Ploutos August Issue

8/12/2019 Ploutos August Issue

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XFIN of XIMB celebrates the resolute spirit of our na-

tion and wishes you all a Happy Independence Day!!

66 years ago, in this very month of August, India began its

tryst with destiny and so do we now with the launch of

Ploutos, the monthly finance magazine of XIMB.

The journey of a thousand miles begins with one step

-Lao Tzu

As we take our first step forward challenges stare us in the

face. One of these challenges is how to put in place a sys-

tem which ensures inclusive and sustainable growth. Even

after 65 years of independence vast majority of the countrylives in deplorable conditions. This calls for a rethink on

our policies and to explore innovative means both at the

macro as well as the micro level. Through Ploutos we in-

tend to inspire and sensitise the prospective managers to-

wards inclusive and sustainable growth. The idea would be

to generate awareness and mould young minds through de-

bates, discussions and participative forums.

Here, the initiative taken by the XFIN team under the guid-

ance of Prof. Ramana deserves a special mention. The

team is preparing the course content on financial literacy for

small-time shop owners, street

-side vendors and other small

retailers. The course content would be distributed in multi-

media format throughout the country by TCS. Ploutos

would like to see many more such initiatives being taken up

and constantly endeavour to disseminate such messages in

all its issues.

In addition, Ploutos attempts to generate debates on the

contemporary financial issues with a view to developing a

perspective on the issues afflicting the financial world and

bring out the essence of the issue at hand. Finance as a dis-

cipline has come under the scanner quite frequently over thepast few years. The lingering global economic crisis and its

repercussions has once again brought to the fore the im-

portance of sound financial practices. Ploutos provides a

perfect medium to exhibit ideas, thoughts and critiques of a

host of issues.

With these objectives we begin our journey of thousand

miles to inspire, catalyse and create changes.

The issue opens with a snapshot of the major financial

events over the past month. The Cover Story this month

focuses on the systemic risks inherent in the global markets

and the lessons learnt from the current financial crisis. The

Article of the Month tries to explore whether there was anexus between the financial markets, financial institutions

and the central bank which perpetuated the current global

crisis. For this months Dialogue we have Mr. Akhil Bajaj,

Assistant Vice-President, Quant Capital who will be sharing

his views on the current financial crisis and the various as-

pects related to it. Focal Point deals with the Libor manipu-

lations and its repercussions in detail. In the Perspective

section we try to figure out as to why the US dollar appreci-

ates despite a high deficit in the US.

Finally, thanks are due to many people who have helped in

making this idea a reality. We are indebted to our guide and

mentor Prof. Asit Mohanty for his inspiration, guidance and

support to accomplish this objective. I would like to con-

gratulate all the members of Ploutos and XFIN who are

behind the making of this magazine. We hope the magazine

would be a vehicle for presenting ideas and innovations

with far reaching effects. Any suggestions to deliver a bet-

ter magazine will always be much appreciated.

FACULTY MENTOR

Prof. Asit Ranjan Mohanty

THE TEAM

The Editorial Team

Shaiwal Parashar

Arijit Asiskumar Majumdar

Nikhil Mathew

Chinmay Nanda

Payal Pathak

The Creative Team

Jayant Mohapatra

Juhi Ujjawal

Shaiwal Parashar

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"Identifying systemic risk in global markets-

lessons learnt from the crisis"

-NIKHIL MATHEW & TOM BABU, XIMB, BHUBANESWAR

The Global Financial Crisis (GFC) did not start with the bankruptcy of Lehman Brothers

but with the collapse of the mortgage backed securities market. We will analyse how some

factors like rising income inequality, international fault line and changing nature of theU.S recession set the conditions which lead to the creation and subsequent bust of the

housing market bubble in the U.S and how it evolved to be a systemic risk for the entire

Financial Sector and the Economy.

Cover Story

Preventing the next crisis:

The nexus between the Financial Markets, Fi-

nancial Institutions & Central Banks

-SAURABH PIPLANI, XIMB, BHUBANESWAR

FLASH BACK3

PERSPECTIVE7

COVER STORY9

DIALOGUE12

FOCAL POINT14

ARTICLE OF THE

MONTH 17

BIZDOM

20

RESULTS 22

Inside this issue:

August, 2012Dialogue

T h e M a g a z i n e b y X F i n , T h e F i n a n c e A s s o c i a t i o n o f X I M B

CONTENTS

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of XIMB

bears no responsibility whatsoever.

Article of the Month


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Finance ministry looks at ETF route for dis-

investment:

The finance ministry is mulling an exchange

traded fund (ETF) for selling shares of state-

owned companies as part of steps to meet the

disinvestment target of Rs 30,000 crore in the

current financial year.

The department is planning to create a pool

of shares of the PSUs it wants to divest and

create a fund (exchange traded fund), whichwould be listed on stock exchanges.

Cabinet Sets Base Price for Spectrum Bids

at 14k cr:

The Union Cabinet on 3rd August set the

minimum price for airwaves in the upcom-

ing auctions at Rs 14,000 crore.

The Cabinet also decided that mobile

phone companies would have to share be-

tween 3-8 %of their annual revenues, as

spectrum usage charges.

Page 3

Rates Unchanged, Slash in SLR:

The Reserve Bank has made it clear its top priority is to rein in inflation, even

if that affects growth.

RBIs monetary policy review on July 31st, 2012 left interest rates un-touched. This is the second straight review in which it has abstained. The re-

po rate continues to stand at 8%. And the cash reserve ratio will remain at

4.75%.

A symbolic move, RBI slashed the statutory liquidity ratio or SLR by one

IMF Cuts Global Growth Forecast:

The IMF shaved its 2013 forecast for global economic growth to 3.9 per cent

from the 4.1 per cent it projected in April, trimming projections for most ad-

vanced and emerging economies.

It left its 2012 forecast unchanged at 3.5 per cent.

The global lender said advanced economies would only grow 1.4 per cent this

year and 1.9 per cent in 2013.

Emerging economies will expand 5.9 per cent in 2013 and 5.6 per cent in

2012. Both figures are 0.1 percentage point lower than in April.


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Public sector banks told to cap bulk deposits at 10%:

After a flip-flop over instructions to public sector banks regarding the cap on corpo-

rate bulk deposits, the finance ministry has finally asked them to cap these at 10 per

cent of total deposits for the current financial year.

From the next financial year, the cap would be increased to 15 per cent, but it would

comprise certificates of deposit (CDs) too.

Bulk deposits are usually term deposits above Rs 1 crore, with a maturity of less than

a year.

Page 4

India Inc capex growth at a 8-year low:

The growth in capital expenditure (capex) on new projects and expansion or

upgrading manufacturing facilities is only in single digits.

It hit an eight-year low in 2011-12.

One big reason given for the single-

digit growth of capex is Reliance Indus-tries (RIL), which saw a reduction in net fixed assets by Rs 33,000 crore,

mainly due to selling of Rs 24,000 crore worth of development rights.

Govt turns down FIIs on GAAR:

The finance ministry turned down foreign institutional investors demand that

capital market transactions be exempted from the proposed General Anti-

Avoidance Rule (GAAR), to be implemented from April 2013.

The ministry prescribed a flat tax on all FII (foreign institutional investor)

transactions but tried to soften the blow by clarifying non-resident investors

among FIIs would not be taxed.

This means the government would tax the net capital gains of only FIIs regis-

tered in India and not seek the identity of sub-account holders.


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BSE's market-making incentive boosts equity derivatives trade:

Nearly nine months after the Bombay Stock Exchange (BSE) launched a market-

making scheme in the equity derivatives segment, its share in the latter has risen to

20-22 per cent.

This is on the back of a rise in the number of broker participants trading on the ex-

change, due to various incentives extended to them.

According to Basel-III norms, banks need to keep minimum 9% capital adequacy

ratio and a capital conservation buffer.

Page 5

Current account deficit hits all-time high of 4.2% in FY12:

With a sharp rise in the import bill and an economic downturn, Indias cur-

rent account deficit (CAD) shot up to $78.2 billion (4.2 per cent of gross do-

mestic product) for the year ended March 2012, from $46 billion (2.7 per cent

of GDP) the previous year.

This is the highest level of CAD ever both in absolute terms and as a pro-

portion of GDP according to the Reserve Bank of India.

For the quarter ended March, CAD rose to $21.7 billion (4.5 per cent of

GDP), compared with $6.3 billion (1.3 per cent of GDP) for the correspond-

ing quarter the previous year.

S&P cut Greeces outlook to negative:

Standard & Poors Ratings Services lowered its outlook on Greeces long-term credit

rating and downgraded Greeces long-term sovereign credit rating outlook to

negative from stable.

Its rating remained at CCC, i.e junk status.

Greeces economy is worsening, so it will likely need as much as (EURO) 7 billion

($ 8.7 billion) in additional financing, or 3.7 percent of its gross domestic product,

from the European Union and the International Monetary Fund, S&P said.


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Sensex ends flat; global cues positive but CAG sours mood

The 50-share NSE Nifty failed to hit the 5400 mark as it has touched an intraday high of 5399.95,

which went up 3.35 points to 5,366.30.

The rise in FMCG, technology, auto stocks and ICICI Bank counter balanced the fall in metals, power,

capital goods stocks and HDFC Bank.

Indian equity benchmarks closed flat on Friday after erasing gains in the second half of trade.

The 30-share BSESensexgained as much as 144 points in an intraday trade due to stability in global

markets on hopes of easing Eurozone credit crisis after German Chancellor Angela Merkel's support to

ECB President Mario Draghi's announcements in last ECB meet.

But the three CAG (Comptroller and Auditor General) reports tabled in parliament in afternoon trade

washed out gains of the market.

The index rose just 33.87 points to close at 17,691.08.

Meanwhile, the 50-share NSENiftyfailed to hit the 5400 mark as it has touched an intraday high of

5399.95, which went up 3.35 points to close at 5,366.30.

SENSEX NIFTY


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Since 1980, the US economy has seen both types of deficits

fiscal and current account. These deficits are referred to as

twin deficits. For a brief period from 1998-2001, US fis-

cal deficit turned into surplus but from year 2002 onwards

this surplus sharply turned into deficit. In this article, we

would explain what these two deficits actually are and how

they influenced the US Dollar.

CURRENT ACCOUNT DEFICIT

Current Account deficit means imports are more than ex-

ports. Balance of payment is the sum of current and capital

accounts of a country. When current account deficit is large,

there is a pressure on the currency to depreciate unless the

deficit is matched by an equivalent or more amount of for-

eign fund inflow. If this inflow is more than the deficit,

there will be a balance of payment surplus in which case the

currency appreciates rather than depreciating.

For the final three months of last year, US current account

deficit jumped 15.7% from $118.7 to $137.3 billion which

is about 3.6% of the whole economy. Imports increased on

account of high spending on oil, machinery & cars. On the

other hand, exports decreased due to low consumption of

US exports in European countries and slow growth of major

export markets like China and other emerging economies.

In spite of such a high current account deficit, US dollar is

continuing to appreciate against almost all the major curren-

cies of the world.

One of the main reasons is the high capital inflows leading

to a capital account surplus-large enough to negate the def-

icit created by the current account. This is majorly due tosafe-haven status of the US dollar.

As the worlds financial markets sink into turmoil investors

across the world are looking for safer assets where they can

park their capital. By doing so, they try to minimize their

risks. More and more assets in Europe and other parts of

developing world are being liquidated (abandoned). The

money they receive after liquidation is converted back into

US Dollars. So, the demand for dollar increases and de-

mand for other currencies decreases leading to an apprecia-

tion of dollar. These US Dollars are then parked in US

treasury bonds as they are considered to be the safest finan-

cial instrument in the world. A close look at the yield of US

Treasury notes demonstrates the same.

The yield on 10 year Treasury notes has fell to a record low

of 1.63 percent. This low return indicates that the investors

across the world are flocking towards them as they are wor-

ried about the safety of their assets and are ready to trade

off high rate of return for safety. In Europe, on the other

hand, quite the opposite is happening. These bond prices

are decreasing because the interest rates are going up indi-

cating that the assets are increasingly being considered asrisky.

Also, several nations use their own currencies to buy dollar

assets. For instance, China has invested close to $1.1 tril-

lion, Japan around $900 billion, U.K. around $300 billion

whereas Hong Kong, Russia and Canada own $100-$280

billion each in US Treasury bonds (source: usecono-

my.about.com). Apart from the above reason, China buys

US Bonds in such large amounts in order to peg Yuan at a

lower rate in relation to the USD thereby ensuring their

Chinese exports to remain competitive.

The risk aversion methodology of parking investments in

USD has hit all emerging Asian currencies. Most of them

have little control over it other than improving their own

domestic fundamentals.

The unspectacular economy in US has reduced the demand

for dollars but since there is so much suction on the supply

side, the dollar is appreciating.

FISCAL DEFICIT : The role of Fiscal deficit or budget

deficit in the overall currency evaluation cannot be ignored.

Federal deficit basically means the difference between the

DOLLAR APPRECIATES DESPITE HIGH

DEFICIT IN US

Article By : DEBSOUMO DAS & CHINMAY NANDA , XIMB, BHUBANESWAR.

Page 7Chart 1: US Twin deficit over the years


9/24

income and expenditure of the government.

In theory, an increase in the fiscal deficit raises the long

term interest rates which attract funds thereby making the

currency appreciate. This in turn creates a necessary tradedeficit and an associated current account deficit which plays

an instrumental role in permitting higher inflow of foreign

capital.

To put all this in US context, there has been a high deficit in

US. Over the years the gap between spending and earnings

has substantially increased for the US government.

While the federal deficit in the FY 2007 was about $161

billion, it grew 7 fold to reach $1327 billion by the FY

2012.Many factors have contributed to this deficit. The eco-

nomic turmoil resulted in a weak US economy which meantdecreased tax collections. Moreover, domestic policies fol-

lowed by the Bush administration such as tax rate cuts fur-

ther added to the problem. For instance, after the financial

crisis of 2008, Bush administration introduced the Troubled

Assets Relief Program to focus on avoiding systemic failure

of Financial Institutions of the country .This programme,

which continues till date, has

an expenditure budget of

$450 billion .At the same

time, expenditure on two

prolonged wars on foreignsoils further added to the

financial woes of the US

Government with military

spending crossing over $800

billion per year.

The increased deficit has resulted in increased borrowing by

the US Government. This has lead to increase in the real

interest rates resulting in a higher inflow of funds. This high

inflow of funds has put an appreciating effect on the curren-

cy helping investors to earn both from high interest ratesand as well as appreciating value of currency.

The recent rally of the US dollar is rather a reflection of the

economic turmoil in Europe rather than sound domestic

economic conditions.

Page 8

US FEDERAL DEFICIT

FY

2007

2008

2009

2010

2011

2012*

Amt.(in bil- $161 $459 $1413 $1293 $1300 $1327

Source: marketvector.com

Chart 2: Yield of US Treasury Notes

Source: advisoranalyst.com

Chart 3: Price of European Govern-

ment Bonds

*Projected US Deficit

Source: http://www.usgovernmentdebt.us


10/24

What is systemic risk?

The financial systems of the developed countries have

evolved into such complex interconnected systems that any

event that affect one entity or system will have a cascading

effect on all the others. This risk of one event leading to a

chain of events that may cause the entire financial market to

collapse is known as systemic risk.

While diversification can reduce concentration risk, it haslittle effect on systemic risk. Insurance on the other hand,

paradoxically increases systemic risk. Similarly, hedging

can also lead to an increase in systemic risk. So, finding

ways to identify these risks and learning how to handle

them has become the primary objective of the financial reg-

ulatory bodies all around the world.

However, this is not the first time the world is looking at

tackling this issue. During the time of the great depression,

bank runs were a common sight. When some of the banks

faced liquidity crunch, the fear of a bank run materialised

into a self-fulfilling prophecy and even the banks with

sound financials collapsed. In order to avoid such events,

the Federal Deposit Insurance Corporation was established

in 1933 to guarantee the safety of deposits in the member

banks. Since then, the number of bank runs has reduced

significantly and the market became more capable of ab-

sorbing small shocks.

But this created a moral hazard. The banks started assuming

more risks as they knew that there was always someone

whom they could fall back upon, in case things went wrong.

This in turn kept adding to the pressure within the market,slowly but steadily, until it the market could no longer sus-

tain it.

This makes us wonder if systemic risks are self-imposing.

In other words, any measure taken to reduce the systemic

risk would be, in effect, an attempt to transfer risk. This

would be adding to the interconnectedness in the market

and though it may seem to absorb small shocks in the short

run, the pressure could be continuously building up.

Factors that support systemic risk

Institutes too big to fail: When an institute is big in relation

to the market, it

becomes neces-

sary for the gov-

ernment to pro-

tect such insti-

tutes, because if

these institutes

fail, it will be disastrous for the whole economy. Once such

protective policies are in place, the institutions may start

leveraging on it to make profits. They will start taking too

many high risk-high returns investment decisions. This will

eventually lead to the downfall of the institute and thereby

the entire economy.

Institutes too interconnected to fail: Here again it is in the

interest of the economy that the government should protect

these institutes. When these institutes fail, the impact is not

just the loss of the institutes product or service but also the

economic multiplier of all the other commercial activities

which are dependent on the institute.

Liquidity: This is not a direct contributor to the systemic

risk, but instead increases the exposure of a market to the

systemic risk. The degree of vulnerability to systemic risk

mainly depends on the stress in the market conditions. For

example, if the liquidity in the market is too tight, even a

temporary liquidity shock could have exponential after-

shock.

Complex economic models: Though each individual model

may be well understood, it becomes very difficult to under-

stand the complex relationship shared between the various

complex models. This might aggravate the systemic risk.

With growing complexities, it becomes difficult to identify

a single indicator of systemic risk. Consequently, it be-

comes even more difficult to predict when a financial crisis

will become systemic and to gauge the quantum of risk we

are dealing with.

Lessons we can learn from the past: : The common view

about the fixes that need to be made in the aftermath of

Global Financial Crisis is that we should make changes in

Banking and their Regulatory Environment and we will befine. Is it that simple? Were there any other underlying so-

"Identifying systemic risk in global markets -

lessons learnt from the crisis"

Article By: NIKHIL MATHEW & TOM BABU, XIMB,

BHUBANESWAR

Page 9


11/24

cial and macro-economic factors that led to the crisis? Fol-

lowing is a list of these factors, pointed out by Raghuram

Rajan (Chief Economic Advisor to the Government of India

and former Chief Economist of IMF), to be the underlying

cause which ultimately led to the GFC:

Growing Inequality : During the Occupy Wall Street Move-

ment that happened last year, the main slogan was We are

the 99% and it refers to the income disparity in the U.S.

Currently the top 1% have a 24% share of the Income. Even

more alarming situation is the wage differential with the

90th percentile (Low level manager) and the 50th percentile

(office assistant and factory worker) as it has increased by

an alarming amount.

...from 1973 to 2005...the real hourly wages of those in the

90th percentilewhere most people have college or ad-

vanced degreesrose by 30 percent or more... among this

top 10 percent, the growth was heavily concentrated at the

very tip of the top, that is, the top 1 percent. This includes

the people who earn the very highest salaries in the U.S.

economy, like sports and entertainment stars, investment

bankers and venture capitalists, corporate attorneys, and

CEOs. In contrast, at the 50th percentile and belowwhere

many people have at most a high school diplomareal

wages rose by only 5 to 10 percent -Janet L. Yellen, Presi-

dent and CEO, Federal Reserve Bank of San Francisco,

November 6, 2006

With the technology changes that has been happening and

the globalization effects (manufacturing going to China),

more skills are needed for people to earn a good income.

American high school graduation rate has remained stag-

nant for many decades. There are several social factors like

increasing number of families breaking up, lack of adequate

primary school training, etc. behind this stagnancy. This has

led to a decrease in the supply of skilled labour.

The problem with inequality is that bad government poli-cies emerge from them. The steps that are needed to fix

inequality are very long term in nature and not necessarily

politically attractive. So the government opt for more short

term measures to protect their political interests and there-

fore resorted to boosting private consumption through

Credit.

Government had the power to influence the housing credit

market and it was a bipartisan effort from Clinton and Bush

administrations to push home ownership. Many of the acts

that were introduced during the depression era were used

for it. There was also the 1977 Community Reinvestment

Act, which prevented banks from discriminating against

lower income neighbourhoods when they made loans. This

made it easier for the poor and minorities to obtain mort-

gages.

The legislations passed in the 1990s compelled Fannie Mae

and Freddie Mac to purchase mortgages that effectivelyincluded subprime loans. The Federal government spon-

sored and subsidized home ownership making it less expen-

sive and burdensome. The subsidies alone might not have

caused the bubble but it created conditions that encouraged

and sustained its growth.

So it was not as if the Private Sector suddenly woke up one

day and decided that they would provide credit to low in-

come people for home ownership. The fault line was the

rising inequality and the pressure on the government to do

something about it.

International Fault line: Since World War 2, many coun-

tries have followed an export led growth strategy to lift

them out of poverty. The main two examples are Japan and

Germany. It was an extremely successful strategy for

growth. Japan set the example for Korea, Taiwan, Chile and

China to follow.

The government help the producers by discriminating

against savers. They keep the producers honest by forcingthem to export to the international where they have to com-

Page 10


12/24

pete and remain efficient. There is a deep flaw in this strate-

gy. It leads to a very weak and inefficient domestic oriented

sector. Whenever these countries are in a slump, they de-

pend on the world economy to pull them out of trouble.

They depend on the international markets, to which they arepumping out goods, to bail them out. In effect they look for

overspending by foreign countries. In the 90s the over-

spending was done by emerging countries (big spending on

investments) and in the 2000s it was done by US, UK,

Greece etc.

Surplus countries were also looking for high yielding bonds

that were presumed to be safe. Many of the securitized

mortgage bonds were rated AAA by the rating agencies and

it became an attractive proposition for the foreign money.

Foreign Central Banks were also supplying cheap money bybuying dollars to preserve the value of their currencies

against dollar for remaining competitive. All these distorted

the prices in the financial market. When the Banks and Fi-

nancial Institutions knew that investors were ready to buy

their securitized mortgaged bonds without asking questions,

it provided them with the incentive to create more and more

of the stuff. Whole lot of mortgages were created, securit-

ized and sold off.

Nature of US Recession

The nature of US recession has changed over the years.Usually it took two quarters to recover the growth back

after a recession and eight months to recover all the jobs

lost. The thin safety net (6 months of unemployment bene-

fits) in US seemed to work as it forced workers to earnestly

look for jobs.

After the 91 recession, it took 3 quarters to get back the

growth and 23 months to recover the lost jobs. After the

2001 recession it took just one quarter to get the growth

back and 38 months to recover the jobs back. The six

months unemployment benefit is not enough when facedwith these kinds of recessions. No central banker would

baulk at increasing rates when the unemployment rate is

high. This was a factor for Alan Greenspan to keep rates at

a low level for too long after the recession. He ignored the

property bubble that was developing as follows:

Banks would issue mortgages through brokers and apprais-

ers of the mortgages, who are there in this business for their

commissions. Banks didnt care for the quality of the under-

lying mortgages as they would sell the mortgages to invest-

ment banks for securitization who also didnt care for the

quality of underlying loans since they were also going to

sell it off to investors after securitization as highly ratedinvestment instruments. The ratings were bestowed by the

rating agencies who stood to gain from them getting a good

rating as it would mean increased business for them. Be-

sides that, they were highly complex instruments created by

the Financial Engineers in the wall street, and was diffi-

cult to understand let alone analyse and rate. The mathemat-

ical models relied on very optimistic assumptions that mini-

mized measured risk. The net result was a truly opaque,

inscrutable financial system ripe for a panic.

The trigger for the panic came when many of the loans thatwere made during the peak period of 2005-06 started de-

faulting. These were largely subprime mortgages with ad-

justable rates (ARM) and had teaser rates below 4% that

would adjust to a higher rate after some period. In Q1 2007,

the Case-Shiller house price index recorded first year-on-

year decline in nationwide house prices since 1991 and the

subprime mortgage started collapsing.

To conclude, as long as these underlying factors are not

fixed, chances for another bubble and bust happening will

be always there. Seeds for this might already have been

sown because of the bail out of financial institutions, quan-

titative easing and the all time low rates. Whilst another

crisis maybe inevitable, steps could be taken to reform the

banking sector so that it may not lead to systemic risk

again.

References:

Fault Lines: How Hidden Fractures Still Threaten the

World Economy, Raghuram Rajan

Crisis Economics: A Crash Course in the Future of Finance,

Nouriel Roubini, Stephen Mirr

Page 11


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Ploutos: How do you think the current scenario is play-

ing out especially in the financial segment? How India

is doing in context to the global financial scenario?

Mr. Bajaj: Major lending issues are linked to the cur-

rent European crisis. If the long term risks are high

there is always a flight of capital to the more developed

economies. Flight of capital leads to rupee devaluation,

current account deficit and capital account deficit.

These are some concerns that will affect Indian econo-

my.

Ploutos: So what about the internal issues India is fac-

ing? Do you think they are less significant in the current

context?

Mr. Bajaj: There are two parts to it. Yes there are inter-

nal issues and there are whole host of them and they are

the major issues. The only affect that is happening form

the Europe side is availability of capital. How easily the

money is flowing globally, that is the concern which

India faces, otherwise there is no impact of European

crisis on India.

Ploutos: Finance was initially meant to support the real

production sector and facilitate other economic activi-

ties. Do you think the role of finance has evolved from

just lubricating the economy and it is trying to fabricate

the economy?

Mr. Bajaj: I wouldnt deny that. I have heard enoughgreat minds talk on this matter and it proves that finan-

cial systems per se, specifically the banking system or

capital market system, are just an enabler from the sav-

ers to the investors. However we do have the Invest-ment banks who were just supposed to be brokers get

into proprietary trading, having their proprietary invest-

ments into businesses which they probably dont under-

stand or are totally unrelated to them. That is obviously

an aberration to what the initial intent was.

Another example would be what hedge funds were basi-

cally created for and what they turned out to be. That is

why you would see that every 2-3 years the list of the

entire hedge funds and all the names change. I mean

there is no consistency. So, obviously they are moving

beyond what their mandate was. So this was obviously

one of the major reasons why these problems are heat-

ing up.

Ploutos: Rating agencies are paid by the companies

who get rated, so there is a conflict of interest. And this

was also one of the enablers of the subprime crisis.

Why do you think no one is addressing this issue?

Mr. Bajaj: If you say none is addressing the issue, that

isnt true. People have sighted that, somehow there are

much larger concerns right now having the snowballing

effect of smaller markets collapsing into larger markets

collapsing and systematic collapse -the kind which we

saw in 2008-2009. So I think that has taken a backseat.

So yes, obviously there are conflicts of interest and

these rating agencies are reacting to it. The S&P down-

grading of the US sovereign is a big step forward

(though it should have been downgraded way back). It

runs an 11percent account deficit, which is way beyond

Mr. Akhil Bajaj

An alumi of XIMB, MR.Akhli Bajaj is currently Assistant Vice-

President, Quant Capital. As part of the investment banking

team he looks into Private Capital raising and Advisory deals.

After a stint of about four years in investment banking he went

for further studies at the University of Cambridge specialising

in finance and strategy.

His areas of interest are Education, Healthcare, Hospitality and

Green Energy

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what a developed country should be running. Its never

going to grow at 11 percent and hence it cannot pay for

that kind of a deficit. So that is a step forward and if

they can keep up with it, its great.

Ploutos: Coming to the investment banking side, the

compensation of the traders are linked to the short term

returns that they make. This tempted the traders to go

for high risk -high return investments. This was another

reason for the collapse. How is the system in India? Is it

any different? And is that the reason we did not see

such risk taking events in India?

Mr. Bajaj:India did not have this issue for more rea-sons than this. Compensation even in India is related to

revenue earned. So that is consistent. However the real

reason seems to be the fact that companies and traders

in developed countries did not understand the kind of

risk they were taking on. Recently academicians have

gone back to the text book to look at the pricing models

that they had been swearing by the end of the last dec-

ade. There has been a lot of questioning on the assump-

tions of the theory like the Random Walk Theory, Black

Schole pricing model. And the models from which thetraders were picking up the pricing from are being ques-

tioned because they did not include the behavioral pat-

terns in the market.

Ploutos: There is a big debate going on about whether

Ring fencing is sufficient to control the systemic risk

or not. What are your views on this?

Mr. Bajaj: I think interim steps were taken on Ring

Fencing on certain markets being secluded out. I dont

think ring fencing is the way out to stop systematic risk.

Have people tried to solve the issue? I dont think so.

They have just thrown money at it. Nothing else has

happened. Have any regulations come? No, they have-

nt. Look at the number of regulations that came after

the great depression, on checking on how market and

market participants behave, in 1930s the amount of

regulations that came in the US, I have not heard of one

regulation that has come since the 2009 collapse.

Ploutos: Now the economists are trying to look for in-

dicators which could warn us about such events occur

again. Has there been any success in this direction?

Whats the progress on this?

Mr. Bajaj: I really doubt we have. One good thing to

have is that the economists went back to the models and

the text books and they challenged the theories which

had been established. The basic assumption that there

are thin tails in the normal distribution of the stock price

is not true. Basically it means there are fat tails. If there

is a negative fat tail at the end, it means there is a higher

probability of the market going bad.

Another assumption was that all actions are not corre-

lated. The entire theory was that the BRICS are moving

in different tangents as compared to developed markets.

Now the understanding is that in a crisis all actions start

to correlate. This is a weird thing because when every-

thing is going right most of the assets are not correlated.

So bricks would grow while the developed markets

would struggle to grow. But when a crisis comes into

play no one is going to grow. All the earlier assump-

tions were questioned. Now, they at least know which is

not the right answer. They now know that this model is

noting going to tell me when the market is going tocrash. So they know that something more is to be done.

Ploutos: What do you think is the road ahead? What are

the main challenges the policy makers need to address

now?

Mr. Bajaj: The financial markets and investment banks

were initially meant to be the oil of the engine of the

economy. They have to go back to do that, so brokeragehouses have to strive being brokering houses not finan-

cial investors, insurance companies have to go back and

give insurance on risks they understand. They have to

go back to the basics. People have to start looking at the

mandate rather than looking at the immediate returns.

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LIBOR (London Inter-Bank Offer rate) might not interest

you but it is going to affect you. The recently revealed LI-

BOR scandal is an addition to the impediments already

caused by the troubles in Europe, USA and China. It may

still appear to many to be a provincial affair involving Bar-

clays, rigging an obscure number, but this is beginning to

assume global significance. The LIBORthe number cur-

rently being rigged is an interest rate calculated daily by

British Bankers Association (BBA), as a benchmark rate

for short term loans, wide range of contracts including

mortgages and derivatives.

The Modus Operandi of the calculation is: Presently 18

Bankers provide the BBA an estimate of rates at which they

could borrow from other banks and the BBA discards the

Top 4 and the bottom four submissions via bootstrapping

and reiterates the process to average the rest to arrive at the

daily LIBOR.

Imagine there are four banks: Bank one quotes 3%, Bank

Two Quotes 4%, Bank 3 quotes 5% and Bank Four quotes

6%. Discarding the top and the bottom quote, LIBOR will

be the average of 4% and 5%, that is, 4.5%. Now for In-

stance, the first banks intends to raise the cut-off rate, so

rather than quoting 3% it would quote 7% and assuming all

others banks submitted the same, 7% would again be dis-

carded, However the bank has influenced the average cut-

off rate, which will now be 5.5%. With the sums of money

involved, this 100 basis points manipulation is huge.

The LIBOR almost settles payments of about US$800 tril-

lion-worth of financial instruments, thus, determining the

flow of billions of dollars each year. Despite being having

such a huge significance in the Banking industry, the rateturns out to have been rigged not only by the employees at

Barclays but at several other banks over a period of more

than 5 years.

The manipulations started with the financial crisis of 2007

wherein various banks suffered huge losses on their hold-

ings of toxic securities and there was no interbank lending

and there was no real data to use as a basis for submitting

the LIBOR and thus the Barclays submissions were con-

stantly above the submissions of their rivals.

What happened at Barclays: As for Barclays a couple of

ways of manipulations

have come to the fore-

front. First involves

groups of derivatives trad-

ers at Barclays and several

other unnamed banks try-

ing to fiddle with the final

LIBOR fixing to increase profits (or reduce losses) on their

derivative exposures. Barclays was a leading trader of these

sorts of derivatives, and even small moves in the value of

LIBOR could have resulted in daily profits or losses worthmillions of dollars. In 2007, the loss (or gain) that Barclays

stood to make from normal moves in interest rates over any

given day was 20m ($40m at the time).

However, Bob Diamond, its chief executive, who resigned

on July 3rd as a result of the scandal, retorted from this say-

ing that

On the majority of days, no requests were made at all to

manipulate the rate

This was like an adulterer saying that he was faithful onmost days.

Hitherto, a second sort of LIBOR-rigging has also emerged

in the settlement. Barclays along with other banks submit-

ted low estimates of bank borrowing costs over at least two

years, including during the roughs of the financial crisis. In

terms of the scale of manipulation, this appears to have

been far more remarkableat least in terms of the numbers.

Almost all the banks in the LIBOR panels were submitting

rates that are said to have been 30-40 basis points too low

on an average. This could create the biggest liabilities forthe banks involved (although there is also a twist in this part

LIBOR Manipulations -Is It Just Another Scandal?

Article By: MUKUL DALMIA & SAVNEET KALRA, XIMB,

BHUBANESWAR

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of the story involving the regulators).

The idea here was to project a false image of stability to

avoid panic in the market and prevent additional regulation

or even nationalization, a solution that looked increasinglylikely during the height of the financial crisis. The effect for

consumers here was to make loans cheaper, but the indirect

effect, was to lessen any chances of government action

against the banks.

What led to the rigging in the first place?

Firstly, the cut-off is decided based upon banks estimates

and not the prices at, which banks have advanced or bor-

rowed from others. Statements such as: There is no report-

ing of transactions, no one really knows whats going on in

the market, you have this vast overhang of financial instru-ments that hang their own fixes off a rate that doesnt actu-

ally exist.-one of the senior trader closely involved in set-

ting LIBOR at a large bank.

-are doing rounds in the markets, showing the lack of ac-

countability in system.

Second reason, which could be attributed to the cause of

manipulations, the incentive the system itself offers to rig,

because the banks earned profit or marked losses based up-

on the levels of the benchmark LIBOR. Worse still, the

transparency (or the lack of it, Should we say) in setting up

of rates may have added to the tendency of lie, Weaker

banks would not have wanted to implicate that fact by sub-

mitting correct estimates of high cost they would have to

shell out to borrow.

The impact of the Scandal:

This is the banking industrys tobacco moment, -CEO of

a multinational bank,

- referring to the lawsuits and settlements that cost Ameri-

cas tobacco industry more than $200 billion in 1998. Its

that big.

The 21st century has been a banner century for financial

and accounting scandals. Enron, the dotcom bust, the sub-

prime-mortgage crisis and the bank bailouts have all con-

tributed to the very low esteem in which the American pub-

lic holds Corporate America in general, and high finance in

particular. We link it with the butterfly effect, according to

which, the slightest disturbance in one part of a system can

trigger a chain of events that creates a hurricane in another

part of the worldLIBOR manipulations by some playershas consequences beyond the concerns for traders them-

selves. Traders who we have to assume were probably mo-

tivated more by their own immediate financial gain than by

some grand conspiracy to disrupt the markets. Yet, this is

what they may have inadvertently done. As many as 20 big

banks have been named in various investigations or law-suits alleging that LIBOR was rigged. The scandal also cor-

rodes further what little remains of public trust in banks and

those who run them.

US lawmakers have raised concerns that the alleged manip-

ulations may hamper households, thus raising the stakes of

the scandal. According to an estimate by the Office of the

Comptroller of the Currency, there are about 900,000 out-

standing home-loans indexed to LIBOR originated in be-

tween 2005-09, when the scandal seems to have surfaced.

In this period, when the LIBOR was being rigged higher,

households with loans tied to the gauge may have paid

higher rates than mandated. If Libor was artificially sup-pressed for a period, payments on those mortgages may

have been lower during that period than they should have

been.

The LIBOR scandal strengthens the argument of those who

feel that the global financial markets are simply a rigged

casino game where the largest banks, always wins. Going

through the text messages and emails between traders at

Barclays about their successful attempts to manipulate

global benchmark will only reinforce those beliefs. Those

traders not only influenced the pricing of LIBOR but that

benchmark then may influence or dictate the pricing of up

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17/24

to $650 trillion worth of swaps -- complex derivatives --

according to the Bank for International Settlements (BIS)

data and several other key benchmarks between 2005 and

2009.

Now there will be offsetting positions as well as back-to-

back positions and not all those swaps key off just from

LIBOR but it sets the ballpark for the quantum of manipula-

tion involved. In addition, this action sends false market

signals and creates a false market in one of the key planks

of the global financial system.

This is a terrible lapse of the moral compass and contributes

in unknown ways to cascading risks which produce butter-

fly effects. Not only Barclays, JPMorgan Chase & Co.,

Deutsche Bank AG (DBK) and HSBC Holdings Plc are

among at least seven firms facing a Canadian probe into

whether they participated in a conspiracy to manipulate

prices on interest-rate derivatives.

HSBC and Royal Bank of Scotland Group Plc are among

banks (along with Barclays) that have said theyve received

requests for information from global regulators in recent

months. UBS AG had been given conditional immunity

from the Swiss Competition Commission as part of an in-

vestigation into manipulation of the Yen Libor, Tibor, and

Swiss franc Libor rates.

The Future:

The following developments might shape up after the turn

of the aforesaid events:

Both the US and UK regulators have expressed

that there are going to be a couple of months before the next

settlement, but the question is who is going to settle next.

The resignations by BOB Diamond (ex-CEO, Bar-

clays) and other top management will set in quite a disrup-

tive precedence, which could be starting point for a trend,that we could see over the next 5 years:

The current Investment Bankers might be pushed

out of the top management and the more traditional

bankers set in

The regulatory pressures could (Infact they should) in-

crease by many folds and Investment Banking might not be

the most profitable because of this, which might make sense

for the traditional Investment Bankers to be in the top man-

agement for a time period of about 5 years to stabilize the

things.

Unlike the assets JPMorgan was trading on, the

LIBOR rate has real consequences for average consumers,

and its manipulation could hurt an economys typical mort-

gage-holder.

At this defining moment whether, the time has come think

about another process of calculating the LIBOR or should

we stick to the current system expecting that the FSA, the

BBA and to some extent the Bank of England and the SFO

would finally start doing their job properly? The only way

to get this fixed is by making the process as robust as possi-

ble.

It will be only fair to end by a quote from Warren Buffet:

Everything is tied in [to Libor]," The idea that a bunch of

traders can start e-mailing each other or phoning each other

and play around with that rate is an important thing, and it

is not good for the system."Warren Buffet

Refernces:

http://www.huffingtonpost.com/2012/07/12/warren

-buffett-libor-scandal_n_1668649.html

http://www.bbc.co.uk/news/magazine-18826396

Page 16


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Executive Summary

The world economy is going through a prolonged slow-

down first signs of which could be traced back to July

of 2007, more than 5 years ago, when the fed reserve

started raising policy rates in order to contain inflation

resulting in increasing payment defaults from the sub-

prime mortgage borrowers. This begs the question;

How can increasing payment defaults by sub-prime bor-

rowers in some part of the world can take the world

economy down and keep it there for 5 years?. The an-

swer to this question lies in the fact that the financial

markets and institutions have become extremely large

and integrated and that the correlation of losses increas-

es manifold in times of a downturn or in other words

risk management practices of banks has not kept pace

with the complexity levels of the structured products.

This coupled with strong linkages of financial institu-tions with real economy has resulted in grave conse-

quences for most of the developed economies which fell

of a cliff with the debacle of Lehman Bros. in Septem-

ber 2008.

What preceded this slowdown was an era of unparal-

leled growth and profitability where every financial in-

stitution under the sun, made a lot of money which con-

sequently led to huge bonuses for their top bosses. This

led to a problem of greed (i.e. framing internal policies

focused on short term gains regardless of their impact

on long term stability and solvency) and moral hazard

(free movement among officials of fed reserve

(regulator of banks in the US) and private financial

institutions). This led to regulations that were pro-profit

instead of being anti-risk (a pertinent example will be

abolition of the Glass-Steagall act in 1999 that prevent-

ed co-existence of commercial and investment banks

under one umbrella).

This era of weak regulation was coupled with advent ofmany complex structured products which facilitated

increased profitability

through reduced capi-

tal requirements and

high off balance sheet

leverage. These prod-

ucts were so complex

that it became nearlyimpossible for the in-

stitutions themselves, regulators, insurance companies

and credit rating agencies to asses the risks associated

with it. Anyways who cares about risks when senti-

ments are bullish and banks are deemed Too Big To

Fail.

Lead up to the crisis: It all started in 2001 when banks

started coming up with innovative structured products

in order to boost profitability. Banks were originating

loans and then pooling them in a bundle and then sell-ing it off to other banks, financial institutions and other

investors. This was done by cherry picking mechanism

i.e. all the good loans (which involved low credit risk)

were pooled together and then sold to investors. These

pools will generally be rated by an external rating agen-

cy and in most cases have a AAA (Highest degree of

safety) rating with credit enhancement from insurance

giants such as American International Group (AIG) or

Fannie Mae or Freddie Mac. These pools will then be

offered through securities known as the Pass throughCertificates (PTC). This solved a dual purpose for the

banks; one release of capital to further originate loans

and two extremely high returns as these AAA rated se-

curities carried a lower interest rate than the rates at

which they were originated (banks made a interest rate

spread with virtually zero investment)

This period was also marked by low policy rates and

strong liquidity in the financial system as low inflation

coexisted with high growth. This induced banks to start

lending to sub prime borrowers in search of high yield

Preventing the next crisis the nexus between

financial markets, financial institutions and

central banks

Article By: Saurabh Piplani, XIMB, BHUBANESWAR

Page 17


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20/24

Absence of proper regulation; incapability, over-

sight, moral hazard, and Greed: The regulating agen-

cies clearly lacked the expertise to identify and quantify

risks of such complex products. They were simply not

big enough to impose regulations on corporations that

had global operations and were making loads of money.

Instead most of the regulations were tweaked in order to

play it into the hands of large banks due to the problem

of moral hazard and greed.

How to prevent such crisis in future

Learning from any crisis should assume prime im-

portance and both the internal control systems and ex-

ternal regulation should come out stronger from the cri-

sis. One key learning from this crisis is that how corre-

lation among different risks increases manifold in times

of economic downturn. This not only leads huge losses

for the banks but leads to significant liquidity con-

straints which may also result in insolvency.

What is needed of Financial Institutions?

Increased emphasis on risk management and assessing

the effectiveness of hedging strategies in times of stress:

The financial institution should lay more emphasis on

building strong internal risk management techniques

even in times of good economic conditions. These tech-

niques should be able to appropriately quantify risk

(especially account for high correlation among them in

times of stress) and be able to devise strategies to over-

come these risks.

Devising an incentive structure that is focused on long

term stability of the banks rather than short term profits:

One of the biggest reasons for the magnitude of the cri-

sis was Greed of the top notch officials of these hugefinancial institutions. The incentive structure should be

designed in such a way that the incentives are based on

sustainability of the risk adjusted profits. One way to do

this is offering a share in the equity of the institution

with a certain lock in period rather than paying out of

hefty bonuses in cash.

What is needed of Central Banks?

Strengthen regulation and supervision: The central

banks need to incorporate off balance sheet leverage inassessing the capital requirement of financial institu-

tions. They should also ask financial institutions to

strengthen their internal processes and risk management

practices and build buffer capital in good times. Further

they should access control over incentive structure of

these institutions.

Collaborating with other Central Banks: Due to

strong linkages prevalent in the overall financial system

there is a need for regulators to collaborate and work in

a collective manner. This way they will be able to

measure systemic risks not just specific to their own

economy, but on the world economy as a whole.

What is needed of financial institutions and Central

Banks Collectively?

Providing system wide analysis and assessing system

wide risks: The central bank should provide system

wide analysis as it has access to all the information as a

result of disclosures to be made by various market par-

ticipants. It should provide a macro perspective of the

overall financial system and the economy. The risks in

the financial system and economy should therefore be

measured on macro basis and not on firm specific basis.

There should be careful analysis of interlinkages among

financial markets and between financial markets andfinancial institutions and most importantly its linkages

with the real economy. One particular risk that should

be managed most effectively is liquidity risk. The insti-

tution should identify diversified sources of liquidity in

times of stress.

Mitigating pro-cyclicality: Central banks in consulta-

tion with financial institutions should devise structures

of incentives such that profits made during benign eco-

nomic conditions are utilized in building buffer capital

or cushion for the stress times. All the financial institu-tions should join hands with the central banks in mak-

ing such an incentive structure a success.

References:

1. Report by the high level group on financial su-

pervision in the EU chaired by Jacques de Laro-

siere Brussels February 2009.

2. Preventing the next crisis the nexus between

financial markets, financial institutions and cen-tral banks - Speech by Mr Masaaki Shirakawa

Page 19


21/24

1. X, co-founder of business Insider popularized the term Y which refers to inves-

tors who are nave and who are enticed into buying hot stocks or securities that

the insiders are selling w/o performing their own research.

2. Connect these logos:

3. Connect Grameen Bank and the year 2005

4. "Preliminary research shows that about 91 percent of clients surveyed after activating their debit card would

recommend that their family and friends sign up for the product.-CEO of a South-East Asian Bank

What product is he talking about and who implemented it?

5. This term has a reference to the movie "Star wars" and refers to a highly anticipated primary way of raising

funds that becomes a blockbuster with the investors.

6. Connect "Common Stocks and Uncommon Profits" and "The Intelligent Investor"

7. Connect the three images below. What is the context and significance?

8. He was born in Kallakurichi, Tamilnadu. His research areas include typography and design research with

special focus on Tamil typography. He came into the limelight in 2010 for this specific contribution to the

country. He was awarded prize money of Rs 2.5 lakhs by the Indian Government?

QUIZ

Page 20


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9. Connect the four images

10. X is usually known to peg its currency against the US Dollar. There is a Y referred to as the new X, active

in the currency markets, according to analysts, battling to weaken its currency thereby inflating its stockpile

of foreign currency reserves. The Country Ys Central Bank was forced to buy tens of billions of euros inMay and June after the euro zone crisis worsened, creating strong haven demand for its currency and threat

ening the ceiling the central bank set for its currency last September.

Identify X, Y and the currency involved?

Please send in your entries to [email protected] by 15th of September, 2012.The winner stands to win a cash prize of Rs. 500.Only all correct entries would be eligible for the prize. In case of multiple correct entries the winner would be decid-

ed by the lucky draw.

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1st: Saurabh Piplani, XIMB

2nd: Nikhil Mathur, IMT Gaziabad

3rd: Debsomu Das, XIMB

Ploutos invites articles for the forthcoming issue on the following theme:

Financial Inclusion: Obligation or Opportunity

Participants need to adhere to following guidelines.

1. Only individual submission is allowed.

2. The article should be an original piece of work and any references to other sources of work should be duly credit-

ed and your article should not have been published anywhere else.

3. Format for articles: Word document, Font Times New Roman, Font size 12, Line spacing 1.15, Double Column.

4. All data/references used must be mentioned in the article. All the tables and illustrations should have proper num-

bered title above and source at the bottom of the table/ illustrations.

5. Word limit is 1500 words.

6. Please mail your entries to [email protected] with the subject and file name as: Ploutos__ e.g. Ploutos_XYZ_Rahul before 11:59 PM, 15th September 2012

7. Please write your Names, Contact Numbers and Name of the Institute on the front page.

8. Winner gets a cash prize of Rs. 2000 and the two runners-up get a letter of appreciation.

The last date for receiving the entries is 15th Sept, 2012Page 22


24/24

Documents

Ploutos August Issue