NIVESHAK

THE INVESTOR VOLUME 2 ISSUE 10 NOVEMBER 2009

GREEN SHOOTS IN INDIAN ECONOMY PG.09 SYSTEMATIC RISK FINANCIAL REGULATION pg. 17

FROM EDITOR’S DESK Dear Niveshaks,
As the Sensex kisses the 17,000 mark and the DJIA fiddles with the
Niveshak 10,000 level, it may seem that the Bull which almost seemed to be resting in
peace for the past six quarters, has returned. Economists and Analysts have
Volume II started to have a short look back at the reason of the crisis, a deep look at
ISSUE 10 the extent of its effect on the world economy and a long look at the road to
recovery ahead. But in this discussion, did we notice one thing – Recovery
November 2009 is taken for granted. Can we afford to take this as granted? Let me throw a
word of Caution.
Faculty Mentor Huge bailout packages, lowering of interest rates and opening of mul-
Prof. S.S Sarkar tiple liquidity windows to flush out the menacing bear from the markets has
created a huge problem. Firstly, this has pushed most of the countries into
a severe fiscal deficit, in the 8-10% range which may take governments a
couple of years to bring them down to 2-3% range. This can have fatal im-
THE TEAM pacts leading to lesser government spending in the next few years leading
to lower growth rate. The value of major currencies with the dollar has been
Editor very volatile over the past few months. Problems with huge inflow and out-
flow of money, heavy volatility in currency values, fiscal deficit prevailing in
Biswadeep Parida most of the countries may lead them to taking drastic measures on capital
account convertibility. So the possibility of a Currency bubble also may not
Sub-Editors be ruled out.
Amit Choudhary The billions of dollars bailout packages rolled out in the west found
Nilesh Bhaiya greener pastures in the emerging economies. As a result, these economies
defied earnings positions of companies & negative market forces and con-
Sareet Mishra tinued to rise up since March’09. The BSE Sensex for instance was trading at
Sujal Kumar 8-10 times P/E during the recession is now trading at 21 times P/E. This can
be attributed to the formation of an asset bubble in the emerging econo-
mies. When liquidity starts to dry out, investors will be seen running for cover
New Team pulling down the market.
Bhavit Sharma In its last quarterly review, Reserve Bank of India, the regulator, marked
Durgesh Nandini Mohanty an end to the easy money era which was continuing since the recessionary
Hitesh Gulati times. Now credit would not be as easy as it was until now. This so-called
Sumit Kedia start of liquidity squeeze may have an impact on the expansionary plans of
corporate India. This month credit growth recorded single digits for the first
Tanvi Arora time in last fifteen years. This is not just the case in India, many economies
Upasna Agarwal of the world have tried to control fiscal deficit and overheating of economy
due to drastic recovery steps by marking an end to the easy money regime.
Now this may stop the economy from recovering at the rate at which it was
Design Team earlier expected.
Bhavya Aggarwal Earlier we have mentioned that the Chinese have set out on a misad-
Sarvesh Chowdhury venture of going on a buying spree and have been stock piling inventory
Swarnabha Mukherjee which was then available at a very low price. Now this led to rise in com-
Tripurari Prasad modity prices all over the world. Indicators like the Baltic Dry Index pointed
that there in heavy shipping of commodities across the world. No one was
wrong. But the reason was deceptive. There was not much increase in con-
sumption in China, rather it was stock piling for future use. After a few days,
the largest buyer in the commodity market will be on leave and consume
from its stockpile.
All images, design and artwork
Now as the dust settles and the smokes clears, we join the dotted lines
are copyright of and one thing will become clear - The recovery in was not for real. We may
IIM Shillong Finance Club fall back again but not as much as we fell last time but after that the recovery
will be real. Let us wait for the best times to come back soon and in the mean
time let us go through some really insightful articles that our friends from
across all B-Schools have penned down. Hope you find this an interesting
©Finance Club read.
Indian Institute of Management
Shillong Happy Investing!
Biswadeep Parida
www.iims-niveshak.com (Editor-Niveshak)

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears
no responsibility whatsoever.
CONTENTS
Niveshak Times
04 The Month That Was
finsight

20 Indian Banking - A Risk

Profile

Cover Story
15 The Great Run fingyaan
is it a bubble again? 11 Derivative Instruments
in the Indian energy market

article of the month

17 Systematic Risk
and Financial Regulation

finlounge
14 Fin-Q
PERSPECTIVE
06 Agro Futures: Is it really
helping the farmers?

09 Green Shoots in Indian

Economy- Hope versus Concerns
 Niveshak Times www.iims-niveshak.com

The Month That Was

Tanvi Arora
IIM, Shillong
Market Watch nies to help them reduce their debts by around Rs
The last one month saw a lot of fluctuation at 60,000 crore. The Cabinet committee on Economic
both the BSE and the NSE. The week ending 23rd Oc- affairs has taken this decision for 12 PSUs in which
tober saw a decline of 515.20 points on Sensex (from the government share is more than 90%.
the previous week) to close at 16,810.81 points. This Even before formulating this policy, the govern-
sharp downfall of 2.97% was majorly due to the fall ment had approved the proposal for 2 major disin-
in prices of the petrochemical giant RIL. Its effect vestments, from Rural Electrification Company (REC)
was also visible on Nifty which fell by 144.75 points and from NTPC. The government currently holds
(2.82%) flattening out at 4,997.05. 81.80% in REC which would be reduced to 66.8% post
In the following week, markets plunged fur- the FPO which would raise around Rs 3500 crores.
ther down due to the announcement by the RBI to REC plans to employ this money fund the on-going
hike SLR rates. The BSE faltered by 5.44% to close electrification projects with this money.
at 15,896.28, i.e. 914.53 points less than the pre- The Government has also cleared the proposal
vious week’s closing price. This was a fall of 10% for sale of 5% of its equity in NTPC in which it has a
from 17th October when the prices had soared up share of 89.50% as of now. The follow-on offer would
to 17,493. Similar results was reflected on Nifty as help them raise around Rs 9000 crore at current mar-
well, which ended at 4,711.70, a decline of 5.71% ket price.
or 285.35 points. The major reasons for this down-
Second Quarter results – Black and White
fall were derivative segments rollover positions and
troubled second quarter results of 2 key players, RIL As the companies declared their second quar-
and Bharti Airtel. ter results ending on September 30, 2009, the mar-
ket experiences a bag of some unexpected and some
The first week of November showed affirma-
disappointing net profits. It turned out to be a bad
tive signs on both Sensex and Nifty. This positive
quarter for the airline sector. Jet airways reported a
sentiment of the market was dominated by huge
loss of 6%, around Rs 407 crore. Kingfisher Airlines
investments by the FIIs. The Sensex rose by 1.65%,
also posted a loss of 13%, reduced from Rs 483 crore
262 points above last week, to close at 16,158.28
last year to Rs. 419 crore.
points and Nifty expanded by 84.45 points or 1.79%
to reach 4,796.15. With intense competition cropping up among
telecom operators, Bharti Airtel did not perform as
The week ending 13th November saw further
per expectations. Their revenue increased by only
rise at Sensex by 690.55 points or 4.27 % compared
9% and net profits was up by 13% to reach Rs 2,321
to the previous week to reach 16,848.83, while Nifty
crore.
closed at 4,998.95, up 202.80 points, or 4.23 per cent.
This rise could be attributed to the increase in global Automobile was one sector where the com-
markets and government’s reform initiatives. The ro- panies performed well. Tata motors reported a net
bust growth data lifted the spirits of steel and auto profit of 110% to reach Rs 729 crore in this quarter.
sectors. This increase was the best weekly gain in Mahindra and Mahindra also reported a net profit
the last 11 weeks. of 288%, a whopping increase of Rs 456 crore from
last year.
Disinvestments to fund Government’s mar-
ket borrowings Inflation surges to 1.34% in October

The cash strapped government has decided to The new monthly index launched on 14th No-
dilute a part of their equity in public sector compa- vember, declared a 0.50% increase in the WPI-based

4 NIVESHAK VOLUME 2 ISSUE 10 NOVEMBER 2009

 Niveshak Times www.iims-niveshak.com

The Month That Was

inflation to reach 1.34% in October. Though fruits 30, 2009, GVK Power and Infrastructure Ltd (GVKPIL)
and vegetables became cheaper by 11%, the height- headed to acquire 12.2% stake in Bangalore Interna-
ened prices of a few commodities like wheat and tional Airport Ltd (BIAL). Flughafen Zurich (Unique),
rice highly affected the index. An increase of 0.1% Zurich airport operators sold 12.2% of their shares at
was also seen in the fuel and power category during Rs 485 crores to GVK Airport Developers Pvt. Ltd, a
October, majorly because of the increase in prices of fully-owned subsidiary of GVKPIL. Unique still holds
furnace oil by 3% and bitumen by 1%. a 5% stake as an operator whereas GVK would center
their attention on the management aspect. GVK is
L&T strengthens Power sector, reduces
the largest shareholder of Mumbai Airport and works
stake in Satyam
for its modernization. Acquiring stake in BIAL is a
The last two weeks saw 2 major acquisitions strategic move by GVK to be a part of one of the big-
by L&T, driving company’s growth in thermal and gest airports in the country. They also intend to look
nuclear power sector. Immediately after bagging the out for any further stake sales by other shareholders
Rs 6897 crore order from Mahgenco- Maharashtra of BIAL, namely L&T and Seimens.
for 3 super critical Boiler – Steam Turbine Genera-
tor Package of 660 MW capacity, L&T entered into Essar arm issues bonds to raise funds
another deal with the Madhya Pradesh Power Gen- Essar Group’s holding company for telecom
eration Co. Ltd. (MPPGCL) on turnkey basis. This Rs services, ETHL Communications Holdings Ltd (ECHL)
1635.30 crore Balance of Plant (BoP) contract was issued zero-coupon bonds to raise Rs 4280 crore. The
signed for two Coal fired plants of 600 MW each. L&T amount would be spent to finance the group’s steel
faced tough competition from domestic BoP bidders and refinery businesses. Non-convertible debentures
for the project. were launched in two series of Rs 2,250 crore each
On the other hand, L&T is also planning to with one maturing in July 2011 at 9.15% and anoth-
sell one-third of its 6.9% stake in Mahindra Satyam er one in December 2011 yielding 9.25%. Vodafone
which would fetch around Rs 304 crores. It is being group has backed these debentures by a put option.
seen as a strategic move to book profits as the mar- RBI diversifies
kets recover.
The Reserve Bank of India has followed the
States speak about GST footsteps of the Central Banks of China, Russia, Phil-
The much awaited discussion paper on GST ippines and Mexico and increased its gold reserves
was released on November 10 communicating the and diversified its holdings. The RBI would soon buy
proposed framework in India. The paper discusses 200 tonnes of gold for Rs 31,490 crores from the IMF.
about the administrative and threshold aspects. This pronouncement by the RBI resulted in an im-
There was broad consensus among various states pulsive rise in gold prices to reach a record high of
on GST. The two-tier structure was proposed to en- $1,093.10 per ounce.
joy concessional rates for some goods by the states,
though it would raise the GST rate. The final law
however, would be passed by the central govern-
ment.

GVK acquires Unique’s stake in BIAL

A week after declaring a 45.19% increase in
net profit for the second quarter ending September

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 5

 Is it really helping the farmers?
Amit kumar
XLRI, Jamshedpur
Through a statistical
study of impact of
future prices on spot
prices in few com-
modities the article
attempts to resolve
the debate of future
of agro futures in
India on farmers.
Perspective
6 NIVESHAK VOLUME 2 ISSUE 10 NOVEMBER 2009
What are Agro-Futures?
Every year farmers face the risk
of what price they would get of their
harvest. This – of course depends on
the quality of harvest (which up to
some extent is under their control).
However, it also depends on the de-
mand supply forces, which is abso-
lutely not under their control. The
farmers thus start the crop season
under tremendous uncertainty of
what price they would eventually
get of their produce, which makes
it difficult for them to take more in-
formed production decisions.
Enter Agro-Futures – the com-
modity futures market for agricultur-
al based commodities. The farmers
can hedge their price risk by getting
into a futures contract at the start
of the season itself. How this works
is like this – say the three months
futures price for sugar is Rs 2500 per
100 Kg. In a good year the farmers
can get as high as Rs 3000, while in a
bad year it can go as low as Rs 2000.
This is an unnecessary risk which
the farmer is taking up. The farmer
can sell a three month futures con-
tract at the start of the season and
be certain that he is going to get Rs
2500 for 100 Kg of his produce.
A brief explanation of how this
works is as follows. If the actual
price of sugar at the time of selling
the farmer’s produce three months
hence happens to be Rs 2000 – the
farmers gains Rs 500 from the con-
tract while he loses Rs 500 on the
actual sale of sugar. In case the ac-
tual price happens to be Rs 3000, the
situation just reverses – the farmer
loses Rs 500 from the contract but
gains Rs 500 on the actual sale of
sugar.
The hot debate!
Why is this important for
farmers in particular? whether futures trading of agro
Agricultural commodities are based commodities should be
different than other commodities banned in India. One view is that the
extremely high degree of speculative
(like metals) because their produc-
tion is seasonal in nature. Moreover,
the producers are very small players
(as against the producers of metals
– the big mining companies). Also,
even though the price of the agro-
good may fluctuate heavily through-
out the year, the farmers are forced
to sell their produce immediately
rather than “hoard” and wait for
prices to rise. Hence futures trad-
ing seems to be a good way out to
protect the interests of the farmer
community.
The other side of the trade
Wholesale buyers also benefit
from this mechanism as they can
lock in the prices at which they buy
the farm produce – thus reducing
their price risk as well.
Enter Speculators!
Apart from the hedgers - farm-
ers who act as the sellers of the fu-
tures contracts and wholesalers who
act as buyers of the contracts, the
other important category of market
participants is the speculators. In
simple terms, speculators do not
have any position in the underlying
– they only take a certain view about
the price of the underlying and thus
enter a futures contract. The whole
idea of a futures market is that it
transfers the price risk from the
hedgers to the speculators.
However, commodity markets
in general are attracting lots of
speculators who enter it to make a
quick buck. The “financial leverage”
aspect of derivatives makes it easy
for someone to make (and of course,
lose as well) with a relatively small
investment.
The matter of argument is
 activity in the futures market has led to price volatil-
ity in the spot market – thus negating the basic pur-
pose of setting up a futures market. The government
set up an expert committee to investigate into this.
The major conclusions of the study are as follows:
• The price rise in agro commodities was indeed
a major reason for the inflation in 2006-07. Also,
most of the food grains showed a rise in price after
the introduction of futures trading for them.
• However, the post futures rise in prices cannot
be attributed to the introduction of futures – since
the prices were very low before the introduction of
futures – hence the base was low, and an increase
in prices was anyway due.
• No conclusion was drawn regarding whether
the introduction of futures trade has caused an in-
crease or decrease in the volatility of spot prices.
However, in stark contrast to the results of
the above mentioned report, a recent study carried
out by the United Nations Conference on Trade and
Thus, futures trading has largely become just
another asset class in an investment portfolio rather
than a hedging vehicle. The ex- Finance Minister Mr.
P Chidambaram had tried to curb this by introduc-
ing a Commodities Transaction Tax on Options and
Futures – just like the Securities Transaction Tax. It
has also been suggested that India should start im-
posing different margin requirements for hedgers
and speculators – thus being more lenient on hedg-
ers and harsher on speculators. Another possible
measure that has been doing the rounds is that we
should switch to “Delivery Based Forward Trading”
rather than “Paper based derivatives trading”.
Data analysis and interpretation
For understanding the behaviour of spot prices
of commodities vis-a vis their future prices, follow-
ing three commodities were selected and regression
analysis was performed over them.
• Wheat
• Tur

Perspective
Development (UNCTAD) has concluded that futures
• Urad
trading in commodities does affect spot prices of
the underlying. This study, however, was carried out Wheat
at a global level and is not India specific. The study The details about the data under consider-
reveals concerns that speculators do tend to take up ations are given below:
extremely large positions compared to the size of
the market which have the power to move spot pric- Commodity – Wheat
es despite the prevalent demand supply forces. The Duration- 1st July 2009 to 5th Sept2009
study has thus highlighted the importance of a com- Contract- 18th September 2009 expiry futures con-
prehensive regulatory framework to keep a check on tract of wheat traded on MCX.
the speculative activity in the futures markets.
Regression of Spot against Future prices
Is Futures trading really benefitting the Due to moderate coefficient of determination (R2)
farmers? value (69%) and low probability –value (0.0000), in-
The big question thus remains – is futures trad- fluence of future prices on the spot prices of Wheat
ing just being used by speculators and large corpo- is significant and can’t be denied. This suggests
rations with no benefits to the farmers? The par- Spot prices are getting driven by Futures prices to
ticipation of farmers in futures trading in India is an extent but not very much. There could be also
abysmally low – primarily because of the complex be some other factor responsible for inflation. The
nature of the commodity markets and the lack of sample chart showing the regression results is given
awareness amongst the farmer community about below: (Table 1)
them. Moreover, the high lot sizes of futures con-
Coefficient Std. Error t-Statistic Prob.
tracts also discourages the small farmers to directly
C(1) -755.3289 166.3 -4.541118 0.0000
participate in these markets. The membership fees
are also exorbitantly high considering the small C(2) 1.617043 0.143 11.24145 0.0000
farmers and also the daily margining requirements
R-squared 0.696753 Mean depen- 1114.2
act as further roadblocks for those few farmers who dent var
are really interested in hedging their price risks via Adjusted R- 0.691239 S.D. dependent 34.891
futures markets. squared var

Speculators do not have any

Futures trading has largely
position in the underlying.
become just another asset
They only take a certain
class in an investment portfo-
view about the price of the
lio rather than a hedging
underlying and thus enter a
vehicle.
futures contract.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 7

 S.E. of regres- 19.38765 Akaike info 8.801607 in spot prices, rather it is helping in curbing the
sion criterion same.
Sum squared 20673.45 Schwarz crite- 8.873293
resid rion Urad
Log likelihood -248.8458 Hannan-Quinn 8.829466 The details about the data under consider-
criter.
ations are given below:
F-statistic 126.3703 Durbin-Watson 0.697448
stat Commodity – Urad
Prob(F-statis- 0.000000 Duration- 10th feb 2006 to 18th aug 2006
tic)
Contract- Aug 2006 expiry futures contract of Urad
Regressions of spot against volume of future trades
Regression of Spot against Future prices
Due to very low R2 value (22.77%), influence of fu-
tures trading volume over spot prices proves to be High R2 value (81%) and low probability figures
very less. (0.0001) suggest that Spot prices are substantially
influenced by future prices of Urad.
Standard deviation comparison
Regression of Spot against volume of future trades
Standard deviation of Spot prices = Rs 34.89
Poor R2 value (1.11%) and high probability fig-
Standard deviation of Future prices =Rs 18.01
ures(19.01%)suggest that Spot prices are not at all
Interpretation influenced by volume of future trades of Urad.
The standard deviation comparison proves that fu- Standard deviation comparison
tures trading in wheat is not adding to the fluctua-
Standard deviation of Spot prices = Rs 173.74
Perspective

tions in spot prices, rather it is helping in curbing

the same. Hence, this can be said that future trading
in wheat is fulfilling its intended purpose.
Tur
The details about the data under consider-
ations are given below:
Commodity – Tur
Duration- 28th sept 2006 to 20th dec 2006
Contract- 20th dec 2006 expiry futures contract of Tur
Regression of Spot against Future prices
Poor R2 value(0.49%)and high probability fig-
ures(56.19%) suggest that Spot prices are not at all
influenced by future prices of Tur.
Regression of Spot against volume of future trades
Poor R2 value (0.03%) and high probability fig-
ures(87.77%) suggest that Spot prices are not at all
influenced by volume of future trades of Tur.
Standard deviation comparison
Standard deviation of Spot prices = Rs 177.25
Standard deviation of Future prices =Rs 43.96
Interpretation
The standard deviation comparison proves that fu-
tures trading in Tur is not adding to the fluctuations
Standard deviation of Future prices=Rs 229.7
Interpretation
The standard deviation comparison proves that fu-
tures trading in Urad is adding to the fluctuations in
spot prices.
Conclusion of analysis
Thus we observe that Spot prices of Wheat
are moderately affected by its futures trading, spot
prices of Tur are not influenced by its future trad-
ing but, Futures trading in Urad is causing its spot
prices to inflate. Further, it can also be inferred that
futures trading in wheat and Tur are helping in risk
management in trades but the same in case of Urad
is helping in speculation.
As we have also got mixed results on the limited
data analysis that we performed, it is clear that
there is need for further research specific to the In-
dian context on the impact of futures trading on the
spot prices of agro commodities. However, there is
certainly an urgent need to make the farmers more
aware about futures trading as a hedging instrument
and to regulate the extent of speculation in this mar-
ket.

The farmers start the crop season

under tremendous uncertainty of
what price they would eventually
get of their produce, which makes
it difficult for them to take more
informed production decisions.

8 NIVESHAK VOLUME 2 ISSUE 10 NOVEMBER 2009

Green Shoots in the Indian Economy
Hopes & Concerns
The global economic meltdown
had forced a cyclical slowdown in
Indian economy in 2008-09, though
Indian financial system was broadly
insulated from the typical problems
of derivative related crisis and cred-
it freeze that pushed most of the
world to the worst recession ever af-
ter ‘The great depression’. This was
due to the fact that Indian banking
and financial system is still actively
regulated by the government and
RBI. After that, time has passed and
due to coordinated effort of govern-
ments in USA and other developed
countries the economies across the
world have shown signs of improve-
ments. India along with China and
Brazil has been at the forefront of
growth in this scenario. But experts
and economists are still sceptic
about the scenario. They have called
these as ‘green-shoots’.
Industrial output for the month
of July was 7.2% higher than July
2008 and in the month of August it
was 10.4% higher than last year. The
passenger vehicle segment grew by
more than 20% in both July and Au-
gust after contracting double digit in
2008 Q4.
Imports and export levels have
shown pronounced sign of improve-
ments in spite of the fact that they
are still below the level of previ-
ous year. The reason for this better
growth has been due to huge fiscal
deficits and sharp tax cuts that In-
dian government implemented to
minimise the effect of slowdown. In
fiscal year 2009-10 also Indian gov-
ernment has projected its fiscal defi-
Foreign inflows have start-
ed to comeback to India in
steady and sustained manner
as India has been identified
as a clear growth destination
in this recession scenario.
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
Souradeep Dey & Rakesh Kumar Choudhary
MDI, Gurgaon
cit to be 6.8% of the GDP. All these
measures have boosted demand in There are some posi-
India and helped the economy to be tive developments
back in track without much hassle. and challenges in
In spite of slowdown and high
Indian economy in
inflation Congress-led UPA govern-
ment staged a convincing victory in
the context of global
the parliamentary election early this economy which is try-
year. This has raised the hope for a ing to heal itself from
stable government in centre which
recession. There is a
can strongly implement regulatory
reforms important for a sustainable gloomy side of the
growth of Indian economy and good picture and challeng-
governance. es lying ahead. This
Perspective
Also, foreign inflows have balancing approach
started to comeback to India in
steady and sustained manner as has been used to as-
sess the green shoots
India has been identified as a clear
growth destination in this recession in Indian economy
scenario. There has been substan-
and put forward op-
tial FDI inflow in 2009H1 in India as
multinationals realized the potential timistic views about
of investing in this country. Portfo- future.
lio investors have been quite sceptic
about investing in Indian securities.
In spite of that, they have pumped
in $10 billion. Sensex has gained
more than 100% to reach a level of
almost 17400.
In addition to all this, compa-
nies have started hiring again in the
midst of this kind of activities after
freezing hiring process for more than
one year.
All these have raised hopes
about growth, investments, employ-
ment and overall prosperity of the
Indian economy. But at the same
time economic news is not unam-
biguously well.
There has been below average
rainfall this year. Till mid of august
But at the same time eco-
nomic news is not unambigu-
ously well.
9
 the aggregate rainfall have been 28% below the nor-
mal. This has affected the Kharif sowing. Paddy,
pulses, bajra, cotton, soy bean and sugarcane are
the crops whose production is expected to be below
average. Lower production of crops will hamper the
economy as agriculture constitutes 17% of the GDP.
At the same time the deficiency of food grains will
cause inflation in the economy.
Fiscal spending and tax cuts have played major FIN-Q Solutions
roles in improving the economic situation. But it is
unlikely for the government to extend such mea-
OCTOBER 2009
sures as the debt level is already too high (59% of
GDP at the end of 2008-09). So it is important for the
1. Agreement on Technical Barri-
government to get back to the path of fiscal stabil- ers to Trade (TBT Agreement)
ity. Too much government borrowing is a concern
as it may restrict the borrowing opportunity of the
private sector. 2. X = Bears Sterns , Y = JPMor-
The reserve bank has supported the econo- gan Chase
my by a series of CRR and SLR cuts in the time of
slowdown to enhance liquidity. They also lowered
repo- reverse repo rate to enhance easier lending. 3. CRISIL , Independent Equity
Research Reports
Perspective

But, very recently they have hinted about tightening

monetary policies to combat inflation.
Along with this, the commodity prices are in-
creasing very sharply with oil reaching $81/barrel.
4. Kit Kat
This kind of inflation in commodity price will hamper
the growth of economy in India as it is dependent 5. Tom Peters
for oil on import mostly.
American and European countries are the main
demand drivers in the world economy. Though the 6. Purchasing Managers’ Index,
situations in these countries have improved, they Manufacturing Firms/HSBC
are still not out of the woods. Until and unless there
is a clear emergence of growth, Indian economy will
face problems as it is integrated to the world trade 7. Raj Rajaratnam
and economic structure.
There are genuine concerns ahead of us which 8. Troubled Asset Relief Program
should be tackled by government aptly. The govern-
ment should not hurry in withdrawing all the life- (TARP)
lines it has extended to support the economy at one
go. Otherwise the green shoots of economic recov-
ery may turn in to yellow weeds at any point of
9. Goods and Service Tax (GST)
time. There lies huge opportunity ahead of India in
these uncertain times as this recession gives India
opportunity to strengthen its position in realignment
of global economic powers. We expect India to stand
firmly and prosper with these green shoots blossom-
ing into colourful and aromatic flowers.

Too much government bor-

rowing is a concern as it may
restrict the borrowing opportu-
nity of the private sector.

10 NIVESHAK VOLUME 2 ISSUE 10 NOVEMBER 2009

Derivative Instruments
i n t h e In dian Energy Market
Indian infrastructure sce-
nario:
The Indian economy has seen
its gross domestic product (GDP)
growth rate dip to 6.7 per cent in
2008. According to reports, to aim
for an annual growth rate of 9 to 10
per cent India needs to make huge
investments in infrastructure devel-
opment. According to a McKinsey re-
port, significant progress has been
made in the field of physical infra-
structure like roads and airports and
telecommunication but a lot needs
to be done when it comes to the in-
frastructure in the power sector. The
poor performance of SEBs due to low
average tariffs and high cross sub-
sidies to agriculture and household
sectors has stifled the growth of this
sector.
Progress was made in this re-
gard with the Electricity Act 2003
moving generation and distribution
out of ‘License Raj’ regime, demol-
ishing the ‘Single Buyer’ model and
opening access to national grid.
However, a lot of restructuring is yet
to be done in this regard. If India
were to grow at a rate of 9% during
the next five year plan (2009-2014)
the country’s demand for power
would grow at a slightly greater rate
of about 10% i.e., from the present
120 GW (2008) to about 210 GW by
2014. The installed capacity needs to
grow from the present 145 GW to 256
GW in 2014. The growth in demand
would be fuelled by growth in the
residential consumption, continued
growth in the services sector and
greater penetration of electricity into
the hinterlands of India.
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
Shitij Chhabra
IIM Lucknow
According to George Diekun,
the Delhi based mission director of India needs huge in-
the United States Agency for Interna- vestments in the power
tional Development (USAID), about sector to sustain its
500MW of additional capacity has
to be installed every week over the growth. Investments
next 25 years, to ensure 8 percent in this important infra-
GDP growth in India. To achieve such structure component
a growth, investments to the tune
of $600 billion would be required in
can be attracted by a
the power sector by 2017. On a linear well functioning and
estimate a further $300 billion would competitive whole-
be required in the next plan. Invest- sale electricity market.
ments in the power infrastructure
can be attracted by a well function- Power exchanges are a
ing and competitive wholesale elec- recent phenomenon in
tricity market. India but they lack the
IEX (Indian Energy Exchange) derivative instruments
IEX has state-of-the-art trading which are traded in
software provided by NASDAQOMX successful exchanges
of Sweden and Financial Technolo-
gies India Ltd. IEX has been modeled
around the world.
based on the experience of one of
the most successful international
FinGyaan
power exchanges, Nordpool. While
IEX takes care of the financial aspect
of the transactions, Regional Load
Dispatch Centers (RLDCs)/ State Load
Dispatch Centers (SLDCs) ensure the
electricity supplies and withdrawals
correspond to the contracts entered
on the Exchange. As of September
2009, Discoms (37), generators (37),
Trading licensees (14), CPPs (48),
IPPs, cogeneration plants and wind
generators from 23 states & 3 union
territories have converged on the IEX
platform for better management of
their energy portfolio.
The key features of this ex-
change are:
1. Transparency for trading
If India were to grow at 9%
in the next five year plan, our
power demand should jump
from 120GW to 210GW requir-
ing an investment of US$ 300
Billion.
11
 electricity. instantly perishable electricity. In September 2009,
2. Diversified portfolio such as trading in the Central Electricity Regulatory Commission (CERC)
smaller quantities and for smaller number of hours. imposed a cap of Rs 8 per unit on the price of power
traded bilaterally and at the two power exchanges
3. Payment security as the exchange is the
— Indian Energy Exchange (IEX) and Power Exchange
counter-party for all trades.
India Ltd (PXIL). The corrective move by the regula-
4. Few transaction overheads/charges. tor has come as a strong reaction to the findings of
5. Efficient portfolio management as a function the latest reports of its “market monitoring cell”,
of consumption or generation. which indicated abnormally high prices of power
From September 2009, these exchanges will sold during certain trading hours at the exchanges
be able to undertake trading in four additional con- last month. Volatility in the price of traded power in
tracts — intra-day contracts for trading on a daily India increased from 13 per cent on August 3, 2009
basis, day-ahead contingency contracts for meeting to 41 per cent on August 10. The ceiling on power
sudden demands for power, daily contracts for trad- tariff at Rs 8 per unit will be applicable for 45 days,
ing power to be delivered in the following week and ending mid-October this year.
lastly, weekly contracts for power to be delivered in However, blanket caps on the trading of power
the following month. may not be the best solution for an efficient mar-
A comparison of some of the best exchanges ket. In order to hedge the congestion of prices and
in the world with the IEX is carried out in the below facilitate trading in power markets, few derivative
table. instruments need to be introduced. These should be
a part of the energy risk management strategies. For
IEX Nordpool NEMMCO
the futures market to fully develop in India, high
Participa- Compulsory Voluntary for day Compul-
tion for day ahead ahead and adjust- sory day-ahead
volumes should be encouraged. Estimates put the
market (DAM) ment market short-term figure to be a regular trading of the order of 15GW.
energy market Indian Energy Exchange (IEX), went on to clock the
Market Day-ahead spot Day-ahead spot, Day ahead spot peak daily unconstrained trading volume of 29.33
offerings for each hour hour ahead, For-
wards, Futures GW worth Rs.22.86 Crore on October 03, 2009. The av-
Pricing rule Zonal Pricing Zonal Pricing Zonal Pricing erage trading volume has been around 11 GW. Thus,
Type of Double-sided Double sided Double sided this seems the right time to do the back ground
bidding closed work to introduce diverse derivative instruments.
Risk Man- Currently trad- Forwards, Futures Bilateral OTC, Some of the instruments to be introduced could be
agement ing in the spot on Nordpool Derivatives on
forwards, transmission rights, load-dependent fu-
FinGyaan

market Sydney Futures

exchange tures contracts, swing options.
Congestion Market splitting Area splitting and Locational
Manage- zonal pricing signals for Electricity forwards, futures and swaps
ment transmission
tariff Electricity derivatives such as forwards, futures
Transmis- Payable in kind Included in zonal To be borne by
and swaps can play a primary role in offering fu-
sion Losses from delivery Price generators ture price discovery and price certainty to genera-
point to its tors. These instruments introduced in the exchange
grid connection
point would enable the flow of investments in this sector
The comparison shows that the Indian Energy as the price risk gets mitigated. Getting new invest-
Exchange is comparable to these exchanges in most ment is extremely important in the Indian context
of the features and products offered. However, the hence these instruments could play a pivotal role in
IEX lacks the diverse derivative instruments present the development of India’s power markets.
in these markets. Financial Transmission rights (FTR)
Need for diverse derivative instruments in It provides FTR owners with the right to trans-
the Indian Electricity market: fer an amount of power over a constrained trans-
Trading in an electricity market is risky because mission path for a fixed price. These can be used to
electricity is very different from other commodities hedge congestion charges on constrained transmis-
as it is non-storable; it has a low demand elasticity, sion paths. These are important in the Indian con-
there are certain transmission constraints and price text as a lot of electricity demand is concentrated in
control related issues. The prices at IEX touched an and around the metro cities.
all time high of Rs 15/unit (kWh) in the pre-election Physical Transmission Right (PTR)
period and rates went as low as 13 paisa/unit (kWh)
PTRs are tradable rights to use transmission
in June’09. This reflects the volatility in demand and
capacity and represent the right to use the physi-
supply and its impact on the price discovery for the
cal transmission system. PTRs guarantee an efficient

12 NIVESHAK VOLUME 2 ISSUE 10 NOVEMBER 2009

use of transmission system capacity and to allocate of one unit of electricity. India generates about 50%
transmission capacity to those users who have the of its electricity from Coal. Going forward sources
most utility. These are important in India as electric- like nuclear power (after the nuclear deal) and other
ity demand is concentrated in and around the metro renewable sources (after full development of car-
cities and the right to a transmission line would be bon credit market) are going to become important
important for any power business house which is in the Indian context. Dealing in these contracts
ramping up its facilities. makes would enable a speculator to bet on electric-
ity units based on the knowledge of future prices of
Base-load and peak-load futures particular fuel types. This will create new investment
As India has predominantly had a focus of opportunities from parties who have specific knowl-
building base load plants rather than peaking plants edge about new fuel types.
these instruments would enable
stabilization of peak load prices if a Tolling contracts
differential pricing scheme is adopt- This requires payment
ed. Thus this would provide greater of a pre-agreed amount to the
incentive to develop peaking plants owner of a power plant. These
in India. This has been missing till contracts give the buyer the
now. right to either operate and con-
trol the scheduling of the power
Options on electricity assets plant or simply take the output
Physical generation assets electricity during pre-specified
may be considered as options on time periods subject to certain
spot electricity. Market prices would constraints. This would bring in
exhibit the risk adjusted expecta- investments from parties who
tions of the future cash flows from bring with them superior man-
the particular electricity asset. This agement skills and know how
would lead to greater scrutiny of electricity genera- to effectively operate power plants. This could lead
tion assets and better valuations of the assets. This to greater operational efficiency of existing and pro-
would clarify the criteria for new market entry as posed power plants.
more information becomes available in the system.
Future Challenges and Conclusion:
Swing options

FinGyaan
Power quality and demand side management
Swing options were widely used in the regu- issues under electricity trading would be a challenge
lated Scandinavian market to address the problems in Indian electricity markets. A pool-based electricity
created by the non-storability of electricity. The vari- market coordinated by a system regulator provides
ations in the demand and generation of electricity a strong foundation for building a wholesale market
tend to smoothen out over time. An electricity mar- with open access and tradable transmission prop-
ket swing option gives the buyer the right to use erty rights as mentioned in the paper.
energy up to a certain limit at a fixed price during a In designing an efficient electricity market,
fixed time interval. It may include the obligation to electricity derivatives play an important role in es-
use at least a certain amount of energy during the tablishing price signals, enabling price discovery,
same interval. India being a very large country the facilitating risk management, leading to greater
marginal utility of electricity in different parts of the investments in generation and transmission. This
country given scarcity of supply in different seasons would lead to electricity demand fulfillment at af-
is bound to differ. Buying these options would en- fordable rates to the Indian consumer. Custom de-
sure businesses to secure their requirements at a sign of electricity financial instruments as per the
critical portion of the year when they expect supply needs of the Indian market can provide energy price
to be unstable. certainty, hedge volumetric risk and synthesize gen-
Spark spread options eration and transmission capacity.
Spark spreads are cross-commodity options
paying out the difference between the price of elec-
tricity sold by generators and the price of the fuels
used to generate it. The holder of a spark spread
call option written on a fuel at a fixed heat rate has
the right, but not the obligation, to pay at the op-
tion’s maturity an amount equal to heat rate times
the fuel price at maturity time and receive the price

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 13

 FIN-Q
1. What was created by an eminent M&A lawyer in 1982, which is used to deter takeover
bids?

2. I was appointed as the Secretary of the Treasury in a leap year and resigned in the very
same year of my appointment. I share my name with a city. Who am I?

3. Identify him

4. What minimum percentage of stake does the UPA government plan to hold in the PSUs
after its disinvestment venture?

5. I was the first discount broker of the US. Not one bank failed during my tenure as the
Superintendent of Banks of New York, despite nationwide failures. However this is not what I
FinLounge

am famously known for. Identify me and what I am famous for?

6. What is the single largest stake-holder of the Tata Group nicknamed as?

All entries should be mailed at niveshak.iims@gmail.com by 5th December 2009 23:59 hours
One lucky winner will receive cash prize of Rs. 500/--

14 NIVESHAK VOLUME 2 ISSUE 10 NOVEMBER 2009

 n
The Gr e at R u
Stock markets are unique in their own way.
They love playing the game of hit-and-run. They tick-
le you with hope and lend dreams, and to catch you
early, run unabated till you become a blind-follower.
For a Sensex, which took approximately 28 years to
touch 12,000 and only one more year thereafter to
climb to a historical statistic of 21K, the fizz never
fizzles out!
The crises, so to say was culminating. And it
surfaced in full form once the spark came up in one
end of the globe. Financial crises, or global melt-
down, or sub-prime crises were just mere terms; the
gravity of the situation was enormous. The era of
praise for securitization landed into a dark reality,
with one of the greatest innovation of the finance
field turning ugly. Investment banks, known for their
financial engineering, were at the receiving end,
with most of them sinking. The crises couldn’t have
shaped up the way it did, had it been restricted
to such banks only. It spread, and spread fast. The
chain of institutions involved was too long to sus-
tain. Commercial banks, credit rating agencies, in-
surance sector, central banks and the government,
all became major stakeholders of the same and the
world experienced what is now referred to as the
‘bubble burst’.
Monetary policies were implemented but to no
true discourse. Short-term relief did not extend for-
ward for too long. The creators of such meltdown
became the victims themselves and had to be sup-
ported by governments and bailed out. Fiscal stimu-
lus became the word of the day and financial insti-
tutions turned beggars. But what about India? With
a more restricted economy and not much financial
re-engineering in this part, the impact of such crises
was presumed to be less. It was, indeed, less but
the globalization impact made sure the economy did
not go scot-free. The Sensex crashed 1408 points on
January 21, 2008 despite good Q3 earnings. The fi-
nancial meltdown had reached India.
A few days later, the Sensex gained 1139 points
(January 26, 2008), thus proving how volatile it can
get. The sentiment was low until March 2009, which
saw a low at 8160 points. But there was no stopping
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
?
Cover Story
MANAV JAIN
IIM Shillong
the bull after that. The Sensex has risen more than
100% and is hovering around 17000 lately. What is
it that is fuelling such a sharp rise? Is the market
basing itself on fundamentals or just going with the
flow? Is the path to recovery so robust or is the path
not even visible in the mist of rise?
It’s surely not the fundamentals. The balance
sheets and profit statements haven’t been as inspir-
ing to register such a booster confidence in the mar-
ket system and the economy. The sentiment, despite
all this, has been quite optimistic. Some analysts
say that a super bubble is being created and the
reasons for them calling it so have to be observed.
A Business Line editorial dated September 09, 2009
captures the picture right.
“In a mere six months, the mood in the stock
market has swung from unrelenting gloom to sun-
ny optimism. When the stock market rally began in
March, it was a case of prices ‘reverting to mean’
from extreme pessimism. The initial leg of the rally
did have strong moorings in fundamentals, backed
by resilient domestic macro-indicators and the im-
proving corporate earnings picture. However, six
months down the line, with the Sensex almost dou-
bling, the worry is if investors are overtaken by ex-
cessive optimism.”
One important evidence of this bubble forma-
tion is the Price-Earnings Ratio in the current capital
market, which is over 21 for most stocks. A P/E ratio
of 21 is not well-supported by economy fundamen-
tals and such a drastic rise in this ratio indicates
that earnings have not grown proportionately with
the market, which is feeding in air into itself each
passing day. Stock prices are highly inflated, as so
is the market in general. The earnings do not justify
the rise, and factors that are leading to a situation
like this are purely technical and propagated by op-
timism that is so very untrue.
Indian markets still seem attractive to inves-
tors among large stock markets all over the world.
Though the Indian market is currently trading at a
premium with respect to markets of other develop-
ing economies, the future outlook is positive. The
economy is expected to grow at more than 5%. Also,
15
 the country’s low dependence on exports and the
high rate of savings are major factors for the opti-
mism. With a savings rate a staggering 38%, India
ranks second only to China, but the problem herein
Cover Story
is the fact that only 3.5% of the savings are invested
in the stock market. However, given the large popu-
lation and subsequently the large amount of sav-
ings, a small percentage increase in this rate would
mean huge investment in the stock market. A half
percent rise in this rate would imply an increase in
domestic capital investment of $15 billion, equiva-
lent to about $10 billion foreign investment. Such
an investment from the savings side would create a
valuation bubble in the Indian economy.
The Real Estate Sector is another area of con-
cern that has contributed highly to the current bub-
ble. Housing prices in India are reaching new highs
and this is reminiscent of the US housing scenario
before the first bubble burst. And such high pric-
es are a fancy for speculators who engage in this
market and inflate stock valuations, thereby raising
prices further. Ground
reality suggests that
the demand for hous-
ing is not as high to
rightly explain the price
rise; neither has sup-
ply been inconsistent.
What led to the melt-
down in America is be-
ing manifested here in
India now, and if this
continues, suspicions
being put up now shall
take actual form in a
few months from now.
The fiscal packages and the stimulus provided
by the government also impact the valuations of the
stock markets. Currently, most of the growth be-
ing experienced in the country is due to the huge
government spending through stimulus packages.
The government lends out hefty sums of money
to needy institutions and for other sectors as part
of fiscal policy measures. What’s important is the
questions as to the source where from the money is
provided. The money lent as stimulus is firstly bor-
rowed by the Government from its various sources
within the nation and/or abroad. There would come
a point where the government would cease to pro-
vide further stimulus. And when such an incident
happens, growth of the Indian economy would slow
down to a trickle.
Liquidity also plays an important role in ana-
lyzing any market. Markets which are more liquid
are generally more stable as compared to those
which are not. Illiquidity, as the term is called affects
valuations in a magnified manner. The low free float
16 NIVESHAK VOLUME 2 ISSUE 10 NOVEMBER 2009
of the market implies that the Indian stock market
is among the most illiquid markets throughout the
globe. Given the situation such as this, a miniature
investment in the market would mean inflated stock
market indices. The lower liquidity has the impact of
raising up valuations every time new equity enters
into the system. Also, since India does not have a
well-developed vast bond market, people generally
look forward for equity market for investment, and
therefore the scope of valuations inflating rises even
further.
However, there are several reasons to make be-
lieve the fact that this bubble would not enlarge and
come down to its mean figure. First and foremast is
the issue of credit availability. The revival of credit
has mostly been to the corporates, and large cap
companies, the middle and small cap companies be-
ing left out. For a sustained recovery to take place,
there should be even recovery in all sectors and all
companies. The biased nature of credit availability
can be sustained by this new bubble only for a short
period of time, and ulti-
mately it would bring it
back to its normal shape.
Another major point
of concern is the recovery
in the developed world.
Emerging markets might
be doing well, but if the
developed economies
dampen the recovery
path, even developing na-
tions will be hard hit. Re-
covery in the west is not
expected to be too fast
and therefore, emerging markets might have to suf-
fer corrections every now and then. With new capital
issues for qualified institutional buyers on the rise,
the stock markets are facing a situation where there
is a flurry of QIPs. Companies coming out with plans
to raise money through this medium enjoy a rise in
their stock prices, which further raises the index.
Where do we stand?
In brief, we’re at a juncture wherein the mar-
kets are showing excessive volatility and valuations
do not suggest the intrinsic values that ought to be.
Stocks and indices are overpriced and the sentiment
is highly optimistic and positive. The bubble has all
the ingredients to grow further; but it has all the
more reasons to burst and impact the economy in
a hard way. The path to recovery is charted, but
the path doesn’t allow us to run. Emerging markets
can jog, developed nations will follow, and the world
would be a happier place quite soon.
 Systematic
“You only find out who is
swimming naked when the tide goes
out”, says the Oracle of Omaha, War-
ren Buffett. The global financial cri-
sis of 2008 has exposed many such
loopholes in the financial systems
across the world. Prominently, it has
exposed weaknesses in the current
regulatory and supervisory frame-
works. Even as governments con-
tinue to fight probably the biggest
financial meltdown ever, the focus
has already started shifting towards
deciding the face of new financial
regulation framework which can cre-
ate a safer and sounder financial
system for the future.
The financial meltdown, which
brought the world down to its knees,
has escalated the need for funda-
mental rethinking on the regulatory
policies pertaining to financial sec-
tor. A need has been felt for setting
up a systemic risk regulator man-
dated with broad responsibility for
the whole financial system, charged
with spotting regulatory gaps and
market pressures that might desta-
bilize the system. It is believed that
regulators failed to head off the re-
cent crisis because no one was ex-
plicitly charged with spotting risks
that could lead to system failure.
Such regulator gaps and overlaps
need to be eliminated. EU has al-
ready formed one such agency while
U.S. is still debating on the structure
of the agency they want to bring in.
This article opens with a dis-
cussion on why there is a need for
systemic risk regulator and what are
the gaps in the regulatory system
that they might help to fill. The next
section argues upon what should be
the ideal shape and structure of such
an agency. While some believe that
the central bank is the right candi-
date to become the super regulator,
many others feel that by taking on
supervision and regulation, central
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
& Financial regulation
Ajay Jain & Piyush Chandak
IIM Bangalore
banks would thrust themselves into
an inherently political role. It would The current regula-
be difficult for them to maintain the tory system has gaps
independence that they require to that need to be filled
conduct monetary policy and thus
this task should be handed over to a
and the Systemic
separate independent authority. Risk Regulator is the
AoM
Finally, in the last section, the potent tool for elimi-
learnings from the previous sections nating systemic risk
are applied in Indian context and
and supervising the
need and the structure of systemic
risk regulatory agency in India are SIFI’s. The structure
discussed. of SRR prior to imple-
Need for a Systemic Risk Regu- mentation needs to
lator be thought upon.
The current financial regula- SRR holds significant
tory structure is institution specific. importance in Indian
So, we have independent regulatory
context as well for
bodies for institutions like banks
and large insurers while some other putting all regulato-
like hedge funds and private equity ry measures in place.
funds go unregulated. In fact a whole
gamut of these bank-like institutions
such as investment banks, hedge
funds, mortgage brokers, venture
capital firms etc. grew outside the
regulatory framework of banks. Such
unregulated financial entities consti-
tuted the shadow banking system
and their growth, which was largely
outside anyone’s control, was a ma-
jor source of the current crisis. This
system became far more important
source of credit than the more heav-
ily regulated banking system. High-
ly leveraged firms supplied large
amounts of capital without having to
expose their activities. These entities
created opportunities for regulatory
arbitrage as banks shifted risk to
balance sheets of affiliated entities
in the shadow system and evaded
capital requirements.
The existing regulations ad-
opted a micro prudential view and
focussed on systemically important
individual institutions, not recogniz-
ing that systemic stability could be
threatened even if individual insti-
17
 tutions within the system are stable. Focusing on
individual institutions while overlooking the overall
financial system can only lead us to win battles not
wars. The system failed because of lack of a macro
level systemic risk regulator as each regulatory au-
thority focused on risks within their purview only
and no one was in charge of spotting regulatory gaps
and market pressures that might destabilize the sys-
tem as a whole. It is important to keep an eye on the
whole system simultaneously for the simple reason
that these institutions do not exist in independence
and there exist heavy interactions among them. Fail-
ure of one financial institution to pay can impose se-
vere losses which might threaten the existence of its
creditors as well. This is known as systemic risk. It is
AoM
2. Have clear rules to identify and include or
exclude SIFIs
3. Standards for liquidity and capital (leverage)
requirements to be employed by SIFIs. Ideally, the
requirements for SIFIs should be stricter than for non
SIFIs
4. Be alert to catch signals of when the insti-
tutions under their watch may be developing prob-
lems. This can be easily achieved by taking note of
stable sources of market discipline the interest rate
on subordinated debt
5. Implement measures like long term debt
convertible to equity when a firm’s financial condi-
tion deteriorates below a point. This would prevent

the risk that simultaneous failure of one or more key
financial institutions destabilizes the overall finan-
cial system. The havoc caused by crisis has
brought to fore the need of a Systemic
Risk Regulator. The mandate of this
agency would be to constantly search
for gaps, weak links and perverse in-
centives serious enough to threaten the
system. It has become necessary that the
Systemically Important Financial Institutions
(SIFI) —banks, insurance firms, investment
firms, and hedge funds—should be subjected to
consolidated supervision by a single agency.
A Systemic Risk Regulator (SRR) is needed be-
cause it is not possible to eliminate systemic risk.
Besides, even if systemic risk is curbed for the cur-
rent scenario, history proves that with the advent
of new technologies, new bubbles are created; new
financial innovations come into force, which bring
together a whole new dimension of systemic risk.
The financial industry is so dynamic that 80% of the
products sold today did not exist even 2 years ago.
The housing price bubble was aggravated (and some
may argue it was caused) by the financial stupidi-
ties: injudicious mortgage lending, excessive high
leverages and short sighted insurances. With an ef-
fectively working SRR, we believe these kind of fool-
ishness would be reported and curbed much before
they cause any significant damages.
At this point, it would be prudent to define the
exact responsibilities of an SRR (what form can this
SRR take is discussed in the next section):
1. Reduce systemic risk to the extent possible
crisis like situations from deepening. However, the
SRR must be confined only to point of provid-
ing regulations. Resolution of failed/distressed
institutions should be left for other appropri-
ate agencies.
6. Enforce minimum early in-
tervention by “early closure and loss
sharing plan” for SIFIs so that timely
actions are taken to prevent bank-
ruptcies.
Structure of an SRR
We propose 4 structures for an SRR and sub-
sequently discuss their merits and demerits: (1) A
new consolidated financial solvency regulator (2)
Broadening the scope of Central Bank to include the
financial regulation as its responsibility (3) A new
SRR agency (4) Simultaneous working of the current
set of financial regulators
A new consolidated financial solvency
regulator
A good way to consolidate current multiple reg-
ulatory agencies is to club them in two heads, one
for solvency and another for consumer protection.
The consumer protection regulator would include
bodies like SEC in U.S. and SEBI in India but would
fall outside the purview of this article. The financial
solvency regulator would be assigned with the re-
sponsibility of reducing systemic risk as much as
possible. It would oversee and regulate all the finan-
cial institutions with special focus on SIFIs. Though
the SRR would be headed by the Central Bank, it
would be the SRR which would have the final say.

Regulators failed to head off the

recent crisis since no one was ex-
plicitly charged with spotting risks
that could lead to system failure.
Such regulator gaps and overlaps
need to be eliminated through SRR.

18 NIVESHAK VOLUME 2 ISSUE 10 NOVEMBER 2009

The Central Bank would just have regular consulta-
tions and interactions with the solvency regulator,
including the right to receive in a timely manner all
information about SIFIs that it believes is important.
The Central Bank
In U.S., the Fed Reserve has literally acted as
the lender of last resort to the distressed companies
and as such an obvious implication is to make Fed
the systemic risk regulator. The Central Bank’s mon-
etary policies are hugely impacted by the failure of
SIFIs. Including systemic risk regulation as a respon-
sibility for the Central Bank would only be a logical
extension. However, in order to avoid agency infight-
regulatory market. It would be redundant and would
not add any value. Simultaneous working of the cur-
rent set of financial regulators would provide huge
coordination problems and in case of crises would
only lead to putting on the blame onto each other’s
heads.
Indian Context
Even in the midst of crisis, India’s financial sec-
tor remained relatively safe and sound. Does this
mean that India is decoupled from the ill effects of
the west and can continue to ignore the idea of a
systemic risk regulator? We believe that it will be a
folly to believe that there is something inevitable

ing before crises and finger pointing after the crises,
the responsibilities must be defined in a non-ambig-
uous and explicit way so that the only authority over
solvency and associated reporting requirements is
the Central Bank. In spite of all these precautions,
the idea is fraught with many dangers:
• Asking Central Bank to regulate would compro-
mise its focus on monetary policy
• The Central Bank needs complete indepen-
dence in order to carry an effective monetary policy.
Assigning explicit systemic risk responsibility to it
would make it responsible to the Government and
thus take away its independence
• Significant political risks underlie the prem-
ise and the Central Bank might be inappropriately
forced to loosen or tighten the regulatory stance to
favour some political gains
• The Central Bank might be extremely risk
averse and in the process it might curb some pos-
sible innovations
• Finally, with the current capacity Central Banks
across the world are very ill-equipped to handle the
regulatory work. While they have huge command
over the monetary issues, the same cannot be said
about their accounting and taxation prowess. Also,
infrastructure and staffing issues need to be taken
care of
On account of so many issues, it is probably
better to have a consolidated financial solvency
regulator as compared to assigning risk authority to
the Central Bank. We out rightly reject the last two
options as they do not have any merit. Creation of
a new SRR agency without consolidation would just
add one more player to the already over-crowded
AoM
about India’s financial stability. As India further inte-
grates with the rest of the world, it will get exposed
to forces of globalization. If financial stability any-
where in the world is jeopardized, India’s financial
stability will become vulnerable too. Thus India also
needs to consider setting up a systemic risk regula-
tory authority.
While RBI could have been handed over the
reins of being a systemic risk regulator given that it
is equipped to deal with financial stability because
of its macroeconomic perspective which enables it
to conduct macro prudential regulation, we believe
that forming a council of regulators would be an
ideal structure in Indian context. The role of sys-
temic risk regulator might make it difficult for RBI to
remain independent in order to conduct monetary
policy. Also, the central bank may lack the expertise
to engage in supervision, where micro-knowledge,
such as on accounting and legal issues, is required.
India already has an informal setup in form
of a High Level Coordination Committee on Finan-
cial Markets (HLCC-FM) comprising all the regulators
from financial sector - RBI, SEBI, IRDA and PFRDA and
the Finance Secretary. It serves as a forum to deal
with inter-regulatory issues arising in the financial
and capital markets. The authorities should con-
sider upgrading the HLCC-FM to a formal structure.
Also, in India there are no specific regulations
for the financial conglomerates which pose bigger
risks to the system than single product service pro-
viders. Setting up of a council of regulators would
make it easy to get regulatory measures for them in
place as well.

As India integrates with the rest of

the world, it will get exposed to forces
of globalization increasing the vulner-
ability of getting destabilized. Thus
India needs to consider setting up a
systemic risk regulatory authority.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 19

 Indian Banking
A RISK PROFILE
Amit Agarwal & Abhinav Berdia
XLRI, Jamshedpur
One question that currently
The current economic
bothers most of the bankers is
slowdown paves the about the shape of banking in days
way for the banking to come. Will banks be doing busi-
system to improve ness differently in future? What are
the changes that are likely to take
their portfolio quality place? A thorough analysis is need-
and move towards ed to understand the issue and the
lower default risks. probable outcomes.
Some of the steps DEPTH OF INDIAN FINANCIAL
to improve banking SYSTEM
industry and reduce Healthy growth of the assets of
risks have been sug- commercial banks in the recent peri-
od, driven primarily by credit growth
gested in the article. and sharp rise in credit-GDP, deposit-
GDP and M3-GDP ratios clearly point
out that we have a significant finan-
cial deepening in India.
While the ratio of bank assets
to GDP has increased significantly to
around 93 per cent in 2008-09 from
48% in 2001 as a result of high cred-
it growth in recent years, it is still
lower than some of the other emerg-
ing countries. Financial deepening,
hence, has been taking place on an
accelerated pace on a macro basis in
recent years and banking productiv-
ity has improved significantly.
Also, the rate of domestic sav-
ings has picked up in the recent
period during 2003-04 to 2007-08
against the backdrop of financial
FinSight
INDIAN BANKING SYSTEM:
TRENDS & FINANCIAL HEALTH
Though public sector banks
(PSBs) account for around 70 per
cent of commercial banking as-
sets and 72.7 per cent of the ag-
gregate advances of the Scheduled
commercial banking system (as on
March 31, 2008), competition in the
banking sector has increased in re-
cent years with the emergence of
private players as also with greater
private shareholding of PSBs. List-
ing of PSBs on the stock exchanges
and increased private shareholding
have also added to competition. The
new private banks which accounted
for 2.6 per cent of the commercial
banking sector in March 1997 have
developed rapidly and accounted for
nearly 17 per cent of the commercial
banking assets by end March 2008.
But, one area that needs to be
watched continuously due to recent
crisis is the off-balance sheet (OBS)
exposure of the banks. The spurt in
OBS exposure is mainly on account
of derivatives whose share averaged
around 80 per cent. The derivatives
portfolio has also undergone change
with single currency IRS comprising
57 per cent of total portfolio at end-
March 2008 from less than 15 per
cent at end-March 2002.

sectors reforms, rise in total factor

productivity and investment boom,
which had led to acceleration in the
growth performance, whereas, in the
developed countries like the US and
Japan, the rise in financial deepen-
ing has had a limited effect on the
savings rates of the economies.
INDIAN BANKING INDUSTRY:
RECENT PERFORMANCE
The graphs below depict the
state of the Indian banking industry
in the recent times:

Innovations in the form of complex-

ity and sophistication of products
and services, coupled with profit-
ability and competitive consider-
ations, have completely changed the
dimensions of risks faced by banks.

20 NIVESHAK VOLUME 2 ISSUE 10 NOVEMBER 2009

 Analysis of the first quarter results of the In-
dian Banking Sector (12 top banks covering 61% of
total credit) by CARE Research reveals the following
five key observations:
• High treasury gains boosted the operating in-
come of the banks
• Net profit zoomed by 55.2% y-o-y, however ad-
justed for treasury gains, net profit declined by 8.1%
y-o-y and 25.4% q-o-q
• Net Interest Margins (NIMs) have declined due
to lower lending rates and higher cost of funds re-
sulted in lower Net Interest Income (NII) growth
• Overall provisions charged to profit and loss
account (excluding tax), decreased by 17.0% y-o-y
and 24.7% q-o-q. However, provision for NPAs in- During the Q1FY10, top 12 Indian banks re-
creased by 3.5 times over the previous year. structured asset worth Rs 32,530 crores, taking to-
tal restructured assets to nearly Rs73, 000 crores.
• Restructuring drive continued in Q1FY10, the
However, as a proportion to total advances, it is still
top 12 banks restructured assets worth Rs 32,500
within a comfortable level of 4.0%. Significant varia-
crores.
tion was observed among the individual banks in
Most of the banks booked the treasury gains restructuring of loans. Among them, public sector
on their SLR investment portfolio which improved banks showed a higher percentage of restructured
the operating income significantly as compared to loans to total loans as compared to private sector
the corresponding period last year. Total operating banks.
income of the top 12 banks was up 25.8% y-o-y dur-
ing the quarter ended June 2009. However adjusted
operating income increased by 14.3% y-o-y. Treasury
FinSight
gains constituted 11.6% of the reported operating
income and 13.1% of the adjusted operating income
in Q1FY10 as compared to 2.7% and 2.8% in Q1FY09
respectively.
Also, lower lending rates pushed up the credit
offtake for majority of the banks but relatively lower
NIM resulted in submissive NII growth.

Financial deepening has been tak- Healthy growth of the assets of

commercial banks in the recent pe-
ing place on an accelerated pace riod, driven by credit growth and
on a macro basis in recent years sharp rise in credit-GDP, deposit-
and banking productivity has im- GDP and M3-GDP ratios clearly
proved significantly. point out that we have a signifi-
cant financial deepening in India.

© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG 21

 RISKS FACING THE INDIAN BANKING IN-
DUSTRY
CREDIT RISK
GROSS NPAs IN INDUSTRY CREDIT TO ALMOST DOUBLE
IN 2009-10
The gross non-performing asset (GNPA) for
the industry is expected to surge from 2 per cent
in 2007-08 to 3.7 per cent in 2009-10. The GNPAs for
large corporate and SMEs within the industry are ex-
pected to rise from 1.6 per cent and 3.1 per cent,
respectively in 2007-08 to 2.9 per cent and 3.7 per
cent, respectively in 2009-10, as reported by Crisil
Research.
SECTORAL RISK
As per the Crisil research, the increase in de-
linquencies alongside a tightening in bank under-
writing standards and exposure limits will cause
the growth in credit to SMEs and large corporate to
moderate over the medium term. Therefore, the es-
timated GNPAs in industry credit comprising of large
corporate and SMEs is likely to increase as the re-
payment capability of corporate would deteriorate
due to leveraged balance sheets, declining profit-
ability due to reduced sales, and lastly, increased
costs due to extended working capital cycles and
idle capacities.
The sectoral risk can be classified as:
FinSight
• Business risk:
Demand-supply gap Nature of fragmentation and
competition across industry
• Financial risk:
Profitability Leverage indicators (debt-equity ratio
and interest coverage ratio)
BUSINESS RISK
Business risk scores for 2007-08 and 2008-09
provide the outlook for business in the short term
for large corporate and SMEs across sectors on the
risk paradigm. As the business risk score is a for-
ward looking indicator of the performance of a sec-
tor in the short term, a low business risk score in
2008-09, with reference to 2007-08, is an indication
22 NIVESHAK VOLUME 2 ISSUE 10 NOVEMBER 2009
of higher stress going forward, in terms of the finan-
cial and business performance of customer profiles
across sectors on the risk paradigm.
Param- Low risk Medium risk High risk
eters
2007- 2008- 2007- 2008- 2007- 2008-
08 E 09 E 08 E 09 E 08 E 09 E
Large 4.81 4.98 3.99 3.77 2.46 2.54
SME 3.10 2.78 2.88 2.61 2.04 2.08
Industry 4.39 4.51 3.74 3.50 2.31 2.36
RESTRUCTURING OF ADVANCES
Banks have been given the option of restruc-
turing the non-performing accounts to avoid increas-
ing their sub-standard and doubtful assets. The re-
structuring practice implemented by the banking
system involves:
• Increasing the moratorium period from 90 days
to around 120-180 days. 
• Reducing the rate of interest.
The increase in GNPAs across sectors is expect-
ed to influence the lending behavior of banks across
sectors. Although, the banking system would be
flush with liquidity, their approach towards lending
would be cautious. This cautious lending approach
adopted by the banking system will help them con-
trol the inflated level of GNPAs in their corporate
credit portfolio going forward. The current economic
slowdown paves the way for the banking system
to improve their portfolio quality and move towards
lower default risks. Banks may curtail lending to
high risk sectors and deteriorated customer credit
profiles, while borrowers will be required to demon-
strate improved balance sheet strength in order to
raise funds from banks. The banking credit market in
India is currently witnessing a major shift from the
buyer’s market to the seller’s market with bankers
adopting selective lending with covenants.
RISK MANAGEMENT BY THE BANKING INDUSTRY
One key line of defense against financial insta-
bility is an improved framework of financial regula-
tion, supervision and oversight. A holistic approach
is necessary, covering stronger safeguards for instru-
ments, markets and institutions. This means put-
ting in place improved mechanisms to assess the
suitability and risks of new financial instruments. It
implies encouraging greater centralization in clear-
ing, settlement and, possibly, trading.
Though more inclusive regulation may be required in
some areas, the solution to the crisis is not putting
in more regulation. Innovations in the form of com-
plexity and sophistication of products and services,
coupled with profitability and competitive consider-
ations, have completely changed the dimensions of
risks faced by banks. The Committee on Financial
Sector Assessment (CFSA) has argued that the pres-
ent global financial crisis has highlighted the limita-
tions of the present Basel Core Principles in as much
as the assessment does not specifically cover areas
like SIVs/NBFCs or aspects like dynamic provisioning
and countercyclical norms. Hence, CFSA has felt that
the Basel Committee on Banking Supervision should
revisit the Basel Core Principles to cover the new
areas.
CFSA has also noted that, though BCPs are not
strictly applicable to financial institutions other than
commercial banks, the efforts to extend the scope of
BCP assessment to other sectors are commendable
in the current context of the potential linkages of
such institutions and their impact on the stability of
the financial system. The Reserve Bank has already
been extending such principles to non-bank entities,
subject to certain thresholds and the nature of their
operations.
As highlighted by Dr.
Y.V. Reddy, the former
Governor of the Re-
serve Bank of India,
some of the reasons
for India’s insulation
from the current cri-
sis are: (1) The na-
scent stage of devel-
opment of the credit
derivatives market;
(2) Regulatory guide-
lines on securitiza-
tion do not permit
immediate profit recognition; (3) Perseverance of
prudential policies which prevent institutions from
excessive risk taking and financial markets from
becoming extremely volatile and turbulent; and (4)
Close co-ordination between supervision of banks
and their regulation.
In order to improve the banking industry, a few steps
which should be implemented by the banks are:
KNOW YOUR CUSTOMER (KYC)
It comprises of three main components. ‘Know-
ing their customers’ is not enough for banks, they
should also know the ‘business’ of their customers;
and if the banks know the business of their custom-
ers, the banks can certainly assess the ‘risks’ associ-
ated with each of their customers. KYC is not only a
risk management process but it also makes a good
business sense.
TREATING CUSTOMERS FAIRLY (TCF)
This requirement is the key to operation of an
efficient retail market for financial services. TCF is
also central to consumers having confidence in the
© FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG
financial services industry. This principle must be ad-
opted and supported by the leadership of financial
firms, and embedded throughout a firm’s operations
and within its culture. In addition, in a competitive
marketplace, TCF should be an important element
(alongside service levels, pricing and customer sat-
isfaction) in determining the success of a bank in
acquiring and maintaining market share.
There should be a blend of regulatory and market-
based solutions to delivering fairness to customers.
Banks need to examine what most effectively con-
stitutes fair treatment of customers. Banks’ senior
management needs to assess their current perfor-
mance against the requirement to treat customers
fairly, identify possible areas for improvement and
ensure that the principle of fairness is embedded in
their work-culture.
PROPER RISK MANAGEMENT
Systemic risk is becom-
ing more and more promi-
nent with the increasing
complexities and the associ-
ated risk factors in the bank-
ing activities. The banks need
to have a proper understand-
ing of all the risk factors and
at the same time they have
to ensure that their custom-
ers also understand and ap-
preciate the associated risk.
In the event of such bank-
ing activities leading to the
emergence of systemic risks, the central bank may
intervene which might result in stricter regulation
and supervision.
CONCLUSION
While the global banking developments have
offered innumerable perspectives, important percep-
FinSight
tions are emerging from the Indian banking develop-
ments. Given the long term objective of achieving
9.0 per cent of GDP growth, there is a need to un-
derstand that there are significant challenges for In-
dian banking industry. Of these, the major challenge
would be to achieve financial inclusion through im-
proved financial penetration in thus far uncovered
areas, which in turn would enable inclusive and sus-
tainable growth for the economy.
Proper risk management tools need to be in place
and effective implementation of the same would
help fight against the challenges faced by the Indian
banking industry.
23
24 NIVESHAK VOLUME 2 ISSUE 10 NOVEMBER 2009
TEAM NIVESHAK
ARTICLE OF THE MONTH
The article of the month winners for November 2009 are
Ajay Jain & Piyush Chandak
of IIM Bangalore
They receive a cash prize of Rs.1000/-

Fin-Q Winner
The Fin-Q Winner for the month of October 2009 is
Ankur Singla
of FORE School Of Management
He receives a cash prize of Rs.500/-
CONGRATULATIONS!!

ALL ARE INVITED

Team Niveshak invites article from B Schools all across India. We are looking
for original articles related to finance & economics. Students can also contrib-
ute puzzles and jokes related to finance & economics. References should be
cited wherever necessary. The best article will be featured as the “Article of the
Month.” and would be awarded cash prize of Rs.1000/-

Instructions
»» Please submit your article with the file name and the email subject as <Title of
the Article>_<Institute Name>_<Author’s name/Group’s name> by 10 December ‘09.
»» Article must be sent in Microsoft Word Document (doc/docx), Font: Times New
Roman, Font Size: 12, Line spacing: 1.5 and maximum of 5 pages.
»» The cover page of the article should only contain the Title of the Article, the
Author’s Name and the Institute’s Name
»» Mention your email id/ blog if you want the readers to contact you for further
discussion
»» Also, if certain entries which could not make the cut to the Niveshak will get
figured on our Blog in the ‘Specials’ section

SUBSCRIBE!!
Get YOUR OWN COPY DELIVERED TO INBOX
Drop a mail at niveshak.iims@gmail.com
Thanks
Team Niveshak
www.iims-niveshak.com
COMMENTS/FEEDBACK MAIL TO niveshak.iims@gmail.com
http://iims-niveshak.com
ALL RIGHTS RESERVED
Finance Club
Indian Institute of Management, Shillong
Mayurbhanj Complex,Nongthymmai
Shillong- 793014