Banking sector in india: a financial engineering perspective
Rohit Sah ONKAR NATH MISHRA ABHISHEK KR. CHINTU
PGDM RESEARCH SCHOLAR RESEARCH SCHOLAR
IIM RaNCHI ECONOMICS BHU ECONOMICs
Abstract
The recently generated turbulence in the global economy has not only drawn attention to various forms of distress, but also has made banking sector the most focused area of all researches, policy formulation discussions and debates. The financial fragility has not only compelled banks to overhaul their working mechanism but has generated many opportunities as well. But exploiting these potentials is not an easy task and it needs a seamless effort and an efficient tool, then only the objectives can be accomplished. This paper argues that this is none than other the financial engineering.
The phenotype and landscape of banking sector is changing rapidly due to technological innovations and innovations in financial market which has also been held responsible for the current crisis. While traditional banking may be more than adequate during the early stages of a country’s development, it may act as an unintended constraint on growth as the real economy becomes more complex.
The financial engineering itself is the only way out to insult from the adverse consequences of the crisis as well as to take full advantage of the present potentials and effectively meet the challenges.
The financial sector reforms particularly reforms in banking sector. in India have completed two decades and it can be considered enough time to appraise the performance and look at the future prospect. While the present economic crisis brought untold woes for the banking sector in the developed world, where many of them were liquidated from the business while those who survived the aftermath have found their balance sheet strength eroded. In this environment the performance of Indian banking sector is quite spectacular. Indian banks are now well compared with their western counterparts in terms of risk management, return on investment and technological standards.
The recently generated turbulence in the global economy has not only drawn attention to various forms of distress, but also generated a flood of introspection on economic reasoning with respect to the financial sector. The banking sector is at the epicenter of all researches, policy formulation discussions and debates.
While satisfactory progress have been made, as the indicators of Indian banking sector reveal, the road to future is not a cake walk. Instead, it demands a greater prudent action and strategic approach for the Indian Banking sector. The sector is likely to clock a growth rate of around 15 – 20 % per annum in the coming future. The financial fragility has not only compelled banks to overhaul their working mechanism but has generated many opportunities as well. But exploiting these potentials is not an easy task and it needs a seamless effort and an efficient tool, then only the objectives can be accomplished. This paper argues that this is none than other the financial engineering.
Crisis and financial engineering
Talking about financial engineering at this juncture, may raise eyebrows from many for innovative financial products which were mismanaged by the bankers and customers are often criticized and held responsible for the Global financial crisis (2008). The passion to succeed, greed to earn supernormal profits coupled with initial success marred the foresight of the professionals from the industry from estimating the risks associated with financially innovated products. To held financial engineering responsible for this financial avalanche, and therefore abandon this path or to adopt a “go slow approach” is just like throwing away baby with the bathwater. Like any other technological innovation, financial engineering is also a double edged sword. How to use it, is purely a matter of choice.
It is often argued that, keeping in tune with the western financial system over the past decade, Indian financial markets have grown explosively both in terms of volume and sophistication. The financial institutions have been constantly introducing newer products across various asset classes; however, neither the education required for understanding these products nor research aimed at pricing and evaluating the risks of these products has kept pace with these developments. This fact is evident from (a) the number of corporates that have reported significant losses from trading in a class of financial instruments called derivatives and (b) the quantum of trading losses reported by various banks (arising from these derivatives).
This crisis is more the result of the failure of the regulatory and supervisory mechanism. Those entrusted with the responsibility of thwarting any unethical and unprofessional acts in the financial industry failed to perform their function smartly. It reinforced the motivation on the part of wrong doers to continue with their actions, spelling disaster for their organisations. None will disagree that the regulatory and supervisory authorities failed miserably to match the design and pace of their standards as well as mechanisms of controlling, regulating and supervising financial innovation with those going in this arena.
However, the situation was entirely different in the Indian Banking sector where our central bank actively played the role of an efficient regulator, supervisor, promoter and mentor of the banking sector with a visionary and pro active approach. This helped us in minimising the losses.
Concept of financial engineering
The phenotype and landscape of banking sector is changing rapidly due to technological innovations and innovations in financial market. The latter has come to be termed as financial engineering. Financial engineering has been most comprehensively defined by Finnerty (1988) as design, development and implementation of innovative financial instruments and processes, and formulation of solutions to the problems in finance. Innovative financial solutions may include new financial instruments (such as payment card, reverse mortgage product, arbitrage fund, Micro Insurance and many more) or new processes such as (Mobile payment service, DMA facility, ABSA process, NOW trading gateway, etc.).
One of the core tasks of any form of banking and financial service is the constant search for opportunities to create new financial instruments. Typically, this task is fulfilled by innovatively combining already existing components to form new financial instruments. By combining a set of elementary components, it is possible to cater to the special needs of individual groups of customers. This process is called “financial engineering”, as financial institutions act similarly to engineers or natural scientists when planning and creating complex financial innovations, on the basis of some elementary building blocks, in order to meet their customers’ needs.
With the daily newspapers carrying advertisements featuring new securities, India as a country is witnessing revolutionary changes in financial instruments and processes. The following passage from Miller (1986) is typical "... the word revolution is entirely appropriate for describing the changes in financial institutions and instruments that have occurred in the past twenty years".
Motivation for financial engineering
Necessity is the mother of invention and it is this logic that spells out the various aspects of this phenomenon- rapid financial innovation that has been witnessed by the global financial industry. Same holds true in the Indian context. The Indian Banking sector is at an exciting inflexion point in its evolution. The opportunities are immense – to enter new segments, to enter new markets, to enter new businesses, to set benchmarks in customer services, to evolve a more efficient asset liability management practices.
The challenges are not less than their counterpart. The changing nature of competition is one of them. As more and more new Non Banking Financial Companies come into being and existing ones expand their presence, competition is likely to heightened. Although devoid of the access to many traditional banking functions, due their small and compact size and flexibility in operation they are now emerging as competititors. Second, there has been erosion of the role of the bank as the main financer of working capital requirement and as a term lender institution. Third, Human Resource management is becoming a tough jobs for the banking industry. Fourth, there is vagueness about the future form of technological application to banking though it is going to play a key role. Moreover, now almost all banks are at par with regard to traditional banking functions, implying thereby, that the battle will be fought on new ground.
The point needs to be recognized that the traditional banking system has its own limitations. There are overwhelming empirical evidence to prove the strong link between the development of financial system of a country and its economic development. This is because sound financial systems serve as an important channel for achieving economic growth through the mobilization of financial savings, putting them to productive use and transforming various risks (Beck, Levin and Loayza 1999; King and Levin 1993; Rajan and Zingales 1998; Demirgüç-Kunt, Asli and Maksimovic 1998; Jayaratne and Strahan 1996).
Consequently, while traditional banking may be more than adequate during the early stages of a country’s development, it may act as an unintended constraint on growth as the real economy becomes more complex and as the demand for financial services expands in a multidimensionally (viz. in terms of magnitude, maturity, direction and pattern. There are several reasons for this:
First, in the absence of robust debt and money markets, the ability of banks to grow their loan portfolio is limited by their access to deposits.
Second, banks are not well placed to meet the significant needs in emerging and developing countries for long-term infrastructure financing. The size, maturity, and illiquidity of such loans make them unsuitable for traditional commercial bank financing. The danger in such operations is that banks would take on inappropriate levels of credit and interest rate risk or else operate under a system where the government provides a financial backstop, and hence, passes on the risk to taxpayers.
And, third, commercial banks often are not well-placed to diversify the credit risk in their loan portfolios—their financial performance therefore typically mirrors the underlying condition of their borrowers and of the local economy.
Implications for India
In the report titled “A Hundred Small Steps” submitted to the planning commission by the committee on financial sector reforms (2005) has drawn three main conclusions. First, India's financial system is not providing adequate services to the majority of domestic retail customers, small and medium-sized enterprises, or large corporations. Government ownership of 70 percent of the banking system and hindrances to the development of corporate debt and derivatives markets have stunted financial development. This will inevitably become a barrier to high growth.
Second, the financial sector—if properly regulated but unleashed from government strictures that have stifled the development of certain markets and kept others from becoming competitive and efficient—has the potential to generate millions of much-needed jobs and, more important, have an enormous multiplier effect on economic growth.
Third, in these uncertain times, financial stability is more important than ever to keep growth from being derailed by shocks hitting the system, especially from abroad. Although the Indian economy dodged the Asian crisis and the recent subprime crisis, a lot remains to be done to secure the stability and durability of the financial system.
However, in terms of overall financial depth—the size of the financial system relative to the economy—India does not compare favourably with other countries or even most other emerging markets at a similar stage of development. Despite the apparent strength of the banking system, the ratio of private sector credit to GDP is still low by international standards.
Moreover, other reasons are also - the average ratio of loans to deposits in the Indian banking system is much lower than in most other countries, the government bond market is large but that is not traded, the equity market is vibrant and deep by global standards but the debt market continue to be narrow despite the fact that forex regime has been liberalised and lack of varied money market players and instruments.
Securitisation – a tool of financial engineering
According to Nobel laureate economist Prof. Modigliani whose contribution in the form of MM theorem is the corner stone to the field of financial engineering regards securitisation as the greatest financial innovation. He even regards corporate bonds as merely a form of securitisation. He views asset securitisation and debt securitisation differently.
Securitization is one of the financial innovations that have a significant impact on the function performed by the banking sector since it implies a shift of credit flows from bank lending to debt securities. Cummings (1987) describes securitization as a process of matching up borrowers and savers wholly or partly by way of financial markets. However it fails to capture other dimensions which are included in the Basel Consultative Documents 2003, which dictates that “(banks’) securitization exposures can include but are not restricted to the following: asset-backed securities, mortgage backed-securities, credit enhancements, liquidity facilities, interest rate or currency swaps, and credit derivatives.” (The Basel Consultative Document 2003, para 504, page 100).
It is outside the scope of this paper, to discuss at length, the role of securitisation in banking sector, nevertheless the discussion cannot be completed without it for in the eyes of many it is the villain of the present economic crisis. The role that market failures in securitisation, particularly securitisations of US subprime mortgages, played in precipitating the financial crisis has been widely acknowledged Securitisation, by converting debt into tradable financial instruments, provides an opportunity for more efficient reallocation of sector specific risks among a more diversified set of players. By offering an exit option, it channelises surpluses that have so far remained untapped, to capital–deficient sectors of the economy.
A widespread opinion before the credit crisis of 2008 was that securitisation enhances financial stability by dispersing credit risk. After the credit crisis, securitisation was blamed for allowing the hot potato of bad loans to be passed to unsuspecting investors. However both are appealing only at superficial level as both views underscore the endogeneity of credit supply.
Securitisation is a relatively new concept in India but is gaining ground quite rapidly. CRISIL rated the first securitisation program in India in 1991 when Citibank securitised a pool from its auto loan portfolio and placed the paper with GIC Mutual Fund. The major players in the asset securitisation market in India are expected to be commercial FIs, PSUs, Corporates, Government bodies, Mutual Funds, Pension Funds, etc. In the context of rated transactions, CRISIL has rated about 50 transactions till date, with volume aggregating to well over Rs 4,500 crore.
India’s largest securitisation deal by ICICI bank of Rs 19,299 mn in 2007 hints at the future. The underlying asset pool was auto loan receivables. Other rating agencies in India, viz., ICRA, DCR and CARE have also been actively involved in the process. The market is thus at a stage where debt is increasingly going to be offered in a tradable form, whether or not secondary market trades take place in individual cases.
In brief, securitisation will grow in future for two significant reasons:
a) securitised paper is rated more creditworthy than the FI itself
b) strict capital requirements are imposed on the FIs
RBI had issued comprehensive guidelines on securitization in February 2006 based on international best practices. The main focus of the guidelines was to encourage securitization in manner that ensures true sale-real risk transfer and banks do not retain risks in the transferred assets beyond a point.
Conclusion
It is not the strongest and wisest of the species that survive but the ones that are most responsive to change. This Darwinian principle aptly applies to the present day banking sector in India. They find themselves in a environment in which it is autumn for them but their western colleagues are facing chilling winter.
The development of any industry requires innovation, the banking sector is no exception. If it abandons it in the awake of present crisis then they would be replicating the role of lysosomes. The financial engineering itself is the only way out to insult from the adverse consequences of the crisis as well as to take full advantage of the present potentials and effectively meet the challenges. Of course, everyone has a unique role to play in this context – central bank, banks and the government.
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