XFIN of XIMB celebrates the resolute spirit of our nation 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 system which ensures inclusive and sustainable growth. Even after 65 years of independence vast majority of the country lives 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 intend to inspire and sensitise the prospective managers towards inclusive and sustainable growth. The idea would be to generate awareness and mould young minds through debates, discussions and participative forums. Here, the initiative taken by the XFIN team under the guidance 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 multimedia 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 discipline has come under the scanner quite frequently over the past few years. The lingering global economic crisis and its repercussions has once again brought to the fore the importance 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 a nexus 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 aspects related to it. Focal Point deals with the Libor manipulations and its repercussions in detail. In the Perspective section we try to figure out as to why the US dollar appreciates 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 congratulate 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 better magazine will always be much appreciated.

Shaiwal Parashar

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

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CONTENTS
The Magazine by XFin, The Finance Association of XIMB
Dialogue
August, 2012

Cover Story

"Identifying systemic risk in global markets lessons learnt from the crisis"
-NIKHIL MATHEW & TOM BABU, XIMB, BHUBANESWAR

Inside this issue:

FLASH BACK

3 7 9 12 14 17 20
22

PERSPECTIVE

COVER STORY

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 the U.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.

DIALOGUE

FOCAL POINT

Article of the Month

ARTICLE OF THE MONTH

Preventing the next crisis: The nexus between the Financial Markets, Financial Institutions & Central Banks
- SAURABH PIPLANI, XIMB, BHUBANESWAR

BIZDOM

RESULTS

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of XIMB bears no responsibility whatsoever.

Finance ministry looks at ETF route for disinvestment: The finance ministry is mulling an exchange traded fund (ETF) for selling shares of stateowned 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), which would 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 upcoming auctions at Rs 14,000 crore. The Cabinet also decided that mobile phone companies would have to share between 3-8 %of their annual revenues, as spectrum usage charges.

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 untouched. This is the second straight review in which it has abstained. The repo 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 advanced 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 corporate 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.

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 Industries (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 AntiAvoidance 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 registered 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 marketmaking 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 exchange, 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.

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.

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 current account deficit (CAD) shot up to $78.2 billion (4.2 per cent of gross domestic 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 proportion 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 corresponding quarter the previous year.

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SENSEX
Sensex ends flat; global cues positive but CAG sours mood

NIFTY

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 BSE Sensex gained 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 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 close at 5,366.30.

DOLLAR APPRECIATES DESPITE HIGH DEFICIT IN US

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

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 fiscal 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 exports. 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 foreign 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 currencies of the world. One of the main reasons is the high capital inflows leading to a capital account surplus- large enough to negate the deficit created by the current account. This is majorly due to safe-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 demand for other currencies decreases leading to an appreciation of dollar. These US Dollars are then parked in US treasury bonds as they are considered to be the safest financial 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 worried 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 indicating that the assets are increasingly being considered as risky. Also, several nations use their own currencies to buy dollar assets. For instance, China has invested close to $1.1 trillion, 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: useconomy.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
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Chart 1: US Twin deficit over the years

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 trade deficit 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 economic turmoil resulted in a weak US economy which meant decreased tax collections. Moreover, domestic policies followed by the Bush administration such as tax rate cuts further 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 foreign soils 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 currency helping investors to earn both from high interest rates and 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.

US FEDERAL DEFICIT FY Amt.(in bil2007 $161 2008 $459 2009 $1413 2010 $1293 2011 $1300 2012* $1327

*Projected US Deficit Source: http://www.usgovernmentdebt.us

Source: marketvector.com

Source: advisoranalyst.com

Chart 2: Yield of US Treasury Notes

Chart 3: Price of European Government Bonds

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"Identifying systemic risk in global markets lessons learnt from the crisis"
Article By: NIKHIL MATHEW & TOM BABU, XIMB, BHUBANESWAR

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 has little 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 regulatory 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 absorbing 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 sustain 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
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to the market, it becomes necessary for the government to protect such institutes, 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 aftershock. Complex economic models: Though each individual model may be well understood, it becomes very difficult to understand 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 becomes 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 be fine. Is it that simple? Were there any other underlying so-

cial and macro-economic factors that led to the crisis? Following 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 Movement 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 advanced 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, President 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 stagnant 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 policies 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 therefore 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
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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 mortgages. The legislations passed in the 1990s compelled Fannie Mae and Freddie Mac to purchase mortgages that effectively included subprime loans. The Federal government spon-

sored and subsidized home ownership making it less expensive 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 income 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 countries 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 forcing them to export to the international where they have to com-

pete and remain efficient. There is a deep flaw in this strategy. It leads to a very weak and inefficient domestic oriented sector. Whenever these countries are in a slump, they depend on the world economy to pull them out of trouble. They depend on the international markets, to which they are pumping out goods, to bail them out. In effect they look for overspending by foreign countries. In the 90s the overspending 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 by buying 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 Financial 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, securitized 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 benefits) 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 faced with 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 appraisers of the mortgages, who are there in this business for their commissions. Banks didnt care for the quality of the underlying mortgages as they would sell the mortgages to investment 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 rated investment 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. Besides that, they were highly complex instruments created by the Financial Engineers in the wall street, and was difficult to understand let alone analyse and rate. The mathematical models relied on very optimistic assumptions that minimized 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 that were made during the peak period of 2005-06 started defaulting. These were largely subprime mortgages with adjustable 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-onyear 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, quantitative 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

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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 cial systems per se, specifically the banking system or capital market system, are just an enabler from the savers to the investors. However we do have the Investment banks who were just supposed to be brokers get into proprietary trading, having their proprietary investments into businesses which they probably dont understand 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 basically 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 heating up.

Ploutos: How do you think the current scenario is playing 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 current 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 economy.

Ploutos: So what about the internal issues India is facing? Do you think they are less significant in the current context? Mr. Bajaj: There are two parts to it. Yes there are internal 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: 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 downgrading 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

Ploutos: Finance was initially meant to support the real production sector and facilitate other economic activities. 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 enough great minds talk on this matter and it proves that finanPage 12

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: Now the economists are trying to look for indicators 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 correlated. 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 everything 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 assumptions 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 to crash. So they know that something more is to be done.

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 reasons 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 decade. There has been a lot of questioning on the assumptions of the theory like the Random Walk Theory, Black Schole pricing model. And the models from which the traders were picking up the pricing from are being questioned because they did not include the behavioral patterns 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 havent. 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: 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 brokerage houses have to strive being brokering houses not financial 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 Manipulations - Is It Just Another Scandal?

Article By: MUKUL DALMIA & SAVNEET KALRA, XIMB, BHUBANESWAR
LIBOR (London Inter-Bank Offer rate) might not interest you but it is going to affect you. The recently revealed LIBOR 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 Barclays, rigging an obscure number, but this is beginning to assume global significance. The LIBORthe number currently 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 Instance, 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 discarded, However the bank has influenced the average cutoff 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 trillion-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 rate turns 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 holdings 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 constantly above the submissions of their rivals. What happened at Barclays: As for Barclays a couple of
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ways of manipulations have come to the forefront. First involves groups of derivatives traders at Barclays and several other unnamed banks trying 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 worth millions 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 saying 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 on most 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 for the banks involved (although there is also a twist in this part

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 increasingly likely 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 borrowed from others. Statements such as: There is no reporting of transactions, no one really knows whats going on in the market, you have this vast overhang of financial instruments that hang their own fixes off a rate that doesnt actually exist.- one of the senior trader closely involved in setting LIBOR at a large bank. -are doing rounds in the markets, showing the lack of accountability 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 upon 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 submitting 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 Americas 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 subprime-mortgage crisis and the bank bailouts have all contributed to the very low esteem in which the American public 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 players has consequences beyond the concerns for traders them-

selves. Traders who we have to assume were probably motivated 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 lawsuits alleging that LIBOR was rigged. The scandal also corrodes further what little remains of public trust in banks and those who run them. US lawmakers have raised concerns that the alleged manipulations 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 outstanding home-loans indexed to LIBOR originated in between 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 suppressed 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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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-toback positions and not all those swaps key off just from LIBOR but it sets the ballpark for the quantum of manipulation 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 butterfly 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 investigation 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, Barclays) and other top management will set in quite a disruptive precedence, which could be starting point for a trend, that we could see over the next 5 years:

Unlike the assets JPMorgan was trading on, the LIBOR rate has real consequences for average consumers, and its manipulation could hurt an economys typical mortgage-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 possible. 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

The current Investment Bankers might be pushed out of the top management and the more traditional bankers set in Refernces: http://www.huffingtonpost.com/2012/07/12/warren -buffett-libor-scandal_n_1668649.html http://www.bbc.co.uk/news/magazine-18826396

The regulatory pressures could (Infact they should) increase 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 management for a time period of about 5 years to stabilize the things.

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Preventing the next crisis the nexus between financial markets, financial institutions and central banks
Article By: Saurabh Piplani, XIMB, BHUBANESWAR

Executive Summary The world economy is going through a prolonged slowdown 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 subprime mortgage borrowers. This begs the question; How can increasing payment defaults by sub-prime borrowers in some part of the world can take the world economy down and keep it there for 5 years?. The answer 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 increases 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 institutions with real economy has resulted in grave consequences for most of the developed economies which fell of a cliff with the debacle of Lehman Bros. in September 2008. What preceded this slowdown was an era of unparalleled growth and profitability where every financial institution under the sun, made a lot of money which consequently 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 prevented co-existence of commercial and investment banks under one umbrella). This era of weak regulation was coupled with advent of many complex structured products which facilitated
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increased profitability through reduced capital requirements and high off balance sheet leverage. These products were so complex that it became nearly impossible for the institutions themselves, regulators, insurance companies and credit rating agencies to asses the risks associated with it. Anyways who cares about risks when sentiments 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 selling 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 agency 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 through Certificates (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 securities 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

and marked the beginning of the basis of such an enormous crisis. The banks not only started lending at teaser rates but also started financing at loan to value (LTV) ratios of as high as 90-95 per cent. These loans were then pooled together and were provided with adequate credit enhancements (loosely called as credit insurance) leading to higher credit ratings and lower interest charges further increasing profits for the originators (higher interest rate spread due to low credit quality of sub prime borrowers). As the originators and investors in the pools were both banks and financial institutions this created a strong linkage between the financial institutions around the world. Also due to off balance sheet nature of these products, the assessment of risk capital was miscalculated and allowed banks to leverage beyond control. Further the primary insurance agencies such as Fannie Mae, Freddie Mac and AIG were providing credit enhancement which is a contingent liability (off balance sheet liability) for them without accurate calculation of their leverage levels leading to a very high leverage at the time of crisis. How the Crisis Unfolded It was in July 2007 that the banks started reporting increasing levels of defaults by the sub-prime borrowers primarily due to increase in interest rates by banks as a result of a tightening monetary policies to curb the inflationary pressures. This triggered what now seems inevitable defaults by the inherently low credit worthy section of borrowers the sub-prime borrowers. As the interest rates started increasing the borrowers who had very little stake in houses (because of high LTV of 9095 per cent) started defaulting this led to mass seizing of houses. As the housing inventory with the banks increased rapidly coupled with slackening demand the house prices started falling leading to huge losses (because of high LTV) and liquidity constraints at the banks. The falling housing prices had a rippling effect on the other sub-prime borrowers who were till then paying regularly as honoring debt obligations of houses, whose prices have fallen below the amount of bank debt taken to finance that house made no sense and hence they too started defaulting. This led to a vicious cycle of defaults and falling housing prices. As the defaults

started taking place the investors started turning towards the insurance companies who had provided the credit enhancement to these pools, the insurers did not have enough capital to pay of such huge unexpected losses and became insolvent. As a result investors or banks which had exposure to these loans either directly or indirectly started facing huge losses and liquidity issues. The losses were so huge that some of the largest banks filed for Bankruptcy. This further led to loss in confidence and market sentiments and freezing of both debt and equity markets and everything fell of a cliff in a matter of some days. Primary reasons behind the crisis of such a scale Size of financial institutions: The abolition of the Glass Steagall act meant that commercial banks and investment banks could co-exist leading to no limitations on growth. Some of the financial institution who had worldwide presence had balance sheet sizes of more than GDP of some of the developed countries. Advent of complex products: This allowed banks to leverage beyond control because of its off balance sheet nature and made risk quantification almost impossible Pro-cyclicality: This means that all the policies which were framed whether by the regulator or by private financial institution internally were based on the assumption that the benign market conditions will continue i.e. housing prices will continue to rise in case of the above crisis. This led to fundamental failures of the risk management policies as the practitioners failed to analyze systemic risks dynamically i.e. in case of an economic slowdown. Strong Linkages of financial markets and institutions leading to crowded trades and liquidity crunch: Most of the worlds largest banks coexist in the major financial centers of the world leading to high level of integration within the overall financial system. Also through money market operations banks usually depend on each other for meeting their day to day liquidity needs which leads to high interdependence among these institutions. These institutions usually accumulate similar positions during the upturn and try to square-off positions as soon as economic conditions turn bad leading to severe losses and liquidity crunch.

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Absence of proper regulation; incapability, oversight, moral hazard, and Greed: The regulating agencies 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 importance and both the internal control systems and external regulation should come out stronger from the crisis. One key learning from this crisis is that how correlation among different risks increases manifold in times of economic downturn. This not only leads huge losses for the banks but leads to significant liquidity constraints 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 techniques 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 overcome 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 crisis was Greed of the top notch officials of these huge financial 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 in assessing the capital requirement of financial instituPage 19

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 participants. 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 and financial institutions and most importantly its linkages with the real economy. One particular risk that should be managed most effectively is liquidity risk. The institution should identify diversified sources of liquidity in times of stress. Mitigating pro-cyclicality: Central banks in consultation with financial institutions should devise structures of incentives such that profits made during benign economic conditions are utilized in building buffer capital or cushion for the stress times. All the financial institutions should join hands with the central banks in making such an incentive structure a success. References: 1. Report by the high level group on financial supervision in the EU chaired by Jacques de Larosiere Brussels February 2009. Preventing the next crisis the nexus between financial markets, financial institutions and central banks - Speech by Mr Masaaki Shirakawa

2.

QUIZ
1. X, co-founder of business Insider popularized the term Y which refers to investors who are nave and who are enticed into buying hot stocks or securities that the insiders are selling w/o performing their own research. Connect these logos:

2.

3. 4.

Connect Grameen Bank and the year 2005 "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. 6. 7.

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

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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 in May 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 xfin@ximb.ac.in 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 decided 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 credited 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 numbered title above and source at the bottom of the table/ illustrations. 5. Word limit is 1500 words. 6. Please mail your entries to xfin@ximb.ac.in with the subject and file name as: Ploutos_<Institute name>_<Participant name> 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, 2012

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