The RBI after Rajan

This article was first published by the Global Association for Risk Professionals on August 25, 2016;

https://www.garp.org/#!/risk-intelligence/detail/a1Z40000003K0bjEAC/deloitte-c-level-client-facing-risk-executive

Continuity, but a contrast in style, at India’s central bank

On September 4, 2013, the internationally prominent economist Raghuram Govind Rajan took charge as the 23rd governor of the Reserve Bank of India. He decided in June to depart at the end of his politically tumultuous three-year term, and with the August 20 announcement of his successor, deputy governor Urjit Patel, the book on Rajan is officially closing.

A former International Monetary Fund chief economist and University of Chicago finance professor, Rajan came in with a “rock star” image, a contrast to his predecessor, Duvvuri Subbarao, whose performance was the worst ever by an RBI governor, according to Arvind Panagariya, then professor of economics at Columbia University and now vice chairman of the government think tank NITI Aayog. Subbarao had kept the Indian economy relatively stable during the global crisis period. By the time he entered into the second phase of his tenure, in 2012, the economy was marred by nearly 10% inflation, a depreciating currency and low GDP growth.

Rajan dazzled with degrees from IIT (Indian Institute of Technology), IIM (Indian Institute of Management) and MIT (Massachusetts Institute of Technology) and a reputation for speaking his mind, was widely credited with predicting the 2008 crisis, and key economic indicators seemed to respond immediately to his moves.

Anticipated Criticism

When Rajan addressed the media after assuming office, he said, “Some of the actions I take will not be popular. The governorship of the central bank is not meant to win one votes or Facebook ‘likes.’” He said he sought “to do the right thing, no matter what the criticism, even while looking to learn from the criticism” — words that turned out to be prophetic.

Over the three years that ended September 4, 2016, Rajan did mostly the right things. He brought inflation down, stabilized the rupee, and GDP was going in the right direction. Yet he could not escape criticism.

There was really no end to the tug of war between him and the government over interest rate cuts. The government continually pushed for greater cuts, while Rajan refused until inflation fell within the targeted range. But even when inflation was within the targeted range, Rajan did not cut the rates as much as the government would have liked, citing risks in the global economy, rising crude oil prices and uncertain monsoons.

Rajan was also quite vocal about issues that did not directly come under his purview. That did not sit well with the government, which needed to tread carefully due to Rajan’s positive image amongst industry, the media and general public.

Return to Academia

Subramanian Swamy, a Harvard University PhD in economics and member of the Upper House of the Parliament of India, stepped up as the central banker’s vocal public critic. He was allowed to rant against Rajan for a long time before Prime Minister Narendra Modi made his unhappiness over the entire issue known, subtly, in a television interview. By then, Rajan had already issued a statement saying that he would not be seeking another term and would return to Chicago’s Booth School of Business, from which he was on leave.

There was outrage. There were letters of support for Rajan, speculations about who would succeed him and how he or she would measure up to Rajan in stature, independence and ability to complete policy and regulatory changes in progress.

Modi’s choice of Urjit Patel was seen as a safe one. Patel has a doctorate in economics from Yale University, along with degrees from the University of Oxford and London School of Economics. He has done stints at the International Monetary Fund, World Bank, Brookings Institution, Reliance Industries and Boston Consulting Group, and has been associated with various central and state government task forces and committees.

Patel is known to be the architect of the current monetary policy framework of RBI, which focuses on inflation targeting. He is quieter and lower-profile than Rajan. The consensus is that continuity in policies will be maintained and that the government did well in appointing an “insider” to succeed Rajan.

Share Pledges and Market Reactions

This article was first published by the Global Association for Risk Professionals on August 03, 2016; Co-authors: Ramana Sonti and Ramabhadran S. Thirumalai

http://www.garp.org/#!/risk-intelligence/detail/a1Z40000003CLgtEAG/share-pledges-and-market-reactions

How and why prices can move when company founders and insiders pledge shares as collateral

Pledging of shares as loan collateral by company founders, insiders and majority shareholders is legal in a number of countries, including the U.S. and the U.K., although disclosure norms vary from country to country. The U.S., U.K., Australia, and Hong Kong, among others, mandate disclosure of share pledges. Pledging of shares by founder-promoters is very popular in India, where disclosure became mandatory from January 28, 2009.

Background

On January 7, 2009, Mr. B. Ramalinga Raju, the founder-promoter of Satyam Computer Services, a company listed on the Indian bourses as well as the New York Stock Exchange, disclosed to the company’s board that he had raised Rs. 12.30 billion (then equivalent to around $253 million) by pledging Satyam shares to various institutions and had used the money for personal purposes. Satyam’s share price on the Indian bourses dropped by 87% over the subsequent two trading days, and they lost 94% of their value on the NYSE on January 7.

In the aftermath of this revelation, the Securities and Exchange Board of India (SEBI), the Indian regulatory equivalent to the U.S. Securities and Exchange Commission (SEC), appended Regulation 8A to the existing Substantial Acquisition of Shares and Takeovers (SAST) Regulations of 1997. The new regulation mandated disclosure of share pledges to the stock exchanges within seven days, which then had to make this information public within a further seven days. This sequence of events led to the popular perception that share pledges on average conveyed negative information about firm value and prospects.

The What and How of Pledging

In the Indian context, share pledges are collateral for secured fixed-maturity personal loans, with the company's shares acting as collateral. The typical tenor of the loan is between three months and two years. The interest rate is two to three percentage points higher than that of corporate loans.

At the lender's discretion, the loan may be rolled over. The borrower could be the company's founder, a member of the board, an executive, majority shareholder, employee, or even a small shareholder. However, disclosure of share pledges is mandatory only for certain shareholders, which vary by country. In the U.S., U.K., and Australia, mandatory disclosure applies to all directors. In Hong Kong, it applies only to the controlling shareholder. In India, it applies only to the promoters.

Under SEBI regulations, at the time of initial public offering (IPO), companies are mandated to identify a promoter or promoter group, or even another company as a promoter. While SEBI regulations do not formally define who or what is a promoter, it is usually the founder of the company. Promoters are not required to have a majority stake in the company.

Bank Limits

As per banking regulations in India, commercial banks may not provide loans against share pledges. Only non-banking financial companies (NBFCs) are allowed to do so. While NBFCs perform functions similar to those of banks, they cannot accept demand deposits. They are not part of the payment and settlement system and hence cannot issue checks drawn on themselves. Their deposits are not covered by India's Deposit Insurance and Credit Guarantee Corporation Act.

The annual value of the share pledge market in India is estimated to be around Rs. 2 trillion (about $30 billion) as of December 31, 2015, as per the data compiled by Prime Database. The NBFCs usually get shares worth two times the borrowed amount. Borrowers receive a margin call if the value of shares drops to between 1.25 to 1.50 times the borrowed amount. The exact multiple depends on the NBFC’s “comfort level” with the promoter.

It must be noted that in addition to the collateral of pledged shares, the loan to the promoter may also be secured by personal guarantees, pledge of other assets, etc. However, the authors’ discussions with NBFCs reveal that they consider the pledged shares as the primary collateral for the loan, especially since enforcing recourse through personal guarantees and other assets almost surely involves going through the notoriously tardy and overburdened legal process in India.

If the borrower does not respond to the margin call, and the share price continues to decrease, the lender invokes the pledge and becomes the owner of the shares and may recover the borrowed amount by selling the shares on the exchange. If the borrower repays the entire principal and all accrued interest by the loan's maturity date, the pledge is said to be revoked and the borrower continues to own the shares.

Reasons for Pledging

The commonly cited reasons for pledging the shares by promoters are:

1.       To increase personal stake in the company through open market purchases.

2.       To fund other group companies.

3.       To meet the company’s short-term working capital requirements.

4.       To provide a long-term loan to the company.

5.       To finance takeovers by group companies.

6.       To cover personal expenses.

Positive or Negative Signaling

The end use of capital borrowed through share pledges became a hot-button issue in the aftermath of the Satyam transaction. Though practitioners and the popular press note that markets react negatively to share pledge announcements, there is no systematic empirical evidence on the issue. Markets could react either positively or negatively to share pledge announcements.

If the promoter uses the funds to increase her stake in the company, an outside shareholder may view this as a sign of the promoter’s confidence in the future performance of the company, resulting in a positive impact on share prices. A lender’s acceptance of the shares as loan collateral also sends a positive signal to the market.

Another positive interpretation of a share pledge is that the company has a positive net present value (NPV) project on hand, and hence the promoter is willing to pledge shares to raise capital for the project.

In contrast to the above, there are a number of reasons for interpreting a share pledge as a negative signal about the company’s current and future prospects. In falling markets, the lender may be forced to invoke the pledge. To recover the loan, the lender may turn around and sell the shares in the market, putting additional downward pressure on stock prices. This could result in huge losses to existing shareholders. If the market believes that this is the likely outcome of a share pledge, markets will react negatively at the time of share pledges.

Further, when the pledge is invoked, the promoters stand to lose control of the company. This may be detrimental to the future prospects of the company, especially if the promoter has some specialized skill or knowledge that is not easily transferable or replicated.

Another interpretation could be that the company is in a dire cash flow situation, and the promoter is bailing it out by borrowing at a higher interest rate. The market may also interpret the share pledge as the promoter having private information of a large negative signal. The promoter may prefer not to sell her shares for liquidity and price impact reasons. Share pledges are an alternate way of encashing her shareholdings before the bad private information becomes public. In this case, the promoter could be perceived to be pledging shares with no intention of repaying the loan.

Empirical Evidence

Since a share pledge can be interpreted in either way, the authors analyzed a sample of 2,567 share pledge announcements in India, with data collected from the National Stock Exchange of India (NSE) website. All these pledges were after the SEBI disclosure rule of January 2009.

Standard event study methodology with a market model, using the S&P CNX 500 Index as a proxy for the market, is used, along with an estimation window of 220 trading days. We find that the average cumulative abnormal return (CAR) on the date of a share pledge ranges between -0.53% [-1 to +1; 3 day window] and -2.35% [-10 to +10; 21 day window], depending on the width of the event window around the day the promoter pledges shares.

There is a much smaller reaction, between -0.05% and -0.58%, around the day the company reports the share pledge to the exchange. Our conversations with practitioners revealed that there is no restriction on the promoters, the NBFC or any other market participant regarding communication of information about the pledge between the date of pledge and the date of announcement of the pledge by the stock exchange. Our results support this as the market reaction is much larger around the share pledge date than on the announcement date. There is most likely immediate leakage of information, and hence the market reaction is larger around the pledge date rather than announcement date.

Interestingly, though the average CAR is negative, only 56% of all CARs in our sample are negative. Contrary to the popular view, only a small majority of share pledges convey bad news.

Revoking Pledges

The authors also examine market reaction around the revoking of share pledges, that is, when promoters repay the loan and recover their pledged shares from the lender. Regulation 8A of SAST Regulations 1997 mandates the disclosure of the revoking of share pledges, much like with share pledges.

Regardless of the reason for a share pledge, revoking it would demonstrate the promoter’s ability to repay the loan. If the reason for the pledge was personal use, its revoking would signal to the market that the promoter had borrowed money for legitimate personal reasons and has promptly repaid the loan. If the reason was a short- or long-term loan to the company or a working capital requirement, revoking of the pledge would signal the company’s ability to repay promptly, and hence its good financial health.

Thus, revoking of a pledge should send a positive signal about the promoter and the company to the market. From study of a sample of 2,171 pledge revocations from the NSE website, it was found that markets do not react significantly on the day the pledge is revoked. This is puzzling, given the expectation that the market will react positively.

Conclusion

Pledging of shares acts as an important signal to the market. Pledging may be an easy way to raise money quickly, especially when capital market conditions are tight. More and more promoters in India are resorting to share pledges in recent years. The reason behind the pledging of shares must be investigated before investing in companies where the promoters have pledged a significant percentage of their holdings.

Algorithmic Trading: Balancing Pros and Cons

This article was first published by the Global Association for Risk Professionals on June 19, 2016

https://www.garp.org/#!/risk-intelligence/detail/a1Z400000035AAdEAM/algorithmic-trading-balancing-pros-cons

Six years since allowing algo trading, India wrestles with questions familiar across financial markets  

Since first being allowed in 2008, algorithmic trading has grown to account for 40% to 50% of the turnover on the National Stock Exchange (NSE) of India.

Widely regarded as a disruptive technology, and creator of advantages for some that harness it, algo trading was defined by the Securities Exchange Board of India (SEBI) as “any order that is generated using automated execution logic.”

The late Gangadhar Darbha, who was executive director and head of algorithmic trading strategies at Nomura Securities, said, “Algorithmic trade per se is nothing but a reflection of what happens in our brains. Algo trading is the use of electronic platforms for entering trading orders with an algorithm which executes pre-programmed trading instructions whose variables may include timing, price, or quantity of the order, or in many cases initiating the order without human intervention.”

Institutional investors, insurance companies and mutual funds use algorithmic techniques for portfolio rebalancing and risk control amid large order flows on either side. Anonymity and mathematical logic to break large orders into small pieces can counter adverse price moves and manipulation.

Financial firms apply the cutting-edge technology to product development and innovation in such areas as liquidity-seeking, cross-asset and multiple-exchange trading.

While it is difficult to know the strategy or logic being applied by looking at the trade data, it seems unlikely that the algorithms act on fundamental information about companies or the economy. Algo trading takes into account quantitative information regarding trends, reversion to mean, arbitrage, etc.

It is argued that computer-assisted trading improves liquidity in the markets by breaking down large trades into smaller trades, reduces bid-ask spread and lowers risks of adverse selection and trade related price discovery. Terrence Hendershott, Charles M. Jones and Albert J. Menkveld, in “Does Algorithmic Trading Improve Liquidity?” (Journal of Finance, Vol. LXVI, No. 1, February 2011), argue that algo traders are more likely to be providers of liquidity. They also increase the speed and efficiency of trades and reduce costs of trading.

Flash Crashes

There are also purported disadvantages.

There have been many instances of flash crashes on exchanges around the world, in which automated trading has been implicated, whether due to erroneous coding, a systems failure or cascading effects of certain trades. Algo is also often blamed for causing large fluctuations or volatility in the markets.

On October 5, 2012, the CNX Nifty Index of top 50 companies traded on India’s NSE fell nearly 16% within seconds (before rebounding), causing panic amid traders and institutional players, as stop losses were triggered. Similarly, the Bombay Stock Exchange (BSE) had to annul all trades on “muhurat day” in 2011 due to extraordinary volumes. (Muhurat day is a special trading session on Indian bourses to mark to beginning of the new financial year on the Hindu calendar. It coincides with the popular festival of Diwali.)

Algo trading’s effect of improving liquidity has been scrutinized. It is alleged that algo trades focus on a few large stocks, resulting in short-term liquidity improvement only for those stocks. If this also means that trading gets concentrated in fewer stocks, then this is not good for an exchange. And if algo trading magnifies panic, it can have an avalanche effect on prices.

Technology is reducing the cost of trading and attracting large volumes. But that requires exchanges to improve the efficiency and capacity of their data servers, matching engines and bandwidth, which in turn increases infrastructure cost and has to be added back to the brokers transaction cost.

Haves and Have Nots?

Does algorithmic trading "discriminate between rich and influential brokers and common investors/retail investors and create inequality” among constituencies on the BSE and NSE, as has been alleged by the Intermediaries and Investor Welfare Association? Algo traders have a technological advantage over the regular market participants, who are not able to afford such high fixed costs.

The Technical Advisory Committee of the SEBI, it was reported in April, noted that a certain broker benefited from loopholes in the systems architecture of NSE, which were not prevented by the exchange. Larger questions regarding the role of the regulator in coming out with policies on co-location and algorithmic trading are being raised as well. The surveillance systems of the exchanges and regulatory actions against manipulative activities have not kept pace with the improvements in technology and the complexity of algorithms.

Interestingly, rampant accusations that flash orders favor insiders led some lawmakers in the U.S. to urge in 2009 that the practice be banned by the Securities and Exchange Commission. It remains legal. The Indian counterpart, the SEBI, has set an agenda for itself to come out with a discussion paper on high-frequency trading, or algo trading, in the coming three months, which could lead to regulations of those activities.

Perhaps the right way to look at it is as Darbha once said in an interview: “Algorithmic trading is not just a facility, but an aid. While algorithmic trading gives you freedom to trade, it does not replace fundamental research. It only enhances trading efficiency.”

The Indian Economy under Rajan

This article was first published by the Global Association for Risk Professionals on June 09, 2016; was updated on June 20, 2016; Co-author: Anisha Sircar, Flame University, Pune

http://www.garp.org/#!/risk-intelligence/detail/a1Z400000034vGa

Results of the central banker’s first term made a strong case for reappointment to a second

Subramanian Swamy, a Harvard University PhD in economics and a member of the Upper House of the Parliament of India, recently wrote a letter to Prime Minister Narendra Modi. It criticized Dr. Raghuram Rajan, the 23rd governor of the Reserve Bank of India, on many different counts, and urged immediate termination of Rajan’s services, on grounds that the central banker, whose three-year term expires in September, is deliberately trying to “wreck the economy.”

After saying he was open to serving a second term and leaving the decision to the Modi government, Rajan issued a statement June 18 saying he will step down.

Rajan has been generally recognized as one of the most influential and proficient governors of the RBI. He was previously chief economist at the International Monetary Fund, chief economic adviser of India’s Ministry of Finance, and the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Booth School of Business. He is credited with predicting, early in 2005, the global financial crisis that hit in 2008. He was regarded as someone with international exposure who could anticipate problems and find distinct solutions.

When Rajan assumed office at the RBI in 2013, the economic climate was characterized by a free-falling rupee, touching nearly 70 against the U.S. dollar, alongside rising deficits, high inflation and overall sluggish growth.

Early on, Rajan announced his “Five Pillars of Reform,” inspired by the three “arrows” of the Japanese Prime Minister, Shinzo Abe. The pillars were an effective monetary policy framework that was transparent, credible, clear, and that could be “understood by the broader public”; banking sector reforms to give anybody the liberty to apply and set up a bank at any time; deepening the Indian markets; providing financial services to rural areas; and the creation of a “simpler, cleaner and less value-reducing” mechanism to address financial distress so that lending was rendered easier, faster and more efficient.

Besides delivering on the promises made at the start of his term, Rajan, along with other key decision makers and other factors, helped in ensuring that India has been the emerging-markets nation to withstand a general economic downturn. Other BRICS countries were considerably weakened in the aftermath of the Chinese slowdown.

Furthermore, facing anticipated Federal Reserve tightening, the rupee remained relatively strong. Last year, when the rupee plummeted to a two-year low, passing the 66/$ mark, and Sensex tumbled after the yuan shock, Rajan assured the world that India was in a far better position to weather the volatility.

Downward Inflation

Monetary policy under Rajan has been regarded as far more clear and systematic than its antecedents. According to the new framework, the challenge was to achieve an inflation target of 6% by 2016 and 4% by 2017; that is on target, with inflation now around 5.4%.

Declining inflation has made India a favorable investment destination and paved the way for continual interest rate cuts. However, containing inflation through interest rates has not gone down well with critics such as Swamy, who has called it “disastrous” to the industry, causing unemployment.

In his May 16 letter to Modi, Swamy voiced objections to the shifting of the inflation target from the wholesale price index (WPI) to consumer price Index (CPI). That the move was recommended by an Expert Committee set up to “Revise and Strengthen the Monetary Policy Framework,” and that the committee was comprised of eminent economists and statisticians from such institutions as the Indian Statistical Institute (New Delhi), Williams College (USA), JPMorgan, Bank of Baroda and Nomura Securities, apart from being represented by the RBI, does not seem to matter to Dr. Swamy.

As explained in the committee report, “CPI inflation excluding food and fuel has remained sticky at an elevated level, averaging above 8% and playing a growing role in determining wage and price behavior in India.”

The report also stated: “Shocks to WPI inflation have no statistically significant impact on inflation expectations, indicating that targeting the WPI would do little to anchor inflation expectations”.

It is also contended that private-sector corporate investing has flatlined after peaking in 2011, that the stressed assets may lead to a decline in investment, and that this is a bottleneck that needs to be dealt with by the RBI. “In the last two years,” Swamy wrote, estimated NPA [non-performing assets] in public-sector banks has doubled.”

Bank Provisions

It needs to be acknowledged that the NPAs have accumulated over several years. But, at least under Rajan, the banks have started to recognize these stressed assets and begun provisioning for them. The first step towards solving a problem is to recognize that there is a problem – and that step seems to have been taken.

It is also argued that despite the success so far with inflation, and interest rates coming down, real borrowing costs remain high. And although it has remained relatively resilient, it is not on a strengthening trajectory, which is a cause for worry as it may engender higher inflation in months to come. The cost of borrowing/lending is determined by the banks, and Rajan has been appealing to the banks to pass on the decrease in interest rates to the customers.

Equity strategist Christopher Wood of CLSA, in one of his “Greed & fear” reports, argued that the biggest risk to India’s bond and currency markets would be to let Rajan’s term expire.

Doyens of Indian industry have come out in support of Rajan, urging a second term at the RBI. These are the same industrialists who have kept up pressure on Rajan to reduce interest rates further. So why would they be so supportive of him? The answer is simple. Rajan has “performed.”

Rajan said on CNBC Awaaz as reported June 8, “The announcement over my tenure will be made between now and September 4 when my term ends.” He acknowledged that his “long-term plan is to get back into academics, to teach and to go for research.

Rajan has now ended the suspense, stating the following in an open letter to RBI colleagues that, in large part, defended his record: “While I was open to seeing these developments through, on due reflection, and after consultation with the government, I want to share with you that I will be returning to academia when my term as governor ends on September 4, 2016. I will, of course, always be available to serve my country when needed.”

The role of TPAs in the Health Insurance Eco System

This interview was first published in IIB Bulletin, Vol. 2, Iss. 4, 2016, pp.11-12

https://iib.gov.in/IIB/Articles/IIB%20Bulletin%20IIRFA2016.pdf

Malti Jaswal, has close to 30 years of experience in the General Insurance industry in India in different capacities; marketing, operations, claims management etc. She has worked with both public sector and multinational insurers. Since 2008, she is working in health insurance field and is an active member of multi‐stakeholder working groups on health insurance in India. She is a regular speaker at health insurance forums and she has published papers relating to Universal Health Care, Third Party Administrators (TPAs) best practices, claims management, and fraud control.  

 

She has also been a member of sub-committees of Ministry of Health on Categorisation of Hospitals and Costing of Care. As a Consultant, she worked on varied projects relating to health insurance training and education, Information Technology (IT), payer-provider exchange platforms, cost control, and fraud control.

 

She has developed a Certification Course on Health insurance for Insurance Institute of India. She is currently working as the Chief Operating Officer of the Health Insurance TPA of India Ltd (HI TPA), a joint venture of the four public sector general insurance companies in India, namely, National Insurance Company Ltd., New India Assurance Company Ltd., Oriental Insurance Company Ltd. and United India Insurance Company Ltd, along with GIC of India.

 

In a conversation with Dr. Nupur Pavan Bang of the Indian School of Business, Hyderabad, Jaswal talks about the need for HITPA, the important role played by TPAs and fraud in Health Insurance claims.

You have worked extensively in the field of Health Insurance. Can you tell us about the role of TPAs in the Health Insurance Industry in India?

The concept of TPAs came to India around the years 2001-2002. That was the time the Insurance sector was opened up to the private players. The private players, when they started, didn't have in- house capability of running 24*7 claims support functions and wished to focus on core areas to build business. Public sector companies also did not have such capabilities though Mediclaim (generic term for health insurance product of PSUs) is being sold since 1986. Thus outsourcing seemed a natural choice. This gave birth to the concept of TPA in India. The TPAs were licensed by the Insurance Regulatory and Development Authority of India (IRDAI) to ensure that certain minimum requirements were met to set up a TPA. 

There are 30 licensed TPAs in India. So what is the purpose of setting up another TPA- Health Insurance TPA of India (HI TPA), promoted by four public sector general insurance companies?

The growth of business in health insurance has been exponential in India in the last decade with a year-on-year growth of 25%-30%.  To handle the growing business, robust processes, latest systems and technology and trained people are needed. However, the required investment did not happen across the spectrum of TPAs and the TPA industry remains under capitalized even today.   

Most of the large private sector insurance companies, including standalone health insurers, gradually started setting up in-house TPA/claims management facilities to have better control and do not use TPAs in big way anymore. Public sector insurance companies however continue to use the TPAs because of certain peculiarities of 24*7 operations. The terms and conditions of employment contracts of public sector general insurance companies are not generally geared for engaging manpower for round the clock services nor is rest of infrastructure.  In my view perhaps, it is also realized that the demanding nature of 24*7 TPA services required by customers, could be delivered more efficiently and effectively through a non-public sector entity.

Thus it seems to be a considered decision for the four public sector companies to come together, pool capital and create such an entity. This way, adequate capital investment could be made in HI TPA from an IT perspective because robust IT infrastructure and trained manpower are the key requirements for the TPAs to handle complexities of current health insurance products and high volumes. The four companies already enjoy the benefit of scale when bargaining with the hospitals together under Preferred Provider Network (PPN) arrangements.

Would HITPA also provide services to private insurance companies? And would the PSU companies use only HI TPA’s services in the future?

As of now the TPA license given by IRDAI to HI TPA is only for the four public sector companies. We have represented to IRDAI to make the license open to service business of private insurers.

There is absolutely no doubt that PSU companies will continue to use multiple TPAs. There is no intention of moving business completely to HI TPA as voluminous business is being serviced by various TPAs and retaining competition in essential to ensure that all parties deliver value to the customer.  At the same time if there is an entity with adequate capital, trained and skilled resources, robust processes and IT infrastructure, which can in a way, set the benchmarks for the entire TPA industry in India; it will surely bring better practices and impact the market in a positive way.  HI TPA aims to be that entity.  

You mentioned that the concept of TPAs came to India around 2001-2002. Prior to that, the public sector companies were managing the claims in-house. Since many of the private companies are now setting up in-house TPAs and claims processing teams, why can’t even the public sector companies continue the earlier practise of settling the claims in-house?

Claims management is an integral part of any insurance operation world over.  Since inception public sector insurance companies have had high quality technical manpower to do so for all lines of their business. The companies were also managing health insurance claims in-house prior to 2002.

In 1986, retail Mediclaim was launched for the first time in India by the public sector companies. The practice from 1986 to 2000 was that the customer would pay the hospital from her pocket and get the expenses reimbursed later from the insurance company which could take many days/weeks. With the entry of private sector companies in joint venture with large and experienced international insurers, cashless facility was introduced, as one of most customer friendly service.

For cashless facility to work, TPAs were inducted to organize and facilitate the same 24*7*365. TPAs facilitate networking with the hospitals on one hand and cashless/claims processing for the customers on the other.   

So the TPAs only process cashless claims?

A claim is a claim whether on cashless basis or on reimbursement basis.  Cashless is a customer friendly process wherein customer need not pay for treatment and then file claim later.  However customer has every right to seek treatment in any non-network hospital (so long as it meets the criteria) and file for reimbursement claim.  A claim is admissible and payable depending on terms and conditions of the policy, on what risks are covered, to what extent etc. The TPAs process both types of claims, however traditionally (and even today), role of TPA is primarily considered to facilitate cashless and all other services around the same e.g. 24*7 call center, issuance of member id cards, hospital network etc.   

Does the TPA pay the claims?

As per IRDAI guidelines, claims are required to be paid and repudiated by insurers directly to customer/provider.  TPA’s role is to process the claims as per guidelines of the specific insurance company and subject to terms and conditions of the policy.   The TPAs do not carry the risk, nor are involved in selling or underwriting. 

Some accounts put Health Insurance frauds to the tune of 15% of all health insurance claims in India. That is huge and puts a lot of burden on the customers in the form of increased policy premiums. Would HI TPA be instrumental, to some extent, in controlling fraud in health insurance?

As the health insurance industry has grown in India, so has the number of fraud cases and also modus operandi of fraudsters is getting sophisticated.  High growth tends to loosen controls and here in India we do not have Health Regulator. HI TPA aims to fulfil the twin objectives of its creation - enhancing customer experience and bringing in greater efficiency in Health Insurance claims processing.  Efficiency in claims processing would also incorporate better handle on controlling and managing fraud.

Can you elaborate on the ways in which fraud may be controlled?

The main job of TPA is claims processing and managing the hospitals network. TPAs handle the claims process right from the point of intimation to the settlement of the claim. TPAs have good IT systems. Policy data is integrated with their systems. Policyholder and members’ (people covered in the policy in the case of family and group policies) profiles are available with the TPAs as also the details about network hospital. All this information, coupled with the knowledge about medical practices and hospital tariff should make it easy to detect any outlier behaviour or pattern.

For example, let’s say a customer reports a non-emergency claim 1000 kilometres away from home.  It should ring a bell. If it's a non-emergency claim, why would a patient go to a hospital which is so far away from home unless it’s a specialty treatment like cancer.  Another example, if there is a very large reimbursement claim of say Rs400,000 or more, it should raise an alert. Why a customer would chose to pay such a large sum out-of-pocket and not avail the cashless facility made available in so many good tertiary care hospitals in normal circumstances.

During the entire chain of events, from intimation to payment, there are at least 5 or 6 trigger points, which a smart system and skilled manpower should be able to detect. Next step is data analytics in retrospect. Sometimes small value claims can slip through. But if analysed appropriately, those leakages would also become apparent over a period of time and amenable to control.

In India, there is no proper definition of what is a financial/insurance fraud. In the absence of a clear definition, even if a fraud is detected, the companies may choose to not pursue it if the amount is small. Even when a company decides to take legal recourse, the battle is often very long drawn and not worth the effort. As an industry, are there any steps being taken to tackle this lacunae?

It's indeed a big lacunae – there is no definition of insurance fraud under Indian laws nor provisos to deal with the same. There are three angles to fraud management; one is detection, second is recovery, and third is prevention/deterrence and punitive action.  Right now the insurance industry in India is primarily focused on detection and to some extent on recovery.  Not losing the money is the first and foremost priority. Unfortunately, prevention through punitive deterrent action is missing because our legal system and penal codes have not yet caught up with the changes in the financial and insurance domain. The Insurance Act of 1938, in spite of the recent amendments to it, doesn’t carry any active provisions to handle fraud. Punitive action is necessary for effective deterrence.

There have been industry level discussions at the Federation of Indian Chamber of Commerce and Industries and the Confederation of Indian Industries about what can be done to tackle fraud in the absence of legal provisions and health regulator. There have been suggestions to involve the Indian Medical Council to prevent doctors from conniving with the customers and hospitals to exaggerate claims or be a party to the fraud in any way. A few companies have started issuing letters to hospitals and doctors to seek explanation when a certain course of treatment seems unreasonable.   ‘Name & shame’ guidelines have been discussed.  

IRDAI has taken cognizance of growing menace and ways to control the same. IIB is also now directing lot of action to health data collection and analysis, hospital registry has been set up for the first time. Though a small step, data sharing of fraudulent customers and fraudulent hospitals has now started. Hopefully in times to come, we shall see more action on this front.  

Beyond the Profit Motive - The Example of Tata

This article was first published on www.famcap.com, an online Family Capital Magazine, on May 13, 2016

http://www.famcap.com/articles/2016/5/13/viewpoint-beyond-the-profit-motive-the-example-of-tata

No company evokes Indian business better than TATA. The legendary family business founded by Jamsetji Tata in 1868, TATA has established a domestic and international reputation that is arguably greater than any other Indian business.

When it comes to the numbers, TATA is truly impressive. The TATA Group is the holding company of 29 companies listed on the Bombay Stock Exchange. It accounts for 8 percent of the market capitalization of the Bombay Stock Exchange. TATA has made its mark in every major industry in India - steel, power, automobile, aviation, information technology, telecommunications, financial services, consumer goods, education, healthcare, and more.

But perhaps its role in the building of India and placing the importance of community before the profit motive are factors that have contributed most to its success - certainly from the point of view of many of its stakeholders. The journey of development of India can be traced through the house of TATA and the businesses that they ventured into. And during that journey profitability was not the only thing on the company’s mind. Indeed, nation building was just as important, if not more so.

For example, when the family built TATA Steel in Sakchi, now Jamshedpur, TATA also established an entire city around it. When the Taj Mahal Hotel was built in Mumbai, it was “to attract people to India”. When Tata Hydro Electric Power Supply Company was established, it was with the hope that Bombay would become a “Smokeless City”. And today the mission of the TATA Group continues to be: “To improve the quality of life of the communities we serve globally, through long-term stakeholder value creation based on Leadership with Trust”.

The early founders of the company - Jamsetji Tata, Sir Dorabji Tata and Jehangir Ratanji Dadabhoy Tata - worked to uplift the country and to improve the quality of life of the people around them. This was so central to their decision making that many times they put the importance of the community before their own wealth. In fact, profits were always secondary to Jamsetji Tata, and this tradition has been followed by his successors. But because they pursued excellence in whatever they did profits followed.

Sometimes in the world where instant gratification is so dominant in most societies there is a need to go back to the life and times of people like Jamsetji Tata and the other earlier pioneers of TATA to understand and appreciate their values just a little bit more.  

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.