Views expressed by Mr. Joshua Felman, Head of IMF office at New Delhi on sub prime crisis and Indian economy during an interview given which appeared in Hindu Business line on 26.12.2007

The lessons that Indian banking industry can learn from the sub-prime crisis of the USA, according to Mr. Felman are mainly three and they are

• In USA the bankers presumed that the housing boom which was less than that in countries like Australia and UK would not be difficult to be managed. However, during 2005-06 when the boom was nearing its end they loosened the norms for client selection and financed even those who otherwise would not be getting the loan( sub prime borrowers from which the crisis got its name).

• Underestimated the impact of the problem of housing loan foreclosure rate which was according to them 1.50% and the default rate of 5 % which is a very small percentage of the mortgage market. Generally in times of a boom problems are not seriously addressed looking at their size.

• Since the mortgaged housing loans were repackaged into sold the eventual investor did not know what they are holding and this is lack of transparency.

Talking about the financial needs of the infrastructure in our country Mr Felman had opined that the quantities that are required are very huge and unless the corporate bond market develops there would be difficulty in mobilizing the needed amounts.

Unless labour reforms are introduced our country would be facing constraints in creating a labour intensive manufacturing industry which would be competitive in global markets. One example which is impacting like this is the textile industry.

Our economy depends more on skilled labour force and the dichotomy is that the country has a large pool of unskilled labour. This means that a significant portion of the work force is not participating in the economic boom.

USE OF RAROC AND EVA IN COMPARING PERFORMANCE OF BANKS

(Extract from an article published by Sri Arindam Bandopadhay and Asish Saha of NIBM)

Emerging scenario demands sizeable infusion of capital by banks both for meeting the regulatory requirements and for the business growth. To attract the discerning investors for investments in their capital banks have to ensure that their operations are efficient and continue to remain efficient. To verify which segments of business and which locations are efficient are to be analysed by the risk manager. Here efficiency is to be determined on the basis of the return from the business segment which is above the cost of capital which in turn is linked to the market expectations. The two indicators which are useful in this exercise according to the authors are RAROC and EVA. The mention these two ratios are more useful and clearer than the traditional measures like ROA and ROE.

RAROC is the ratio of risk adjusted net income to the risk level of the asset/portfolio. This definition can be used to understand the profitability of a portfolio of a bank’s business or a geographical segment of the bank’s business. The RAROC for an efficient bank should be more than the hurdle rate of the cost of equity capital. The cost of equity capital can be calculated suing the CAPM where the beta of the bank’s share, the rate of return on a risk free investment like a G-Sec and the average market return are used. For the sake of simplicity if we assume that the risk free return is 8% and beta of the bank’s share is 1.2 and the average return on the index is say 28%. Since this is return net of taxation the return gross of taxation will be 18.76% with corporate tax at 33%. The cost of equity capital for such a bank will be as under:

COE = 8 + 1.2*[18.76 -8] = 8 + 12.91 = 20.92

The difference between the RAROC and COE will be called the EVA (Economic Value Addition)

The higher the EVA, the more efficient is the bank.

These concepts can also be used for

• allocating all segments of business levels, deciding return targets,

• introduction of or modification in existing products

• fund transfer pricing mechanism to generate desired business profile etc.

ARE FIIs TO BE BLAMED FOR RUPEE RAISE DURING 2007-08

Against the common perception that the raise in the value of rupee against the dollar during 2007 2008 was mainly due to inflows by FIIS through investments in stock markets, Mr.Vidya Mahambre reports that the reasons are something different. According to him the reasons are as under:

The rupee rose twice during the period under consideration. First from 44.56 to 40.56 during March 7th to May 7th against the US dollar. Second it rose between August 16th to October 16th when the rupee against USD rose from 41.09 to 39.31. During both these periods the correlation between the exchange rate and the stock market increased significantly.

However, from the RBI data of forex reserves accumulation indicate that as and when the FF inflows increased there was corresponding increase in forex reserves indicating that RBI had moped up the foreign currency. This means that the reason for the currency appreciation is not the FII inflows but something else and this is the Foreign currency borrowings by Indian corporates. This is strengthened by the statistic that the increase in ECB during March and May 2007 was to the tune of a very significant amount of USD 10.8 billion as against net FII inflows of USD1.4 billion. During this time there was a time lag in the hiking of the ceiling for MSS because of which RBI could not mop these foreign currency inflows of ECBs and these found their way into the stock market resulting in a boom. A similar situation happened during the second instance during August to Oct 2007 despite a restriction imposed by RBI on the utilization of funds raised through ECBs. This is despite imposition of restriction on usage of ECB funds beyond a limit in India.

Thus the reason for the appreciation of Rupee and a boom in stock markets during the above periods is mainly due to the inflows from ECBs permitted by GOI for the Indian corporates.