Money Manager 4.0

8/3/2019 Money Manager 4.0

1/46

THEOCTOBE

MONEY MANAGEAn IIMA, IIMB, IIMC Ini

Publication sponsored by UTI Mutual Fund

Can Dalal Street be

the next Wall Street?

Can Dalal Street be

the next Wall Street?

Also inside

Special Feature on financial crisis

Dr. K. P. Krishnan on Unfinished Agenda in

Indian Financial Markets

Also inside

Special Feature on financial crisis

Dr. K. P. Krishnan on Unfinished Agenda in

Indian Financial Markets

For feedback/querries contact Manu Jain (9916950146), Neha (9916950101)

BETA, the Finance Club of IIMA

BETA is the most prestigious club of IIM Ahmedabad has been

an integral part of IIMA culture since decades.

Beta aims to generate and promote interest in finance among

IIMA students. However its activities are not limited to IIMA

alone. It has organized several national level case contests,

trading games and workshops in the past. It has also been

associated with distinguished people from academia and

industry. Some of Beta's regular activities are organizing

placement oriented sessions, internship experience talks,

interesting contests and informal discussions on current

issues.

NetWorth, the Finance Club of IIMB

With the growing importance of finance and the plethora of

activities that financial institutions have become a part of,

knowing about 'Finance' becomes not only important but also

imperative. Networth's activities are used to bring out thevery best and disseminate the gyaan the movers and shakers

in this field have to offer. So be it a Private Equity talk, a

session to know if you have the skill sets for an I-banking job

or an analysis of mergers and acquisitions from experts - we

have it all. If you love finance and are an avid follower then

this club is the place to be.

Finance and Investments Club of IIMC

popularly known as the Finclub is a student driven initiative

that collaborates with both the corporate and academia from

the financial sector to provide a platform for students to

improve their quantitative and analytical abilities. The

collective effort is towards gaining a comprehensive picture of

the world of finance.

The club organizes industry talks, workshops, stock trading

and other finance based simulated events. It plays an activerole during summers and final placements to help students in

their preparation

BETA, the Finance Club of IIMA

BETA is the most prestigious club of IIM Ahmedabad has been

an integral part of IIMA culture since decades.

Beta aims to generate and promote interest in finance among

IIMA students. However its activities are not limited to IIMA

alone. It has organized several national level case contests,

trading games and workshops in the past. It has also been

associated with distinguished people from academia and

industry. Some of Beta's regular activities are organizing

placement oriented sessions, internship experience talks,

interesting contests and informal discussions on current

issues.

NetWorth, the Finance Club of IIMB

With the growing importance of finance and the plethora of

activities that financial institutions have become a part of,

knowing about 'Finance' becomes not only important but also

imperative. Networth's activities are used to bring out thevery best and disseminate the gyaan the movers and shakers

in this field have to offer. So be it a Private Equity talk, a

session to know if you have the skill sets for an I-banking job

or an analysis of mergers and acquisitions from experts - we

have it all. If you love finance and are an avid follower then

this club is the place to be.

Finance and Investments Club of IIMC

popularly known as the Finclub is a student driven initiative

that collaborates with both the corporate and academia from

the financial sector to provide a platform for students to

improve their quantitative and analytical abilities. The

collective effort is towards gaining a comprehensive picture of

the world of finance.

The club organizes industry talks, workshops, stock trading

and other finance based simulated events. It plays an activerole during summers and final placements to help students in

their preparation


2/46

EDITORSNOTE THE MON

Editor's NoteAs I type this note, the Indian Capital Markets is witnessing the turmoil's

of the Global Financial Crisis with SENSEX falling off the tenth floor.

Some say that now they can see the bottom, while others argue that thisis a Grand Canyon. We are beyond doubt in midst of a crisis the depth of

which is still unknown. In this context it will be apt to quote Napolean

Hill: "Every adversity, every failure, every heartache carries with it the

seed of an equal or greater benefit." It is an established fact that the

genesis of crisis is not in the Indian economy itself, which is by all

means fundamentally sound - or would be with a proper regulations to

oil the wheels of production. This adversity in fact provides us great

opportunities since our economic growth is primarily driven through

domestic savings of which 28% constitutes household savings, FDI and

FII put together is merely 8% of our gross savings in any one of the past

several years. The focus of the world is now towards the Asian

economies and India & China are going to be the next epicenters of

economic activity. However at present, though the license-permit raj has

been dismantled in the real economy, it is still flourishing in finance.

The financial muscle of the lower half of Manhattan and London's

business engine have been most important driver's of economies of US

and UK. No wonder that cities like Shanghai, Dubai and Singapore arebusy trying to turn themselves into the hubs of their respective regions.

The recently published MIFC report is a call to arms to replicate this

success story in India through turning Mumbai into an international

financial center, by laying down a blueprint for how India must globalize.

We have tried to bring an Indian flavor in this edition of Money Manager.

While the Cover Story and the article by Dr. K. P. Krishnan (Joint

Secretary, Ministry of Finance) talk about the potential of Mumbai in

becoming a global financial hub; we have also received a whole range of

articles on Indian economy, ranging from Reforms in Indian Pension

Funds, Financial instruments to tackle inflation, Sustainability Index for

BSE to Bid Ask Spread in Indian markets and Indian VIX. We have the

regular stuff like the Book Review on Black Swan, note on few

nontraditional financial products, puzzles, trivia and a lot more. Starting

this issue we also plan to bring out a Special Feature on the latest

developments in the financial markets. This issue's special feature

focuses on The Global Financial Crisis.

We hope you like this edition. Feel free to send your feedback to us at

[email protected] or [email protected]. Happy reading!

Neha Verma (IIMB)

Editor in Chief

As I type this note, the Indian Capital Markets is witnessing the turmoil's

of the Global Financial Crisis with SENSEX falling off the tenth floor.

Some say that now they can see the bottom, while others argue that thisis a Grand Canyon. We are beyond doubt in midst of a crisis the depth of

which is still unknown. In this context it will be apt to quote Napolean

Hill: "Every adversity, every failure, every heartache carries with it the

seed of an equal or greater benefit." It is an established fact that the

genesis of crisis is not in the Indian economy itself, which is by all

means fundamentally sound - or would be with a proper regulations to

oil the wheels of production. This adversity in fact provides us great

opportunities since our economic growth is primarily driven through

domestic savings of which 28% constitutes household savings, FDI and

FII put together is merely 8% of our gross savings in any one of the past

several years. The focus of the world is now towards the Asian

economies and India & China are going to be the next epicenters of

economic activity. However at present, though the license-permit raj has

been dismantled in the real economy, it is still flourishing in finance.

The financial muscle of the lower half of Manhattan and London's

business engine have been most important driver's of economies of US

and UK. No wonder that cities like Shanghai, Dubai and Singapore arebusy trying to turn themselves into the hubs of their respective regions.

The recently published MIFC report is a call to arms to replicate this

success story in India through turning Mumbai into an international

financial center, by laying down a blueprint for how India must globalize.

We have tried to bring an Indian flavor in this edition of Money Manager.

While the Cover Story and the article by Dr. K. P. Krishnan (Joint

Secretary, Ministry of Finance) talk about the potential of Mumbai in

becoming a global financial hub; we have also received a whole range of

articles on Indian economy, ranging from Reforms in Indian Pension

Funds, Financial instruments to tackle inflation, Sustainability Index for

BSE to Bid Ask Spread in Indian markets and Indian VIX. We have the

regular stuff like the Book Review on Black Swan, note on few

nontraditional financial products, puzzles, trivia and a lot more. Starting

this issue we also plan to bring out a Special Feature on the latest

developments in the financial markets. This issue's special feature

focuses on The Global Financial Crisis.

We hope you like this edition. Feel free to send your feedback to us at

[email protected] or [email protected]. Happy reading!

Neha Verma (IIMB)

Editor in Chief

THE

MONEY MANA

Chairman

Manu Jain (IIMB)

Editor - in - Chief

Neha Verma (IIMB)

Editorial Board

Chintan Valia (IIMB)

Shubham Satyarth (IIM

Gaurav Parasrampuria (II

Neha Gupta (IIMB)

Coordinating Committe

Manik Lather (IIMB)

Sharmili Phulgirkar (IIM

Piyush Sonee (IIMA)

Ravi Shankar Saxena (IIM

Rajatdeep Anand (IIMC

Anuja Lele (IIMC)

For any feedback/querries m

[email protected]

[email protected]


3/46

ContentsContents

CONTENTS THE MON

Message from theDean, IIM Bangalore..... 06

Acknowledgements...... 06

Cover StoryCan Dalal Street be the Next Wall

Street?.....07

Special FeatureFinancial Crisis.....16

Book ReviewThe Black Swan: The Impact of the Highly

Improbable....23

Invited Article1. Indian Financial Markets:

The Unfinished Agenda.....24

Did you know.....22

2.Indian Mutual Fund Industry....28

Did you know.....30

Student Articles1.Bid-Ask Spread and its Asymmetric Nature:

A Case of Indian Nifty Futures.....33

2.Pension Funds & Capital Markets -Reforms

& Implications in the Indian Context......38

Puzzle Questions.....37

Did you know.....43

3. An Introduction to Volatility Index (VixAnalysis of India Vix.....44

4. Inflation: The Future is in Futures.....

5. Can BSE Sustain a Sustainability Ind

6. Re-Introducing G-Sec Futures In Ind

Crossword.....63

7. The India Vix - "An Effective Financia

Instrument?".......64

8. Sub-Prime Crisis - Are We Done Now

A $5.2 Trillion Question.....69

9. Understanding the movements in Cr

Prices......73

10. Islamic Financial Products: Road A

India.....77

PrimerAdoption of BASEL II Norms

Are the Indian banks ready?......82

Know this Product1. Target Redemption Notes (TARN).....8

2.Variance Swaps......90

ForewordForeword

THE MONEY MANAGER FOREWORD

44

UTI Mutual Fund is proud to be associated with Money Manager 4.0. We at UTIMutual Fund have always believed that some of the best ideas come up from the

young brains of the country and Money Manager seeks to achieve just that. It is

thus our constant endeavour to associate ourselves with these new minds formore vibrant and, perhaps, more effective ideas. Simultaneously, we believe that

finance being an integral part of any career path that an individual charts out; any

number of steps to popularise and explore this stream cannot exhaust its scope.

For the fulfilment of this objective Money Manager provides a great platform for

management students in the country to share insights with the academia and

industry experts across the globe. What makes UTI Mutual Fund to associate with

Money Manager 4.0 is that, it is not an academic oriented research journal but a

compilation of relevant practical views from different streams of the industry.

Therefore, it can be and is of use to people connected to finance in any which way,

namely the students, faculty, researchers and the industry.

IIM Bangalore is undoubtedly among the top business schools in India and to

interact with students from here has been a two way learning process. Money

Manager 4.0 seeks to capture the views of some of the best minds of the country

on the pulse of the economy. These views are only then corroborated by the

industry experts and prominent academicians writing for Money Manager 4.0.

We are at a significant point in the history of finance. The Indian economy is

burgeoning today - growing leaps and bounds. With strong fundamentals and

improved efficiency, the time is ripe for the markets to move ahead. At this point

in time the inevitable question thus becomes: Is Dalal Street on its way to

becoming the next Wall Street? Does India have it in itself to emerge as the next

power to reckon with in the capital markets? This is what Money Manager 4.0

seeks to find out. It has sought the opinions of all who matter: the who's who in

the industry, those who teach and research on the theories behind each of these

phenomenon and those who actually will be in there in the times to come.

UTI Mutual Fund proudly presents the Bangalore chapter of Money Manager 4.0.

U.K.Sinha

Chairman & Managing Director

UTI AMC Ltd


4/46

THE MONEY MANAGER ACKNOWLEDGEMENTS

6

Acknowledgements

Message from the

Dean, IIM Bangalore

We would like to thank UTI Mutual Fund; sponsors of this issue of Money Manager who not only

supported us with the finances but also advised us on the content part. It would have been

impossible to bring out the issue without t heir support.

Special thanks to Professor Sankarshan Basu and Professor Prakash Apte for their constant

support and encouragement during all the issues of the magazine. We thank Professor Shyamal

Roy and Professor Basu again for taking out their valuable time to select the best student

articles.

We are grateful to Dr. K. P. Krishnan and Mr. A. Balasubramanian for their insightful articles.

While Dr. Krishnan speaks of the unfinished agenda in the Indian Financial Markets, Mr.

BalaSubramanian writes about the success of the Indian Mutual Fund industry.

A special mention to Anshul, Sourav, Amit, Rahul, and Sumeet whose contribution has been

instrumental in bringing out the issue. Lastly we would like to thank all students from IIMA, IIMB,

and IMC for their feedback and all those students who sent us their well researched article for

this edition. These articles are truly the backbone of the magazine.

The past one month has witnessed the worst turmoil in the global financial system. What is its

geographical spread and how long it will last is anybodys guess. One thing is clear. No country is

immune to such turmoil; the difference is only one of degree. The effect of the global meltdown is

being felt across sectors all over the world. Even the elite global business school students are

worried about what this turmoil holds for them in terms of placement opportunities. Against this

background of uncertainty, an effort like Money Manager is a tremendous help in assessing the

magnitude of the problem. The articles written in Money Manager are well-researched and cover

topics that are at the top of the mind of B-school students. With summer placements of most B-

schools round the corner, I find this a very commendable effort on the part of the students of

IIMA, IIMB & IIMC to apprise their peers about the latest developments in the financial world,

help them allay their unknown fears and make an informed decision on the career path that lies

ahead.

My heartiest congratulations to Money Manager. I wish the editorial team the very best in all

future initiatives,

Shyamal RoyDean, IIM Bangalore

COVER STORY

Can Dalal Street be the

Next Wall Street?

COVERSTORY THE MON

Chintan ValiaManu JainNeha Verma

Shubham SatyarthSourav Das(IIM Bangalore)


5/46

Executive Summary

India's financial system holds one o f the keys, if not the key, to the country's future growth trajectory. A growing and increasingly

complex market-oriented economy, and its rising integration with global trade and finance, require deeper, more efficient and

well-regulated financial markets. Financial markets in India in

the period before the early 1990s were marked by administered

interest rates, quantitative ceilings, statutory pre-emptions,

captive market for government securities, excessive reliance on

central bank financing, pegged exchange rate, and current and

capital account restrictions. In recognition of the critical role of

the financial markets, the initiation of the structural reforms in

the early 1990s in India also encompassed a process of phasedand coordinated deregulation and liberalization of financial

markets. As a result of various reforms, the financial markets

have transited to a regime characterized by market-determined

interest and exchange rates, price-based instruments of

monetary policy, current account convertibility, phased capital

account liberalization and an auction-based system in the

government securities market. The Indian stock markets are

now amongst the best in the world in terms of modernizationand the technology. It also had its shares of scams which were

huge even by international standards, revealing the many gaps

in our existing financial system. Fortunes were lost overnight, middle class people and retirees were the hardest hit because of

the irregularities. As a result, the ambit of the Securities Exchange Board of India, the stock exchanges and regulatory financial

institutions was widened. While India remained unaffected by the contagion effects of Asian crisis o f 1997, it could not escape the

sub-crime crisis. Today, India is some way from this ideal, and progress on reforms has been glacial at best. But this is not an

intractable problem. However, the groundwork that has been laid will allow us to move rapidly towards the regulatory

architecture that is appropriate for a country of India's size and aspirations. While building on past successes, it is also important

to remember there are gaps keeping it away from the status of an International Financial Center. A number of problemsexemplify the substantial road that still has to be travelled in achieving an adequate financial regulatory and supervisory

structure in India.

Background

It was October 19th 1987. The Dow Jones witnessed its

biggest percentage fall (22.6%) on a single day. The day is

known as "Black Monday". While all the major indices across

the world caught the cold, India remained insulated from this

global crash. "Pundits" lauded it as a victory of closed Indian

financial system which made the system immune to world

crises. It was 1987, and India was still very much caught up

with the idea of a closed self sustaining economy! If someone

talked about developing Mumbai as an International Finance

Centre, the response would have been akin to what Galileo

received from the Church for proclaiming the Earth to bespherical.

Twenty one years hence we are in midst of another crisis.

Unlike 1987, India has lost its immunity & is moving in line

with the global hysteria. Rather it is an active participant.

Numerous changes in the financial system have given rise to

this coupling phenomenon. And talks about developing

Mumbai as an International Financial Centre are no longer

subjected to same mockery as it was 20 years ago. In fact

there are people who claim that the current crisis could well

be the required trigger! In an article, Prof. Vaidyanathan from

IIM Bangalore says - "The decline of these institutions - many

more to come - is the best thing that has happened to

countries such as India, which are poised to play a larger role

in global financial affairs".

India Shining

As optimistic as this may sound, the truth is that not only we

Indians, but the entire world believes that India might just be

poised to make it to the big league. With the largest markets,

a rampant growth in GDP and sustained optimism, it isalready a preferred investment destination along with China

and few other emerging economies. Through this article, we

will put forward various significant changes in the Indian

financial system along with the impact it had on our capital

markets. Following that, we will highlight some major

deficiencies that still prevail in our system. Finally we will

have some recommendations for making Dalal Street the

next Wall Street.

8

THE MONEY MANAGER COVERSTORY

COVERSTORY THE MON

What Changed?

As discussed above, the times of isolated and insulated

financial markets are now history. The success of any capital

market would depend upon its alignment with the global

economy. The Indian economy

adopted the process of

liberalization in 1991 under the

watchful eyes of the now Prime

Minister, Dr. Manmohan Singh

- a move not designed, but out

of compulsion. But as thesaying goes "It's the runs that

matter, not how they come".

This initial step has had far

reaching effect in the next 17

years thus far and the capital markets are the ones most

benefited out of it.

However, liberalization was not the only contributing factor to

the emergence of the strong Indian capital markets.

Liberalization spurred the economy which is essentially the

backbone of any developed financial market. However, the

development of financial markets would not have been

forthcoming had the liberalization not been coupled with

series of market reforms. We will focus on some specific

changes that we believed played a significant role in bringing

Indian markets to the forefront of the global financial

markets.

The initial transformation of the Indian capital markets

was initiated with the establishment of the Securities and

Exchange Board of India (SEBI) in 1989, initially as an

informal body and in 1992 as a statutory autonomous

regulator with the twin objectives of protecting the

interests of the investors and developing and regulating

the securities markets over a period of time.

The incorporation of The National Stock Exchange of India

Limited in 1992 as a tax-paying company unlike the other

stock exchanges in India. It put in place a country-wide

stock exchange similar to The Bombay Stock Exchange

Limited.

The regulatory changes in the Primary Market

free pricing resulted in a surge in the prima

activity broadening the base of the companie

the Indian bourses and thus providing ample

diversification. The increased transparenc

process was crucial to the success of the IP

recent past.

o < IPO Trend>

The introduction of 'Online / Electronic tradin

through the price time priority matching thr

10,000 terminals across the country resulted price discovery and improved the efficiency of

markets. This infrastructure set-up is ultra-m

has resulted in bringing down the transaction

level which even the developed exchanges

hard to match.

The establishment of the National Securitie

Corporation of India Limited in 1995 elim

concept of 'counterparty risk', which re

increased participation and improved liquid

market. The establishment of depositorie

eliminated the need for maintaining the secur

physical form and thus further eased the

settlement.

The introduction of Trade Guarantee Funds and

trading in 2000 further strengthened the deIndian markets. The Derivatives trading enab

price discovery and the Trade Guarantee Fund

sustainability of the Exchanges in bearing th

the defaults. The Investor Protection

introduced around the same time provided the

with the desired security.

Adoption of more stringent accounting practicof disclosure and also the board room prac

resulted in better dissemination of inform

helped investors make informed decisions.


6/46

COVERSTORY THE MON

Source: MIFC Report

Acquirer Target Co. Deal Value(in mn $) Investment Banks involved

Tata Steel Corus Group plc 12000 ABN Amro, Credit Suisse andDeutsche Bank.Debt Financing by StandardChartered and Citi

Hindalco Novelis 5982 UBS, ABN Amro, Bank of America

Suzlon RE Power 1000 Debt financed by Abn Amro, ICICI,and SBI

UB Whyte & Mackay 1170 Debt financing by Citigroup & ICICI

Vodafone Hutch 1110 UBS

Mumbai London NewYork Tokyo Sing

DemandFactorsforIFSDomestic Demand for IFS 10 10 10 10 4Demand for IFS fromregional clients 1 10 10 3 Demand for IFS fromGlobal clients 0 10 10 3

SupplyFactorsforIFSFullarrayof internationalbankingservices for corporates and individuals 5 9 9 9 1Fullarrayof internationalcapitalmarkets, products, and services 3 10 10 7Full arrayofrisk mgmt services 2 10 10 5Full arrayof insurance services 1 10 10 7

Existenceofwide,deep andliquidderivativesmktfor:Equities and indexes 5 10 10 6Interest rates 1 10 10 8Currencies 1 10 10 7Commodities 3 10 8 7

ServicesOfferedFundRaising,wholesaleandcapital mgmt 5 10 10 8Asset Mgmt 4 10 10 8M&A(national, regional, and global) 3 10 10 6FinancialEngineeringforLargeComplex Projects and PPPfinancing 3 10 10 8

Attributes, Characteristics and Capabilities of an IFC (scale= 0-10; 0 = worst; 10 = best)

As a result, the ambit of the Securities Exchange Board of

India, the stock exchanges and regulatory financial institutions

was widened. Today, India is some way from this ideal, and

progress on reforms has been glacial at best. But this is not

an intractable problem. However, the groundwork that has

been laid will allow us to move rapidly towards the regulatory

architecture that is appropriate for a country of India's size

and aspirations.

While building on past successes, it is also important to

remember there are deficiencies in the current regulatory

system. A number of problems exemplify the substantial roadthat still has to be travelled in achieving an adequate financial

regulatory and supervisory structure in India. We through this

story try to bring out the deficiencies in the Indian market

which need to be overcome for India to become a financial

powerhouse.

Huge domestic demand; but where'sthe supply

Inspite of the growing number of Indian MNCs, the increasing

no of cross border M&A deals, and the rising GDP; the

financial services industry have barely been able to keep pacewith the huge demand created due to the India Shining story.

Rarely do we see these deals being funded by Indian financial

system. Tata - Corus deal (the $12 bn deal) generated

financial services revenue for Singapore and London. Thetable below lists a few big M&A deals by India Inc. and the

investment banks involved in the deal

he total value of M&A deals in a year in the country

(averaging for the last 3 years) is close to $20 bn1; and this

figure is expected to grow at an exponential rate.

banking transactions typically involve fees of 2%

transaction value. Even a 2% revenue for the

Services industry will result in $360 mn of revenue

of the country per year!

The total trade has also grown immensely over t

years. The trade GDP ratio in 2005 - 06 was 36.1%

7.5% in 1970 - 73 period. Even this 35% under

country's globalization as the export of servic

accounted in the trade figure. The overall (two w

funds stood at $657 bn for the period 2005 - 06. Thservices required in trade (say currency hedging, o

management services, etc) are carried in the co

access to high quality, low cost financial services

India doesn't have developed currency markets mo

transactions takes place in the other country (usua

or America). Annual fees for asset management s

typically between 1-2% of the portfolio under ma

with entry fees varying from 2-5%. Private banking

funds involve higher annual loads and. Assum

conservative 1.5% revenue for the financial se

industry out of this $657 bn figure; still turns omassive $10 bn per year! Thus there is a huge

demand for the FS in India.

10


Allowing Foreign Institutional Investors (FII) to participate

in the Indian markets have resulted in improved liquidity

in the markets. Opening up of the Indian markets to

investors such as Mutual Funds, Pension Funds, other

country funds, etc have allowed the integration of the

Indian markets with the global economy / markets.

Each of these factors has contributed in taking the Indian

Capital Markets to its present position. The robustness of the

markets was severely tested during the markets crashes in

2004 and then again in 2006, where the Indian capital

markets sustained them thanks to the financial systems inplace. To its credit, not a single c ase of default was registered

during these crashes.

Yet another comforting factor is that our markets are no

longer overly dependent on the whims of FIIs. Simply put,

although a mass FII exodus would depress our market, it

would not cause a mass hysteria. This was evident when SEBI

ban on participatory notes (P-Notes) in September 2007. FIIs

exited in massive numbers, but domestic mutual funds,

insurance and pension funds helped prop up the market.

What makes India click?

Having said that, there is no denying the fact that FII inflows

have played a crucial part in making Indian markets what they

are today. And regulations and policies directed towards

supporting and encouraging these inflows have been the keycontributor but not the only ones. In spite of the fact that the

FII's were allowed to participate in the Indian Capital Markets

since 1992, the activity levels increased only after 2004. The

primary reason for this is the fact that the Indian economy

started showing signs of rapid growth then. It was a period

when India consistently clocked a GDP growth rate of 8% with

indications of sustainability. Also, closed structure of Indian

economy over last so many decades ensured that most of the

sectors in the economy though being substantial in terms of

revenue have remained highly unorganized leaving a lot of

scope for investment and consolidation.

Thus, a plethora of reasons, namely, growth opportunities,

partial capital account convertibility, consolidation options,

rising GDP, robust equity markets, etc have resulted in India

emerging as a preferred investment destination. In a survey

conducted by Ernst and Young in June 2008, India was voted

as the 4th most preferred investment destination in the world.

Advantage Mumbai

Some other factors that have contributed and will continue to

contribute towards India's competitive advantages are:

Democracy - Properly functioning financial markets require

a constitutional basis and machinery for system governance

that is stable, reliable, resilient and flexible. India has

proven strength in upholding liberal values, protecting

property rights and maintaining political stability

Human Capital - Proficiency in English along with proven

technical and quantitative knowhow give Indians the edge

over their counterparts in Dubai, Shanghai and Singapore.

Location - Mumbai is well located in being able to interact

with all of Asia and Europe through the trading day. Apart

from the Americas, transactions with most of world GDP

can occur in daylight

However, in spite of all these positives, the Indian capital

markets are still far from reaching the volumes and tradeswitnessed by the likes of New York, London and Tokyo. The

next section would deal with the deficiencies of the system

that are slowing us down in our race to become the next Wall

Street.

A tough road ahead

India's financial system holds one of the keys, if not the key, to

the country's future growth trajectory. A growing and

increasingly complex market-oriented economy, and its rising

integration with global trade and finance, require deeper,

more efficient and well-regulated financial markets. The

Indian stock markets are now amongst the best in the world in

terms of modernization and the technology. India remained

unaffected by the contagion effects of Asian crisis of 1997 &

have escaped the effects of Sub-prime crisis as well, which

has plagued the developed economies. However, it has alsobeen a decade marred with scams, which were huge even by

international standards, revealing the many gaps in our

existing financial system. Be it the Harshad Mehta scam in

1991, or Ketan Parekh in 2001, or the US-64 scam. Fortunes

were lost overnight, middle class people and retirees were the

hardest hit because of the irregularities.


7/46

12


OTC Debt Market Lot Spread Average Daily VolumeDerivatives (million $) (million $)

OIS Swaps 5 1.5 -2 basis points 50 -150

MIFOR Swaps 5 10 -15 basis points 50 -150

CurrencyFwds 5 0.5- 2 ps 500 - 700

Source: BIS Quarterly Review, March 2008

Domestic DebtSecurities 55,389 23,899 1,354 8,706 435 1,528 89 155 90

a) Government 26,200 6,480 901 7,034 396 1,042 80 66 64

b) Govtsecurities

as a % of total 47% 27% 67% 81% 91% 68% 90% 43% 71%Domestic Debtsecurities

c) FunctionalInstitutions 23,053 14,499 429 969 29 400 4 31 19

d) CorporateIssues 6,135 2,918 23 703 8 86 5 57 6

Domestic Debt Securities - Amount outstandingas on Sept 2007 (USD Billion)

World US UK Japan India Chi naIndonesia

Malaysia

Singapore

The offshore Demand

Due to lack of liberal policies, weak institutional

mechanisms, and small liquidity in the OTC derivatives

(currency, OIS (Overnight Indexed Swaps), etc); investors buy

these derivatives products on Indian underlyings from

offshore markets like Hong Kong, Singapore, and London.

There is perhaps a billion dollars a day of notional value of

derivatives which are traded outside the country on Indian

underlyings.

These markets could wax and wane with the entire demandcoming to India if Indian financial regulations got more

sophisticated. More liberal policies could shift a great part of

this market to India. The table below shows the offshore

demand for Indian OTC derivatives

An Almost Nonexistent CorporateBond Market:

The state of India's corporate bond market has been thesubject of much discussion and analysis but little progress

over the last ten years. This is in contrast to the stronggrowth witnessed in the equity markets as well as the

government securities market. The corporate bond market

remains practically non-existent. Most of the large issuers

are quasi-government, including banks, public sector oil

companies, or government sponsored financial institutions.

Of the rest, a few known names dominate. There is very little

high yield issuance, and spreads between sovereign debt,

AAA debt and high yield debt are high in comparison to other

markets. Very few papers trade on a regular basis. Trading in

most papers dries up after the first few days of issuance,

during which the larger players "retail" the bonds they have

picked up to smaller pension funds and cooperative banks.

Most trading is between financial institutions.

The reasons for the near-absence of a corporate bondmarket can be divided into constraints on both demand and

issuance side. On the demand side, pension funds, who invest

heavily in corporate debt outside India, are constrained by

their prudential norms and conservative investment policies.

Mutual Funds, and to a lesser extent insurance companies,

are buyers of higher yield debt, but do not create enough

demand for the market to grow. Banks tend to prefer loans to

bonds, because loans can be carried on the books without

being marked to market, thus reducing the possibility of

unexpected demands on bank capital. Foreign investors, who

do not suffer from the same sources of risk aversion as

Indian institutions, are allowed only to a very limited extent

into the market (a total of $1.5 billion). Given the very limited

liquidity, they are not always eager to even take up the

available quota.

On the issuance side major detracting factors are, the high

interest rates demanded by buyers, because bonds are

illiquid and because bond holders are poorly protected in

bankruptcy, means that bank debt is available at much moreattractive terms. Add to this the issuance and compliance

costs, and issuers do not find significant reasons to run a

regular issuance program. Also, until the recent credit crisis,

larger corporate issuers had access to much cheaper funds

in the offshore debt capital markets. Even after hedging their

currency risks, the total cost of borrowing offshore is much

lower than the cost of borrowing in the domestic market. This

is reflected in the strong growth of External Commercial

Borrowings (ECB) in recent years.

Slow pace of Innovation:

The pace of innovation is very slow. Products that have been

well established in the financial markets worldwide &

subsequently are proposed to be introduced in India take

several years to get regulatory approval. The following

examples illustrate the long delay from serious proposal by a

potential innovator to actual successful launch:

Index futures were proposed in early/mid 1990s andlaunched in 2000

Gold Exchange Traded Funds were proposed in 2002 and

launched in 2007

Interest rate futures were proposed in 2003 (and there was

also an abortive launch of an unviable variant) but have yet

to be permitted in a viable form

COVERSTORY THE MON

Currency futures in India launched only now on Aug 29,

2008 and currently are allowed in only INR/USD

Bond and Derivative market - Themissed synergies

One of the crucial factors behind the success of New York

(hence wall street) as a financial centre is the presence of

deep, highly liquid bond and derivative market. Any financial

centre will generate huge demands in all currency spot and

derivative markets. With the current rate of growth Indian

would soon become fourth largest economy by 2012, and INRwould soon emerge as the one of the six most traded

currencies (i.e. USD, JPY, EUR, GBP, CNY and INR) in the

world. International bond issues both sovereign and

corporate will be denominated in the six currencies. If

Mumbai has to compete with Wall Street then it's imperative

and Mumbai attracts global issuers both in the bond market

as well. This will require an arbitrage-free INR yield curve,

backed by interest rate and credit default protection

derivatives of every kind.

It must be appreciated that the yield curve and interest rate

derivatives markets and the currency spot and derivatives

markets are inextricably bound together by arbitrage. At

present these markets are plagued by absence of liquidity,

have structural weaknesses with no price discovery

mechanisms. Arbitrageurs and risk takers are key

participants of these markets as they provide liquidity andensure informational efficiency. The effect is too obvious if

one looks at the basic arbitrage relationship in the currency

forward market, Covered interest parity (CIP). The CIP

principle requires that two alternatives for borrowing should

have identical returns: (a) borrowing in USD and using funds

in India with a locked-in INR/USD exchange rate for

repayment in USD; versus (b) borrowing in INR over the same

maturity. In India, the CIP principle is persistently violated

(see figure) to a point where the CIP deviation is utilized as a

predictor of future currency fluctuations.

Though considerable progress has been made in equity and

equity derivatives, commodity and recently with the launch of

currency futures, the development of a concomitant BCD

nexus has lagged.

Full Capital Account Convertibilinot there

All the dreams of Dalal street being the next Wall

involve a paradigm shift in many of the current

policies, the most important being making the r

convertible on both current and capital account

without saying that our conservatism in the 1997

regarding capital controls saved us from the scou

Asian currency crisis. The central bank's interventi

these effects causes problems and affects the in

monetary policy operation.

However we have to appreciate the fact growing int

India with the world economy is pushing us towa

account convertibility in any case. Also there are

models where countries have combined convert

independent monetary policies. In order to have h

in the world economic order it's imperative that we

the successful models and learn lessons from the

of failure. This will not only open the opportunity o

financial services for India but also send a strong

the international markets about our confiden

liquidity and efficiency of our financial markets.

Regulatory Gaps

1) Rule based Regulation: High standards of regu

governance are the prerequisite for the establany financial regime. If Dalal Street aspires to

financial powerhouse then its imperative t

establishes a robust governance regimes whic

weeds unviable institutions and structures

promotes financial innovation.

India's strategy for financial regulation dep

based regulation - the same strategy used in c

Europe. This prescriptive rule based approach

avoids legal ambiguity through precise codifica

also causes excessive regulatory micro-ma

leading to a counter-productive interaction be

regulator and the regulated. The regulated res

needs and opportunities in the market pl

attempting to comply only with the letter of the

based approach also inhibits innovation.


8/4614


Every new idea on products, services, markets or even

new ways of doing business requires going to the

regulator requesting a modification of rules. This tends to

eliminate the temporary profits obtained by innovative

firms who obtain an edge over their competitors by

coming up with new ideas, which (in turn) tends to reduce

investments into research and development.

2) Flaws in Regulatory Structure: Some areas of the

financial sector have multiple regulators, while others

that could pose systemic risks have none. Both situations,

of unclear responsibility, and of no responsibility, aredangerous. Some examples of regulatory overlap include:

Overlap between SEBI and MCA in the regulation ofissuer companies

Overlap between SEBI and RBI in the regulation offoreign institutional investors as well as in exchangetraded currency and interest rate products

Overlap between RBI and state governments in theregulation of cooperative banks

Some examples of regulatory gaps include:

Absence of any mechanism for regulatory review ofcorporate accounting statements for compliance withdisclosure requirements.

The growing number of credit co-operative societies andMFIs involved in deposit taking or gathering, with littleoversight

Absence of supervision of cross-market activities

3) Wrong regulatory incentive structure: The quality of

regulatory output is influenced by the overall environment

in which the regulator operates, the consequent

incentives they face, and the performance standards they

are held to. In fact, the perceived inadequacies in the

quality of regulatory output may have more to do with

incentives and environment than with fundamental

deficiencies in the quality of talent that regulators attract.

Also, regulatory incentive structures lead to excessive

caution, which can be augmented by the paucity of skills

among the regulator's operational staff relative those ofthe regulated. Such caution could actually exacerbate

risks

Recommendations

Deep markets with varied participants can absorb

overall risk better. While indeed the risk that has infected

world markets started in the U.S. sub-prime sector, in

part because of excessive financial exuberance, despite

its proximity and exposure the United States financial

system has been so far capable of weathering the losses

surprisingly very well. It can be attributed partly to the

openness to & variety of investors in U.S. financial

markets. U.S. banks could recapitalize quickly by tapping

into sovereign wealth funds elsewhere. Even while banks

are hamstrung by overloaded balance sheets, hedge

funds and private equity players are entering the markets

for illiquid assets and establishing a bottom.

Two-pronged structure for Derivatives Market. With

the growing importance of risk management, the growing

size of exposures by financial and nonfinancial firms, and

the growing sophistication of financial firms, India is likely

to witness the explosive growth of derivatives positions. In

order to control the associated systemic risks, a two-

pronged strategy should be followed. First, standardized

products should be encouraged to migrate to exchanges.

Second, clearing corporations such as NSCC and CCIL

must be encouraged to offer risk management services

for the OTC market. If these two strategies are appliedfully, systemic risk will then be limited to the small class

of OTC derivatives positions which are not understood by

the clearing corporations.

Though India has three major and several smaller

modern commodity futures exchanges with billions ofdollars of transactions on a daily basis, small farmers are

not able to benefit from these. This is because the key

functions - quantity aggregation and price assessment -

are currently played by traditional commodity brokers,

who often collude to make lower payments to small

farmers. To ensure that they do not exploit farmers, apart

from wide dissemination of price information, which is

happening already, farmers need the ability to sell to a

processor right from the village (as is currently happening

with ITC e-Choupals) if they find the price attractive.

Alternately, farmers bringing their produce to a mandi,

but not finding the price attractive, should be able to sell

to another distant mandi. This is being enabled by the new

generation of "spot" exchanges like NCDEX Spot

Exchange Ltd (NSEL) and SAFAL National Exchange (SNX)

but requires a network of reliable warehousing and

assaying agents. It is important to support theselegitimate functions and let banks finance them, so as to

encourage the emergence of this commodity marketing

eco-system.

Effective co-operation among regulatory authorities.

There is no perfect regulatory system. The problems with

Northern Rock in the United Kingdom are being attributed

COVERSTORY THE MON

to the fact that the United Kingdom had moved to a single

supervisor, the Financial Services Authority (FSA), with the

monetary authority having no supervisory powers. At the

same time, the Bear Stearns debacle in the United States

is being attributed to the absence of a single supervisor.

What is essential is effective cooperation between all the

concerned authorities, which transcends the specifics of

organizational architecture.

India is at a turning point in its financial sector. There are

many successes-the rapidity of settlement at the NSE or the

developments in derivatives market and the increasing levelof interest shown by foreign institutions. There is justifiable

reason to take pride in this.

However, there is an opportunity here to gain a unique edge

& scale up to become internationally competitive. We actually

need a paradigm shift in financial sector. The shift in

paradigm, if implemented, could usher in a revolution in the

financial sector almost as dramatic as the revolution that hitthe real economy in the early 1990s, whose fruits we are now

reaping

There has been an enormous amount of attention paid to

issues like capital account convertibility, bank privatization,

and priority sector norms. While they are extremely

important, there are many other areas where reforms are

less controversial, but perhaps as important. With the right

reforms, the financial sector can be an enormous source ofjob creation and is fundamental to the development of other

sectors. The implications for inclusion, growth, and political

stability would be enormously beneficial for the economy.

Without reforms, however, the financial sector could become

an increasing source of risk, as the mismatches between the

capacity and needs of the real economy and the capabilities

of the financial sector will widen. Not only would the lost

opportunities be large, but with not insignificant probability,

the consequences could be devastating for the economy.

Right now, however it is a difficult time to propose financial

sector reforms in India. The meltdown of the US financial

sector seems to be proof to some that markets and

competition do not work. The right lesson for India from the

debacle is that markets and institutions do succumb

occasionally to excesses, which is why regulators have to be

vigilant, and constantly finding the right balance betweenattenuating risk-taking & inhibiting growth. At the same time,

well-functioning competitive markets can reduce

vulnerabilities-the U.S. equity, government debt, and

corporate debt markets, despite being close to the epicenter

of the crisis, have remained far more resilient than markets

in far away countries. We see with the current developments

that vulnerabilities are also building up in India.

Underdeveloped markets and strict regula

participation are no guarantee that risks are co

fact they may have created additional sources

forewarning of which has already come from

decline in the Stock Market and substantial losse

by corporations on currency bets.

Yet the primary lesson of the Global financial crisis

foreign capital or financial markets are destabilizin

poor governance, poor risk management, ass

mismatches, inadequate disclosure, and excess

party transactions make an economic system pronFinancial sector reform can reduce these vuln

substantially. As on the timing of these refor

Vaidyanathan comments "The existing institutions

and the existing market mantra has been expo

most compromising position wherein the m

government are caught in the act.

Unless we internalize the fundamental truth that t

of the West is a pre-requisite for the emergence of

global power, we are not going anywhere. To do tha

to be pro-active and not supplicant. To bui

architecture, India should take the lead. Unfortu

have the US lobby, Chinese lobby, Pakistan lobby an

of lobbies in the Capital, but no India lobby yet. U

we cannot but be mouthing inanities and d

inconsequential things.


9/46

SPECIAL FEATURE

Financial CrisisFinancial Crisis

Gaurav Parasrampuria,Manu Jain,Neha Gupta,and Neha Verma(IIM Bangalore)

THE MONEY MANAGER SPECIAL FEATURE

August 2008 marked the end of an era, the end of investment

banks, the reigning of capitalism, and the increasingly gettinglouder voices of a post American world. Almost everywhere,

governments are stepping in to rescue the banking system.Even America and Britain, the pioneers of free enterprise and

privatization are being forced to accept the part ownership bythe state of the financial system.

The end of an era

The financial services industry is one of the great

generators of the US economy. Its share of totacorporate profits rose from 10% in the early 1980s

its peak last year. But the industry had probably big, and probably at the expense of some lax

measures too. The credit boom not only inflated ait also inflated finance itself.

The signs of break-down were first noticed in June two Bear Stearns hedge funds ran into troub

downgrade. The firm had to pay billions to assume

funds' mortgage-backed securities holdings. Scontagion spread as banks worldwide took heftyincluding the likes of Citi, Lehman, Merill Lynch &

that it was carnage - the seizure of Fannie Mae aMac by their regulator, the record-breaking ban

Lehman Brothers, Merrill Lynch's shotgun marriaof America, and most shocking of all, the g

takeover of a desperately illiquid American Int

Group (AIG).

SPECIAL FEATURE THE MON

Figure 1 How did it start? : From Innovation to collapse


10/46

THE MONEY MANAGER SPECIAL FEATURE SPECIAL FEATURE THE MON

Figure 2: The death trail...

March 16: Bear Stearns Cos. bought by JPMorganChase & Co. In a deal orchestrated by & backed by the

Fed following a sharp decline in shares due to collapse

in confidence in the company

Sept. 7: Government Seizes Fannie Mae, Freddie Mac;

putting the liability of more than $5 trillion of

mortgages onto the backs of U.S. taxpayers

Sept. 11: Lehman Brothers Says it's Actively Looking to

be Sold; Shares of the investment bank plunge 45% as

traders feared it was having a difficult time finding a

suitor

Sept. 14: Bank of America Says it Will Buy Merrill Lynch

for $29 a Share

Sept. 15: Lehman Brothers Files for Bankruptcy: This isthe largest bankruptcy filing in the history of the United

States, at $639 billion

Sept.16: Government Announces $85 Billion Emergency

Loan to Rescue AIG

Sept. 17: Barclays Makes Deal With Lehman to Buy

North American Banking Division; The British bank,

which had passed on buying Lehman before it filed for

bankruptcy, picks up the failed firm's North Americaninvestment banking and trading operations for $250

million

Sept. 19: Bush Administration Announces Bailout Plan

to Confront Crisis

Sept. 21: Goldman Sachs, Morgan Stanley to Become

Bank Holding Companies

Sept. 23: Bernanke and Paulson Testify on Capital Hill

on Bailout; The Fed Chairman says, "If financial

conditions fail to improve for a protracted period, the

implications for the broader economy could be quite

adverse."

Sept. 24-27 Bush Works With Legislators on Bailout

Plan

Sept. 26: Washington Mutual Becomes Largest Thrift

Failure With $307 Billion in Assets

Sept. 29: Citigroup Acquires Wachovia's Banking

Operations

March 08

Debacle of bear stearns

Sept 08

Fall of lehman

Dec 08*

18

Thus, ten short days saw the nationalisation, failure or rescue

of what was once the world's biggest insurer, with assets of$1 trillion, two of the world's biggest investment banks, with

combined assets of another $1.5 trillion, and two giants ofAmerica's mortgage markets, with assets of $1.8 trillion. Big

regional lenders have fallen too - regulators have seizedSeattle-based Washington Mutual, the country's largest

savings and loan institution. WaMu had more than $300

billion in assets. The previous largest failure, Continental

Illinois, had $40 billion-worth when it toppled in 1984.

Wall Street has asked for a massive bail-out-some $1.6

trillion so far, but most believe that this is just a downpayment.

The Lehman Debacle

Lehman Brothers a 148 year old Wall Street Institution, was

left with large holdings after the sub-prime crisis curtailed

investor appetite for the fixed income products. Its share

prices slumped this year after large writedowns on the banks

troubled mortgage portfolios.

The beleaguered bank was in August holding talks with

Private Equity funds and strategic bidders to sell all or part

of its asset management arm, to replenish its bleeding

balance sheet. On September, Lehman shares fell by 45%,

sparked by a report that Korea Development Bank decided to

pull out of talks to take 50% stake in Lehman Brothers. What

followed was a death trail and the fate of this Wall Street

veteran was decided over the following weekend.

Lehman went bust with $613 billion of debt, of which $160

billion was unsecured bonds held by an array of investors

around the world, including European pension funds and

individuals in Asia who had taken comfort in Lehman's high

credit rating. The price of this paper quickly collapsed to 15

cents on the dollar or less, destroying overnight twice as

much value as Lehman's shareholders had seen evaporate

over several months. These losses set off a spiral in moneymarkets. Investors yanked $400 billion from money-market

funds, a supposedly super-safe source of funding, when

several money-market funds that held Lehman debt reported

negative returns, sparking a flight of cash to the safety of

Treasury bills that briefly pushed their yields c lose to zero. On

September 18th companies could no longer issue

commercial paper. Banks, anticipating huge demands from

companies seeking funds, began hoarding cash, sending the

federal funds rate as high as 6%. That week, no in

grade bonds were issued, for the first time (holid

since 1981.

Several Washington-based experts have argued L

not endear itself to the authorities by walking a

earlier rescue proposals because it felt the price

were too low. A few critics claim, that Lehman CEO

could not accept that Lehman had to do unpalata

and failed to react timely.

AIG

The story of AIG bailout is another colossal story. A

the insurance firm was the world's largest with

value of $239 billion. At one stage, its investme

unit contributed over a quarter of profits - mostly

credit-default swaps with a giant notional exposu

billion as of June 2008. Of this, $58 billion is e

subprime securities which have already gener

mark-to-market losses. But, the real horror story billion of contracts written on instruments owned

America and Europe and designed to guarantee t

asset quality!

What Future beckons

In its latest calculations the IMF reckons that

losses on debt originated in America (primarily mortgages) will reach $1.4 trillion, up by almost ha

previous estimate of $945 billion in April. The IM

case" is that American and European banks will s

$10 trillion of assets, equivalent to 14.5% of the

bank credit in 2009. In America overall credit growt

to below 1%, down from a post-war annual avera

That alone could drag Western economies' growth

by 1.5 percentage points. Without government ac

the lines of America's $700 billion plan, the IM

credit could shrink by 7.3% in America, 6.3% in B

4.5% in the rest of Europe.

Figure 3: Fall of the Mighty


11/4620

Source: ISDA

As of date, the day this magazine goes to print, of the five

independent investment banks open for business at the start

of the year, only Goldman Sachs and Morgan Stanley remain.

The culprit?

The rating agencies for the subprime, the regulators andpoliticians for lax regulations, and investment bankers for

their greed - no one has been spared in the blame game.

It is not that markets have been unregulated. But the

intellectual tide of the past 30 years, have resulted inregulator not being able to keep pace with the financial

innovations.

The financial innovation

Economic theory suggests that financial innovation must lead

to failures. And, in particular, since successful innovations

are hard to predict, the infrastructure necessary to support

innovation needs to lag the innovations themselves, which

increases the probability that controls will be insufficient at

times to prevent breakdowns in governance mechanisms.

The roots of the innovation could be traced back to the end of

Bretton Woods era - resulting in capital account convertibility.

Today's complex derivatives are direct descendants of the

early currency trades.

Forwards, Options, Swaps all helped companies to change

their risk exposure dep ending on their view of the asset

prices and where rates would go. The final stage emerged

only in the past decade. A credit-default swap (CDS) allows

investors to separate the risk of interest-rate movements

from the risk that a borrower will not repay. For a premium,

one party to a CDS can insure against default. From almost

nothing just a few years ago, CDSs grew at an explosive rate

until recently.

Alan Greenspan, the chairman of the Fed from 1987 to 2006,

was in the vanguard of this view. In his book, "The Age of

Turbulence" (2007), he welcomed the growth of CDSs,

arguing: "Being able to profit from the loan transaction but

transfer credit risk is a boon to banks and other financial

intermediaries which, in order to make an adequate rate ofreturn on equity, have to heavily leverage their balance sheets

by accepting deposit obligations and/or incurring debt. A

market vehicle for transferring risk away from these highly

leveraged loan originators can be critical for economic

stability, especially in a global environment."

Securitisation, which has been at the centre of the current

crisis, is another child of the 1970s. It involves bundling loans

into packages that are then sold to outside investors. The first

big market was for American mortgages. When homeowners

pay their monthly payments, these are collected by the

servicing agent and passed through to investors as interest

payments on their bonds. Again, this business was

encouraged by the authorities as a means of spreading risk.

Everybody appeared to win. Banks earned fees for originating

loans without the burden of holding them on their balance-

sheets (which would have restricted their ability to lend to

others). Investors got assets that yielded more than

government bonds and represented claims on a diversified

group of borrowers. No wonder securitisation grew so fast.

Securitisation eventually gave rise to collateralised debt

obligations, sophisticated instruments that bundled together

packages of different bonds and then sliced them intotranches according to investors' appetite for risk. The opacity

of these products has caused no end of trouble in the past 18

months.

The authorities did make a more fundamental attempt to

regulate the banks with the Basel accord. The first version of

this, in 1988, established minimum capital standards. Banks

have always been a weak link in the financial system because

of the mismatch between their long term assets and short

term liabilities. The Basel accord was designed to deal with a

different problem: that big borrowers might default. It

required banks to set aside capital against such

contingencies. Because this is expensive, banks looked for

ways around the rules by shifting assets off their balance-

sheets. Securitisation was one method. The structured

investment vehicles that held many subprime-mortgage

assets were another. And a third was to cut the risk ofborrowers defaulting, using CDSs with insurers like American

International Group. When the markets collapsed, these

assets threatened to come back onto the balance-sheets, a

prime cause of today's problems.

Bankers and traders were always one step ahead of theregulators. That is a lesson the latter will have to learn next

time.

THE MONEY MANAGER SPECIALFEATURE SPECIALFEATURE THE MON

Henry M. Paulson Jr., left; Ben S. Bernanke, center; and Timothy F. Geithner,of the New York Federal Reserve

Role of Leaders

Politic ians encouraged banks to make riskier loans through

series of measures, starting with the Community

Reinvestment Act of 1977, which required banks to meet the

credit needs of the "entire community". In practice, it meantmore lending to poor people. Fannie Mae and Freddie Mac,

the two government-sponsored giants of the mortgage

market, were encouraged to guarantee a wider range of

loans in the 1990s.

The share of Americans who owned their homes rose

steadily. But more buyers meant higher prices, making loans

even less affordable to the poor and requiring even slackerlending standards. The seeds of the subprime crisis were

sown, and the new techniques of securitisation allowed banks

to make these loans and then offload them quickly.

Impact in India

With nearly half of their revenues coming from banking and

financial services segments, India's top software exporters

are closely monitoring the financial crisis spreading across

markets. The IT giants which had all these investment banks

as their clients are TCS, Wipro, Satyam and Infosys

Technologies.

The government is worried the ongoing crisis would have an

adverse impact on Indian banks. Lehman Brothers and

Merrill Lynch had invested substantially in the stocks of

Indian banks. The banks, in turn, have invested in derivatives,which might have exposure to these investment bankers.

ICICI bank is the worst hit as of now. The country's largest

private bank ICICI Bank is expected to lose approximately $80

million (Rs 375 cr), invested in Lehman's bonds through the

bank's UK subsidiary. The meltdown is also expected to hit

Axis bank but the impact is not clear yet.

Lehman Brothers Real Estate Partners had given Rs 740

crore to Unitech Ltd, for its mixed-use developmen

Mumbai. Lehman had also signed a MoU w

Piramal's real estate company-to fund the its proj

tune of Rs 576 crore. Another major real estate or

whose valuations are affected by this meltdown is D

in which it had invested $200 million.

The crisis management

The world's governments are shocked and dismay

inability to stop the increasingly grave financ

Nothing they have attempted has gotten lendinormally. Profitable companies are cut off from b

Confidence is at is an all-time low. Through Oct.

stock market had its worst five-day performance

on fears of a severe economic downtur.

The central banks are pumping money but the q

how the money should be spent. Buying out equi

banks will put undue govt control on them. Exten

lines to banks (the Swedish way of coming out of t1990s) will require a much larger package than t

proposed 700 billion USD relief package. The best

to protect the assets.

The federal government has put some 7% of GDP

a vast amount of money but well below the 16% o

the average systemic banking crisis (see box on s

world crisis) ultimately costs the public purse. America's proposed Troubled Asset Relief Program

will work is still unclear. The Treasury plans to

amounts of distressed debt using a reverse auctio

where banks offer to sell at a price and the govern

from the lowest price upwards. The compl

thousands of different mortgage-backed assets

this hard. If direct bank recapitalization is still n

Treasury can do that too.

Treasury's attempt to buy out distressed debt (whic

signals to other buyers that quality of assets is no

rather than buying into the equity of banks is lau

above all, the main point is that America is prepa

and act decisively.


12/4622

What future holds?

It seems implausible that the investment bank will make a

comeback, given the speed with which it has unravelled. Yet,

75 years after the legal separation of commercial and

investment banking, America has made a full return to the

one-stop-shop model practised by John P ierpont Morgan.

Power may shift in two other directions: abroad and, to a

lesser extent, to boutique investment banks. MUFG will be

joined by others. After a brief wrangle in the bankruptcy

courts, Britain's Barclays has taken over Lehman's American

operations and quickly put its logo on the fallen firm's

headquarters. "Global financial power is becoming morediffuse," says Andrew Schwedel of Bain & Company, a

consultancy. Merger boutiques, such as Lazard and Greenhill,

will emphasise their stability to pick up business. Their

shares have done relatively well this year.

Emerging economies also offer a sense of optimism in the

current global crisis, and this crisis could well see transition

to a new Post American World. It would not be one clear

superpower this time but the rise of the collective rest (BRIC,

turkey, South Africa, and a whole host of others). Although

these economies are not as "decoupled" from the rich

world's travails as they once seemed - their stock markets

have plunged and many currencies have fallen sharply, but

domestic demand in much of the emerging world is not

collapsing (it's slowing down a bit). The IMF expects

emerging economies, led by China, to grow by 6.9% in 2008

and 6.1% in 2009. That will cushion the world economy but

may not save it from recession.

While we believe that some rebalancing is needed,

particularly in financial regulation, where innovation outpaced

a sclerotic supervisory regime, it would be a mistake toblame today's mess only, or even mainly, on modern finance

and "free-market fundamentalism". Amid the crisis of 2008,

it is easy to forget that liberalisation had good consequences

as well: by making it easier for households and businesses to

get credit, deregulation contributed to economic growth.

Deregulation may not have been the main cause of the rise in

living standards over the last 30 years, but it helped more

than it harmed. Will the new, regulated world be as benign?

Figure4:

Future Implications:

Planned Bailouts

THE MONEY MANAGER SPECIALFEATURE

GLOBAL ACTION

THE MONBOOK REVIEW THE MON

The Black Swan:

The Impact of the Highly Improbab

While world over the financial markets have been in doldrums

for the better part of 2008 with investors losing a major share

of their wealth there was one set of investors guided by a

completely different way of working who stood vindicated.

Investors advised by The Black Swan author Nassim Taleb

have gained 50 percent or more this year as his strategies for

navigating big swings in share prices paid off .

The Black Swan is Nassim Nicholas Taleb's follow-up to his

immensely popular Fooled By Randomness (chosen by

Fortune as one of "The Smartest Books of All Time"). While

Fooled talks about the fallibility of human knowledge, The

Black Swan is all about randomness and uncertainty. The

book deals with the "highly improbable" and its impact. It

says that these events, dubbed Black Swans are

much more common than we would like to

believe. The black swan refers to high

impact, rare events which are hard topredict and beyond imagination also

known as "fat tails". The WTC

attacks and the rise of the internet

are examples of black swans.

"Lucky fools do not know that

they may be lucky fools."

The book often has a light-

hearted take on how people react

to black swans. Success according

to Taleb is more often an outcome of

completely random events than due to

reasons retrospectively attributed for the

success. The book delves deeply intohuman behavior and how we are often blind to

black swans calling it "our blindness with respect to

randomness". Taleb also goes on to debunk Modern Portfolio

Theory and explains the collapse of Long Term Capital

Management using his black swan theory taking a swipe at a

few Nobel laureates who were involved in it. Taleb considers

most of history to be silent and hence questions

past information to analyze the cause of events.

A follower of Popperian philosophy, Taleb uses th

Mediocristan and Extremistan as the core of

Mediocristan is the land where all events fit benea

curve while Extremistan is the land where extreme

all but too common. While in Mediocristan

observation does not have a significant impact on t

the observation; in Extremistan, a single observatio

well overshadow all the other observations. Taleb

explain how most of the real world lies in Extremist

in the popularly believed Mediocristan. The financi

are in Extremistan something which many

agree in the current circumstances.

Unlike normal practices Tausing a "barbell" strateg

most of your money

yielding and low ris

bills and a small

allocated to ex

occurrence of a b

like deep out-of-

put or call opt

strategy provides f

returns in normal

assumes significan

black swan event oc

widely expected that

of the last few mo

increase the followers of

Swan theory making Taleb'sinsights relevant once again.

Amit Mantri

(IIM Bangalore)

1. http://www.bloomberg.com/apps/news?pid=20601103&sid=aDVgqxiT9RSg&refer=us


13/46

A sound financial system is indispensable for any economy to

sustain a high and stable rate of growth. The financial system

and financial infrastructure that are in existence at a given

point in time are an outcome of a continuous process of

interactive exchange and a series of actions and reactions

between regulators, regulated institutions, financial markets,

and the consumers of financial services and products. Thus, a

financial system obtaining at a particular instant is a function

of the thought process of the regulators; their attempt to

achieve balance between innovation and risk and that of the

investors and consumers of their felt-needs. With changes in

these variables, the financial system of an economy shapes

itself, adapting to changes in circumstances, innovations and

to competition.

The evolution of Indian financial markets and the regulatory

system has also been along a similar path. Financial service

providers like banking institutions, insurance companies,

securities market intermediaries and stock exchanges and

their regulatory agencies are in place. In the early stage of its

evolution, the country's financial regulatory system has been

nurtured; given a direction and purpose and the necessary

strength in a gradual way as warranted by the circumstances

and contingencies. The role of regulators, in the process, has

evolved over time from that of an instrument for planned

development in the initial stage to that of a custodian of

modern, complex and robust financial sector at present.

Over this period, a variety of financial sector reform measureshave been undertaken in India with many important successes.

An important feature of these reforms has been the intent of

the authorities to align the regulatory framework withinternational best practices keeping in view the developmental

needs of the country and domestic factors. To list a few

reforms and their achievements, in the securities markets we

now have

fully automated trading on all stock exchanges;

a wide range of products- equities, government bonds,corporate bonds, futures and options on equity index andindividual stocks;

corporatized and de-mutualized stock exchanges ; modernrisk management systems at these exchanges; a fiercelycompetitive mutual funds industry with an array of productsto suit differing risk profiles of investors and a well

articulated and relatively less cumbersome investmentregime for foreign investors.

In the banking sector, achievements have included

deregulated interest rates

diversified ownership and consolidation; foreign directinvestment in the private sector banks up to 74 per cent.

enhanced efficiency and productivity through competition

The insurance sector has also been progressively op

domestic and foreign competition. In addition,

sector regulation and supervision has been str

considerably.

In a growing and increasingly complex marke

economy such as India's , with increasing integr

global trade and finance, our financial system w

important element in the country's future growth

Further steps are required to make the financia

deeper, more efficient and well-regulated. In thi

two important Government Committees, the High

Expert Committee on Making Mumbai an Int

Financial Centre (HPEC on MIFC) and High Level

on Financial Sector Reforms (CFSR) have charted ou

ahead for India's financial system to prepare

challenges of the future. Despite differences in their

terms of reference , the two reports have a common

theme of reference, viz. to recommend next gen

financial sector reforms for India. The mandate of

MIFC was to look ahead and prepare for the emerg

Mumbai as a regional/international financial

reviewing the existing legal, regulatory, tax

accounting framework related to financial services i

recommend an enabling framework to facilita

transformation of Mumbai. The CFSR has on the o

focused on financial sector reforms with a view to

more Indians in the growth process; (ii) foster growt

(iii) improve financial stability and thus protect thefrom any kind of turbulence that has affected markets in the past and is affecting industrial countr

The two reports emphasize that recognizing

linkages among different reforms, including broad

to monetary and fiscal policies, are essential to a

progress. The reports outline the key elements of

system that India will need in its quest for higher g

the next few years. Drawing from these reports, I

some broad areas on which our financial sector

need to focus on and act upon in the near future.

INVITEDARTICLES THE MON

1. The author is at present Joint Secretary (Capital Markets DivisioDepartment of Economic Affairs, Ministry of Finance, GovernmenThese are his personal views and not the views of his present empNor are these necessarily the views of his teachers in IIM Bangaloauthor was a student from 1999-2002!

THE MONEY MANAGER INVITED ARTICLES

INVITED ARTICLE

Dr. K. P. Krishnan

Dr. K.P. Krishnan currently holds the position of Joint Secretary (Capital Markets), Ministry of Finance,

Government of India. Prior to this Dr. Krishnan has served as Managing Director, Karnataka Urban

Infrastructure Development and Finance Corporation, Bangalore and Secretary, Urban Development andSecretary, Finance Department, Government of Karnataka. He has also worked as Advisor to the

Executive Director, World Bank in Washington DC. Dr. Krishnan belongs to the Indian Administrative

Service, Karnataka Cadre, 1983 batch. He received Ph.D. (Eco) from IIM Bangalore and M.A. (Eco) from

University of Mysore. He has carried out extensive research in the area of financial sector including role of

financial intermediaries in financing sub national governments and targeting financial education

campaigns to vulnerable groups and has presented his work in national and international

seminars/conferences.

1


14/4626

THE MONEY MANAGER INVITEDARTICLES

Financial inclusion

A robust financial system is not hugely relevant if most people

in the country don't have access to it. Financial inclusion is a

key priority for India, especially rural India. This means

providing not just basic banking, but also a variety of other

financial instruments. One example would be instruments to

insure against adverse events such as low crop yields due to

bad weather. Even regards credit, nearly three-quarte rs of

Indian farm households have no access to formal sources of

credit, leaving the rural poor especially vulnerable to

moneylenders. Most of the loans taken by those in the bottomquarter of the income distribution are from informal lenders

at an interest rate above 36% a year, nearly two times above

the mandated lending rate for banks.

At present, all banks must lend to "priority" sectors such as

agriculture. They are also subject to interest rate ceilings on

small loans, which restrict rather than improve access to

institutional finance. Banks have no incentive to expand

lending if the price of small loans is fixed by fiat. The solution

is not more government intervention but more competition

between formal and informal financial institutions and fewer

restrictions on the former.

What is required is a set of deeply intertwined reforms which

level the playing field between banks and non-bank financial

institutions by easing the requirement of banks financing

priority sectors. But making these changes while thegovernment continues to have huge financing needs, and

without a more uniform and nimble regulatory regime, could

be dangerous. Broader macroeconomic reforms could

reinforce individual financial sector measures. For instance,

allowing foreign investors to participate more freely in

corporate and government debt markets could increase

liquidity in those markets, provide financing for infrastructure

investment and reduce public debt financing through banks.

Innovation

History shows that financial innovation has been a critical and

continuing part of the economic landscape over the past few

centuries. Innovative changes in financial institutions,

regulatory structures and practices, and financial

instruments have occurred from time to time, over a long

period. Financial markets have continued to produce amultitude of new products; including many new forms of

derivatives, alternative risk transfer products, exchange

traded funds, and variants of tax-deductible equity. We, in

India, have adopted some of these products with success.

However, it is poignant to note that such innovations have

appeared ground in the country after years of additional toil

and wait. Stock index futures took five years to be offered to

the investors, from the time they were conceived; Exchange-

Traded Fund for Gold again took four years to become a

reality; interest-rate derivatives though launched in 2003 have

not taken off mainly due to constraints on the participation of

banks in this market. These experiences highlight the

adverse environment that financial innovation is currently

witnessing in the country. This should not continue if we wish

to project ourselves as the next International financial centre

of the world.

Framework for institutionalinvestments

Various segments of the financial markets can develop and

thrive only when participation in them is not artificially

constrained. The most successful parts of Indian finance at

present are those in which non-institutional participants have

taken a lead and engaged in speculative price discovery. This

large mass of retail participation in financial markets in a

unique edge that India has when compared with other

international financial markets. However, considering that we

are striving to project Mumbai as an International financial

centre, the capabilities and strength of institutional investors

need to be harnessed. This class of investors brings with

them sophisticated analytical tools in quantitative trading

systems, pools of capital and help link Indian finance with the

rest of the world. Thus, the strategy should be to remove the

constraints on the institutional sector to allow them to reap

the benefits of financial market innovations and in turn assist

these markets with depth and liquidity. The regulators s

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