Its all about money, Honey!

Reserve Bank of India, the Money Pump.

This article would be published in two posts. I’ll try my best not to intimidate you.

Overview:

- RBI, myriad roles, and the instruments used
- Jargon Demistified and their impact
- Prior to liberalization
- Policies, Banks, and You!

Next post:

- Stock Markets and the policies
- Foreign exchange and the Rupee evaluation
- Overview of the Monetary Credit Policy 2006 – 2007

An intro:

RBI is governed by a central board (headed by a Governor) appointed by the Central Government. The current governor of RBI is Dr.Y.Venugopal Reddy (who succeeded Dr. Bimal Jalan on September 6, 2003). RBI has 22 regional offices across India.

Myriad roles:
1) Formulates, implements and monitors the monetary policy, maintaining price stability and ensuring adequate flow of credit to productive sectors, optimum Liquidity in the economy.
2) Prescribes broad parameters of banking operations within which the country's banking and financial system functions.
3) Manages the Foreign Exchange Management Act, 1999, facilitate external trade and payment and promote orderly development and maintenance of foreign exchange market in India.
Related Functions - Banker to the Government: performs merchant banking function for the central and the state governments; also acts as their banker, owner and operator of the depository (SGL) and exchange (NDS) for government bonds.

Jargon demystfied:

Bank Rate - Bank rate is the minimum rate at which the central bank provides loans to the commercial banks. It is also called the discount rate. Usually, an increase in bank rate results in commercial banks increasing their lending rates. Changes in bank rate affect credit creation by banks through altering the cost of credit.

Cash Reserve Ratio - All commercial banks are required to keep a certain amount of its deposits in cash with RBI. This percentage is called the cash reserve ratio. The current CRR requirement is 8 per cent.
Inflation - Inflation refers to a persistent rise in prices. Simply put, it is a situation of too much money and too few goods. Thus, due to scarcity of goods and the presence of many buyers, the prices are pushed up. The converse of inflation, that is, deflation, is the persistent falling of prices. RBI can reduce the supply of money or increase interest rates to reduce inflation.

Money Supply (M3) - This refers to the total volume of money circulating in the economy, and conventionally comprises currency with the public and demand deposits (current account + savings account) with the public.
The RBI has adopted four concepts of measuring money supply. The first one is M1, which equals the sum of currency with the public, demand deposits with the public and other deposits with the public. Simply put M1 includes all coins and notes in circulation, and personal current accounts.
The second, M2, is a measure of money, supply, including M1, plus personal deposit accounts - plus government deposits and deposits in currencies other than rupee.
The third concept M3 or the broad money concept, as it is also known, is quite popular. M3 includes net time deposits (fixed deposits), savings deposits with post office saving banks and all the components of M1.

Statutory Liquidity Ratio - Banks in India are required to maintain 25 per cent of their demand and time liabilities in government securities and certain approved securities.
These are collectively known as SLR securities. The buying and selling of these securities laid the foundations of the 1992 Harshad Mehta scam.

Repo - A repurchase agreement or ready forward deal is a secured short-term (usually 15 days) loan by one bank to another against government securities.
Legally, the borrower sells the securities to the lending bank for cash, with the stipulation that at the end of the borrowing term, it will buy back the securities at a slightly higher price, the difference in price representing the interest.

Open Market Operations - An important instrument of credit control, the Reserve Bank of India purchases and sells securities in open market operations.
In times of inflation, RBI sells securities to mop up the excess money in the market. Similarly, to increase the supply of money, RBI purchases securities.

What is the Monetary Policy?
The Monetary and Credit Policy is the policy statement, traditionally announced twice a year, through which the Reserve Bank of India seeks to ensure price stability for the economy.
These factors include - money supply, interest rates and the inflation. In banking and economic terms money supply is referred to as M3 - which indicates the level (stock) of legal currency in the economy.
Besides, the RBI also announces norms for the banking and financial sector and the institutions which are governed by it. These would be banks, financial institutions, non-banking financial institutions, Nidhis and primary dealers (money markets) and dealers in the foreign exchange (forex) market.

What are the objectives of the Monetary Policy?
The objectives are to maintain price stability and ensure adequate flow of credit to the productive sectors of the economy.
Stability for the national currency (after looking at prevailing economic conditions), growth in employment and income are also looked into. The monetary policy affects the real sector through long and variable periods while the financial markets are also impacted through short-term implications.
There are four main 'channels' which the RBI looks at:
1) Quantum channel: money supply and credit (affects real output and price level through changes in reserves money, money supply and credit aggregates).
2) Interest rate channel.
3) Exchange rate channel (linked to the currency).
4) Asset price.
In recent years, the policy had gained in importance due to announcements in the interest rates.
Earlier, depending on the rates announced by the RBI, the interest costs of banks would immediately either increase or decrease.
A reduction in interest rates would force banks to lower their lending rates and borrowing rates. So if you want to place a deposit with a bank or take a loan, it would offer it at a lower rate of interest.
On the other hand, if there were to be an increase in interest rates, banks would immediately increase their lending and borrowing rates. Since the rates of interest affect the borrowing costs of corporates and as a result, their bottomlines (profits), the monetary policy is very important to them also.
Since the financial sector reforms commenced, the RBI has moved towards a market-determined interest rate scenario. This means that banks are free to decide on interest rates on term deposits and loans. Being the central bank, however, the RBI would have a say and determine direction on interest rates as it is an important tool to control inflation.
The bank rate is a tool used by RBI for this purpose as it refinances banks at the this rate. In other words, the bank rate is the rate at which banks borrow from the RBI.

….. to be continued in the next post, get ready for RBI fundae, phase 2.

Sources: http://sify.com/finance/fullstory.php?id=14186963, http://en.wikipedia.org/wiki/Reserve_Bank_of_India , rediff and others

- Swap

Subprime mortgage financial crisis

What is subprime lending?
Sub-prime lending usually refers to the practice of giving loans to those who do not qualify for regular loans at market interest rates because of their poor credit history. Due to the increased risk associated with the takers, sub-prime loans are offered at a rate higher than market rates.

These loans are risky for both, those who are giving and those who are taking, because these combine high interest rates, bad credit history, and often, murky financial situations of the takers.

What caused the subprime mortage financial crisis?
The current sub-prime mortgage meltdown in US refers to the rash of sub-prime housing loan defaults that began in late 2006 and has continued into 2007. The sharp rise in foreclosures has caused several major sub-prime mortgage lenders to shut down or file for bankruptcy, leading to the collapse of stock prices for many in the subprime mortgage industry.

About 21% of all mortgages between 2004 and 2006 were sub-prime, up from 9% during the previous eight years. By 2006, sub-prime mortgages totalled $600 billion, accounting for about 20% of US home loan market.

In depth analysis of the crisis
Over the past few years, the issue has become more complex, as policy interest rates went to historical lows. The surge in liquidity was compounded by the economic recovery over the next few years and the boom in commodity prices. As crude oil rose to new highs, it poured into the already swollen corpus of the major oil exporters’ funds. With higher prices for commodity producers acquired vast pools of cash.

And with defined contributions becoming the norm across Europe, inflows into pension funds swelled. To top this off, the current account surpluses of East Asia piled up trillion dollar hoards.

So funds went hunting for yields and arbitrage opportunities - borrow cheap in yen and buy high yielding Australian, New Zealand and other securities.

There was of course much more. With so much liquidity sloshing around and all kinds of assets trading well, the collective euphoria is easy to understand. The price of risk plummeted across the board.

Some time around 2003, mortgage lenders branched out big-time into lending to people who would not normally qualify for lending.

The bet was that with house prices rising, the value of the underlying security offset potential credit losses. It became a booming business: people whose income background would not stand scrutiny bought houses they did not need and could not afford. Some took second mortgages on their existing homes to do up their kitchen just because someone was willing to hand them cash.

This was subprime debt.

Now remember, the borrower typically is low income, with negative savings and even if able to service the loan at 1% interest, is in no position to do so at 8 times that level.

So the house is foreclosed and auctioned. In the old days, this used to be called usury. These days it is known as predatory lending. However with so many homes coming to market, prices plummet and the collateral starts looking very scrappy.

Does the subprime crisis have the potential to become a full-blown debacle that can sink the world economy?
Commercial banks’ direct exposure to subprime mortgages is extremely low. But banks, along with other financial institutions, are exposed to subprime mortgages through derivative instruments known as collateralised debt obligations (CDOs). But the total volume of CDOs outstanding from US-based issuers is not a very large share of the aggregate value of marketable US financial assets. Banks hold the lion’s share of CDOs but only 17% of the CDOs have been created out of subprime mortgages. So how could a problem in subprime mortgages rock the international financial system?

Hedge funds hold the riskier part of the CDO tranches. Their holdings of CDOs form a high proportion of their portfolios. As a result, hedge funds are extremely vulnerable to a problem in subprime mortgages. The other, more important part of the answer is that hedge funds happen to be highly leveraged. With high leverage, a small drop in the value of assets suffices to create bankruptcy.

The vicious spiral that then sets in is by now distressingly familiar. The perception that a hedge fund is on the verge of bankruptcy triggers redemption calls from investors. Lenders too want their money back. This forces the hedge fund to liquidate assets.

When this happens at several hedge funds, there is a wave of selling. Panic grips the markets quickly. Risky assets begin to get dumped as investors seek refuge in government securities. All of a sudden, assets become highly correlated. The risk management models that financial institutions use compel them to reduce market exposures. This leads to more selling, more bankruptcies.

Subprime lessons for India
A need for credit rating even in the personal loan, or retail financial services, market. The Indian personal credit market has still retained vestiges of the old, inelastic interest rate system where, for the same loan amount, a man with a successful repayment record pays the same interest rate as somebody who was either taking out a loan for the first time or has an erratic repayment record.

Here’s another example: Indian banks offered the same interest on housing loans, irrespective of whether you had other loans running concurrently or your salary was inadequate to meet the repayment burden for your car loan. Credit shopping is common in if you already had taken a loan from Bank A, you could take another one from Bank B without A knowing about it. And, when you defaulted, it hit all the banks equally hard.

The Reserve Bank of India has made some progress by approving the launch of the first credit information bureau Credit Information Bureau of India (Cibil).Cibil is still in its formative stages and the regulator is still groping his way about the whole process. There are many regulatory gaps that need to be ironed out before the whole process can start yielding productive results.

Firstly, there is an urgent need to regulate the credit rating agencies.

Secondly, banks currently provide all their customer, loan and repayment details to Cibil, which then processes this data to form an opinion on the borrower’s creditworthiness. This is likely to be extended to mobile phone companies, stock brokers and insurance companies. Callous data entry or even manipulation by one participant in the chain can skew the credit score of any borrower, leading other lenders to charge a higher rate of interest to the hapless borrower. Cibil should check the authenticity of the data submitted.

Finally,India should have more credit rating companies, as every developed financial system has more than one credit information company today. This is necessary to obviate the kind of issues that may occur in the example mentioned above. Multiple credit information companies use different systems to iron out the kinks and to spot aberrations in the data. The market, banks in this case, then decide which is the better, and more reliable, company.

---Sweta