A case for lobbying in India


Kaushiki Sanyal[1] and Harsimran Kalra[2]

This article was first published in the Livemint and the Wall Street journal on June 19th, 2013



Lobbying is arguably one of the most controversial activities in modern democracies. Lobbyists provide governments with valuable policy-related information and expertise but if the activity is not transparent, public interest may be put at risk in favour of specific interests. India currently does not have a law to regulate lobbying. But recent corruption scandals involving lobbying by big businesses have increased public pressure for a law to regulate the activity.

Should lobbying be treated as a legitimate activity in a representative democracy? It is worth noting that no country in the world, including India, has banned lobbying. In fact, only a few countries even regulate the activity, prominent among these are the US, Canada, Australia, Germany and Taiwan. These countries treat lobbying as a legitimate right of citizens. Regulations serve as a tool to enhance transparency in the policymaking process rather than restricting access to policymakers. In fact, that is one of the key reasons why the UK regulates the lobbied rather than lobbying. Therefore, the thrust of the Indian law should be to incentivize lobbyists to identify themselves and ensure that competing groups have reasonably equal access to policymakers.

The effectiveness of the law largely depends on how it defines lobbying and lobbyists. Countries such as the US, Australia and Canada define lobbying as any communication with a legislator or a bureaucrat to influence decisions on a policy matter. However, the law generally exempts communication with parliamentary committees and responses to requests made by the government from specific individuals or groups.

In India, there is some confusion among policymakers about what constitutes lobbying. For example, during the furore over Wal-Mart’s disclosure of lobbying activities in India, Bharatiya Janata Party (BJP) leader Ravi Shankar Prasad denounced lobbying as nothing but a euphemism for bribery. In contrast, a private member’s Bill to regulate lobbying was recently introduced in the Lok Sabha by Kalikesh Narayan Singh Deo, which defined the term as “an act of communication with and payment to a public servant with the aim of influencing” legislation or securing a government contract. The Bill required lobbyists to register with an authority and declare certain information.

However, a lobbying law should not legitimize bribery or corrupt practices since it prioritizes private gain over public interest. Lobbying should be defined to include only those activities that further the ideals of participative democracy.

In countries such as the US, Australia, Canada and Poland only professional lobbyists are regulated. Taiwan, however, includes both individuals who lobby on their own behalf and professional lobbyists.

In the Indian public consciousness, lobbyists are viewed as representatives of big businesses who indulge in corrupt practices to push their agenda. However, there are a large number of advocacy groups who campaigns for policy reforms. One of the most successful campaigns was run by the Mazdoor Kisan Shakti Sangathan (MKSS)—a coalition of non-governmental organizations—for the Right to Information Act. Women’s organizations have campaigned for women-friendly laws such as the Protection of Women from Domestic Violence Act, 2005. More recently, Anna Hazare led a popular campaign for the establishment of an anti-corruption body called the Lokpal.

The influence of these groups lies in the public support they command. Therefore, there is merit in including both commercial and advocacy groups in the definition of lobbyists so that neither have undue advantage in influencing policymakers nor is there a restriction to access for any group.

Most countries require lobbyists to register with an authority and disclose information about their clients and the methods they employ to lobby. For example, in the US, lobbyists are required to make quarterly disclosures of their expenses. In Germany, law makers are required to disclose their communications with lobbyists. Countries also levy different penalties for contravention of the law. In Australia and Slovenia, a lobbyist may be prohibited from engaging with policymakers if he violates the law. In the US and Canada, a defaulting lobbyist may be fined or imprisoned.

India needs to determine a regulatory model that suits its socio-political needs. Furthermore, it should tread a fine line while drafting the disclosure requirements. Too high disclosure requirements could drive lobbyists underground while too low penalties may not act as sufficient deterrent for law-breakers. It may be noted that the Right to Information Act, 2005, also stresses on voluntary disclosures by public authorities. If public authorities pro-actively disclose information, it can complement the disclosure requirements under a lobbying law.

Although lobbying by various interest and advocacy groups is widespread in India, the public mostly remains unaware of it unless a scandal breaks. A law to regulate lobbying could pave the way for transparency in the policymaking process. Disclosures of expenses incurred by lobbyists and financial accounts of law makers are likely to force interest groups to engage in the legislative process through legitimate means. Universal access to information on expenses and details of communications with policymakers would give impetus to more debates in the public domain. A shift to lobbying as a means of engaging with the legislative process would further the ideals of a participative democracy.

[1] Senior Analyst, Bharti Institute of Public Policy, Indian School of Business, Mohali (Kaushiki_Sanyal@isb.edu)

[2] Public Policy Scholar, The Hindu Centre for Politics and Public Policy, India.

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A Perspective on the Mutual Fund Industry in India

This interview was first published in ISB Insight, Volume 11, Issue 1, 2013, pp55-58


Authors: Vikram Kuriyan[1] and Nupur Pavan Bang[2]

Aditya Agarwal, the Country Manager of Morningstar India, has 20 years of experience in the financial services and investment management industry. He was the promoter of one of India’s leading fund research companies, ICRA Online, and is highly regarded as a subject matter expert on mutual funds. In a conversation with Professor Vikram Kuriyan and Nupur Pavan Bang of the ISB’s Centre for Investment, Agarwal discussed the reasons for the slow growth of the Indian mutual funds industry compared to developed markets and explained why investor education and awareness is required.


India accounts for 18% of the worlds population but only 0.37% of the global mutual funds industry in terms of assets under management, as per data from the Investment Company Institute. India has one of the highest savings rates in the world at about 33% for the year 2012. But this money does not find its way into the stock markets or mutual funds. Why is this so?

It is true that only a meager fraction of the savings in India goes into stocks or mutual funds. Indians prefer real assets such as gold and property to stocks or equity mutual funds. Many risk-averse investors prefer to keep their money safe with bank fixed deposits, and some even prefer to hold cash.

The primary reason for this is a general lack of awareness among individual investors about how stock markets work. Thirty years ago, the BSE (Bombay Stock Exchange) Sensex was at 125, whereas 10 years ago, it was near 4,000 levels. Thus, if you held a portfolio of the top blue-chip stocks similar to the BSE Sensex and left it untouched, your wealth would have grown 150 times and 4.5 times in 30 and 10 years respectively, or at a compounded annual growth rate (CAGR) of about 18% in both cases.

However, in most cases, investors fail to recognise that stocks and mutual funds are best when held over a longer term, say five years or more, for the volatility to even out, and instead, trade in stocks for the short term, leading to disappointing results. Financial literacy needs to improve in the country. Despite all the efforts from the regulator and various investor education initiatives run by fund companies, financial planners, and so on, the buy-in from investors just isn’t there. Funds are still not bought; they have to be sold to investors.

It is no secret that stocks generally outperform all other asset classes over the long term – this has been demonstrated and proven in every market over different time frames; however, a relative lack of understanding of this among investors, and as a result, their bitter experience with the asset class, has resulted in Indian savings not being channeled into the asset class as much as they should be.


Private players entered the mutual fund industry in 1993. The industry is 20 years old today, but yet it is far from mature. What are the reasons for this? In terms of accountability, mutual funds have not performed well or beaten the benchmark consistently.

The entry of private players has definitely raised the standard and professionalism of the industry, but that is unlikely to have a bearing on the industry’s growth. The reason for this is that with 75% of the industry’s assets in debt and liquid funds, it serves institutions well to park their surplus funds and gain a tax advantage. Until the average retail investor starts to believe in a big way that wealth can be created from equity investments, we won’t see the industry maturing in the way it has in developed markets.

On the question of funds not performing well, we often confuse poor returns stemming from the market’s dismal performance during the past five years (five years ago, stocks were nearing the end of a multi-year bull run) with relative underperformance. One cannot expect equity funds to post sterling returns when the market itself has given zero or negative returns. At the relative level, we need to do more comprehensive studies to see how many funds are underperforming relative to their benchmarks before concluding that it is an alarming picture. It all depends on which way you look at the data.

For example, a recent study pointed out that over the past five years, over 50% of equity funds underperformed their benchmarks. But the study looked at the absolute number of funds, and not at the funds in light of their assets under management (AUM). Consider, for instance, a hypothetical category comprising two funds managing INR one billion (100 crores) and INR nine billion (900 crores) respectively. If one of them underperforms, it means that 50% of the funds underperformed. However, if the bigger fund outperforms the benchmark, then we can say that 90% of the AUM outperformed. At the asset level, a preliminary analysis we did over the same time period showed that about 80% of funds (assets) outperformed their benchmarks because the more successful funds tend to manage larger assets.


It is the perception of investors that mutual funds do not give returns. Year on year, mutual funds may perform well, but investors are actually losing money. The number of investors who lose money is greater than the number of investors who make money.

Over the long term, equity mutual funds have shown robust performance, but in the short term, stocks and stock funds can post disappointing results. It’s the nature of the beast. Investors often tend to have a herd mentality and flock to asset classes after they have seen years of outperformance and the markets are at near peaks. The recent mania for gold and for stocks towards the end of 1999 and 2007 are a case in point here; investors entered the markets at precisely the wrong time and burnt their fingers badly.

Then there is also the problem of capital-weighted return. Suppose a fund with INR one billion (100 crores) in assets gains 100% in one year. By the end of year one, due to the fund’s stupendous performance and investors chasing it and putting money in it, the asset size swells to, say, INR 10 billion (1,000 crores). Then the next year, the fund returns a negative 50%. In such a scenario, the net return at the fund level would be the same, but far more investor money would have been lost as the fund had fewer assets when it gained and more when it lost. At Morningstar, we call the concept “investor return,” and in countries where flows data is available, we often see a considerable difference between a fund’s total return and investor return (or the internal rate or return investors got, capital-weighted) over any time frame.

In markets such as the United States (US), the gap between a fund’s investor return and total return is often glaring and remains wide for some volatile categories of asset classes. We would love to see the difference between the two for Indian funds, but we do not have enough disclosure data to calculate it. However, considering that Indian markets are more volatile than many other markets and because, as we mentioned earlier, investors tend to pour in capital more often than not at the wrong time or near market peaks, we think the gap would be significantly large.

Until we have sufficient investor awareness and disciplined, buy-and-hold investing becomes more widespread, we will see the problem of investor disappointment manifest itself even if overall fund performance is good.


People in India view insurance only as a means of tax saving. Are mutual funds going the same way? If so, what can be done to prevent such a mindset?

Mutual funds will remain a push product as long as investors feel more comfortable with the 9% stable return that fixed-income instruments such as fixed deposits (FDs) provide. They tend to forget that this 9% return is often entirely eaten into by inflation and ignore the higher 20-21% return that the average mutual fund has logged over the past 10 years, albeit with greater volatility.

A big driver of this growth could be the introduction of mandatory savings into equity products by the government, something similar to the 401k in the US (a kind of defined contribution plan to save for retirement). The (National Pension System) NPS is a start, but if we revamped something like the Employees’ Provident Fund (EPF) and partly linked its returns to the market, 10 or 20 years down the line, investors would have, out of force, learned the magic of disciplined investing in stocks.

Over the course of time, as investors develop greater comfort with equities, we will see more investors come out and buy equity mutual funds.


Exchange-traded funds (ETFs) have not done well in India, whereas they are popular across the world. ETFs have only about 2% of the market share in spite of their many benefits. Is this due to weak distribution networks and low sales commissions for agents?

ETF is a wonderful product as seen by its popularity in the West, offering passive, often niche strategies for investors who focus on asset allocation. But ETFs are far ahead of their time in India. Active management is preferred here, and we do see large outperformances by managers compared to the West, where beating the market is becoming exceedingly difficult. Further, investing in ETFs in India also has its set of operational issues. One of the challenges for small investors who do not invest in stocks is the lack of a demat account. To buy an ETF, one needs to open a demat account, and not everyone wants to do that. The point about low commissions is also one of the key reasons why they are not sold as widely in India.


One argument put forward by some commentators is that if Indians prefer to invest in gold and real estate, why not give them funds that invest in gold and real estate?

We do have gold funds and ETFs that offer an excellent way to invest in the yellow metal. Real estate mutual funds are a different equation, however. Asset management companies say they face practical difficulties with respect to regulations, valuations, and so on.


Who is accountable for the performance of the funds? Do fund managers in India have the necessary qualifications to manage thousands of crores of someone elses money? A person without a background in finance may not be the right candidate to manage funds. What is your view?

As a whole, we believe that the industry’s assets are in good hands with adequately qualified people to manage the money. Of course, there will always be times when some managers are outperforming while others aren’t, but that is the nature of the market. If some are underperforming for a long time, you will see investors leaving the fund and assets drying up and going to better performing managers and funds. It is a self-correcting mechanism.

At the ecosystem level, we believe the regulator has drawn up enough regulations and put in place processes that safeguard investor interest.


What are some of the things that the Securities and Exchange Board of India (SEBI) can do to better support the industry? What are the regulatory bottlenecks that keep the industry from growing?

We believe SEBI has done a brilliant job of regulating the industry, especially after the 2004-2007 boom and subsequent crash when some of the practices were less than ideal. The abolition of entry load and the introduction of direct plans are good moves to help the investor save on expenses and make the product more attractive. The regulator has set the ground for the industry to grow in a sustainable manner. Now, it is left to market performance to pick up and start drawing in more investors, and for investor awareness to increase, all of which will launch the industry into its next growth orbit. That said, we would like to see a greater focus on independent research and higher levels of transparency and disclosure in the industry.


You spoke about research. What research topics in this industry would you advise budding researchers in India to pursue?

If the question pertains to fund research, I would like to point out the acute lack of awareness that exists in India on this subject. For many distributors, recommending funds means picking the recent top performers. At Morningstar, our unique approach, developed through decades of expertise in the field, is to offer investors not just unbiased and independent but also cutting-edge research that helps investors take informed decisions. I would urge budding researchers to try and stay up to date with the best global fund research practices, qualitative and quantitative, followed by our firm and also our peers. Knowledge, information and widening your perspective will give you an edge over others.

[1] Vikram Kuriyan is the Executive Director of the Centre for Investment at the Indian School of Business (ISB).

[2] Nupur Pavan Bang is a Senior Researcher of the Centre for Investment at the Indian School of Business (ISB).

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Islamic Banking: A Central Banker Looks Back

Ishrat Husain on Pakistan’s reforms, global banking risks and emerging-market prospects


Nupur Pavan Bang and Vikram Kuriyan

The interview was first published by the Global Association for Risk Professionals on July 2, 2013


For six years starting in 1999, Dr. Ishrat Husain was governor of the Central Bank of Pakistan. He was responsible for a significant restructuring of the central bank and implementation of banking sector reforms. During his tenure, a court decision mandated that the nation’s banking system conform to Islamic law. Husain’s skillful oversight helped to maintain banking sector stability during a period of economic growth.

“Islamic banks did not suffer as much during the financial crisis as conventional banks because they did not deal in exotic derivatives or artificial money creation instruments such as collateralized debt obligations,” Husain observes.

As central bank governor, he was a member of the government’s economic management team. Later, from 2006 to 2008, he was chairman of the National Commission for Government Reforms, reporting to the president and prime minister. In March 2008 he took charge of the office of the dean and director of the Institute of Business Administration, Karachi, the oldest graduate business school in Asia. He was also a member of the Mahathir Commission 2020 and advised the Islamic Development Bank on the creation of its poverty reduction fund.

With degrees from Williams College (master’s in development economics) and Boston University (doctorate in economics), Husain also graduated from the joint executive development program of Harvard University, Stanford University and INSEAD. He spent much of his earlier career with the World Bank, including as head of the Debt and International Finance Division and chief economist of the East Asia and Pacific region.

Author of numerous books and monographs including “Pakistan: The Economy of the Elitist State” (Oxford University Press, 1999), Husain is currently a member of the International Monetary Fund’s Middle East Advisory Group and the United Nations Development Program’s Regional Advisory Group; chairman of the World Economic Forum Global Advisory Council on Pakistan; and board member of the Benazir Income Support Program, the largest social safety net and conditional cash transfer program serving the poor in Pakistan.

In this recent interview — conducted by Dr. Nupur Pavan Bang (Nupur_Bang@isb.edu), senior researcher, and Dr. Vikram Kuriyan, director of the Centre for Investment, Indian School of Business, Hyderabad — Husain reflects on the introduction and development of Islamic banking in Pakistan, as well as risks faced by the conventional banking system, financial crises and the challenges faced by emerging economies.

Please give the historical background on the origin and development of Islamic banking in Pakistan.

The Supreme Court of Pakistan has an appellate bench that deals with Islamic laws. Someone approached this bench in 2000 and represented that the banking system in Pakistan was anti-Islamic, as it is based on usury and exploitative interest rates and Islam is against usury and exploitation. Thus, the banking system should be declared illegal. The court decided that by June 30, 2001, all banks should conform to Islamic banking, and the existing banking system should be abolished. I was astonished because the repercussions on the economy of such a drastic measure were not fully realized. The economy would have been completely dislocated if a change of such a magnitude was implemented in a short period of time.

As central bank governor, I formed a commission for the transformation to Islamic banking. The commission comprised academicians, practitioners, bankers and Islamic scholars. It recommended that there should be a parallel banking system that allows Islamic banking to coexist with conventional banking. The choice would be available to consumers to shift from conventional banking to Islamic banking if they wished to do so. If every consumer decides Islamic banking, it will emerge in the country. I persuaded the cabinet and the president that we would implement the Supreme Court decision in a practical way that did not adversely affect the smooth functioning of the economy. The decision ought to be taken by 28 million customers whether they wish to opt for Islamic banking, and not by the government or the central bank. On this basis, we introduced Islamic banking in 2001 and provided the regulatory framework.

What options were available to the public?

We decided that there could be three forms of Islamic banking. First, full-fledged Islamic banks could be established and licensed if they met the prescribed criteria. Second, conventional banks could set up a subsidiary bank that would be totally separate in terms of deposits, assets, balance sheets, etc. Third, the conventional bank can have Islamic banking windows that operate independent of the conventional bank without any commingling of deposits and assets. They would offer only Islamic instruments and products to the public. Meezan Bank was the first to apply to become a full-fledged Islamic bank, and it was granted the first license. It has since done extremely well with innovative products, services and staff. It is the market leader with a one-third market share.

What is your view on Islamic banking in the context of the recent crisis?

There are two characteristics of Islamic banking which distinguish it from conventional banking. One is that every transaction has to be backed by real assets. Every loan should be backed by collateral such as real estate, business, etc. You cannot create wealth or money without associating it with real wealth creation.

Second, the borrower is a partner in the business in which the bank has invested as financier. There is no guaranteed fixed rate of return. If the business is not doing well, the bank will suffer along with the account holder. In contrast, conventional banks offer a fixed return to depositors. The bank has to pay interest irrespective of the performance of assets.

In Islamic banking there is no predetermined interest rate. The rate is determined at the end of the year based on the profits and losses. These distinguishing features of Islamic banking, if applied to International banking, would have avoided the possibilities of panic, failure and crisis. The fact is that Islamic banking is too small and insignificant to contribute to the safety of the international banking system, because 98% of the banking is done in the other way.

What major reforms are necessary to prevent future crises?

First, there should be separation between trading and retail banking, because banks have become trading platforms putting the depositors’ money at risk. Assets are piled up, and buying and selling happens at prices which are not related to the intrinsic value of the underlying assets. That is what the Dodd-Frank legislation and the Volcker Rule in the U.S. are about — that client-based trading should be separate from proprietary trading. Proprietary trading should be carried out separate from the main bank and limited in scope.

Second, the bank should have adequate capital. In manufacturing and services sectors, 60% to 70% is shareholders’ money and 30% to 40% is borrowed. The financial services business is quite different. Shareholders’ equity is 7% to 8%, and 92% of the money belongs to depositors. If shareholders take excessive risk with the depositors’ money, the upside gains are captured by the shareholders and managers, and the depositors don’t get anything extra. But, if they lose money, taxpayers have to bail them out. This asymmetric relationship in incurring risk and appropriation of reward makes the financial sector more vulnerable to exogenous shocks. Indian and Pakistani central banks had tough regulations, and thus their banking systems survived during crises. This was not the same in the U.S. and Europe.

What are your views on Basel III?

I believe the capital and liquidity buffers are appropriate, but the risk-weighting schema needs to be carefully reviewed. Internal models do not always adequately capture the risks assigned to different loans, and the supervisors have to develop the capacity to test the veracity and accuracy of these internal models by rigorous stress testing. Risk management systems and internal controls within the banks, particularly the systemically important institutions, have to be strengthened and examined from time to time.

What can the emerging markets learn from the crisis? Can it happen in India and Pakistan?

The crisis can happen there if financial institutions are not continuously monitored and supervised. It is asymmetric risk taking in the sense that all positive gains are preempted by shareholders and managers and losses are borne by someone else. Therefore, government regulation becomes important. This was not done in the U.S. and Europe. In India and Pakistan, shadow banking was not allowed to emerge, exotic products were discouraged, and cautious liberalization was pursued in respect to capital account opening. These are the safeguards that need to be observed.

A lot of countries are facing very high debt-to-GDP ratios and fiscal deficits. Are populist politics and subsidies to blame?

The starting point and initial conditions of a country determine what policies need to be pursued. The current debate between fiscal and monetary stimulus versus fiscal austerity cannot be taken as an abstract proposition, but rather in the context of prevailing circumstances. If Spain has half of its youth unemployed, fiscal austerity measures over an extended period of time will become politically and socially unacceptable. Japan, despite having a very high debt-to-GDP ratio, has recently decided to embark on monetary easing because for the last 15 years the economy was trapped in low-level equilibrium and was not able to come out of it.

Is austerity the answer?

No. Lending standards by the banks should not be compromised, and credit should flow to the private sector to stimulate the economy if public sector imbalances do not permit this. We should not overextend and must learn from the subprime mortgage crisis. Why should we give a loan to a person who does not have income to qualify for a loan? The lenders were assuming that the price of housing will keep on going up and the owner’s equity in the house will be built up, enabling him to repay the loan. That was a wrong premise — it was unrealistic to expect a unidirectional movement of housing prices.

What about regulatory and political challenges in emerging markets, particularly South Asian countries?

South Asian countries must strengthen their supervisory and regulatory bodies. There should not be a division between the central bank and supervisory authorities. The Financial Services Authority model in England that everyone cheered did not work out, and supervision has gone back to the Bank of England. This is because the central bank has information both at the macro and micro level, but the FSA had information only at the micro level. They could not use macro-prudential regulation to supplement the micro-prudential measures. Furthermore, they did not have bank resolution authority that the Bank of England had as the lender of last resort. Likewise, South Asia should strengthen its central banks and not have separate regulatory bodies.

Is Africa the next BRICS? Which countries might investors look at favorably?

Africa has done remarkably well in the last decade. It has grown at 5% a year on average. And this pattern was not limited to the commodity- and oil-producing countries, but also encompassed Ghana, Kenya, Tanzania, Rwanda, Mozambique and others. Investment opportunities in Africa are enormous, and the first-mover advantage will certainly help.

What challenges does Africa face as the next investment destination?

Political instability and fragility of institutions of governance continue to pose serious risks, although this varies from country to country. Investors have become more discerning; they do not treat Africa as a monolithic, homogeneous territory and are selective in their choices. The effect of these choices on the countries that are left out is positive, as they also take measures to improve their policies and business environment.

Financial inclusion and financial literacy are challenges for many emerging nations. What is the way out? Do multilateral organizations like the World Bank and IMF have a role to play?

I think the multilateral institutions can only provide the lessons of experience and exchange information as to what has worked and what has not in some countries. The primary responsibility for raising awareness and financial literacy remains with the central banks and governments. The conditions of each country differ, and therefore the solutions have to be tailor-made and specific.

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Number crunching needs the human touch

This article was first published in the Financial Times on June 21, 2013


Companies must use a combination of data analytics and managerial experience

Is it advisable to let analytics replace human judgment or experience in business decision making? Not really. Given that there are several instances where complete reliance on analytics has resulted in faulty decisions, there is a clear case for business schools to highlight the relevance of human judgment in decision making.

Why has analytics acquired such prominence? Is it because of the vast amount of data that is now available? Or is it because of the ever-increasing computing power at the disposal of organisations? Both factors have contributed.

As complexity in the world of business grew, objective decision making became the need of the hour. Subsequently, several analytical models were developed by academia and industry experts.

For example, an important part of marketing analytics is churn analytics which helps organisations project customer attrition and retention rates. However, the effective application of this model depends on the judgment of the decision maker as well as proper communication within the organisation. This way other stakeholders within the organisation stand to gain from the experience of the decision maker, and the analytical model deployed can be understood holistically across the organisation.

Einstein once said: “Not everything that can be counted counts and not everything that counts can be counted.” The oft-quoted example of financial analytics going wrong before the 2007-08 recession substantiates this. The model was not faulty, but its deployment was. The models used by financial institutions clearly identified the subprime customers. Nevertheless, loans were given to them and the outcome was inevitable. By not paying much heed to what the numbers told them, top management at financial organisations faltered in their judgment and this led to a major global financial meltdown.

It is obvious that in putting all the ducks in a row, one cannot change some of the ducks that err and data can be chosen selectively or even fabricated to support a hypothesis. But if dishonest twisting of numbers is a concern while deploying analytics, rigidity in frameworks is another.

Take the plagiarism-check software used for school students, for example, where wrong implementation without sound judgment by the decision maker can lead to unfair punishment. The software looks for 1phrases with three or more words that are common across submissions. The similarity between submissions could be as innocuous as: “As per this reference . . . ” If two students start a sentence with this phrase, the software would brand them as cheats. Thus, if teachers do not read through all the submissions to elicit the finer nuances and blindly depend on analytics, they could jeopardise the future of their students.

To take quick decisions, managers often rely on real-time analytics. Whether the data comes in real time or not, it is the quality of judgment that is paramount.

From what we know, short-term data and information should not be the basis of critical decisions related to things such as budget reallocation. Since patterns and trends are better judged if studied over a longer period, models that use long-term data are typically better predictors. Thus, prudence demands that managers are cautious about the type of analytical models they use.

Business schools need to teach students that they must go beyond the hype of crunching numbers and understand the business problem first, because numbers may not tell the complete truth. Numbers are a drop in the bucket and will serve their purpose best when they are used in alliance with the depth of a business manager’s judgment and experience.

Couauthored: Sanjay Fuloria[1] and Nupur Pavan Bang[2]

[1] Senior Researcher, Cognizant Research Center, Hyderabad; Sanjay.fuloria@cognizant.com

[2] Senior Researcher, Centre for Investment, Indian School of Business, Hyderabad; nupur_bang@isb.edu

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The Falling Rupee

This article was first published in the business section of www.rediff.com on June 14, 2013


Slowdown in the Economy
The issue of the relationship between development of financial systems (including currency markets) and economic fundamentals has been a much studied topic. The numerous studies on the topic confirm a positive and significant relationship between them. Successful financial sector reforms should translate into higher GDP for a country.

Dr. Manmohan Singh, the architect of India’s liberalization policies and the person credited with ending the license raj, had slipped into oblivion in the last few years. He has been often criticized of being a puppet at the hands of Mrs. Sonia Gandhi, increasingly so in the past couple of years when the Indian Economy has experienced a slowdown and loss of investors’ confidence. Lack of reforms has pushed the GDP down to 4.8 percent in the last quarter.

Last two years

In the last two years, Indian Rupee has depreciated by 25 percent, Brazilian Real by 33 percent, Russian Rouble by 15 percent and South African Rand by 47 percent. We are not considering the Chinese Yuan as the value of the Yuan is not market determined.

The global economic crisis caused a slowdown and period of uncertainty amongst most of the BRICS nations, as also the developed and the other emerging nations. In the financial year 2011-2012, the events in the EURO region were widely blamed for the depreciating currencies against the US dollar. Though rupee had fallen much more than the other currencies in fiscal year 2012. It clearly indicated that the domestic woes of high trade and fiscal deficits, high inflation, low confidence, lack of will for reforms, were adding to the fall of rupee.

Half-Hearted Reforms

Concerns about the falling rupee and constant threat of downgrade by the rating agencies, forced the government to make some noise regarding reforms. Inflation was also tamed to some extent by keeping interest rates high, following which RBI cut interest rates. These measures cheered the markets and stabilized the exchange rate for about three quarters between June 2012 and April 2013, as something was better than nothing.

But now, with poor corporate earnings, continued bad news in terms of the economic numbers, and flight of foreign financial investments to safer assets, both the rupee and the markets have been sliding.

The Impact

While talking to a seasoned investor from Kolkata, he told me, “I have a bad feeling about this. My son is happy as he works in the US and for him a depreciating Rupee means more money in his Indian bank account. But what about the value of our currency? If our currency is not valued, if there is no demand for it, how will the economy and the stock market grow? Who would want to invest in an economy whose currency is not valued? I would feel much more confident if our currency was strong.”

The conversation explains the impact that the falling rupee has. While non-residential Indians who send back money home may be happy about it, people who study abroad or who want to travel abroad for medical or tourism purposes, will not be happy about it. Similarly, firms who are net importers, their costs will go up many folds, while firms who
are net exporters, may be able to capture more market by giving discounts or offering better prices.


If we look at the data for the last week alone, most of the currencies have depreciated heavily against the dollar owing to the better than expected US jobs data and the improved outlook for the US economy. While it is easy to blame the global economic cues once again (like many other times in the past), the fact of the matter is that if our economy was sound and the investor confidence intact, it would have been easier to revive the Rupee. It may not be so easy now due to the lack of these.

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In Conversation with a Macro Hedge Fund Manager

This article was first published in ISB Insight, Volume 10, Issue 4, 2013, pp48-50

Vilas Gadkari, founder of the Nilgai group of companies, was formerly the Managing Director and Chief Investment Officer of Salomon Brothers Asset Management from 1992-1999, a co-founder of Rubicon Hedge Fund and Partner at Brevan Howard Asset Mgt LLP from 2008-2011 He is currently the non-executive Chairman of Pratham Institute for Literacy, Education and Vocational Training. During a visit to the ISB in January 2013, Gadkari shared his thoughts on identifying global macro imbalances, managing risk and his predictions for the coming years.

Following is an excerpt of the interview between Nupur Pavan Bang, Senior Researcher, Centre for Investment with the fund manager who has more than 30 years of experience in global markets.

Tell us about your journey from a degree in operations research to becoming a hedge fund manager.

After graduating from IIT-Powai, I went to the US to earn a Master’s Degree in Operations Research. In the late 70s, US investment banks were starting to use a lot of quantitative techniques and this attracted many analysts. For example, Salomon Brothers had a number of nuclear physicists and PhDs in mathematics on board. Like many others, I also turned my attention to Wall Street and joined Salomon Brothers. I was initially in the systems development department developing quantitative models. I quickly realised that the heart of the firm was on the trading floor, but I had never studied either finance or economics. I decided to return to university and learn as much as possible about these subjects. I became a PhD student at Columbia University and my thesis topic was “Foreign Currency Option Pricing.” While I was doing my PhD, I continued to work part-time in the economics research department of Salomon Brothers, which was headed by the legendary Henry Kaufman. My years at Salomon Brothers were a tremendous learning experience.

In 1998, the firm was bought by Smith Barney and then merged with Citibank. It went from being a 6,000-people company to a 160,000-people global conglomerate. It was such a large cultural change that five of us left Salomon and started our own hedge fund called Rubicon.

What is the thought process behind your global macro strategy?

Global macro strategy is principally about macroeconomics. There are always imbalances in global economies. The idea is to try and locate if there is a macroeconomic dislocation or imbalance somewhere. Economic policies are often designed to achieve certain political goals. European integration is a classic example where the idea of a single currency has very strong political desires supporting what is arguably an imperfect economic policy. This situation has turned Europe into a classic global macro trade that many types of global macro fund managers have taken advantage of for the last two decades.

The existing global financial crisis that started in 2008 is another example of global macro imbalances that resulted in very large dislocations in the financial markets. This crisis is still playing out and may continue to play out for another five or ten years.

The investment strategy then focusses on instruments and positions in the financial markets that would benefit from further evolution of the crisis.

How do you identify imbalances?

To begin with, we monitor several macroeconomic variables such as GDP growth, inflation, trade and current accounts, etc. In-depth research and analysis can usually point to sectors and countries that are moving away from sustainable trends. The key is always to find countries that are moving away from sustainable equilibriums.

There are three main financial markets that we track: one is the equity market, the other is the interest rate or the bond markets, and the third is the foreign exchange market. They all tend to react to a given crisis at different times. The pricing or valuations in these markets allow us to take positions to benefit from the evolution of the expected crisis.

Interest rates, if you watch the monetary authority, are relatively easy to predict. Monetary authorities are focused on fewer variables, so they are easier to identify and they are usually transparent. In fact, they are more and more transparent these days. Monetary authorities try to tell you what are they looking at and how they make their decisions. Even if this still doesn’t make it very easy, at least you have a lot of information to work with.

Equity markets and currency markets are very difficult because there are many different players in these markets who buy and sell for very different reasons. If you take the foreign exchange markets, there are short-term speculators, investors making medium-term investment decisions and importers and exporters. Thus, it is much harder to identify which flows are occurring and which flow is dominant.

Similarly, business cycles across countries create opportunities. If the cycles in major economies are desynchronised, it can create disruptions in certain sectors, whereas if they are synchronised, some sectors will get a tremendous boost. Once again, we turn to in-depth macroeconomic research to understand these economic developments.

Movements in capital flows, changes in interest rates, economic cycles ¾ many of these variables would depend on social, economic and political policy making, would they not?

Yes. Policy framework is very important for us. As macro managers, we look to identify an imbalance in the policy framework. As fund managers, we want asymmetry. For instance, if there is a recession and policy makers have responded to it, then the chances are that the economy is going to start emerging from recession. On the other hand, the asymmetry would suggest that the chances of the economy plunging into deeper recession are lower. As a result, taking positions with that view has a higher probability of success.

How do you identify whether the policy framework supports or reduces the imbalance?

A typical business cycle (you can start anywhere in the cycle) is where the economy is in recession or going into recession. The monetary authority will then start cutting interest rates and provide some stimulus. Often, the fiscal authorities will also take some form of action. Sometimes, there are automatic stabilisers. As unemployment starts rising, governments start providing unemployment benefits. That means the government is infusing more money into the economy. What you have to do as a global macro player is to follow the capital flows and price actions to look for the signs of change and predict when that is going to happen.

Can you give us a few examples of the sort of imbalances that you have seen in the past?

The last 10 years have been the favourite of global macro fund managers in this respect ¾ where imbalances were created by economic policies that were put in place for political reasons. There is no shortage of such examples. China, for instance, has a mercantilist policy where they intentionally encouraged investment in the export sectors and subsidized those investments so that Chinese exports became cheap and Americans would buy them. That created significant trade and current account imbalances. Cheap Chinese goods kept US inflation under control. It tempered US inflation. US interest rates were lower than they should have been; US bond yields through the nineties remained very low.

European integration, specifically German unification, is another fantastic example.

Let’s take the case of the European integration. What were the imbalances and how would you take positions?

European exchange rates were pegged between the countries in the European Union, within a band, in order to achieve greater economic integration in the region. It followed that German and French interest rates were very similar. In 1990, when East and West Germany unified, capital flooded into Germany in search of opportunities, such as cheap labour and cheap assets.

In order to cool the economy, Germany needed to raise rates. France, however, needed to cut rates as they were experiencing a slowdown at that time due to the global environment, but they were locked into pegged exchange rate regimes. Hence, neither could Germany raise their interest rates nor could the other countries cut rates. This put a lot of pressure on the exchange rates. The central banks initially said that they would not change things and that the exchange rates would remain same. However, they slowly started to intervene in order to try to stabilize exchange rates. The imbalance here was really in the exchange rates. The actual exchange rates were increasingly getting out of line with the fundamentals.

This was a great opportunity for macro managers. Because of the pegged exchange rates, the Deutsche Mark was grossly undervalued and the French Franc was overvalued, so we bought Deutsche Mark-Dollar Calls and sold French Franc-Dollar Calls as the currencies were free against the dollar.

Hedge funds are highly leveraged. Risk management becomes very important as margin calls could quickly go out of hand. How do you ensure the safety of your principal along with being leveraged?

Options offer a good tool for risk management. Buying calls is a safe bet as the initial investment is lower. If the bet goes wrong, you only lose the premium. And if you both buy and sell options, as we did in the case of Deutsche Marks and French Francs, the initial investment becomes even lower. The probability of losses are lower when taking positions in long calls. The gain could be considerable if the bet pays off and the situation starts to turn. We often also use covered positions and stop losses to manage our risks. It is also important to realise that there are no free lunches. There is a cost associated with each alternative. These are tools for risk management.

You had a dream run at Rubicon for five years and then a couple of difficult years. When there is an imbalance, and you are correct in identifying it, how can you go wrong?

We were fortunate that after the NASDAQ crashed in 2000 and 2001, our strategy, “global macro,” became quite fashionable and we significantly grew our assets under management. By 2005 we were up to about US$3.5billion.

The problem with global macro is that while it may be relatively easy to identify the macro imbalances, it may be a long time before those imbalances begin to reduce. You first have to decide whether you want to bet on the imbalances continuing to grow, or on the likelihood that something will soon happen to reduce these imbalances since they cannot be sustained forever. It sometimes takes a very long time before the imbalances and the markets turn. Therefore, when we start taking positions with a view that the turn will come soon, we need to be patient and also take positions in such a way that we do not lose a lot of money while we wait for the markets to do the right thing ¾ or what we think is the right thing. In the mid-2000s, the US housing market was booming. By 2005, we were convinced that it had gone too far; thus, we started shorting the US housing market in late 2005 ¾ a little bit too early. It wasn’t until the middle of 2007 that it really started to turn. We had a couple of difficult years. It is a part of the ups and downs of the business.

What is your outlook for the coming years?

The US economy is starting to grow, but slowly. The risk of a fiscal cliff continues to hang over their heads. Emerging markets have relatively more healthy fundamentals, but the risk of a Chinese hard landing remains. Europe continues to be in recession and will continue to have very low growth for many years. The global monetary policy will remain loose to stimulate developing economies for several years as well. I feel that there are opportunities in fixed income instruments of countries with lower default probabilities and in a sub-set of emerging markets. In equities, one ought to look at companies with resilient earnings, low leverage and high dividends.

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Put India’s Gold to Work

This article was first published in the Financial Times, Beyond Brics, on May 1st 2013


Co-Author: Saumya Rastogi (Intern, CFI)

When gold prices fell below $1400 in mid-April, investors across the globe panicked and tried to exit their gold-based investments. Yet the scene was quite different driving through the Somajiguda area of Hyderabad, in India. Both sides of the road, which is lined with jewellery shops, were overflowing with customers. As a valet at one of the largest shops put it: “People have been buying like gold is being distributed for free.”

The scene is testimony to the craze for gold among Indians. This craze is often blamed for India’s burgeoning current account deficit, and for a failure of household savings to reach the financial markets.

With cultural values that laud fiscal sagacity and shun profligacy, Indians traditionally save more than they spend. The household savings rate in India has always been above the global rate of 20 per cent. It was close to 30 per cent in 2012, making the year’s savings around $400bn.

But a very small part of these savings gets invested in stock markets (just 2 to 5 per cent). A large portion goes into fixed deposits (45 per cent) and a significant amount finds its way into buying the yellow metal (8 to 10 per cent).

Reduced real rates on bank deposits and small savings funds coupled with a volatile stock market have made gold even more popular among Indians. The risk-averse Indian considers gold a hedge against inflation and a safe asset with high investment potential – and rightly so.


Source: authors

Let’s look at the normalized prices of gold and the Sensex equities index of the top 30 companies listed on the Bombay Stock Exchange. A person who invested in the Sensex in 1997 and held his investment until today would have earned as much as a person who had invested in gold. However, it is also evident from the graph that while gold prices have risen steadily in the last 15 years, the Sensex has been very volatile since 2007. Since it is very difficult to time the market, a lot of investors might have ended up losing money if they had invested in the Sensex in 2006-2007 and then tried to exit. However, gold continued its steady rise even during those tumultuous years.

It is ironical that people buy gold and hoard it for years, but people buy stocks and sell at the first opportunity. If they held onto stocks as they do gold, their stocks might give them the same or maybe better returns. The difference in behaviour may be attributed to an emotional attachment to gold.

Another point worth noting is that aversion to risk is inversely proportionate to the level of education. According to a study by the National Council for Applied Economic Research, supported by the Securities and Exchange Board of India, risk-taking ability is highest among individuals with 15 years of schooling. Investment in mutual funds is much higher in villages close to urban centres, than in villages in remote areas.

There is a lack of financial awareness and innovation in India. Only 55 per cent of the country’s population has bank deposits, 9 per cent has bank credit accounts, less than 20 per cent has life insurance coverage and only 10 per cent has access to other kinds of insurance.

Clearly, financial services in India are under-penetrated and there is a need for inclusion of financial products and services to channel household savings into the financial markets. It is essential that people are educated about the existence of investment options and their associated risks and possible returns. The Indian market is up for grabs but more financial players will have to be encouraged to develop products and services aligned with the risk-averse nature of Indian households.

It would be wrong to expect that investment in gold can be quickly replaced with investment in financial instruments in India. However, measures that integrate gold and financial markets can provide a solution. Instrument like gold-backed deposit schemes, where households can deposit their surplus gold, in any form, in a bank and earn interest on it, gold exchange-traded funds, and so on, could facilitate the penetration of financial products in India. Better penetration and participation of households in the financial markets would definitely stoke the country’s economic engine.

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The Financial Sector Legislative Reforms Commission: Financial Liberalisation, Law and Market Architecture

The Financial Sector Legislative Reforms Commission[i] (“FSLRC”) submitted its report to the Ministry of Finance at the end of March.[ii] The report is significant both for its composition and mandate.  The FSLRC was chaired by renowned Supreme Court Justice, B.N. Srikrishna,[iii] and had a broad mandate to review the institutional arrangements of Indian financial sector regulation writ large.  The panel and its recommendations will likely be read in the light of the pro-market impulses of a weak central government facing elections in a year.  This is perhaps too narrow a frame.

The FSLRC’s report, complete with draft authorizing legislation, and in line with the high standards set for the body, proposes a sweeping reorganization of the country’s financial architecture.  The Commission was conceived of over 4 years ago[iv] and has been in operation for 2 years.[v] FSLRC draws on the work of over 100 people and extensive consultations with regulators, market participants and stakeholders across the Indian financial world, not to mention jurisdictions ranging from Australia and Singapore to the US and the City of London.  Indeed, the Act draws from some of the notable features of the US Dodd-Frank Act, the UK’s Financial Services and Markets Act of 2000, financial liberalisation in South Korea and recent Indian government committee reports.[vi] In particular, FSLRC proposes:

  • a consolidation of regulation of securities, pensions and insurance into a single, UK Financial Services Authority-style regulator.  The current work of the Securities and Exchange Board of India (SEBI), the Pension Fund Regulatory and Development Authority (PFRDA) and the Forward Markets Commission (FMC) would be rolled into a new Unified Financial Authority (UFA);
  • institutional arrangements to deal with systemic risk by giving the existing Financial Stability and Development Council statutory authority as well as financial and operational autonomy;
  • the creation of a resolution corporation to deal with— important given the significance of large family conglomerates to the Indian economy—“too big to fail” problems;
  • legal guidelines to norm policy initiatives promoting financial inclusion and redistribution;
  • an independent public debt management agency combined with;
  • a narrowing of the central bank’s (the Reserve Bank of India or “RBI”) mandate to focus largely, though not exclusively, on monetary policy, as defined by the Central Government;
  • a streamlining of the country’s system of capital controls in line with new IMF thinking that would allow restrictions of capital flows in narrowly defined instances (primarily natural disasters and balance of payment crises). In particular, the Central Government would promulgate ‘rules’ governing inbound capital flows while the RBI would promulgate ‘regulations’ governing outbound flows;
  • the creation of a financial consumer protection agency;
  • a clean-up of certain matters related to financial contracts and market infrastructure; and,
  • the formalization of procedures of administrative governance, including requirements of cost-benefit analysis, familiar to any student of US administrative law.

A number of the Commission’s recommendations are particularly notable.  First, FSLRC, in its work on systemic risk, calls for institutional arrangements to deal with future financial crises.  Dodd-Frank creates a Financial Stability Oversight Council within the US Treasury Department.  FSLRC would codify in statute the longer standing Financial Stability and Development Council composed of the Finance Minister, the chairs of the Reserve Bank of India, the newly created UFA and Resolution Corporation as well as an administrative law member, and provide the Council with operational and financial autonomy.

The US saw fairly significant battles over the creation of the Consumer Financial Protection Bureau in 2011.  In a country where 40 percent of the population lack access to the most basic of financial services,[vii] the creation of a body promoting financial awareness can help deepen understanding of, and trust in the financial system.

Financial regulation in India has often been criticized for piecemeal regulation by sectors and unnecessary complexity that prevents entities other than large firms from breaking through the home bias of foreign investors;[viii] for example, investment limits vary by industry sector and conditions have been attached to individual licenses for reasons which many find inconsistent.[ix] FSLRC’s arrangements would promote unified treatment of financial firms for prudential reasons rather than sectoral, and general ownership neutrality in regulation.  The FSLRC’s recommendations would also formalize and make administrative governance more transparent by requiring statements of objectives and principles, cost-benefit analysis and allow for notice and comment procedures.  Not least, the Commission’s recommendations would create specialized administrative courts to review violations of financial regulations that, while not unfamiliar in an Indian context,[x] have been a basic part of the American regulatory landscape, on a broad scale, across various levels of government, since the New Deal.[xi]

Economic policy debates in India have also been characterized by tensions between pressures to reduce budget deficits and promote social welfare.  Perhaps interestingly, the Commission does not require or prohibit any particular policy measure, but recommends that cost-benefit-analysis be required for any initiative promoting financial inclusion and redistribution.[xii]

Still, the Commission’s report will not be without controversy.  Perhaps the most significant effect of the FSLRC’s recommendations, if implemented in toto, would be to limit the role of the central bank.  The RBI has been both lauded and pilloried for taking a cautious approach to financial liberalization.[xiii] The FSLRC would create a separate agency responsible for managing public debt, removing these functions from the RBI.[xiv] The FSLRC would also hand control over critical policy matters such as the objectives of monetary policy[xv] and the administration of at least inbound capital flows[xvi] to the political branch of Government, the Central Government.  Indian economic policy has been characterized by a high-pitched, if largely internal to the system, turf warfare between the Central Government, specifically the Ministry of Finance, and the RBI, over the pace of financial liberalization.  While not taking an explicit position on financial liberalization,[xvii] and notwithstanding the many merits of these recommendations on their own terms, the Commission’s prescripts would rewrite the rules of engagement in economic policy in favor of the political branch of government and place a long term bet on broad-scale financial development—a contested proposition given the experience of OECD nations with financial deregulation in recent decades—as a means to realizing broader economic and social development.

[i] Bikku Kuruvila is a US trained lawyer who worked as a consultant for the National Institute of Public Finance and Policy in New Delhi from 2009 to 2013.  The views expressed here are personal.

[ii] See, Ministry of Finance, Financial Sector Legislative Reforms Commission,  http://finmin.nic.in/fslrc/fslrc_index.asp (Viewed on April 4, 2013).

[iii] Justice Srikrishna is, of course, first famous for leading a 5 year inquiry into the Mumbai riots and bomb blasts of 1992 and 1993.

[iv] The idea of a Commission undertaking a broad review of Indian financial sector regulation was first mentioned by then Finance Minister Pranab Mukherjee in his budget speech to Parliament in 2009.

[v] The Commission was notified on March 24, 2011.

[vi] See generally, Report of the Committee on Fuller Capital Account Convertibility, 126 (2006) (Commonly known as the Tarapore Committee); Committee on Financial Sector Reforms, A Hundred Small Steps 35 (2009); The High Powered Expert Committee on Making Mumbai an International Financial Centre (2007) (Also known as the Percy Mistry Committee); Report of the Working Group on Foreign Investment (2010) (Also known as the UK Sinha report).

[vii] See, Dr. K.C. Chakrabarty (2011): “Financial Inclusion: A Road India Needs to Travel.” Livemint (12 Oct). Viewed on February 18, 2013 (http://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/FICHI121011S.pdf) (This is an article of Deputy Governor Chakrabarty’s that originally appeared in, Livemint, and that is reproduced on the RBIs website.  Financial inclusion, to begin with, would include measures such as access to checking accounts or basic banking facilities, particularly in rural areas).

[viii] See, the UK Sinha report, 70-75. “Home bias” would be understood as the tendency of foreign investors to overweight their portfolios with investments in their home countries as well as to minimize investment in foreign firms operating in less familiar regulatory climates.

[ix] Id. at 56-59.

[x] For all the common critiques of the Indian legal system, particularly overwhelming case loads and delays in resolution of disputes, Indian courts have created vigorous bodies of law and institutions, such as the Securities Appellate Tribunal that should inspire some confidence in Indian rule of law.  Processes of consultation of stakeholders, too, appear to be an accepted, if informal practice of regulators, which FSLRC would institutionalize.

[xi] The US Administrative Procedure Act specifying the procedures that administrative agencies of the federal government must follow in creating regulations was enacted in 1946. Formal requirements such as notice and comment, administrative adjudication, cost-benefit type considerations have long been a part of the discourse and practice of US administrative governance.

[xii] Specifically, Chapter 60, Section 322 of the draft Indian Financial Code would only authorize the political branch of government to initiate measures of financial inclusion, and would require a review of these measures through a lens of ensuring “effective and affordable access” while reimbursing financial service providers for their efforts. In particular, the draft Code would require explicit and formal review of the efficacy, impact and cost of a given measure and seek, expressly, to identify best practices in a given area of endeavor.  These are not hard norms banning given initiatives of financial inclusion, but would norm the efforts of any regulator seeking to promote greater and deeper access to the financial system.

[xiii] See generally, Bajaj, Vikas (2009):  “In India, Central Banker Played It Safe.” The New York Times (25 Jun). Viewed on February 18, 2013 (http://www.nytimes.com/2009/06/26/business/global/26reddy.html?_r=0).  Some economists have argued that the RBI, particularly under former Governor Y.V. Reddy blocked important measures such as opening domestic bond markets to foreign investors, restricted trade in currency markets and kept Indian institutions from investing freely abroad.  Others, mindful of the causes of the financial crisis in the U.S., have praised the central bank for measures such as restrictions on bank lending to real estate developers, increases in the amount of reserves that banks must set aside and prevention from using certain derivatives.

[xiv] See, Draft Indian Financial Code, Part II (Establishment of Financial Regulatory Agencies), Chapter 9 (Establishment of the Public Debt Management Agency) and Part XII (Public Debt Management Agency), Chapter 73 (Objectives and Functioning of the Public Debt Management Agency).  See also, Report of the Financial Sector Legislative Reforms Commission, 111-114 (2013).   Currently, the RBI manages the market borrowing program of Central and State Governments while external debt is managed directly by the Central Government.  The Commission argues that some functions critical to managing public debt, such as cash and investment management, or the consolidation of information regarding contingent and other liabilities, are not currently carried out.  The Commission notes the RBI’s position that “to achieve public policy objectives of ensuring growth, price stability and financial stability, co-ordination between monetary policy, fiscal policy and sovereign debt management is critical” but argues that the governance arrangements recommended by the Commission—with RBI and Central Government voice in the debt management agencies deliberations—addresses these concerns.

[xv] See, Draft Indian Financial Code, Chapter 61, Section 326.  The objectives of the RBI, for example growth versus employment or price stability, are not specified.  However, vesting authority to define the mandate of the central bank in the political branch of government (the Central Government) works against the classic respect for central bank autonomy in economic policy-making worldwide.  See also, Report of the Financial Sector Legislative Reforms Commission, 103 (2013)(Chapter 11, Monetary Policy).  The Commission also states that “[w]hereas the Commission recognizes that there is a broad consensus at an international scale on the need for a central bank to have a clear focus on price stability, after much discussions it has decided not to specify such a requirement in the draft Code.  Instead, the objective that the central bank must pursue would be defined by a Central Government and could potentially change over the years.”

[xvi] See, Draft Indian Financial Code, Chapter 68 (Inward capital flows) and Chapter 69 (Outward flows).

[xvii] Report of the Financial Sector Legislative Reforms Commission, 81 (2013).  The report notes that “[t]he Commission has no view on either the timing or the sequence of capital account liberalisation.”

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Fat tails have a tale to tell

This article was first published in Moneylife on March 11th, 2013. Co-author: Khemchand H. Sakaldeepi


Between 1998-2013, out of a total of 3,785 days, movement in the CNX 500 was outside 3 sigma on 60 occasions, that is 1.59% of the total. By normal distribution, less than 0.03% observations should fall outside the 3 sigma

In the world of investments, returns are measured by the first moment of prices (mean) and the risks are measured by the second moment (standard deviation or sigma). Most of the classical theories of finance are based on the assumption that the returns are normally distributed. In the probability theory, the normal distribution is a bell shaped curve of probability values for various natural events—hence the word ‘normal’. This distribution assumes that the tails or the ends are flatter and extreme events are rare. For example, this means that the probability of returns moving more than three standard deviations beyond the mean is 0.03%, or virtually nil. But what is ‘normal’ in markets?

In the Indian context, taking daily CNX 500 data from 1 January 1998 to 28 February 2013 (more than 15 years), 99.73% of the daily returns should ideally fall within -4.97% and 5.09%. Or less than 0.03% observations should fall outside the 3 sigma.

Out of a total of 3,785 daily observations during the period of analysis, 60 times the returns were outside 3 sigma in the case of CNX 500, that is 1.59% of the total observations. Clearly much more than we bargain for. The rule book says that if we are looking at daily events, a 5 sigma event would occur once in 4,776 years. A 6 sigma event would occur once in 1.388 million years and after that, the numbers are, let’s just say too big to bother.

On 17 May 2004, the financial market experienced a more than 7 standard deviation fall, when markets crashed due to political uncertainty. Markets fell more than 5 to 6 standard deviations many times in 2007 and 2008, owing to global melt down. Similarly, the market posted a more than 9 standard deviation gain, once again due to the political scenario in the country at that time.

In reality, we have experienced 5, 6, 7 or even more than that, sigma events more frequently than what the normal distribution suggests and we dare to accept.

This is true globally, not just in India. For instance, Goldman Sachs, Citigroup, UBS, Merrill Lynch, all experienced large (as large as 25) sigma events on multiple days in 2007 and 2008. There was the South East Asian crisis, the 11 September 2001 attacks on the World Trade Centre, the Euro crisis, all in the past two decades.

It is not just that these events occur more frequently, these events have greater impact, as well. The impact is, in fact, higher due to the surprise element attached to them. It hits one at the place where it hurts the most and makes it very difficult to recover.

Our observations suggest that the distribution is more leptokurtic in nature, with fatter tails. This means that more observations are concentrated around the mean and tails are fatter, or have greater number of observations than suggested by the normal distribution.

So what we must do is first, acknowledge the limitation of our knowledge that we cannot explain everything and second, we must believe that such events occur more frequently than we had thought. This must call for better risk management systems. Perhaps these events indicate that we must prepare for more incorrigible things that will happen.

What this also points to is that the assumption of normal distribution does not hold. Hence, financial mathematicians must look at distributions with fatter tails for building their theories and models.

Additionally, Daniel Kahneman’s prospect theory says that humans are more likely to act to avoid loss than to achieve a gain, articulated very well in his book “Thinking fast and slow”. If we accept this to be true, then it becomes all the more important for the theorists and professional money managers to rethink the way they build models or the appropriateness of the models which they use.

As for the investors, it would be wise to question their financial advisor on the soundness of their advice during a large sigma event!

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