Mutual Fund Liquidity, Interfund Lending and the Role of Governance

This interview was first published by the Global Association for Risk Professionals on April 14th 2016

http://www.garp.org/#!/risk-intelligence/detail/a1Z40000003Bs4TEAS/mutual-fund-liquidity-interfund-lending-role-governance

Lending programs best help fund families weather crises when the funds are well governed, Prof. Vikas Agarwal says

Liquidity dries up during periods of crisis when there is flight to quality in the markets. The credit crisis of 2008 was exacerbated by illiquidity of assets. The Southeast Asian currency crisis of 1997 and the collapse of Long Term Capital Management in 1998 also brought attention to liquidity as a factor in systemic and market risks. In late 2015, it was an issue in the closing of the Third Avenue Focused Credit fund, which faced redemption pressures on its holdings of distressed-debt assets.

A March 21, 2016 U.S. Treasury Department press release (https://www.treasury.gov/press-center/press-releases/Pages/jl0393.aspx) regarding a Financial Stability Oversight Council meeting, stated that “the Council discussed its ongoing assessment of potential risks to U.S. financial stability from asset management products and activities, including a discussion regarding potential financial stability risks related to liquidity and redemption risks and risks associated with the use of leverage by asset management vehicles.”

Vikas Agarwal, H. Talmage Dobbs Jr. Chair and Professor of Finance, J. Mack Robinson College of Business, Georgia State University, says that open-end mutual funds bear significant costs because of their unique obligation to provide continuous, sufficient liquidity to their investors. “One potential channel for these costs is the fire sale of assets by fund managers to meet investor redemptions,” he says, citing Joshua Coval and Erik Stafford, “Asset fire sales (and purchases) in equity markets,” Journal of Financial Economics 86, 479—512 (2007). “An investor in an open-ended fund can exit anytime. Investors especially withdraw their money when the market is down, when it is the worst time for the fund manager to sell the assets.”

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 Risk and Economic Analysis, Prof. Agarwal (http://www2.gsu.edu/~fncvaa/vikasgsucv3.pdf) has published extensively on hedge fund and mutual fund subjects. Interviewed recently by Dr. Nupur Pavan Bang of the Indian School of Business, Hyderabad, the professor discussed the provision and impact of interfund lending within mutual fund families, once they have obtained permission from regulators to set up interfund lending programs (ILP).

Would it be less expensive if the funds maintained enough cash or borrowed from banks to deal with redemption pressures?

Funds can easily hold the cash to deal with the problem, but cash does not earn any returns. If the fund has a liquidity buffer, then it can lead to a drag on performance. Funds have to pay fees to maintain any committed lines of credit, and interest expenses when borrowing takes place. If the fund has an uncommitted line of credit, it is possible that when things go bad, even the banks may refuse to lend. There can also be some restrictions imposed by shareholders on external borrowings in order to avoid leverage in funds.

What kinds of costs do funds incur in the event of a fire sale of assets?

A fire sale forces unwinding of illiquid positions in a short period of time at disadvantageous prices. In addition, there can be costs related to predatory trading. If a mutual fund experiences outflows, other market participants such as hedge funds can try to take advantage of “distressed” funds by front-running (e.g., short selling the securities that the mutual funds are expected to sell in a fire sale) or by buying the securities sold in a fire sale at cheap prices.

How can funds minimize some of these costs? Can they borrow money when facing redemption pressures?

The 1940 [Investment Company] Act prevents affiliated funds (those belonging to the same fund family) from engaging in any kind of transactions — for example, borrowing and lending — with each other. The rationale is that such interfund transactions should not result in one set of investors being worse off than others who might benefit. There is some evidence in the literature that in order to create star funds, fund families engage in cross-fund subsidization. For example, families can allocate the hot IPOs to their better-performing funds and, as a result, other funds in the family are worse off. [Jośe-Miguel Gaspar, Massimo Massa and Pedro Matos, “Favoritism in mutual fund families? Evidence on strategic cross-fund subsidization,” Journal of Finance 61, 73—104 (2006)]

But, in the 1940 Act there is a provision that allows the fund families to obtain an exemption from the Securities and Exchange Commission to engage in interfund lending if they can fulfill certain requirements. The underlying idea is that if there are controls in place to make sure that there is no cross-fund subsidization, then it seems okay for the funds within a family to borrow/lend amongst them. This is something that the fund family needs to convince the SEC about when applying for the ILP.

How would an interfund lending program work?

There can be saving on the transaction costs when funds engage in borrowing and lending to each other within a fund family. Let’s say that the borrowing fund can borrow outside at 5%, and the lending fund can lend outside at 3%. In such a case, the funds can settle down at a rate between 3% and 5%, say 4%. So the lender is actually able to earn a return which is greater than what they would earn outside 4% rather than 3%). The borrower’s rate of 4% is cheaper than the 5% rate outside.

Effectively, ILP creates an “internal capital market” for fund families and has become more popular over time. In 1987, Fidelity Investments was the first to apply to the SEC for the ILP. By 2013, funds with almost 40% of the equity holdings of all mutual funds had applied for the ILP.

What kind of compliance and controls does the SEC look for?

The onus is on the fund family to convince the SEC about the proper administration and implementation of the program. The board of directors is obliged to monitor and review the fund’s participation in the ILP for compliance. If the fund is not well governed, it can be expensive in the long run to ensure compliance and to make sure that the program is implemented in the right way. It takes about a year or so for the SEC to finish the process of reviewing an application and deciding whether to grant permission to the fund families for interfund borrowing and lending. In addition, the funds are required to obtain shareholder approvals and fully disclose material information about ILP to engage in interfund lending.

If the lending fund has cash, why would it not invest directly in risky assets rather than lending to the other fund?

The lending funds are typically money-market funds, which are not really trying to do fancy stuff. The borrowing funds are mostly equity funds. The idea here is that liquidity shocks to funds within the fund family are not perfectly correlated. The ILP essentially relies on the heterogeneity in the assets and liquidity characteristics of the funds within the family. So if one fund is experiencing outflows while the other is not, then one fund can demand liquidity while the other can supply it.

Can you elaborate on how governance of the fund has an impact on the performance of the fund?

In my working paper with Haibei Zhao, “Interfund lending in mutual fund families: Role of internal capital markets” [version: March 8, 2016], we show that families which are well governed perform better than those that are not. A better governed fund indicates that the ILP will be implemented in the right way.

Some of the proxies of fund governance are the size of the fund family and the fund itself, and the characteristics of the managers. Larger fund families and larger funds are likely to be better governed. Funds with fewer managers are less likely to have the free rider problem and hence should be better governed. Younger managers with career concerns are likely to be more disciplined, and hence associated with better governance.

Then there is certainly a reputational cost if the program is not well administered. When investors realize this to be the case, the fund will face outflows, and such cost is greater for larger funds and families.

How do the managers’ characteristics play out?

We find that there is a decline in the sensitivity of the managerial turnover to past performance after the funds apply for the ILP. This, in turn, implies that there will be less pressure on the managers in terms of outflows after they have performed poorly. As a result, bad managers will continue to stay in the funds, which can actually hurt future performance. So this is a cost of applying for the ILP for funds that are not well governed. Note that in well-governed funds, such costs will not be borne by the funds since the managers would be fired subsequent to poor performance.

Do fund families that have ILP perform better than those that do not?

We find that funds belonging to families that have ILP show better performance — if the funds are well governed. Moreover, as mentioned earlier, the sensitivity of flows to past performance goes down after the ILP.

In the mayhem that followed the September 11, 2001 attacks on the World Trade Center, a lot of funds experienced outflows. The funds which had the ILP actually suffered less, because ILP helped them absorb liquidity shocks much better. In fact, there was a release from the SEC [No. 25156, September 14, 2001] which stated that those funds which have the ILP could borrow from other funds within their families, and the borrowing limit was relaxed for a period of five business days after the markets reopened.

Incidentally, we also notice that the number of applications to the SEC for ILP approval is more around crisis periods such as 1998-1999 (LTCM), 2001-2002 (dot-com bubble) and 2008.

What is the impact on funds’ liquidity after their families participate in ILP?

Illiquidity of portfolios goes up, and there is an increase in the portfolio concentration of borrowing funds. Specifically, our analysis shows that there is a drop in the overall cash holdings of the equity funds, as they do not need to keep as much cash to meet investor redemptions.

Overall, how would you rate the ILP as a tool for liquidity management?

In principle, the ILP is a good idea, but it has costs associated with it if the funds are not well governed. In other words, the benefits of ILP accrue to well-governed funds. We also show that the funds use the ILP for the right reasons. Only about 7% of the funds which have ILP used it during the period of our study. We find that funds borrow when they experience outflows and poor performance. Also, we observe that well-governed funds are more likely to borrow, consistent with the benefits accruing to such funds.

India’s Path toward Open Trade

This article was first published by the Global Association for Risk Professionals on March 14, 2016; Co-author-Anisha Sircar (Flame University, Pune)

http://www.garp.org/#!/risk-intelligence/detail/a1Z400000031uPG

FCAC – full capital account convertibility – may be inevitable but requires careful preparation

“If countries do not plan for an orderly integration with the world economy, the world will integrate them in a manner which gives them no control over events. Thus, the question is not whether a country should or should not move to capital account convertibility, but whether an orderly or a disorderly transition is required.” — SS Tarapore, former deputy governor, Reserve Bank of India

SS Tarapore, a former deputy governor of the Reserve Bank of India (RBI), passed away on February 3, 2016. He wore multiple hats — writer, columnist and teacher — apart from being a dyed-in-the-wool macro-economist and central banker. He was well known for his views on full capital account convertibility (FCAC). It is as a mark of respect that we revisit the issue of FCAC for India.

The Reserve Bank of India has been contemplating permitting FCAC — an important step that would bring about many changes through liberalization of the use of foreign exchange as well as domestic currency. At the same time, one is left wondering whether India is ready for such a move, considering the impact on movement of capital, volatility of exchange rates and potential disruption of overall macroeconomic stability.

In the recent foreign policy adopted by the government, India aims to be made an integral part of the global trade system by 2020. Given this background, Capital account convertibility (CAC) emerges as a key factor in determining the feasibility of trade between countries.

Integral to the monetary policy of any economy, CAC defines the ease with which financial assets may be converted into those of a different currency. Simply put, flexibility in capital account would ensure no restrictions exist on foreign investments with respect to ownership of assets or purchasing of capital — factors commonly involved with phenomena such as real-estate bubbles or setting up subsidiaries in other countries. A flexible capital account would also involve the ability to convert domestic into foreign currency for a resident to purchase a foreign asset, and vice versa.

Investment Flow

CAC enables movement of foreign capital into the country, paving the way for foreign direct investment (FDI) into domestic projects and portfolio investment in the capital market. With the investments comes access to a global pool of resources and technological advancements.

Lifting capital restrictions could be looked at as a policy measure or incentive to bring about more macroeconomic prudence and stability. This could all potentially result in a stronger domestic and even international economy, as India may expand its market share in foreign economies, receive better returns and possibly experience more progressive policies overall with foreign exposure to the reform processes. Flexibility in the capital account can thus accelerate the economy of an emerging market.

Indian policymakers have until now maintained certain restrictions on asset inflows and outflows: on foreign investors, on resident Indians, and on companies wanting to borrow or spend money abroad.

As part of the reforms process in India, triggered by the balance of payments crisis in 1991, and since 1994, the Indian rupee has been convertible on the current account. Many types of controls have since been replaced. The currency is no longer pegged. FDI norms have been significantly eased. For foreigners and non-resident Indians, there is an equal and reasonable amount of convertibility in India, despite the persistence of several procedural restrictions.

Concerns from Abroad

While FCAC is desirable in principle, events elsewhere have been discouraging and lead some to believe that an open capital account invites economic crisis, and closed capital accounts ensure security.

The Asian financial crisis of 1997-98 saw easy and hazardous fleeing of capital from the country, which severely hampered the economy. During the crisis, Thailand, Indonesia, South Korea (followed by Hong Kong, Laos, Malaysia and the Philippines) were severely affected; India was relatively insulated because of a stabilization policy that involved restrictions on capital flows.

The ‘Grexit’ fiasco also resulted in harsh capital controls.

Globalization and risks of contagion are almost inescapable today. Not to miss the bus on globalization, yet remain insulated from crisis due to the contagion effect, is a task, not many would envy.

As India’s economy grows, FCAC is regarded as inescapable, and resisting it would be futile and counterproductive. Much more macroeconomic management and safeguards would be required to facilitate this movement.

Preparatory Steps

Most evidence points to the inevitability of full capital account convertibility in the near future, and thus the focus must be on the need for better preparation. The RBI has been creating prudential regulations for a framework to guide, monitor and enforce FCAC in India.

However, many things must be kept in mind before FCAC is undertaken, such as monetary policy, fiscal and foreign trade balance and, in the Indian context, banking system reforms. Strong macroeconomic stability is required before implementing full convertibility, especially to withstand global shocks.

As the late Deputy Governor Tarapore envisioned, FCAC must be implemented in an orderly fashion, taking into account all risks and other influencing factors, along with a well-researched, holistically-approached analysis of its impact on the Indian market, informed by successful policies and paradigms in other countries and supervision by analysts and committees from the field.

Budget 2016: Healthcare cannot wait, Mr Jaitley; healthy India can hasten wealthy India

This article was first published by www.firstpost.com on February 26, 2016.

http://www.firstpost.com/business/budget-2016-healthcare-cannot-wait-mr-jaitley-healthy-india-can-hasten-wealthy-india-2644650.html?utm_source=FP_CAT_LATEST_NEWS

The Indian Health care industry is growing at a rapid pace (CAGR of 17%) and is expected to become a US$ 280billion industry by 2020^[1]. Even so, nearly one million Indians die every year due to inadequate healthcare facilities and close to 700 million people have no access to specialist care^[2].

There are wide gaps between the rural and urban population in its health care system. A staggering 70% of the population still lives in rural areas and has no or limited access to hospitals and clinics^[3]. 80% of specialists live in urban areas^[4].

Improvement in health care infrastructure and facilities and ease of access to them is the only way India can fight against diseases. For that to happen, the Government spending on Healthcare must go up. However, the state of affairs, as they are now, is not very encouraging.

The average growth in expenditure on total healthcare is not only lower than the average GDP growth rate, the expenditure is still lower (as a % of GDP) than the expenditure of even low-income countries, as classified by the World Bank (See Figure 1). India is a low-middle income country as per the World Bank classification. In fact, the growth in expenditure on total healthcare in India has been decreased from what it was a decade ago (from 4.3% to 4.05%).

Figure 1: Health care expenditure as a % of GDP

Sources: Health care expenditure as a % of GDP has been taken from the world development indicators, World Bank.

In a talk at Harvard School of Public Health (HSPH) in 2012, it was noted that India spent about $40 per person annually on health care where as the United States spent $8,500. The entire GDP of India was $1.6 trillion then while the U.S. health care spending alone was $2.6 trillion.

K. Sujatha Rao, a former secretary of health and human welfare in India (2009-2010) and director-general of the National AIDS Control Organization (2006-2009) iterated, “What is very interesting is that India spends so little, but there are hospitals there that are comparable in terms of outcomes”^[5].

The problem essentially lies with the Government hospitals and their infrastructure. While there are many universal health care schemes being run by the Central and the State Governments in India and the Government hospitals offer treatment and essential drugs free of charge, the fact that the government sector is understaffed, underfinanced and that these hospitals maintain very poor standards of hygiene forces many people to visit private medical practitioners and hospitals. 

Besides the lack of overall healthcare infrastructure, the second most important influence on India’s healthcare industry is its lack of a medically insured population and high out-of-pocket expenditure.

According to Annual Report to the people on Health by the Ministry of Health and Family Welfare, Government of India (December 2011) about 71% of the total health care expenditure in the country was borne by households out of their pockets^[6]. Out of pocket expenditure is any direct outlay by households, including gratuities and in-kind payment, to health practitioners and suppliers of pharmaceuticals, therapeutic appliances and other goods and services whose primary intent is to contribute to the restoration or enhancements of the health status of individuals or population groups, as per the definition given by the World Bank. Out of Pocket expenses figures by World Bank for India stand much higher at 86% for the year 2012.

The NDA Government did plan to bring about a 'complete transformation' of the health sector and even worked on the blueprint of the world's largest universal health insurance programme, partially inspired by US President Barack Obama's grand insurance-for-all project which is popularly known as "Obamacare"^[7].

The Government now needs to act on its plans. The Union Budget 2016 must allocate more money to the healthcare sector. The sector is in dire need for funds to improve their infrastructure and skill sets and to increase capacity. There are leakages of allocated funds at all levels. It is important to link initiatives like the Digital India to bring in more transparency in the allocation of funds and its expenditure by the Government Hospitals and Medical Officers.

It is said, “Health is Wealth”. Mr. Jaitley, while steps to improve the Economy are much appreciated, a healthy India will hasten the progress towards a wealthy India!

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[1] http://www.ibef.org/industry/healthcare-india.aspx

[2] http://www.indus.org/healthcare/HealthcareIndia.html          

[3] http://forbesindia.com/blog/health/5-things-to-know-about-the-indias-healthcare-system/

[4] http://www.indus.org/healthcare/HealthcareIndia.html          

[5] http://www.hsph.harvard.edu/news/features/jha-rao-us-india-health-care-systems/

[6]http://mohfw.nic.in/WriteReadData/l892s/6960144509Annual%20Report%20to%20the%20People%20on%20Health.pdf

[7] http://ibnlive.in.com/news/indian-government-working-on-worlds-largest-health-insurance-scheme/482670-37-64.html

Mr Jaitley, we expect a 'positive' Budget from you

This article was first published in the business section of www.rediff.com on February 24, 2016; Co-author: Anisha Sircar (student at the Flame University, Pune).

http://www.rediff.com/business/report/budget-2016-special-mr-jaitley-we-expect-a-positive-budget-from-you/20160224.htm

India’s economic growth and foreign investment have been picking up and inflation has been falling under the Reserve Bank of India Governor Raghuram Rajan after a long time. Even the Balance of Payments appears to be in a better shape. All eyes are now on the Union Budget 2016. It is left to the structural announcements of the Budget to inspire markets into taking a directional call. The indices (Sensex and Nifty) have been falling ever since the beginning of 2016, due to oil prices, Chinese economy, global economic uncertainty and the bank NPAs back home.

In the last Budget, incentives to businesses like 100 per cent deduction for Swachh Bharat and Clean Ganga contributions, and hike in service tax was appreciated. The last Budget focussed on long-term growth by propelling fiscal consolidation, capital expenditure, and revised deficit targets to be met over the next 3 years. What needs to be seen is how much of what was Budgeted was achieved or implemented.

In this article, we visit the key areas in which announcements by Finance Minister, Arun Jaitley are anticipated.

In the pre-Budget consultations by Arun Jaitley and his team, it was implied that the Budget this year will revolve around the social sector and inclusive growth. Key demands throughout the sectors are:

·         Financial aid for medical innovation,

·         Increases in pensions,

·         More allocation for secondary education and schemes like Krishi Unnati Yojana, and,

·         Crop insurance.

With the Make-in-India project coming into fruition, higher education will need massive funds from the government to meet manpower needs and import duties will need cutbacks.

Hike in anti-dumping duties is expected, particularly since the devaluation of the Chinese yuan, which has increased the chances of China dumping cheap goods into the Indian market, thereby jeopardising India’s domestic manufacturers and ‘Make-in-India’.

The ‘100 Smart City’ project rides on expectations of increased funds. The start-up industry has been promised benefits from Modi’s Start-up India launch, and hopes of increased avenues of PPP continue to give shape to Digital India.

With the government’s focus on IT/digitisation and business-friendly investments, the general positivity regarding the Union Budget 2016-17 is justifiable; a focus on infrastructure, employment, skill development and monetary encouragement for companies to focus more on R&D and fund allocation will be appreciated. Additionally, further increase in standard deductions for the Income Tax will be very welcome, given the increasing cost of living.

GST would bring in favourable uniformity in the tax system and lower tax rates, is expected to be discussed in the upcoming Budget. Measures to combat issues such as black money and escalating NPAs for banks (March 17, 2016 is the RBI deadline for clearance of bank balance of sheets) especially inhibiting sectors from achieving self-sufficiency are awaiting concretisation.

Announcements with respect to divestment plans, foreign direct investments, capex for private investment, start-up policies, and the overall tax framework are being looked forward to. An increase in public expenditure and encouragement of private investment could be the key to boosting growth.

Without allowing expectations to hit the roof, the Union Budget 2016-17 may be thematically inclined towards all-inclusive economic growth for India. The year may witness the establishment of stronger ties between micro-economic and macroeconomic growth, which would invariably be reflected by stock markets in some measure, as well as by its impact on individuals, companies and the overall economy.

The country has achieved a considerable amount of positivity, activity and attention in the past year through digital inclusion, local manufacturing and entrepreneurial inspiration. The new Budget would do well to fill up the gaps and pave a strong way forward to ensure that the optimism surrounding it is not short-lived.

The Union Budget and the Stock Market reaction

This article was first published by www.yahoo.com on February 23, 2016; Co-author: Anisha Sircar (Student at the Flame University, Pune)

https://in.news.yahoo.com/the-union-budget-and-the-1371194351231030.html

“…The President shall, in respect of every financial year, cause to be laid before both the Houses of Parliament a statement of the estimated receipts and expenditure of the Government of India for that year … referred to as the annual financial statement.”…(Article 112, Indian Constitution)

The Union Budget is the most watched, anticipated, debated and discussed politico-economic event in India. Reviewing what the government achieved in the last fiscal year and what it aims to do in the next fiscal year, the much awaited budget reflects the present economic conditions while forecasting future conditions, and is a key indicator of the financial health of the country. While core fiscal issues (such as taxation, expenditure, and fiscal deficits) are addressed in this session, the budget speech is also used by the Finance Minister to announce new schemes, reforms, policies and plans for the future.

This is why the run-up to the budget is often accompanied by considerable volatility in the stock market. The two are intimately related: how the Finance Minister spends and invests money affects the fiscal deficit, and the extent of this deficit influences the money supply and interest rates of the economy. Simplistically, for example, higher interest rates would mean higher industrial costs of production, lower profits and hence, lower stock prices. Similarly, the budget also deals with fiscal measures taken by the government which affect public expenditure. For example, a direct tax hike would reduce disposable income, which would, in turn, negatively impact consumption. This would affect production levels and cause a decline in economic growth. An indirect tax hike would have a similar effect: indirect taxes may be translated as higher prices onto the consumers, who are often made to bear the ‘incidence’ of the tax, so this would decrease demand for relatively elastic commodities and end up potentially slowing down production and growth.

Susan Thomas and Ajay Shah (Economic and Political Weekly, Vol. 37, No. 5, Money, Banking and Finance (Feb. 2-8, 2002), pp. 455-458) studies 26 Union Budgets to find out the “Stock Market Response to Union Budget” in India. They find that the budget session has on an average resulted in 10 percent higher stock index in the post-budget trading days (about 30 days). According to them, the reaction of a stock market is usually viewed as a measure of the ‘quality’ of a budget.

The announcements in the budget have an impact on the sectors with respect to which the announcement is made. For example, it is often seen that if the market expected a positive announcement regarding say the banking sector, in the pre-budget days, the banking stocks would rally. If the announcements on the budget day are in line with the expectations, there may be very little impact on the day itself. Whereas, if the announcement is better than expected, the banking stocks further rally on the day and may even continue to rally in the next few days. On the contrary, if the announcements are not as expected and are perceived as negative for the industry, the stock prices go down. After the 2005 and 2010 budget sessions, the stock price of almost every company in the banking sector went up. Whereas in 2004, 2007, 2009, 2012 and 2013 most of the banking stocks fell.

On the budget day, one invariably witnesses significant movements in the stock market, which depend on investors’ interpretations of economic activities. However, in an analysis of 31 budgets, done by Livemint (http://www.livemint.com/Opinion/LNs25k8uD6dZsi9Z10gLgK/The-budgets-declining-effect-on-the-stock-market.html) and published on February 17^th 2016, it is seen that the impact of the budget on the stock market is going down. As per the analysis, from average gains in the upwards of 4% on the budget day in the 90s, to a gain of about 2.5% in 2015, the budget is no longer an ‘inflexion point’ for the market.

As expected, the forthcoming Union Budget, which is to be presented by the current Finance Minister Arun Jaitley before the Parliament at 11am on the last day of February, has been a subject of widespread discussion in the recent weeks. Key announcements with respect to the ‘Make in India’, ‘Digital India’, ‘Start up India’ and schemes such as the Pradhan Mantri Krishi Sinchai Yojana, etc. are expected. Goods and Services Tax (GST), Smart cities and Infrastructure reforms may also feature in the budget speech.

The speech will definitely act as a roadmap to the Indian economy in the coming fiscal year. However, with Oil prices, Chinese economy and global uncertainty already playing on the minds of the investors, impact of the forthcoming budget on the stock markets may be just another factor this year!

News: Speed and technology

This article was first published by the Analytics India Magazine on February 15, 2016; Co-author: Sanjay Fuloria (Cognizant Research Centre)

http://analyticsindiamag.com/news-speed-and-technology/

The advent of social media has meant that information travels fast. Everyone participating is judged, liked, trolled, and slammed, every moment. A decade after the advent of Facebook and Twitter, no one can afford to ignore the impact that they have. Businesses, politicians, actors, academicians, writers, have all used social media to advance their cause.

In fact, taking a step forward are companies like Banjo. Banjo released a consumer app in 2011. This was a news app and the sources of information were social media feeds. This might not sound new as there are hundreds of such apps available for download. What’s new is the enterprise software they have developed recently that can detect events. The events are organized by location. The events are shown in great detail using pictures, texts and location. The posts are sourced from the mobile devices closest to the location of the event.

There are implications of such technology for different industries. A tweet posted by an expert about the possible price of a stock could make or break billions of dollars for investors. In the field of finance, especially in high frequency trading, time lag is the key. Research has shown that effective use of Twitter sentiment about a company can result in superior returns.

In another example, if there is a group of people witness to a crime and they are able to post pictures and messages via their mobile devices, the police can be alerted as they would get to know the exact location of the happening. Similarly, in the case of a disaster, the government can be alerted into action to manage the disaster.

Google can predict the onset of epidemics based on individual’s searching for particular medicines. They can even predict hurricanes and storms based on searches for emergency rations, blankets, torches and other items. Now, compare and contrast this to the ways news was gathered and disseminated historically.

A popular method was to appoint messengers to either collect or send news. There were people who were designated as ‘criers’ to shout out the news loud and clear. People were asked to gather at cross roads of their respective localities to spread the news. The great travelers were a good source of information and news from distant lands. They were accorded grand welcome and one of the reasons was their news carrying capability.

Then there are examples of daily handwritten news sheets started by Julius Caesar. The present day marathon can also be traced back to the phenomenon of spreading news through a messenger. Marathon celebrates the courage of Pheidippides who ran 26 miles from Marathon to Athens to carry the good news of Athenian victory over the Persians. He sadly collapsed and died shortly after providing the news due to exhaustion.

As a method of spreading news, pigeons were used by Persians. They trained these pigeons. The Mughals and Romans used pigeons. In fact they were used to aid the military. Surprisingly pigeons were used by financiers before the advent of the telegraph. Just imagine how much time all these modes of communication would have taken and sometimes the message would simply be lost owing to the mortality of pigeons.

From pigeons who would take days to deliver news we are at a stage where we can get the news almost instantly. The use of pigeons to deliver news now seems a very distant past. But the truth is that they were used for transmission of news and information till just about a century ago. With the advent of the telegraph in the late 19th Century, the use of pigeons started to decline.

The world has really evolved. However, there are some privacy issues involved. Not every individual who is privy to an event would like that information to be seen by everyone with an internet connection. The privacy settings in the respective social media sites should do the job. If some individual doesn’t want his/her location information to be shared, they can simply turn that off. There could be some deleterious effects of news spreading fast. During riots, quick news could incite more people pretty fast and soon the mob would become difficult to handle. On the other hand, the law keepers would get the information quickly and they could arrive on the scene pretty quickly before much damage has been done.

There are both positives and negatives like the proverbial two sides of a coin, to this lightning transfer of news. Used judiciously, this technology could redefine the world we live in forever.

A Long View on Liquidity

The interview was first published by the Global Association for Risk Professionals on February 04th 2016

http://www.garp.org/#!/risk-intelligence/detail/a1Z400000031hmbEAA

Concerns about market liquidity and related crises are nothing new, but memories are short, says NYU’s Yakov Amihud

Yakov Amihud, the Ira Leon Rennert Professor of Entrepreneurial Finance at the Stern School of Business, New York University, has been studying liquidity for more than three decades. He is the coauthor of “Market Liquidity: Asset Pricing, Risk and Crises” (Cambridge University Press, 2013). His recent work has been around pricing illiquidity, illiquidity premium and liquidity risk of corporate bonds – at a time when liquidity issues are of growing concern among fixed-income market participants and regulators.

Institutions need “built-in mechanisms and standards to ensure that investments are made in assets that can be liquidated at the lowest possible cost,” says Yakov Amihud of NYU’s Stern School.

“If a bond is liquid, the company can sell it at a quarter point less. That is equivalent to the central bank lowering interest rates by a quarter points,” Amihud says. Although his first paper on the subject, “Liquidity and Stock Returns” (with H. Mendelson), was published in May-June 1986 (Financial Analysts Journal 42, pages 43-48), he believes that liquidity risk naturally captures attention in the aftermath of a crisis – as it did post-2008.

Amihud focuses his research on the effects of stock and bond liquidity on the assets’ returns and values, and on design and evaluation of trading methods in the securities markets. The New York Stock Exchange and Chicago Board Options Exchange are among the markets he has advised.

In this interview with GARP Risk Intelligence contributor Nupur Pavan Bang, the professor discusses liquidity risk, difficulties in assessing it and what the U.S. corporate bond market can learn from the Indian corporate bond market.

Why wasn’t the world of finance paying much attention to liquidity before 2008?

My research shows that the pricing of liquidity becomes more important after crises. As with a natural disaster like a hurricane or earthquake, people buy Insurance after the event. The next year and the following years, if the disaster does not repeat, they may not renew the insurance. Similarly, when a liquidity crisis happens, people say, “Wow, this is important and we should take it into consideration.” But they soon forget about it. And when the crisis hits again, they are not prepared for it.

What previous events may have been forgotten?

There were multiple occasions. During the crash of 1987, the Dow fell by approximately 25% in a single day, and during the crisis of 1998, liquidity was scarce worldwide. There were always more than single reasons for each of these events. However, illiquidity of assets also remains an important reason for the losses.

The collapse of Long Term Capital Management in 1998 is also attributed to illiquidity. LTCM had good positions. It’s just that the market did not have the liquidity to absorb the trades that would result from unwinding LTCM’s positions.

In spite of these historical events, which clearly pointed towards the perils of not taking liquidity risk into account, we have clear evidence of people forgetting. In “The Big Short” by Michael Lewis (2011), pages 216-218, the author recreates a conversation between John Mack, the CEO of Morgan Stanley, and investors on December 19, 2007, explaining the trading loss of $9.2 billion:

“Mack: This was the result of an error in judgment incurred on one desk in our fixed income area, and also a failure to manage that risk appropriately . . .

William Tanona, from Goldman Sachs: “…I am surprised that your trading VaR stayed stable in the quarter given this level of loss, and given that I would suspect that these were trading assets. So can you help me understand why your VaR didn’t increase in the quarter dramatically?”

Mack: Bill, I think VaR is a very good representation of liquid trading risk…”

The risk management tools assumed that the assets can be bought and sold indefinitely without changes in the price. Now that is ignoring liquidity risk completely. So people had really forgotten lessons from the past. I hope people will be more sensitive towards the issue now.

With more commentators and experts talking about it, let’s say people want to tackle liquidity risk. What can actually be done about it?

You and I will not face the problem of liquidity risk, but the institutions which invest large amounts of money will. When billions of dollars are being invested by a single institution, the investment needs to be designed in such a fashion that assets can be liquidated at minimum cost.

Think about it. If the government does not force people to meet certain standards and build an earthquake-proof home, they will not do it. They will look at it as an unnecessary expense. Even in places that are declared to be high-risk zones, people don’t build earthquake-resistant houses. Similarly, an investment may look good on paper and may perform well in good times. It may not do so during periods of crisis. So the Institutions need to have built-in mechanisms and standards to ensure that investments are made in assets that can be liquidated at the lowest possible cost.

What is the problem with corporate bonds in the U.S.?

In the U.S., traditionally the corporate bond market is not very transparent. There is no centralized marketplace where one can see the quotes or post quotes. If you look at the equity markets, NASDAQ or NYSE, it is all electronic and automated trading. Thirty years ago, you would see hundreds of market makers sitting by telephones, providing quotes and taking orders. In the equity markets, they are all gone now. Electronic trading has brought about greater transparency and more liquidity. The cost of capital in the equity markets has gone down.

People say that the U.S. corporate market is not liquid because small investors avoid it. I would say that it is a chicken-and-egg story. Investors avoid it, and it is not liquid, because it is so difficult to trade. In fact the U.S. can learn from India here. India has automated electronic trading platforms for corporate bonds as well.

This is not a question of helping the traders or investors. It must be done for the economy. It must be done to help companies raise capital at a lower cost. Research shows that if a bond is liquid, the company can issue bonds at a lower interest cost. Therefore, the people designing trading systems need to think about this and how to help businesses access the market to raise capital at lower cost. And if the private sector does not do that, the government should help this happen, because greater liquidity generates widespread positive externality in capital markets that the developers of the trading system cannot fully capture.

What kind of impact would the Fed’s recent rate increase have on liquidity?

It is true that when there is a shortage of funds, liquidity problems become serious. But I don’t think the quarter percent increase will have much impact.

In India, the central bank under Raghuram Rajan lowered interest rates one percent in 2015. Will a downward trend in India and an upward trend in the U.S. result in a flight of money to the U.S.?

Not necessarily. If the rate reduction in India brings about greater economic growth and more robust business activity, then the flows from U.S. to India may continue and even grow. Inflation should also be looked at. Investors look at real rates in the end. The strength of the currency must also be assessed. The impact of interest rates must be looked at holistically.

Regarding your work on entrepreneurial finance – in India, many startups have raised money from angel investors or venture capitalists at very large valuations, but they are not making money. What are the prospects for exits or liquidity to enable transactions of any kind?

Amazon wasn’t making money for years and years. The market looks forward. It looks at the potential. If Amazon could get valued at billions of dollars without any profits, so can the startups in India. About liquidity before IPO, in the U.S. there is a platform called Second Market that facilitates private transactions in non-public equity claims. This helps the VCs and other funds and investors to trade in the shares of VC- and private-equity-backed ventures. The greater liquidity in these claims, enabled by this and other, similar trading platforms, makes it more feasible for entrepreneurs to raise capital at lower cost.

There are problems with respect to information asymmetry. But it is something that has been improving over time and continues to improve. Something similar in India will be helpful for both the startups and the investors.

Micro Insurance: Opportunity, Not Charity

This article was first published by the Global Association for Risk Professionals on January 12, 2016

http://www.garp.org/#!/risk_intelligence_detail/a1Z400000031bGL

With India’s under-served population as a case example, there is potential for economies of scale through efficient deployment of technology

In his 2014 book “Capital in the Twenty-First Century,” Thomas Piketty focused on income inequality and called attention to India, where inequality appears very stark despite a lack of data to prove or disprove it. Some of the homes of the ultra rich, in the city of Mumbai, among the most expensive homes in the world, overlook Dharavi, one of the largest slums in the world.

Within the context of access to financial services, insurance is a very critical financial risk management tool. Yet those who may need it the most, such as people vulnerable to natural catastrophes, loss of Income and infectious diseases due to lack of sanitation or access to health care, often have no Insurance.

Twenty-two percent of India’s population is below poverty line (according to estimates published by the Indian government’s Planning Commission in 2013), and a major chunk of the overall population is excluded from the protection of insurance. Life insurance penetration is 2.6%, and the general insurance penetration is merely 0.7%, whereas mobile phone penetration is close to 80%.

Furthermore, the insured in India are covered for just six months of income, and 60% to 70% of health care expenses are borne out of pocket.

Regulatory Push

Micro insurance regulations by the Insurance Regulatory and Development Authority of India (IRDAI) in 2005 were steps in the direction of making Insurance accessible and affordable. The regulations compelled insurers to look at an otherwise neglected market segment. A 2015 regulation, Obligations of Insurers to Rural and Social Sectors, provided further micro insurance impetus, requiring insurers to write fixed percentages of their business to the segments classified as “rural” and “social” each year.

There has thus been a steady increase in number of policies sold to individuals, though the overall premium collected from individuals have declined in the recent years (Exhibit 1). Almost 5 million policies, bought by individuals, are mostly self-funded, which indicates that the targeted segments have a need and are willing to purchase insurance.

Exhibit 1

While the individual micro insurance business is catching up, the group business dominates the sector. There was a significant decline in the premium collected and lives covered in FY2010-11 & 2011-12. There was resurgence in FY2012-13.

Insurance in India is generally a “push-based” business, with face-to-face selling by agents playing an important role. Agents’ importance increases in the micro insurance context, as this segment needs greater convincing and push. Although there has been a steady increase in micro insurance agents, the numbers are not adequate to cater to the vast population (Exhibit 2).

Exhibit 2

In spite of efforts by the regulator to enable the Insurers to remove rigidities in accessing the rural markets and customizing the insurance solutions for the targeted, a large number of the segment remains uninsured.

Factors in Under-Penetration

Temperament and awareness are the most important of the many reasons for under-penetration in the market. Those who are aware about Insurance often have the attitude that they will never need it — that catastrophes or accidents will strike others. Insurance can seem an unnecessary expense when it is a struggle to get two square meals a day. What’s more, a large swath of the population lacks awareness about insurance.

From an insurer’s perspective, this part of the population is mobile (in search of work), does not have a steady stream of income and takes a lot of cajoling to buy a policy. There are challenges in distribution, as not many agents are willing to target those below the poverty line. This segment lacks access to or knowledge of technology to buy online, and reinsurance support is not forthcoming.

There is also the question of whether the products are suitable for very low-income customers who would prefer to insure crops or cattle or loss of income, with premium payment schedules that match the seasonality of their income. Policy document can be complicated, the products too cumbersome to understand.

The Solution

Reaching such a sizable, under-served market entails solutions that are extremely specific to the prospective customers. The approach must be to simplify, customize and create awareness. Use mobile technology, and speedy settlements. And rely on people with local knowledge to convince the customers about the need for protection.

It is important that insurers start looking at micro insurance as a business opportunity, rather than charity. Given the large population, in India as well as globally, who can benefit from micro insurance policies, economies of scale will set in as technology is put to efficient use.