we increase its allocation. But after all the adjustments we make, the variance of the portfolio remains the same. So both solutions start with a simple solution and then modify it a bit in accordance with some auxiliary insights.

You discuss coherent measures of risk. Can you shed some light on this?

The theory of coherent risk measures was developed by Artzner, Delbaen, Eber and Heath in the mid to late 1990s. It turns out that many popular measures of risk, such as VaR, have some undesirable properties. In particular, they don't satisfy something called the diversification axiom. If you combine two risky portfolios, you expect that the overall risk of the combined portfolio will not exceed the sum of the risks of its constituents. But Artzner et al. showed that under some widely used risk measures, you could have two portfolios with zero risk in isolation, but positive risk when combined. In essence, diversification was creating risk!

Any reasonable risk measure should not have this flaw. They went on to define a set of axioms that any reasonable measure of risk should satisfy, and call a risk measure that satisfies these axioms a coherent measure of risk. Markowitz used variance as his preferred measure of risk because it was both intuitive and tractable. Unfortunately, it is not coherent. We use expected shortfall as our risk measure because it is coherent and easily computed.

You are an example of how academic research blends with practice. How do you actually use your model?

FFTW is a fixed-income house, and we manage portfolios against a variety of benchmarks. We start by replicating the benchmark, and then layer on a set of active alpha strategies to build a complete portfolio. The alpha strategies come from several alpha teams. There is a structured securities team that analyzes mortgages, a rates team that analyzes the shape and level of yield curves, a money market team that focuses on the short end of the yield curve, a sector rotation team that rotates allocations between sectors, an FX team that focuses on currencies, a quant team that builds quantitative strategies, and an EM team that focuses on emerging markets. We compute the risk profile of each team's model portfolio and use our model to allocate risk among the various alpha teams.

Have you found this to be much better than the traditional portfolio?

Yes, but in a very specific way. It reduces tail risk by 10% to 20% while leaving portfolio variance unchanged.

Could your model be extended to stocks, real estate and options?

It is easily applied to any asset class. However, as a general rule, I'd suggest using the simplest model that captures the key aspects of the problem you working on. Most optimization models work well when returns are approximately normal. If there is non-normality involved, tail risks get amplified, and you ought to use something like our model.

It is widely believed that asset allocation is 70% to 80% of the job and accounts for 70% to 80% of the returns that any investor gets. Stock selection, or selection of bonds/options or any other assets, accounts for just about 20%. Your model is a big step in deciding what an asset allocation should be in a portfolio. What are your general views on asset allocation?

This is an interesting question, and it is often misunderstood. There is a very nice paper by Roger Ibbotson and Paul Kaplan that appeared in the Financial Analysts Journal a few years ago and answers the most common variants of this question. If you are asking what fraction of the variability of your portfolio over time is explained by its asset allocation, the answer is about 90%. If, on the other hand, you ask what fraction of the cross sectional variation in return across funds is explained by asset allocation, the answer is about 40%. If you ask what fraction of your total return is explained by asset allocation, the answer is 100%.

I don't think asset allocation has to be hugely subjective. But I do think that a few simple rules of thumb are very useful. You absolutely ought to diversify globally. And you ought to hold a wide range of assets. You won't go too far wrong by having half your money in stocks and the other half in bonds, half domestically and half internationally. Is this perfect? No. Is it a reasonable starting point? Yes. It is even better if the bonds are indexed for inflation.

If you know your utility function, or if you can build good estimators of expected return, you could do better. But most investors don't know what their utility function is. The only utility function that makes intuitive sense to me is the log utility function, because it corresponds to maximizing target wealth. Jarrod Wilcox had a paper in the Journal of Portfolio Management some years ago on an approach to maximizing return while preserving capital. In essence, he invested his discretionary wealth log-optimally and kept the remainder in cash equivalents. It's a very clever idea.

What is your view on risks pertaining to countries? In the past two to three years, we have seen economies default which we never thought could go down. What are your thoughts generally on deleveraging and defaults by such economies.

Any country can get into trouble. A number of things went wrong in Europe and the U.S. in 2008, but they could well have happened anywhere. The deleveraging process is not easy, and it takes time. But I believe Europe will recover from the mess it is in. Policy makers are finally getting their act together, and pro-growth policies will soon start to take root.

What about India? Last year, the rupee depreciated by almost 25%, and "India shining" seems to have become a thing of the past, with uncertainties in policies and politics coming in the way of performance. What is your take?

I think you are being overly pessimistic. India is not a complete disaster that is falling apart, and it never was a perfect country that was headed straight up. It has always been something in between. There are (and were) pockets of innovation and pockets of stagnation. No one expected the IT industry to spring up in India. And I can see that happening again with pharmaceuticals. So, both good and bad things are happening, but I believe that India's problems (like most problems) are fixable.

What is your view on the state of research in the field of finance and how disconnected it may be from the real world.

I always tell young people who are starting out on a career in research that the world offers them incredibly interesting problems to solve. Take a look at the world -- don't just read journals. The other thing that I stress is the need to be interdisciplinary. I am always shocked by the number of solutions to problems I face that come from other fields. For example, at FFTW we monitor portfolios using ideas from statistical process control, and we estimate volatilities using ideas from digital signal processing. It is also a good idea to study history. As the old saying goes, all that's new under the sun is what you didn't learn in your history class.

Mobile Banking

This article was originally published in Postnoon on October 19th, 2012, Co-Author: Anuj Hetamsaria


http://postnoon.com/2012/10/19/mobile-banking/81448

Mukherjee was pacing furiously at the lounge of our building when I arrived after a long day. He generally waited for me there when he wanted to ask me something. He was an impatient man and I knew from experience that I did not have a choice. I will have to answer his questions before I was allowed to proceed to the elevator. Reluctantly, I asked him the reason for his anger.


Mukherjee: I had to transfer money to my daughter studying in Delhi for her college fees. It was urgent. I went to the bank so that I could take out cash from my account and deposit it in her account.

There was a long queue at the teller’s counter. At 1pm the teller got up and went for his lunch. I waited for half an hour for him to return. After he came back and when my turn came, he refused to let me withdraw cash with my PAN card as the amount was more than Rs50,000. I was not carrying my PAN card. By the time I came back home, took my PAN card and reached the bank again, the bank had closed. My daughter is furious with me. I am furious at the teller. Overall, I am very upset.

Nicky: Why do you need to go to the bank to transfer the money? Aren’t you registered for mobile banking?

Well you must get registered for it then. This time, you don’t have a choice. You will have to go to the bank again tomorrow morning and deposit the amount in your daughter’s account. But you must immediately apply for the username and password for mobile banking. In future, you can transfer the money to her through your mobile.

Mukherjee: Really? Is it simple? What are the things that I can do using mobile banking?

Nicky: Ofcourse. Mobile banking is becoming popular by the day. You need not wait in the queue. You need not confront any rude tellers. You can transact sitting anywhere and at anytime. You can check your account balance, see transaction history, transfer money, pay bills, etc.

Nicky: Mobile banking is very safe, if not 100 per cent. But then, nothing is 100 per cent safe! Once you register, you will get a Mobile Money Identifier (MMID). It is a unique user ID which the bank gives you. You also have a Mobile PIN, that is, a password. This MPIN needs to be changed at regular intervals for safety purposes. There are always issues like viruses attacking your mobile. But they are rare occurrences.

Mukherjee: Will this work on my mobile?

Nicky: I don’t know that. You must have a phone that is compatible with the software/application that your bank uses. The customer care of the bank will help you download the necessary software and will also be able to guide you on compatibility issues. Your phone number will be linked to your bank account number.

Mukherjee: Is it free? Or is mobile banking free?

Nicky: Well… mostly its free. Only a few may charge a small fee. But even if there is a small fee, its worth it because it saves time and effort or physically going to the bank.

Discipline and Dispute in Credit Cards

This article was originally published in Postnoon on October 5th, 2012, Co-Author: Anuj Hetamsaria


http://postnoon.com/2012/10/12/discipline-and-dispute-in-credit-cards/79604

Two days after our conversation on credit cards, once again there was a message from Sethu, blinking on my desktop. I put my coffee down with one hand and clicked on the Gtalk tab with the other. Even though taking a credit card is mostly harmless if one is disciplined in its use, Sethu is so suspicious about anything even remotely modern, that he is difficult to convince. He has more doubts before he applies for a credit card.

Sethu: I have heard that some of the shopkeepers charge an additional percent if the payment for purchases is made by credit card. Is it true?

Nicky: While most shop keepers or service providers do not charge anything extra, a few do charge about 2.5% extra if you pay by credit card. Also, some of them may not accept payment through credit card if the bill amount is very small, typically below Rs250 or Rs200. So, the ideal thing is to pay by cash if the shop keeper or the service provider charges an extra fee for payment through credit card.

Sethu: Hmmm...what about payments to online stores? Do they charge anything extra? Are they secure?

Nicky: Most of them don't charge anything extra. Site like flipkart.com, ebay.co.in or irctc.co.in have very secure payment gateways and credit cards are immensely helpful in making online payments. However, you have to be very careful with your credit card details like card number, cvv code, expiry date etc. Because, anyone who has these details, can make a payment online. It is a good practice to take benefit of services like mobile alerts. This will help you identify any payment that you did not make, immediately. You can then report misuse of the card to the bank and block your card to prevent further misuse.

Sethu: All this is fine. But don't you think that credit card encourages people to buy things they don't need?

Nicky: No. I don't think so. You cannot blame credit cards for lack of planning and discipline.

Sethu: You are right. But what if there is a dispute regarding either the credit card bill or charges or benefits?

Nicky: All banks have a well established grievance redress mechanism. Small issues can be settled at the customer care officers level. For the others, you may approach the bank branches, or write to the appellate or banking ombudsman. However, you too have to be careful about not signing any blank application forms or documents, provide correct details to the bank officials, take everything from the bankers in writing about the charges and the benefits, keep copies of all documents that you submit to the card issuer for your future reference, don't share your card pin or password.

Sethu: Thank you Nicky. I feel more comfortable now regarding applying for a credit card.

Smart users stand to gain

This article was originally published in Postnoon on October 5th, 2012, Co-Author: Anuj Hetamsaria


http://postnoon.com/2012/10/05/smart-users-stand-to-gain/77924

I have known Sethu since at least a decade. A manager at a Multi National Company, Sethu always had strong opinions against the growth of internet, internet banking, credit cards etc. He is the kind of person who feels that these developments compromise on security and lack personal touch. I was surprised when he recently pinged me on Google talk to discuss credit cards! He was contemplating taking up a credit card finally.

Sethu: Nicky, I know you are going to say that I have finally converted. Well you can say so. Credit cards have become so popular now a days that I am forced to rethink my beliefs. And honestly, I have also started to feel that it is safer to carry a credit card than cash. Since you carry many credit cards, I thought you would be the best person to tell me a bit more about them.

Nicky: You are right. Credit cards are not only safer, but they also provide credit facility for as much as 50 days if you time your purchases well. A number of banks also offer cash back, discount, bonus and reward benefits on the purchases using their card.

Sethu: The banks offer either VISA or MATER CARD mostly. Isn't there an Indian gateway?

Nicky: Ah...the swadesi! You are in luck. The National Payments Corporation of India launched the indigenous RuPay in March 2012. You can take up a RuPay card through banks like SBI, BoB, BOI, Axis Bank, etc. RuPay is all set to give tough competition to VISA and MASTERCARD in India and abroad.

Sethu: Oh that's nice. But how do I decide the bank?

Nicky: Compare factors like joining costs (if any), annual maintenance cost, interest rate on rollover, cash withdrawal limits and charges, reward points, special benefits etc. Credit limit being offered by the bank may also be a deciding factor. Different banks adopt different policies in calculating limits extended to the customers. Steady income, income range, good credit history, etc. are some the factors the banks look at.

Depending on these, they will offer to you an appropriate card. It could be gold, platinum, titanium, classic, world, etc

Sethu: I have heard that the rollover facility come with very steep interest rates?

Nicky: That's right. But you should not use your credit card as a means for longer term loans. You must have the discipline to pay on time. Also, you should not use your credit card for cash withdrawals. As the free credit period is not available on cash withdrawals and interest is charged on them from the day of withdrawal, till it is paid back in full. These facilities are available, but they should be used only in the event of an emergency requirement, not regularly.

Sethu: Thanks Nicky. I think I am now ready to apply for a credit card, albeit, after some research!

Magical or Menace

This article was originally published in Postnoon on September 28, 2012

http://postnoon.com/2012/09/28/magical-or-menace/76337

Dr. Raghuram G. Rajan, former chief economist of the International Monetary Fund (IMF), and currently the Chief Economic Advisor (CEA) in the Ministry of Finance, Government of India, a proponent of Foreign Direct Investment (FDI), supported the recently announced 51% FDI in retail by the Indian ruling government, calling it (FDI) the 'safest form of financing' because it is 'long-term' and brings in 'competition'. He is also hopeful that the FDI would result in improvements in the logistical infrastructure.

The ruling United Progressive Alliance government has also claimed that the FDI in retail will change the supply chain and infrastructure at the farm level and will reduce wastages. On the other hand, the opposition claims that the FDI in retail will wipe out the so-called mom-and-pop store.

The infrastructure is needed. But, the so called proposition that the infrastructure landscape will change due to FDI, it's a misnomer. Why is it that the large retail chains like Reliance and the Aditya Birla group have not been able to do it? They have deep pockets and the best talent in the world. The answer lies in the bottlenecks and the systemic problems that are there in the sector. Such infrastructural projects are not financially viable.

The cost of funds are typically around 16-17% for such projects. At this cost, a simple agricultural warehouse, without land, costs between Rs 400-500/- per sqft to construct. And the going rentals are Rs5-7 per sqft. The return is less than the cost of funds. How will investment come into this sector? And this is without land. If you don't have land, if you include the cost of land, the costs will go up to Rs1200-1300sqft. Even if you take the best of rentals (10-15 sft) at the most prime locations, it is still a negative NPV project.

It is often said that food is being wasted due to lack of infrastructure. Yes, the food does rot in the Food Corporation of India's (FCI) warehouses. Have you seen any trader's stock rotting? No. That's because FCI has a populist mandate. FCI is supposed to be a trading organization. It is supposed to buy the grains depending on the capability to sell, based on the demand from the Public Distribution System. It should have storage space, only then buy. They don't do it and hence the grains get damaged.

The mom-and-pop stores too will survive. They offer a different kind of paradigm and value proposition in comparison to the large stores. Another allegation is that the foreign retail companies have very deep pockets and can afford to make losses for 3-5 years. By then they will wipe out the mom and pop stores and then they will monopolize the market. It seems baseless. While the theoretical possibility is there, the cultural and systemic nature of India makes it a very remote possibility.

Well, the reality is that FDI is neither a magical wand, nor a menace. It is about giving choice to the people of this country.

CRR and Repo explained

This article was originally published in Postnoon on September 21, 2012


http://postnoon.com/2012/09/21/crr-and-repo-explained/74537

The Reserve Bank of India (RBI), announced on Monday, that they with keep the policy repo rate unchanged at 8% and cut the Cash Reserve Ratio (CRR) by 0.25%, to 4.5%. What does this mean for you (the readers)?

The repo rate is the rate at which RBI lends money to the commercial banks. Using this rate as the benchmark, the banks decide their Prime Lending Rate (PLR). PLR is the rate at which a bank lends to its most credit worthy customers. They add basis points (one basis point is 0.01%) to PLR, if a customer's credit worthiness is lower.

The credit worthiness of a customer is determined by the repayment capacity of the customer, repayment of both interest and principal. It is also determined by the past record of the customer with respect to payments. For example, does the customer pay his credit card bills on time, does he pay his loan installments on time etc. There is an agency called Credit Information Bureau (India) Limited (CIBIL), which assigns a credit score to each individual depending on the past payments records. Banks use this score when determining the creditworthiness of an individual.

Now back to repo rate. So when repo rate goes up, our loans get more expensive as the banks will raise the PLR and if the repo rate goes down, our loans will get cheaper. RBI has kept this rate unchanged at 8% this time.

CRR is the percentage of money that the banks are supposed to keep with the RBI to meet the withdrawal demands for fixed deposits or any other time liabilities. The CRR is a percent of the Net Demand and Time Liabilities (NDTL) of the bank. When CRR is high, banks have lesser money with them to lend out. On the other hand, when CRR is reduced, the banks have more money with them to lend. This brings in more money supply in the market. Since RBI has reduced the CRR, the money supply should go up in the market.

What is meant by money supply going up? It means that the banks will have more money to lend, and hence more people may be able to get loans. This means that more money will be circulating in the economy. A few banks may decide to decrease the interest rates for auto or home loans. Though it is unlikely as the repo rate is same.

Why did the RBI not reduce the repo rate as well? That's because they are being cautious. They are worried about inflation. If the repo rate is reduced, people will be able to borrow money at a cheaper rate. This will encourage them to borrow and spend. If they borrow and spend, the demand for goods and services will go up. If demand goes up, prices will further go up.

Hence, the RBI has kept the repo rate unchanged.

Is Inflation Good for Growth?

Published in the business section of www.rediff.com on 21 September, 2012


http://www.rediff.com/business/slide-show/slide-show-1-column-is-inflation-good-for-growth/20120921.htm

In a G-24 Policy brief (2012), Anis Chowdhury (UN-DESA) and Iyanatul Islam (ILO) sum up the Inflation Targeted as well as non-targeted)-Growth debate. From their brief, it can be said that monetary policies targeting inflation may not result in better growth than countries that do not have a policy of targeting Inflation.

They quote Friedman (1973): “Historically, all possible combinations have occurred: inflation with and without [economic] development, no inflation with and without [economic] development”.

A little bit of Inflation is good. But too much is bad. Empirical Analysis of inflation and growth over the past 50-60 years, in multiple nations, have concluded every possible combination of the two variables is possible, which ratifies Friedman's statement.

The monetary policy announced on Monday, left the interest rates unchanged at 8%. However, in a surprise move, the cash reserve ratio (CRR) of scheduled banks were reduced by 25 basis points from 4.75 per cent to 4.50 per cent of their net demand and time liabilities (NDTL) which according to RBI is expected to infuse approximately Rs170 billion of primary liquidity into the banking system. While the move will give greater freedom to the banks to lend, the unchanged policy repo rate, may not bring in many takers for the loans.

The Reserve Bank of India has maintained that Inflation is too high for their comfort. The point to note here is that the correlation between interest rate and inflation, in India, in the past 10 years, taking September to September rates, is a very small 0.16 only. On the other hand, they are highly correlated with GDP (-0.31) and stock market performance (-0.60).

In a research done by Muneesh Kapur and Harendra Behera (2012), who were both with the RBI at the time of doing the research, they concluded, " the evidence for both India and other countries suggest that the impact of monetary policy actions on inflation is modest and subject to lags... Despite the monetary tightening by Reserve Bank of India during 2010 and 2011, inflation remained high and this could be attributed to the structural component of food inflation as well as the surge in international commodity prices beginning the second half of 2010 and continuing into the first half of 2011".

Inflation can be controlled by controlling budget deficits and by easing bottlenecks to improve supply, as well. But burgeoning subsidies expenditure by the government and inefficiencies have resulted in an expected fiscal deficit of more than 7%; and if the government fails to raise money by divesting the proposed public sector undertakings in the coming year, it will be a reality.

Because of this, the entire onus of controlling the inflation has fallen on the RBI. Which is having an impact on the growth rate.

The stock market rejoiced on Friday, with the benchmark index (SENSEX) moving up by 443 points as the government, led by Dr. Manmohan Singh, announced a subsidy cut on Diesel and easing the FDI norms for the retail and aviation sectors. Monday was not to be the icing on the cake.

Corruption and Money Laundering

This article was first published in Moneylife on September 20th, 2012, co-authored with Khemchand H Sakaldeepi


http://www.moneylife.in/article/corruption-and-money-laundering/28564.html

First the Gandhian, Anna Hazare and then the yoga guru, turned social activist, Baba Ramdev; India has witnessed two major voices against corruption in the last year. While Anna and his team's movement primarily focused on bringing a strong Lokpal Bill, Baba Ramdev has been crusading to bring back the black money stashed away in Swiss banks, to India.

Corruption has assumed unprecedented proportions with the Coalgate allocation scam running into billions of dollars and everyone from the erstwhile Bhartiya Janta Party government (now the main opposition party), led by Atal Bihari Vajpayee to the current United Progressive Alliance (UPA) government, led by Dr. Manmohan Singh, being under the scanner. The Indian parliament hardly worked in the monsoon session, with the ruling party and the opposition at loggerheads with each other.

A ray of hope, in the midst of the political circus, seems to be the Indian banking system, that has been resilient in the past, conservative and cautious. The recent cases of laxity in vigilance and violation of regulations at the HSBC and the Standard Chartered banks, have resulted in trillions of illicit money gaining access to the US markets. This raises questions about the steps taken towards the prevention of money laundering by countries across the globe.

India became a full-fledged member of the Financial Action Task Force (FATF), an inter-governmental body which works towards combating money laundering and terrorist financing in the year 2010. Since then, India has been co-operating with the other member nations in sharing information regarding suspicious, money laundering and terrorist financing activities.

According to FATF, "corruption has the potential to bring catastrophic harm to economic development, the fight against organized crime, and respect for the law and effective governance". Early this month, both NSE and BSE, the leading stock exchanges of the nation, urged the investors to exercise caution in dealing with entities linked to Iran, following warnings from FATF.

The question is, being a member of FATF and at the same time struggling with corruption at home, is India doing enough to combat money laundering? A survey on Anti Money Laundering by KPMG in India (2012) revealed that about 11 percent of the respondents find that more than 25 percent of their SWIFT messages have incomplete originator information. The survey also finds that more that majority of respondents found the client screening, handling of filter hits and maintenance of sanction lists was either moderately challenging or challenging. And less than 50 percent use either internal or external sophisticated IT systems to identify potential money laundering cases.

In the US there exists a list of Specially Designated Nationals and a list of Countries identified which should be screened for identifying potential risky transactions, better known as OFAC (Office of the Foreign Asset Control) List. US people and companies are banned from dealing with entities in this list.

In India too, Financial Intelligence Unit - India (FIU-India) along with the RBI, has been working towards making the screening system more rigorous. If the processes are implemented in letter as well as spirit, financial companies like Banks, NBFCs and Insurance companies, who collectively control the flow of money in the economy can directly hinder the plans of rogue elements by making their financial life miserable.

Also, there exists Know Your Customers (KYC) and Customer Due Diligence (CDD) guidelines in India, which can be easily flouted due to the multiple ways in which one can fulfill these requirements. India still does not have a single identity for its citizens, on the lines of the US Social Security Number. Same person can have multiple address and identity proofs in the form of state issued passport, driving license, ration card, or the most recent being the Aadhar card.

Going by the KPMG report, while India is taking baby steps in the right direction, there are major milestones to be covered in terms of training, reporting and technology to be able to use some of the most sophisticated algorithms involving abnormality detection, predictive models and social network analysis. In fact, it is said that if Facebook was a country then it would be the 3rd biggest in the world. The combination of data from social network and technology can help us create sophisticated bad behavior detection tools.

The recent technological advances have helped many institutions to harness the power of large datasets. The companies can process and collect data at close to real-time and with the help of certain algorithms, classify and detect malicious behavior instantly. This is like any other antivirus system found on computers, but different in terms of target units i.e. money laundering and terrorist financing.

The existing systems in India have clearly not prevented black money and the proceeds of corruption from leaving the country. Hopefully the next generation revolutionaries can actually use technology to bring about the change we want to see instead of relying on the old fashioned political rhetoric. Next time when someone says “Hum bahar ka paisa vapas layenge” (Read: Baba Ramdev claiming to bring back the black money stashed in Swiss banks) then we must ask “What’s your analytics quotient?”

CRAs wake up Singh

This article was first published in the Free Press Journal on September 17th, 2012


Prime Minister, Dr. Manmohan Singh, the architect of India's liberalization policies and the person credited with ending the license raj, had slipped into oblivion in the last few years. He has been often criticized of being a puppet at the hands of Mrs. Sonia Gandhi, the President of UPA. Increasingly so in the past year when the Indian Economy has experienced a slowdown and loss of investors' confidence. Dr. Singh seems to have reincarnated himself in the light of the downgrade threats from Credit Rating Agencies (CRAs).

Empirical analysis of credit rating downgrades conclusively point towards a fall in benchmark indices across the world, by 0.3% to 1.2% on the day of the downgrade and the next day. Research also shows that the CRAs do provide new information to the market, and the information is especially significant in the case of downgrades.

However, the failure of CRAs to warn the investors of many a recent events (both at company as well as country levels), have raised questions on the worthiness of the CRAs itself. Marwan Elkhoury, Economist and Mathematician, writes in the Compendium on Debt Sustainability and Development (UN, 2009), "Ratings tend to be sticky, lagging markets, and then to over react when they do change. This over reaction may have aggravated financial crises in the recent past, contributing to financial instability and cross country contagion".

But the point of interest to us in India is the next line written by him, "Moreover, the actions of countries which strive to maintain their rating grades through tight macroeconomic policies may be counterproductive for long term investment and growth". To the credit of RBI, they have resisted any efforts of bowing out to the calls of a decrease in interest rates by the industry.

The UPA government though has bowed down to the fear of a credit rating downgrade, to junk status. They have announced a hike in Diesel prices and unleashed the reforms to bring in FDI in retail, aviation, power exchanges and broadcasting services.

The thing is, bowing down is not always bad. So the question is are these reforms really good for India? Are the reforms enough? Is it too little, too late? While a downgrade will have adverse impact on the stock market, FII inflows, credit and growth, the reforms announced will not have much of an impact if the entire ecosystem to do business is not made more favorable. Delays in projects due to multiple clearances required at the state and centre level and rampant corruption will only keep the investors at bay and push the exports, industrial output and GDP further down.

Dr. Singh, if you have really woken up from your slumber, go all out, leave no stones unturned. You do want to be remembered as the "Reformer" and not the "Underachiever"!

Commitment Rewards

This article was originally published in Postnoon on September 14th, 2012

http://postnoon.com/2012/09/14/commitment-rewards/72810

I saw Abhi waiting for me again near my office. He had applied for a home loan about two weeks back. I had explained the process of applying for the home loan and also how the EMI's work. I wondered what's brought him back to me so soon. I didn't have to wait long. He had his papers out, even before I could open the door to my office.

Abhi: Nicky, the bank has sent people over to my house to check if I actually live there. They even called and visited my office.

Nicky: That's routine. Nothing to be worried about. They are just doing their job. Due diligence.

Abhi: Yeah, yeah. I understand. I am not here for that. Yesterday, my friend told me about a scheme that Axis Bank has come up with. He told me that if I take a loan for a period of 20 years and keep paying all my EMIs on time, without any defaults, the bank will waive off my last one year installments (that is last 12 months' installments).

Nicky: Oh yes, I heard about that. You need to be locked with them for 15 years time to avail of that offer.

Abhi: How does that matter?

Nicky: Oh it does. Because it means that you cannot avail this benefit if you decide to prepay your loan before 15 years. It also means that you cannot avail this benefit if you transfer your balance to another bank, if they offer to charge a lower rate of return.

Abhi: Does this mean that the scheme is useless?

Nicky: Not at all. I'll explain this with an example. A person taking Rs 50 lakhs as loan, for a period of 20 years, at 11%p.a. interest, will need to pay an EMI of Rs 51,609 per month. According to this scheme, he will be able to save Rs6,19,308 after 15 years, the equivalent of one year's EMI.

Abhi: That's quite a lot of money!

Nicky: Well. So it seems. But then, you see, the value of money 15 years down the line, is not the same as the value of money today. So its present value, after accounting for an average inflation of say 7%, is just Rs 2.24 lakhs. The value could be lower if you take a higher inflation or a higher opportunity cost.

Abhi: You are getting into a lot of jargons. Just tell me what should I do?

Nicky: Take an informed decision. All other terms being same, with no intentions to default, or switch your lender and if you are sure that you will keep the loan for at least 15 years, then this scheme is for you. The benefit in present value terms is not as big as you think. But it is definitely a benefit.

On the other hand, if you think you might want to repay earlier or might want to change the lending bank sometime in the future, then this scheme may not benefit you and this scheme should not be the deciding factor for choosing a home loan provider.

Understanding EMIs

This article was originally published in Postnoon on September 9th, 2012


http://postnoon.com/2012/09/07/understanding-emis/71082

A week after our first set of discussions about home loans, Abhi came back to me for further assistance with understanding home loans. He told me that he had approached his bank and started the process of getting a loan sanctioned. He had already submitted self attested copies of four months pay slips, six months' salary bank statements, past three years Form 16s, ID proof, address proof, PAN Card and the employee ID.

Abhi: Nicky, tell me, what are EMIs and how are they calculated?

Nicky: Equated Monthly Installment or EMI, as they are popularly known as, is a fixed amount of money that you return to the bank, on a specific date of each month. The EMI consists of part repayment of principal and the interest. It is calculated in such a way that over a period of time, if you pay all the EMIs on time, your loan will get completely repaid.

Abhi: Why don't we just pay the interest every month and repay the principal after the term of the loan is over?

Nicky: Well, you could do that. But that would mean that you pay interest on the entire principal throughout the term. Also, when the term gets over, you may not have enough money to repay the principal. In EMIs, because you are also repaying a part of the principal every month, the interest component keeps decreasing every month. Every month, you pay interest on a lesser principal.

Another advantage is that the principal repayment is spread over many months, typically 240 or 120 months, relieving you of the burden of paying a very large amount at one time in the end. For example, if you were to take a loan of Rs10 lakhs at an interest of 11%, you will need to pay an EMI of Rs10,322 per month. This is equal to Rs1,23,864 per annum. If you look at the Table, you can clearly see that every year, your payment towards interest is coming down, as the interest is calculated only on the balance of the principal amount. If you keep paying Rs10,322 every month, for 20 years, you would have cleared your entire loan, along with all the interest.

Year Principal Repayment Interest Paid Outstanding Principal

Abhi: That's very comforting.

Nicky: And that's not all. You can also avail of tax benefits on both the principal as well as the interest paid.

Abhi: Hmmm...I just wish that my sanction letter comes soon and we are able to move into our new home as soon as possible!

Paperwork Check Must

This article was originally published in Postnoon on August 31st, 2012


http://postnoon.com/2012/08/31/paperwork-check-must/69584

My recently married cousin, Abhi, was contemplating buying a home. After putting all his savings together, he was still short of around Rs20 lakhs to buy the house that his wife and he liked. Being an engineer by education and by profession, he always found it difficult to handle financial matters. It is more a mental block than the capability to understand or deal with finances.

He came to me to understand the home loan process.

Abhi: A lot of the banks advertise that the home loan will be processed, sanctioned and made available within a week or 10 days. Is it so simple?

Nicky: Abhi, that's what they say. But you have to be realistic. It's not so simple. You first need to get a whole lot of documents in place like your recent bank statements, salary slips and job offer letter, Form 16 issued by the company, passport sized photographs, Pan Card, Address Proof, Agreement of Sale etc.

After you submit these to the bank's sales team, they will then send it to their loan processing officer. Who will, rest assured, ask for more documents. You provide those, they will ask for something else.

Abhi: But why does this happen?

Nicky: That's because of inadequate training to the sales team and their half hearted efforts. They do not give a complete list to begin with, to the customer. They do not check the documents properly and take it from the customer. If they did, they would know that the photo in the ID proof is not clear and hence the loan processing officer will not clear the file. Or, the amounts in the bank statements showing the down payment to the builder do not add up to at least 20% of the value of the property.

Once they collect the cheque for the processing fees, their motivation to help you is lost. So they keep coming back to you and asking for more and more documents. And they will always justify by saying that the 'regulations have changed'.

Abhi: This is de-motivating. If the process is so tiresome, why would anyone take a home loan?

Nicky: Do you have any other choice? Can you get a loan from somewhere else? Well, the answer is No. For most of us. So, whether we like it or not, we are stuck with this system. And then look at it this way, after you get the loan, you will be the owner of your dream house. So keep your cool. Patience is the key. You will get your loan.

Abhi: That's true. How about the interest rates and the EMI?

Nicky: Ah that! Can we do it later? I have a class now...

Algorithmic Trading

This article was originally published in Postnoon on August 24th, 2012


http://postnoon.com/2012/08/24/algorithmic-trading/67942

From time to time, Algorithmic Trading (AT) or High Frequency Trading (HFT) hits the headlines, mainly due to regulatory concerns. The main concerns of the regulators being transparency, fairness and systemic stability.

A couple of days back, they were back in the news as the Delhi Highcourt issued notices to the regulator, Securities Exchange Board of India (SEBI), the exchanges: NSE and BSE, the Finance Ministry and the RBI. The notices were sent as a result of the plea of Intermediaries and Investor Welfare Association, which has alleged that AT "discriminates between rich and influential brokers and common investors/retail investors and creates inequality and finally casts a deceptive data to common investors and retail investors while trading in shares and securities on online trading platforms of BSE and NSE".

Let's look at what is AT in today's article.

Definition

According to wikipedia, AT, also called automated trading, black-box trading, or algo trading, is the use of electronic platforms for entering trading orders with an algorithm deciding on aspects of the order such as the timing, price, or quantity of the order, or in many cases initiating the order without human intervention.

A special class of algorithmic trading is (HFT), in which computers make elaborate decisions to initiate orders based on information that is received electronically, before human traders are capable of processing the information they observe.

Characteristics

• Very high speed of trading due to the use of high speed computers

• Use of algorithms to process data feeds and take decisions to buy and sell automatically

• Use of co-location services

Concerns

The International Organization of Securities Commissions (IOSCO), reported in July 2011 that AT also contributed to the flash crash of May 6th, 2010 in the US when the benchmark index, Dow Jones Industrial Average crashed and then quickly recovered.

In India too, in the last couple of years, there have been instances where the markets have lost a large amount of money in a very short span of time and then recovered quickly. Once such instance happened during the Muhurat Trading on Diwali day of 2011.

These events brought to light the highly correlated nature of trading strategies using AT. This means that the markets can quickly become one sided. AT also results in very high short term volatility which could be detrimental to retail, non algorithmic traders.

Pros

AT enhances the speed of information dissemination and its supporters claim that it helps in making the markets more efficient. Large and multiple trades can be processed and carried out quickly. Complicated strategies can be implemented through algorithms. 75% to 80% of total trades in US and UK can be attributed to AT.

These are also the very reasons why the Intermediaries and Investor Welfare Association has accused the regulators of being "silent spectators". AT gives unfair advantages to institutions or brokers who have of co-location facilities and high speed computer prowess which are not available to the common man or ordinary retail investors.

SEBI, exchanges and the Ministry clearly need to put some thought into the advantages of speed over fairness to all.

We object Mr. Chetan Bhagat

This article was originally published in rediff.com on August 22, 2012

http://www.rediff.com/getahead/slide-show/slide-show-1-specials-we-object-mr-chetan-bhagat/20120822.htm

Do the young Indians really just want a job and a girlfriend? Which India is Mr. Chetan Bhagat talking about?
Chetan Bhagat became an instant hit with the Indian youth with his first book, "Five Point Someone". The book took the youth through a journey of three engineering students at the prestigious Indian Institute of Technology, which every young Indian either related to or wanted to be able to relate to. It was easy to read and witty, but no literary masterpiece. His subsequent books, One night @ the call centre, The three mistakes of my life, and 2 States, too went on to become bestsellers but established Bhagat as a 'dud' in literary circles.

Bhagat's latest book, 'What young India wants' is a non-fiction, unlike his previous books, and an attempt by Bhagat to establish himself as a serious, thinking, author. The book title indicates that Bhagat is trying to capitalize on his popularity with the Indian youth. The book may go on to become a bestseller, but he has clearly chewed more than he can bite this time.
There are essays in the book which have nothing to do with the youth or the young India. They are plain criticisms of politicians, policies and processes. And we are all on board there. Even though some of the observations are a bit over the top. For example, comparison of cricket with opium or suggesting that Indians are 'suckers for power'!

However, he has got the pulse of the youth wrong in many place in the essays which are related to the title of the book, "what young India wants". And the biggest one in my opinion is that according to him Indians lack a good set of values and are a confused bunch of people.

Indians are definitely not confused and have solid set of values.

The young India I know wants to fulfill the aspirations of their parents. We want to bring home a boy or a girl whom our parents would approve of. We want to come home for Diwali, wherever in the world we might be. We want to take care of our parents in their old age and protect our children, always.

We believe in God. We know the right from the wrong. We know the difference between honesty and corruption. Sometimes we deviate from our values to survive. To survive the same processes and policies which Bhagat has so lucidly criticized in his book.

We are fighters who get to schools, colleges and offices, running behind buses, dangling through the door, because of inadequate frequencies and public transport. Would we ever reach the destination on time if we were to form a queue? Queue works when 10 or lower number of people board a bus with 10 empty seats. But if 20 people need to board a bus which is already full, it will not work. Have you seen Indians break queues in the developed countries?

The youth of the nation know that all service providers are bad. We stick to a service provider as long as we don't decide to change, on a bad morning, in frustration. But the change is not in anticipation of better service. Same goes for their votes. Bhagat suggests that change can be brought around if everyone decides to vote for honest politicians. Isn't that an oxymoron in India? There are no honest politicians to vote for. Whether it's one party or the other, they are all corrupt.

We look up to our corporate czars because they survived and found their way through this corrupt system. Even if they inherited, as against innovated, they stayed afloat. And the suggestion that Indian youth does not look up to innovators or entrepreneurs is a bizarre one. Narayana Murthy (Infosys), Kiran Mazumdar Shaw (Biocon), Sunil Bharti Mittal (Airtel), and many more, are all first generation entrepreneurs, and we look up to them!

In spite of the education system, Indians think (unlike what Bhagat suggests)! We think, therefore a significant percentage of the scientists, doctors and academicians in the US are Indians. The fact that they go to the US and invent or innovate, and not in India, is a reflection on India's processes and policies. Not on the quality of our brains.

And seriously, the comparison between opium and cricket, is inane by any stretch of imagination. Yes there was a controversy. The business part of it isn't transparent. There are glamorous people involved. But what does that have to do with the game? Indian's enjoy watching the game, the country has some world class players, they idolize some of them, how's that different from basketball in the US or Football in Brazil? And trust me Mr. Bhagat, no child in India thinks about or sees "cricket as yet another example of India's rich and powerful treating the country as their fiefdom".

Truly, there is only one thing wrong with India. Its politics and the politicians. That is the root cause of our socio-economic troubles. And all we want, as youth of the nation, is a country free from these corrupt politicians. There is no confusion about that!
Author: Chetan Bhagat
Title: What young India wants
Publisher: Rupa Publications India Pvt. Ltd.
Pages: 181