Economic consequences of higher regulatory capital for banks
Higher regulatory capital or leverage ratio would mean involuntary monetary tightening as it were!

Pre-crisis, luxuriant supply of liquidity in an exceptionally low interest rate environment led banks to expand credit in any way they wanted, and inflate in the bargain the now infamous credit bubble, with all its cataclysmic consequences. All through the inflating of this bubble, banks actively engaged in excessive leveraging of their balance sheets. The regulators asked no questions, ostensibly because banks were consistently Basel 2 compliant based on their risk weighted assets. One very compelling reason for this, was that banks were looking for ways to pay excessively high  executive compensations. This was linked to a given NIM (net interest margin) and a given level of borrowing costs, resulted in ever increasing compression of RoA (Return on assets) parameters, which in turn, left no choice for banks but to correspondingly increase leverage with a view to keeping shareholders happy by delivering competitive equilibrium ROE (Return on equity); this reached a point where hedge funds, traditionally considered a byword for leverage, looked like apostles of defensive strategy in comparison. 
After the fact, regulators became wiser and thought up Basel 3 norms, which mandate a minimum leverage ratio of 3%, or a  maximum leverage of 33 times! Given that even this 3% is rather low, one can imagine where banks were on this parameter before the cataclysm. Even this rather modest number seems very ambitious if one reckons the fact that even this has to be complied with only by March 2018. Significantly though, this is a redeeming feature,  because any quicker transition would be counterproductive for the real economy given the state in which it currently is. 
To have a sense of what a quicker transition could mean for the real economy, it is instructive, intuitively appealing and insightful to model changes in output/growth in the real economy through an analogy of ICOR ( incremental capital to output ratio) by conceptualising IAOR (incremental assets to output ratio). Any quicker increase in regulatory capital will, as it already has, result in de-leveraging or shrinking of growth in bank balance sheets, hurting output and jobs. Specifically, the IAOR for India is empirically estimated at 2.5, which means that for every 1% decline in bank assets, output will decline by 0.4 %. This then is the  powerful and intuitively compelling way to model the impact of  an increase in the regulatory capital or leverage ratio for banks on the real economy and explains the caution on the part of  regulators, in calibrating the phased application of higher regulatory capital and leverage ratio. 
The other way higher regulatory capital and leverage ratio will hurt growth/output/jobs is expressed by the Taylor Rule. In this formulation, higher regulatory capital or leverage ratio would mean involuntary monetary tightening as it were. This would happen because all else being equal, which means NIM-RoA also remaining unchanged, RoA would need to rise for banks to be able to continue to deliver  market competitive equilibrium return on equity (RoE) to attract equity capital. With no further cost cutting and efficiency gains immediately possible, this in turn will, through corresponding increase in NIM, increase borrowing costs for the real economy. The effect of which would be the same as that of involuntary monetary tightening. It is precisely to mitigate this adverse impact on growth/output/jobs that a calibrated transition to higher regulatory capital/leverage ratio has been envisaged, although the 3% leverage ratio itself is rather low and needs to be higher at around 5 % to 7%. Indeed, Indian banks are already here and therefore, already 2.5 times Basel 3 compliant. Of course, the upside of a longer transition would be that in spite of increasing RoA, banks may even succeed over time  in reducing, or even minimizing, NIM-RoA via endogenous business process re-engineering and technology upgradation, resulting in reduced  borrowing costs for the real economy.
Incidentally, but significantly, Indian banks being already 2.5 times Basel 3 compliant, with leverage ratio of 7% plus, will need to increase equity capital only to maintain their existing leverage ratio; i.e. to remain compliant with themselves and not at all to comply with Basel 3 as is widely, but erroneously, made out in many quarters!
(The author is a former Executive Director, Reserve Bank of India)



Gopalakrishnan T V

3 years ago

The article is highly technical and carries a strong message that higher regulatory capital or leverage ratio would mean involuntary monetary tightening as it were. This is true provided the balance sheet is drawn strictly as per the regulatory prescriptions and accounting staandards.Is this happening in India is a major question? Fudging and window dressing of balance sheets is an established practice in India and the ratios referred to in the article cannot be given a serious weightage as such. The NIM,ROA,Capital Adequacy Ratio etc are all to a great extend only showing indicative trends and not necessarily the correct position. The NPAs are grossly underestimated and the off balance sheet items which get converted into risky assets do not seem to be getting a realistic assessment. The regulatory capital ratio exceeds the requirement level by a wide margin cannot be taken as a correct and comfortable picture. The ratio of pure equity capital in relation to all risky assets is perhaps a better assessment as regulatory capital has some components which are manipulative in nature.If pure equity capital is taken as a yard stick,the Indian banks particularly Public Sector banks cannot be said to be showing a comfortable position as increase in pure capital ie equity capital may not be proportionate to the increase in risk weighted assets.

The Little Book of Market Wizards: Book Review

This 'Little Book' is a selection from Jack D. Schwager's classic set of four previous 'Market Wizards' books.

In any list of ‘must-read’ books on trading, you would certainly find two titles of Jack Schwager: Market Wizards and The New Market Wizards. These two books—and a few later books of Schwager—have a fascinating format. They are questions and answers with the world’s largest and best traders. Schwager set out to find answers to what differentiates the highly successful market practitioners, or market wizards, from ordinary traders? What traits do they share? What lessons can we learn from those who achieved superior returns for decades while maintaining strict risk control? Schwager has spent decades interviewing legendary traders in search of answers. Himself a trader, he has been able to draw out ideas and strategies of the world’s best minds churning out great risk-adjusted returns in bonds, equities, commodities and forex markets.

Every interview charts their career paths, recording early failures and later successes. Many of them were almost wiped out early in their trading lives before they pulled themselves up and reapplied themselves, realising that controlling risk is the key to returns. These inspiring stories have resonated with traders all around the world. These two books, and later Stock Market Wizards and Hedge Fund Wizards, have become Bibles for traders. Peter Brandt, a successful trader, writes in the introduction that it is an annual ritual for him to read these books during Christmas holidays.

The Little Book of Market Wizards is a combination of the four books in the Market Wizards series. It provides the major insights garnered across the four Market Wizards books, spanning a quarter century. Schwager has extracted lessons and concepts that are essential to success in trading, regardless of the methodology. For instance, chapter five discusses the ‘Importance of Hard Work’. Schwager points out “I interviewed Marty Schwartz in the evening after a long trading day. He was in the middle of doing his daily market analysis in preparation for the next day. It was a lengthy interview, and they finished quite late. Schwartz was visibly tired. But he wasn’t about to call it a day. He still had to complete his daily market analysis routine. As he explained, “My attitude is that I always want to be better prepared than someone I’m competing against. The way I prepare myself is by doing my work each night.”

Chapter eight discusses ‘Risk Management’, the one a factor that can make or break a trader. When Schwager asked Paul Tudor Jones what was the most important advice he could give to the average trader, he replied, “Don’t focus on making money; focus on protecting what you have.” As the author explains, “most trading novices believe that trading success is all about finding a great method for entering trades. The Market Wizards I interviewed, however, generally agreed that money management (i.e., risk control) was more important to trading success than the trade selection methodology. You can do quite well with a mediocre (i.e., slightly better than random) entry methodology and good money management, but you are likely to eventually go broke with a superior entry methodology and poor money management. The unfortunate reality is that the amount of attention most beginning traders devote to money management is inversely proportional to its importance.”

Chapter nine elaborates on ‘Discipline’. When the author asked the market wizards what differentiated them from the majority of traders, the most common reply he got was ‘discipline’.
This may seem too simplistic to some, vague to others, and too obvious to many more. But Schwager underlines how Randy McKay, a very successful trader, once lost millions over a few days just because he slackened a bit and let a losing position grow too large.

One of the most important lessons from successful traders is that losing is a part of the game. Traders who have developed a method that works, and have a risk control system in place, are never bothered about losses. They know that trading is a business of probability—not certainty. If you have read at least the first two volumes of the Market Wizards series, you will find this a good refresher. If you haven’t, this would be a great appetiser.


For God’s Sake: Book Review

A look at how gods and goddesses play a pivotal role in deciding trends in the Indian marketplace

This book provides a trivia-heavy look at the pervasiveness of religion in India, from the point of view of the fast-moving urban Indian. Even though breezy, the book is valuable, especially for young readers.

As a compilation of case studies and reference for marketing professionals, the book delivers  a useful compendium of instances. At the end of one such anecdote, author Ambi Parameswaran declares, “The real lesson from this story is that while Indian consumers may be hidebound in their religious views, they are willing to suspend these beliefs when it comes to getting a good bargain.”

Parameswaran discusses how the Indian consumer repeatedly makes his choices based on long-held religious biases and ideas. He contextualises this with the launch of the first Ramayana serial on Doordarshan and the concurrent drift away from Nehruvian socialism. He  shows how these old ideas direct Indians’ consumption of products in relation to marriages, travel, media and entertainment, music, and food.  

The book is heavy on tidbits of information like the classifications of matter in the Vedas and the Upanishads, the pillars of Islam, the percentage of Muslim women who wear a burqa, gospel music from Aretha Franklin, and the fact that MTV Coke Studio originated in Brazil.  For most younger readers, this is not a bad thing. From planetary positions to mythology to why non-vegetarian food in Chennai used to be available only in ‘military’ hotels. For those who know, it reads like a revision and, for the uninitiated, it tells them what they should know.

Parameswaran’s vast experience is never in doubt, when you read through the sheer range of topics he uses to make his points. Gems like the story of how astrology nearly held up the declaration of India’ s Independence, and how it was eventually resolved by KM Panikkar, are peppered throughout the book.

Parameswaran has done a better job with the book than Penguin though; the cover is so hideous that you would skip the book if you walked past it on a bookshelf. Ironically, Parameswaran is an ace marketer himself.

The book’s jacket is much like an advertising pitch, the pitch exceeding the end product, as usual. It poses heavy questions at the outset, like what can “Harvard Business School learn from the Kumbh Mela?” and “Are Indians becoming more religious and more consumption driven at the same time?” Eventually, it delivers a confabulated take on modern India. For younger readers, the book is a repository of information on the cultural life of an older generation.

A special mention of a chapter on Muslims in India is a must. It is one of the book’s best written chapters. He also delivers some masterful myth-busters for the stereotyping glasses many of us carry around. Like the notion that Islam and women’s rights are antithetical to each other. Parameswaran shows us how Islam is the only major religion where women are explicitly supposed to be equal to men. What it has become today, is another matter altogether. One of Parameswaran’s preoccupations throughout the book seems to be the explosion in religiosity in modern India and the pervasive consumerism.

This cannot be understood without a deeper understanding of both, but that could have deviated from the focus of the book. Still, one may find an aching need to get a sense of the depth of these and other matters. Nevertheless, the end of the book, which contains “Religion: an essential vocabulary” is a brilliant list of ideas that shape, and have created, the modern Indian ethos in Parameswaran’s own experience. The book suffers from not exploring how ideas in the religious lives of people interact with their buying decisions. The causes, the unconscious drives behind our religiosity, are left unattended. To some, the book may seem to drag on longer than it should, in the absence of anything other than the idea that is already expressed in the first half—that religion drives buying and, in turn, must drive marketing.


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