Saturday, August 23, 2014

NPAs processed by asset reconstruction companies -- where did we go wrong?

by Ajay Shah, Anjali Sharma, Susan Thomas.


Asset reconstruction companies (ARCs) in India came about after the SARFAESI Act of 2002 empowered banks and some financial institutions to seize collateral in secured loans, without the intervention of courts. This is about the in-sourcing vs. out-sourcing choice of banks. Some banks could choose to build internal distressed assets teams. Others could choose to sell distressed assets to specialised firms that have skills in dealing with distressed assets. This is a good thing because: (a) In general, specialisation is a good thing and (b) Processing distressed assets requires a certain kind of toughness that PSU banks are often unable to muster.

So far, this approach has not worked. Stressed assets at banks (NPAs + restructured loans) have increased from Rs. 0.7 trillion in 2003 to Rs. 5.3 trillion in 2013. In this period, the annual sale of assets by banks to ARCs has stagnated at Rs.0.05 to Rs.0.1 billion a year.

At the outset, the Indian approach to ARCs was better than that seen in many other countries, where specialised `asset management companies' (AMCs) were just a thinly disguised method for government recapitalisation of banks. But this clear thinking at the outset has not been translated into a well functioning private ARC industry.

In this post, we look at what went wrong with ARCs, recent developments and the way forward.

What went wrong?

  1. Excessive regulatory interference. The right way to think about an ARC is that the ARC is a buyer of distressed debt. After that, what the ARC does is the business of the ARC. The ARC might be an individual, or a private equity fund, or any other structure. The sale should be a clean transaction where distressed debt is sold and cash is paid to the lender. There are no problems with the working of the ARC on the counts of consumer protection, micro-prudential regulation or systemic risk, therefore the working of ARCs should be completely unregulated. This clarity of thought has been absent, and the working of ARCs has been riddled with poorly thought out RBI regulations.
  2. Mistakes in regulations about how banks sell distressed assets. Micro-prudential regulators of banks are often keen to cover up the problems of bank fragility. This problem has hampered sound thinking about regulations governing provisioning and the sale of assets by banks to ARCs.
    Provisioning norms by Indian banks, are driven by regulatory prescriptions rather than risk assessment. Even though an asset becomes non-performing after being overdue for 90 days, provisions for the loss associated with this are spread over a period of four years. This generates a perverse incentive to not sell NPAs: provisioning for an NPA has a gradual impact on the balance sheet of the bank while sale of the NPA has to be booked as an upfront loss. As a result banks either hold on to these assets for longer than it is economically sensible, or sell assets to ARCs only when the transaction is at or above book value. In addition, there are a variety of procedural problems with the process of banks selling NPAs including auctions that do not give adequate time for due diligence by ARCs, and auctions that are cancelled after bids are received.
    A closely related issue is the approach that the sale of bad assets is not a true sale for hard cash. Banks would think in a sensible and commercial way when and only when: (a) Tough provisioning rules kick in the moment an asset is NPA and (b) The sale of distressed debt is a simple sale in return for cash. Neither of these conditions holds today, reflecting poor thinking in banking regulation.
    The mistakes in regulation of banks interact with the HR practices of PSU banks. The typical CEO of a bank has a horizon of two years. On that horizon, it's been made preferable for him to hide bad news by not selling as compared with recognising bad news by selling. This peculiar situation represents a juxtaposition of mistakes at the Ministry of Finance in HR practices of PSU banks and mistakes at RBI in the regulation of banks.
  3. Weak bankruptcy process. The ability of ARCs to realise value is defined by the bankruptcy process. The legal framework for recovery are the debt recovery tribunals (DRTs), set up under the RDDBFI Act, 1993, and the enforcement of security interest under the SARFAESI Act. Both these mechanisms have performed poorly in resolving NPAs. Recovery as a percentage of the outstanding amount for cases filed was at 17 percent and 14 percent for DRTs, in 2012 and 2013 respectively. The recovery percentages were 24 percent and 22 percent under SARFAESI, in the same period.
    While RBI has allowed ARCs to takeover the management of the defaulting firm, restructuring under the provisions of the Companies Act is a time taking process. It requires specialised management skills and long term financing, both of which ARCs may not currently possess. Given the time and cost involved in this type of restructuring, only NPAs with very high recovery potential will be selected for this type of resolution.
  4. Is insourcing vs. outsourcing of distressed asset management a level playing field? Ideally, the rules about resolution should be neutral to the identity of the debt holder. However, in India, at numerous points, the powers in processing distressed debt favour banks and do not give non-bank actors comparable powers. This creates incentives for insourcing of the distressed debt function.
    SARFAESI provides for several mechanisms to enable ARCs to carry out recovery. These include taking possession of the collateral security, settlement or rescheduling of payments, sale or lease or takeover of the borrower's business and conversion of debt into equity. But the operational guidelines for many of these were issued by RBI much after 2002. For example, the guidelines for management takeover of the defaulting firm were issued in 2010, eight years after the Act was passed, with subsequent amendments in 2011, 2012, 2013 and 2014. The guideline allowing ARCs to sell assets to each other, which enables them to aggregate assets of a borrower for a management takeover, came in 2013. As a consequence, from 2002 to 2013, ARCs were handicapped.
    Banks have been given additional mechanisms for dealing with stressed assets, that are not available to ARCs. These include loan restructuring for individual assets, and the corporate debt restructuring (CDR) mechanism for dealing with stressed consortium loans. Banks have greater restructuring flexibility, under the CDR process, than do ARCs. For example, both the CDR lenders and ARCs have been allowed to convert debt of the borrower firm to equity. SEBI guidelines on lock-in period for share issuance, have been relaxed for issuance under the CDR mechanism. Unlike the requirement in the Indian Takeover Code, the acquirer of shares in the CDR process is exempted from making an open offer. No such exemptions have been provided for the conversion of debt to equity by ARCs.
  5. Barriers to foreign skills and capital. A natural pool of expertise are global firms with a specialisation in distressed debt management. Perhaps the only pool of capital that can pay cash for distressed assets is found overseas. However, autarkic policies by RBI have hampered the entry of foreign players, and capital controls have been used to block the inflow of foreign capital. This choked ARCs of both capital and knowledge.
In an environment riddled with mistakes in regulation, how have ARCs survived at all? There are two things that enable ARCs to remain viable even in such a market. The first is the low levels of capital that ARCs need to acquire NPAs. When ARCs issue SRs to finance the NPA acquisition, it is done through trusts in which ARCs, as per RBI guidelines, need to have at least 5 percent of own investment. These SRs have a maturity of 5 years, which can be extended to 8 years in special cases. This is the time-frame that ARCs have, in order to recover value from the acquired assets. Any loss at the end of this period has to be borne by SR holders proportionately. Since the ARC share in the loss from the asset is limited to 5 percent, it allows ARCs to acquire assets even at uneconomic valuations. In most cases, the seller bank, who can sell assets at close to book value, itself subscribes to the balance 95 percent SRs.

The second is the annual management fee that ARCs receive from the seller bank. This is typically 1.5-2 percent of the acquisition value of the asset. The fee has no link with the recovery from the asset. Hence, the ARC has little incentive to recover or resolve assets. They just need to hold the assets till maturity of the SRs, during which they continue to earn the management fee income.

This yields an exercise in sound and fury that achieves little. In this form of the sale transaction, the NPA risk remains in the bank balance sheets -- it is merely being reclassified as investment in SRs. Further, there is little improvement in the overall economic efficiency in resolution of NPAs. With this, the ARC industry in India suffers from the syndrome of numerous other parts of finance (e.g. the bond market or the currency market), where there is a show on display with apparent institutional arrangements and plenty of huffing and puffing, but the actual soul of a market economy is absent.

Recent developments

  1. On 30th January, RBI released the Framework for Revitalising Distressed Assets in the Economy, with several changes in the operational framework for ARCs.
  2. In April, a report estimated that banks sold Rs. 270 billion of non-performing assets (NPA) to ARCs in FY 2014, with most of the sale taking place during January to March 2014.
  3. The June release of the Financial Stability Report raised concerns that bank-ARC transactions were being used by banks as an option of evergreening their balance sheets. The report also questioned the 'real' incremental value addition of ARCs in the process of 'reconstruction' of assets, over banks' traditional skills and informational advantages.
  4. On 5th August, 2014, RBI issued a notification with amendments to the regulatory framework for securitisation companies and ARCs.

Evaluating recent policy changes

In the January 30th 2014 Framework for Revitalising Distressed Assets in the Economy, RBI proposed the following changes in the ARC framework:

  • Assets in the 61 to 90 days category can also be sold to ARCs. This would encourage early sale of distressed assets and better recovery.
  • Banks allowed to spread loss on sale over a two year period, for assets sold till March, 2015. They are also allowed to reverse provisions made for NPA, if there is gain on sale. This would address banks' concerns on loss on sale of assets.
  • It is mandatory for banks to accept bids in an auction that are above reserve price and fulfill conditions specified.
  • Steps to be taken to improve price transparency in bilateral sale of assets.
  • Sale of assets between ARCs and their sponsor banks is permitted only through a transparent and arms length auction. These would improve transparency in the sale process.
  • Promoters of companies allowed to buy-back assets from the ARCs, with ARCs demonstrating no prior collusion between the ARC and the defaulting borrower, to the RBI.

On one hand, these measures removed procedural hurdles faced by ARCs. On the other, there is pressure on PSBs to offload their growing NPAs or face an erosion of profits in the medium term. Both factors contributed to a sudden spurt in sale of NPAs from banks to ARCs in the last quarter of FY 2014. Most of this sale was by public sector banks (PSBs). For example, State Bank of India (SBI) in its Annual Report for FY 2014, has reported a sale of Rs. 36 billion of NPAs to ARCs. The book value and the sale value of these assets are Rs.15 billion and Rs.16 billion respectively, with SBI making a profit of Rs.1 billion on these transactions.

The spurt in NPA sale transactions in 2014 led to further changes through the 5th August, 2014 notification:

  • Increase ARCs capital commitment in the acquired asset from 5 to 15 percent.
  • ARCs fees linked to the net asset value (NAV) of the acquired assets rather than the outstanding value of the security receipts. Shortfalls in recovery now affect ARC fees.
  • Increased reporting and disclosure requirements for ARCs, specially for asset sale by banks above book value and for asset sale by ARCs at a significant discount.
  • Increased time that ARCs get for due diligence at asset auctions, at least two weeks.
  • Reduced planning period for acquired assets from one year to six months. This is also the time frame within which the acquired asset need to be rated and re-valued.
  • Inclusion of ARCs in the Joint Lenders Forum (JLF) and a mandate for them to put up a list of willful defaulters on their website.

These changes will help reduce three aspects of bank-ARC transactions as they have been proceeding:

  • Banks selling assets to ARCs without actual risk transfer, since 95 percent of the value of the sale got back into banks' balance sheets as investment in SRs.
  • ARCs earning fee income linked to the book value of the asset and not to its recovery value. Low levels of ARCs capital commitments meant no real incentive for them to resolve NPAs.
  • Promoters, even the willful defaulters, getting relief from repaying their dues under the ARC model, which was focused on warehousing instead of resolution of NPAs.

These latest amendments have increased the ARCs risk in acquiring assets. ARCs will now need to make recoveries to earn fees and to get returns on invested capital. However, the larger problems of these arrangements remain unresolved.

The way forward

In order to make distressed debt processing and ARCs work, the work plan for policy makers consists of the following elements:

  1. A clear understanding is required that the role of RBI in regulations should stop at the point of sale of distressed assets to the ARC. The working of the ARCs should be unregulated as there is no market failure there.
  2. Mistakes in micro-prudential regulations of banks, in recognition and provisioning by banks, need to be addressed.
  3. Banks should be required to do true sales in exchange for cash of distressed debt. This will yield closure on the books of the bank. After the transaction, the ARC would work to obtain recovery with no relationship to the original lender.
  4. The bankruptcy process should be improved.
  5. ARCs should be first class participants in the bankruptcy process. There should be no bias in the bankruptcy process in favour of any one kind of financial firm such as bank.
  6. Establishment of operations by foreign ARCs should be feasible with 100% equity ownership. Foreign capital into ARCs (whether private or foreign) should be welcome through private equity structures. All institutional investors in India -- but not banks -- should be able to invest capital into these private equity structures. Banks should only face the choice of selling (in exchange for cash) or not selling.

We are grateful for Harsh Vardhan of Bain Consulting and Badri Narayanan of Third Eye Capital for useful discussions.

Finance Research Group, IGIDR, Bombay

Tuesday, August 05, 2014

What you can't infer from a regression

We are inundated by results of research papers such as:

  • Companies which have women directors do better; hedge funds which have female GPs do better [link].
  • Parents who have children graduating from college tend to live longer [link].
These correlations are facts. Almost everyone who reads about the result jumps to the conclusion that these have consequences for decisions that we can make. E.g.:
  • Since companies which have woman directors do better, let's add women directors to our company and it will fare better.
  • Since hedge funds with female GPs do better, let's add women GPs to our hedge fund and it will fare better.
  • Since parents that have kids that graduate from college tend to live longer, if we take extra trouble to put our kids through college, then we will live longer.
All these statements are flat wrong.

The fact that there is a correlation absolutely does not imply that there is a causal connection that can be used to make a decision. When x and y are correlated there are numerous possibilities. Maybe x has a causal impact on y. Maybe y has a causal impact on x. Maybe there is a z which has a causal impact on both x and y. We cannot jump to the conclusion about which of these causal pathways is at work when we observe a correlation.

Let's take women on boards as an example. Suppose the evidence shows that firms with women on boards do better. It could just be the case that these are firms with a more socially progressive outlook, and maybe more progressive teams fare better than socially backward teams. If so, a band aid of two women added to the board of a neanderthal bunch is not going to change their outlook.

Let's take parents and children and college. Some kinds of parents have the household environment where children delay gratification, work hard, immerse themselves less into mass culture. Those kinds of kids make it to college and graduate from college. Those kinds of parents live longer. There needs to be no causal connection.

The problem of reverse regression

When we see a linear regression

y  =  a  +  b x  +  e

we jump to the conclusion that changing x by 1 unit will have a causal impact on y of b. There is absolutely no justification for this with observational data! If you want to terrify your young students in a dark alley, do the reverse regression:

x  =  a  +  b y  +  u

The slope will be significant here also. So does changing y have an impact on x or does changing x have an impact on y?

Let's be more careful

To take the results of conventional linear econometrics, and imply that there is a causal interpretation, or that someone can use the result to make a better decision, is immoral and unethical.

Many economists are a bit cavalier about these distinctions. The only way to learn about the impact of a treatment is to observe natural or artificial experiments where events happen for exogenous reasons, through which we get to see what happened in the aftermath of the change for near-identical units of observation where one is treated and one is held as a control. The two key tools for this are matching (to figure out what are the near-identical units of observation) and event studies (to figure out what happened after the event).

The old style regressions, where vast datasets are thrown into some matrix algebra, are dangerous and best avoided. No amount of torture by matrices can rescue a bad design. Under observational data, OLS is not BLUE. Everything we have been told in traditional econometrics is suspect when faced with observational data.

Corollary when working with Indian firm data

The emphasis on "near-identical units of observation" has an interesting implication when working with firm data. Imagine that you're doing something involving y and x and firm data. There are some natural experiments where x changes for some firms. You are looking for near-identical firms where the x did not change. This would make possible an event study to figure out the impact of the change.

Suppose the treatment was applied to Reliance Industries. You're out of luck because there is no company in India which is near-identical to Reliance Industries. You have to drop this observation and move on. Reliance Industries is sui generis.

Suppose the treatment was NOT applied to Reliance Industries. No treated company will ever be much like Reliance Industries. You will not find Reliance Industries in your matched dataset.

Suppose you were not careful in this data preparation and Reliance Industries somehow showed up in your dataset. It is quite likely to be an outlier and will mess up your results.

Hence I fear that any regression done with a dataset that contains accounting data for Reliance Industries is wrong.

(This is not a problem with returns data, as the returns data for Reliance is much like that seen for other firms).

Tuesday, July 29, 2014

Concerns about individual investors on the Indian equity derivatives market

by Nidhi Aggarwal, Rohini Grover, Susan Thomas.

A recent article in the Business Standard by Praveen Chakravarty and T. V. Somanathan questions the quality of the Indian equity derivatives market. India is ranked next only to South Korea in terms of both the intensity of derivatives to spot traded volumes and the dominance of retail participation in derivatives trading. It is argued that complex financial instruments are better suited to the requirements of sophisticated institutional investors.

Korea has tried to reduce the large fraction of retail participation in their derivatives markets by increasing the minimum contract size twice between 2012 and 2014. The authors suggest that India consider taking similar action, or increase securities transactions taxes, to deflect retail interest in equity from derivatives trading to spot trading.

Facts about retail investors and their dominance in equity derivatives trading in India

The article says there are "97% retail speculators", and later says there are 83-87% of both retail and proprietary trading. What are the facts?

Exchanges record every trade as a pair of buy and sell orders originating from a specific participant category. There are three broad categories of participant. Custodian trades which mark trades by institutions. Proprietary trades which mark trades by brokers for their own account. The remainder, which are Neither custodian or proprietary trades, are recorded as the retail investor, which include individual investors along with others. Not all that is not an institutional trade is a trade by an individual investor.

We focus on the fraction of the derivatives trade the options, both options on Nifty and single securities. In trading on these instruments, the shares are:

  • Nifty options where daily traded volumes are around Rs.1200 billion
    • Institutions = 20%
    • Proprietary = 48%
    • Neither (retail) = 32%
  • Stock options where daily traded volumes are just under Rs.100 billion
    • Institutions = 17%
    • Proprietary = 42%
    • Neither (retail) = 41%
Thus, retail individual investor participation are just 30-40 percent of the options trading in Indian equity.

Korean thinking on reducing retail participation

A series of research papers using trade data from Taiwan and Korea found some evidence that individual investors consistently made losses on their trades, and that institutional investors made profits at their expense on average. Such evidence led Korean regulators to explore interventions to reduce the participation of individual investors in these markets and thus, minimise their losses. Their solution to the problem was to increase the minimum contract size so that individual investors find it more expensive to participate in the market, and reduce the positions they take.

Is this malady present in India? We don't know. Would the Korean treatments pass the cost-benefit analysis as required by the Handbook? We don't know.

In order to carry out a regulatory intervention to improve customer protection, it is first important to establish a market failure. We need to establish that there are such investors who are consistently losing. In order to do consumer protection, we must:
  1. Understand whether the Korean empirical regularities hold in India;
  2. Establish WHY this is so;
  3. Establish a set of optimal alternative regulatory interventions;
  4. Do a cost-benefit analysis of each a la the Handbook; and
  5. Do a phased roll-out of the interventions and post-hoc analysis to see if the correct effect is achieved in terms of market outcomes.
The Koreans had the first step done for them (establishing that there is a problem), and by the looks of it, are still searching for solutions. The present state of knowledge on household finance in India does not answer these questions. We don't know if the malady is present, so the question of the treatment cannot arise.

What ails institutional participation?

The BS piece presents the participation of various players on the Indian derivatives markets as based on choice of both institutional investors, and the others. However, institutional investors have often been kept out of these markets by regulation. Examples:
  • IRDA has given in-principle approval but has not given operational clarity for equity derivatives trading by insurance companies.
  • Banks are not permitted to do equity derivatives trading by RBI.
  • Equity mutual funds lack operational clarity on critical sub-components of equity derivatives trading.
  • FII participation has been hampered by capital controls and the messy transition into the FPI framework. Trading in the overseas OTC derivatives market (the "PN" market) is hampered.
  • The onshore OTC equity derivatives market is banned.
  • Position limits are tiny and do not address the requirements of institutional investors.
This market does not have institutional investors because they are being systematically kept out by regulators.

On a related note, the regulation of currency derivatives is also riddled with mistakes.

The large ratio of derivative to stock traded volume

The discomfort of a much larger traded volume in the derivative compared to the spot is an age-old one, based on fears are that (a) derivatives markets lead to higher volatility, (b) there is market abuse deriving from the leverage of derivatives, and (c) small investors get consistently and persistently hurt.

These fears are not borne out by the facts. Over the entire period that India has had equity derivatives, the volatility has come down, there has been little evidence of a larger incidence of market manipulation in stocks with derivatives, and liquidity has improved.

A research paper from the Finance Research Group analysing the single stock futures markets in India offers a possible explanation for these large derivatives volumes. This paper suggests that in markets where there are severe funding constraints there is a larger participation in derivatives, because these leveraged products allow traders to preserve the efficiency of their trading capital. These funding constraints can be for several reasons. Partly, it could be because emerging economies have a shortage of capital. Partly, it could be because institutional investors who have the capital are forcibly kept out of participating in securities markets. Other mistakes of regulation which are shaping this outcome include the failures on securities lending which hampers short selling.

The paper finds that the Indian markets have the highest dominance of price discovery in equity derivatives compared to what has been recorded in all the other literature on this subject. Information is flowing from the derivatives into the spot prices in Indian equity.


We should be do thorough homework before introducing regulations that interfere with the freedom of private persons. Most of the ills of Indian finance derive from weak financial economics, and lack of due process, at regulators. The solution lies in fixing the regulatory process and not in further reducing freedom.

Finance Reseach Group, IGIDR, Bombay

Saturday, July 19, 2014

What does socialism do to ethics

Marginal Revolution has a post about the moral effects of socialism. In this, we are pointed to a fascinating new paper. Ariely, Garcia-Rada, Hornuf, Mann have a new paper where they analyse the natural experiment of one Germany that was arbitrarily sub-divided into communist GDR and capitalist FRG. They find that people with a greater exposure to socialism are more likely to cheat.And, a paper by Al-Ubaydli et al on PLOS One in March 2013 finds that the framework of markets and trade increases trust in strangers.

I have heard similar concerns about low ethical standards in China as the outcome of many generations of communist rule.

Was it just a matter of stamping out religion? Is the causal chain composed of destroying organised religion that leads to cheating by individuals? This does not square with some other evidence. This paper by Gregory S. Paul in the Journal of Religion & Society finds that highly secular democracies consistently enjoy low rates of societal dysfunction.

In the comments on the Marginal Revolution post, mm says that P. J. ORourke says that he knew communism was not going to work when it managed to convert Germans into lazy workers.

These ideas resonate for us in India, with our experiences with the corruption and cheating that is associated with government-controlled resource allocation. There is a fundamental tension between socialism and our core aspirations like the rule of law, a Calvinist work ethic, and fairness and honesty in our dealings. What mechanisms might be at work in the corrosion of values under socialism? From my observation of India, I may conjecture:
  1. When things are available through connections or the black market, this gives everyone incentives to engage in illegality, and to violate the rule of law. When storage is proscribed as `hoarding' and forecasting the future becomes `black marketing', people get used to the idea that illegal activities are to be pursued, and the people who are willing to engage in greater illegality get ahead in life.
  2. In the parts of India where land reform took place, it became more acceptable to steal other people's stuff.
  3. People became supplicants in front of a powerful State, and detested the bureaucrats and politicians who wielded discretionary power. This created pervasive hatred and disrespect for the State, an environment that was conducive to breaking laws more frequently.
  4. When inequality is bemoaned and envy becomes fashionable, there is reduced incentive to engage in hard work as a tool to get ahead in life.
  5. A big State employs more people, and employees of government and public sector companies tend to have a diluted work ethic.
  6. There is a big gap between all the talk about poor people and the reality of the socialist State. This breeds cynicism about politics and government, and fewer wonderful people get involved in matters of the State.
  7. When the political leadership allocates time and money to doing central planning and running welfare programs, this comes at the expense of time and money focused on catching crooks.
If we are able to retreat from an intrusive State, and build the rule of law for a narrow set of interventions that do public goods and address market failures, this will help create a new tone of flesh in the Republic. But the changes in behaviour that come with a socialist phase take many decades to get stamped out. We should change things from here on -- but we will live with the consequences of Indian socialism for a long time.

Hence, questions about ethics are going to be a key feature of the Indian story for years to come. I have written before on related themes: Indian capitalism is not doomed, and Ethics and entry barriers. There are now 40 posts on this blog with the label `ethics'.

Wednesday, July 02, 2014

Securities lending: A key missing link in the Indian securities markets

by Rohini Grover.

The importance of securities lending

Securities lending is a temporary exchange of securities between two parties against some collateral with an obligation to return the borrowed securities at a future date. The collateral may be in the form of shares, bonds, or cash. It serves the following objectives:
  1. It allows market participants to 'short-sell' by borrowing securities temporarily. A well functioning securities lending and borrowing (SLB) market enables efficient execution of trading strategies based on short selling. For example, in cash and futures arbitrage, an arbitrageur will buy futures and short sell borrowed shares in the spot market if the futures price is lower than the spot price. This ensures that the futures price returns to its fair value and restores market efficiency.
    There is ample research on the gains from short selling. E.g. Boehmer et al, 2008 shows that banning short selling lowers market quality as measured by spreads, price influence, and volatility. Recent research by Rajat Tayal and Susan Thomas suggests important links between short selling constraints and asymmetry in liquidity.
  2. Investors with a long term investment horizon earn additional returns in the form of lending fees by lending securities. Portfolio returns go up when securities are lent, but there might be credit risk if there is inadequate collateral.
  3. Additionally, in a money market, investors with large inventories of securities can post them as collateral to obtain short term finance.
The features of a well functioning SLB market include: wide market access with large number of borrowers and lenders; transparent regulation to mitigate uncertainty and encourage participation on both sides; and low transaction costs. Several countries like the US, Brazil and South Korea have established successful SLB markets. In India, while the equity market achieved transformative change, securities lending is the last big component which has not fallen into place.

The Indian experience

The SLB market in India was introduced by the National Securities Clearing Corporation Ltd (NSCCL) on April 21, 2008. The market design featured automated screen based trading platform with online matching of trades based on price-time priority; all classes of investors permitted, including FIIs; settlement guarantee; and NSCCL as an Approved Intermediary acting as a Central Counterparty (CCP).

All over the world, securities lending is generally done OTC and generally involves credit risk. The Indian launch was quite novel in two respects: the emphasis on anonymous order matching (so as to remove the infirmities of OTC transacting) and the use of a clearinghouse which eliminated credit risk.

The Indian SLB market has grown through two distinct phases:
  1. From 2008 - 2009: After introduction, the initial market volume was negligible. SEBI revised the SLB framework in October 2008 to tackle this. The key changes were: increasing SLB tenure from 7 days to 30 days; increasing trading timings from one hour to a full trading day; accounting for corporate actions such as dividends and stock splits. This phase was largely a failure.
  2. From 2010 - present: Starting January 2010, a number of market microstructure changes were introduced to improve the segment's liquidity by easing participation. These steps increased volumes significantly in percentage terms, but in absolute terms it is still a highly inadequate market.

Regulatory changes

Two broad regulatory themes emerged since 2010. Where SEBI amended the framework to improve market microstructure, IRDA widened the market by allowing insurance firms to participate.
The following are the details of the changes introduced by SEBI:
  • SEBI circular: Jan 06, 2010 w.e.f June 28, 2010:
    1. The tenure of SLB was extended to 12 months.
    2. Early recall and early repayment facility were introduced.
    3. In case of an early recall by lender, the clearing house will procure securities for the lender on a best effort basis. A fee will be charged to the lender seeking early recall.
    4. In case of early repayment by the borrower, the clearing house will release the margins on the returned securities. It will try to lend these securities onward on best effort basis. If it is unable to do so, the borrower will have to forego the lending fee for the remaining period.
  • SEBI circular: Nov 22, 2012 :
    1. Liquid ETFs were introduced with position limits based on their AUM. Trading in these commenced in September, 2013.
    2. A roll-over facility was introduced which provided roll over for 3 months (original + 2).
    3. Netting of counter positions, i.e. netting between the "borrowed" and "lent" positions of a client was not allowed.
  • SEBI circular: May 30, 2013:
    1. New stocks (other than F&O stocks) were added to SLB. Trading in these started in July, 2013.
    2. Collateral for margin obligations was made similar to that for cash market.
In addition to the changes introduced by SEBI, IRDA opened up SLB participation to insurance firms via IRDA guidelines: July 12, 2013. It limited lending to a maximum of 10% of the securities in the fund. In February 2014 (after an odd gap of six months) NSE clarified the position limits for insurance firms and other institutional investors via NSE circular: Feb 14, 2014. These were to be the same as that of a participant i.e. lower of 10% of the market wide position limit (MWPL) or Rs.50 crore.


The enhanced flexibility, due to longer contracts and early recall and repayment, considerably improved the liquidity of the market. The four week average number of shares traded increased from 0.0006 million to 0.049 million after the implementation of the changes.
Provision of roll-over facilities and relaxation of collateral requirements had a modest impact. The former increased traded volume by 40% and the latter by only 7%.

The introduction of liquid ETFs and 46 new stocks was expected to increase the trading activity by widening the market. Nevertheless, with the onset of trading in ETFs, the market observed only a meagre 9% increase in the average number of shares traded in the four week period prior vis-a-vis the four week period after the change. Moreover, there was no significant change in these averages after the commencement of trading in new stocks. If anything, the traded volume dropped from 0.41 million to 0.32 million.

Permitting insurance firms to trade in the market was a positive move by IRDA because it added to the shallow lending side ailing the SLB segment. Once again, the step yielded insignificant gains. On Feb 14, 2014, when the position limits for insurance firms and other institutional investors were revised to the participant level, the liquidity improved dramatically clocking a 70% increase in average number of shares traded after revision.

Diagnosing the failure

Since the securities loan is made on the exchange platform and covered by the clearing house, there is no risk to the lender of not receiving the lending fee. However, the risk of not procuring the security lent, on early recall, persists.

In an early recall the lender has to quote the lending fee he is willing to forego for the balance period. However, an early recall request is fulfilled by the clearing house on a best effort basis only – the exchange does not guarantee liquidity so that there is a matching order on the other side offering securities to the recall order. The lender has to wait for a match to his early recall order, failing which, he will have to keep the loan position open till the reverse leg day.

Suvanam and Jalan (2012) find that the SLB market in India has typically been a borrower-driven market with the presence of few lenders. The borrowing side in India is primarily proprietary traders, whereas in other countries the borrowing side is more diversified and includes hedge funds, mutual funds, foreign investors etc. Market diversity and depth on both the sell and the buy side is essential for proper functioning of a market. Suvanam and Jalan (2012) conclude (pp. 27) that "such diversity is currently absent in the Indian SLBM".

Globally, pension funds are large players on the lending side but in India they are not allowed to participate. The investment guidelines under the Investment Management Agreement between the NPS trust and pension funds impose restrictions such as "the assets are not to be encumbered", and further, "the PF shall buy and sell securities on the basis of deliveries and shall in all cases of purchases, take delivery of relative securities and in all cases of sale, deliver the securities and shall in no case put itself in a position whereby it has to make short sale or carry forward transaction or engage in badla finance".

Suvanam and Jalan (2012) find that foreign investors constitute 90% of the buy side and 86.4% of the sell side in the South Korean SLB market – another market that limits the segment to only the exchange. The Indian segment may also benefit from easing FII participation norms. While domestic institutional investors are likely to require time to understand the mechanism and set up processes to participate, FIIs are likely to be rapid entrants into this market.

There are numerous mistakes in regulations which have to be fixed in order to open up the market for FIIs:
  1. RBI's rules for FII participation in the SLBM prescribe that shares may be borrowed only for short selling. There is no clarity on what happens if the FII sells short and is unable to procure stock in the SLB market.
  2. FIIs must maintain collateral only in the form of cash while domestic institutional investors have a wider range of collateral options such as cash, fixed deposit receipt, bank guarantees and most recently included Gsecs and T-bills.
  3. FIIs may need to access the SLB market despite having stock in their portfolio. FIIs may hold an omnibus account while client positions are maintained internally. This warrants participation in SLB for one client while the FII holds stock for another. The regulatory stance on this is unclear.
  4. The RBI prohibits NRIs from participating in the SLB market.
The client level position limit of 1% of MWPL is too small especially for institutional investors. The presence of extremely low limits on trading ETFs may be a reason for their failure in improving liquidity. For example, the market wide position limits in NIFTYBEES for June 2014 was 548,557 shares. Hence, the client level position was 5,486 shares (1% of MWPL) which is ridiculously small.

An over the counter (OTC) market provides greater contract flexibility and wider position limits that encourage greater participation. The low volumes in India may, in part, be because the Indian regulator has limited the SLB segment to the exchange – unlike the US which is primarily an OTC market and Brazil which allows trading in SLB on both the exchange and OTC.

The way forward

  1. Removing lenders' risk: Absence of a settlement guarantee mechanism in case of early recall by lenders erodes incentives for large lenders to enter the market. The existing SLB framework does not provide such a guarantee (SEBI circular: Jan 06, 2010). In contrast, the CCP in South Korea provides settlement guarantee for a fee. In Hong Kong, the CCP forces borrowers to return the securities to the lender in case of early recall. The Indian regulator should either adopt a model for providing this guarantee or at least provide monetary compensation in lieu of it.
  2. Adding pension funds to the list of lenders: It will be useful for PFRDA to invite debate about the costs and the benefits of allowing participation of pension funds in the Indian SLB market. Guidelines similar to those released by IRDA for insurance firms should be issued to allow their participation.
  3. Increasing FII participation: The RBI rules: Dec 31, 2007 permit only cash collaterals for FIIs. Given that RBI already allows FIIs to maintain a wide range of collaterals in the equity and F&O segment, this could easily be extended to the SLB segment. Also, there should be clarity on issues such as failure to procure the securities lent and access to SLB market when they already hold stocks in their portfolio.
  4. Increasing position limits: SEBI and the exchanges should reconsider the client level positions. They should seek market consultation and set position limits accordingly.
  5. Establishing a parallel OTC market: The SEBI circular: Dec 20, 2007 states 'that stock exchanges shall put in place, a full fledged securities lending and borrowing (SLB) scheme, within the overall framework of "Securities Lending Scheme, 1997".' It designates clearing houses/corporations of stock exchanges as the Approved Intermediary under the Securities Lending Scheme, 1997. This prohibits an OTC market in the SLB market. As Suvanam and Jalan (2012) note "a parallel OTC market with a CCP or without a CCP can augment this market." The regulator must invite debate with market participants and researchers to consider this possibility with the objective of improving liquidity.

Author: Arjun Rajagopal

Difficulties with PFRDA's Draft Aggregator Regulations, 2014

by Arjun Rajagopal and Renuka Sane.

Recent mis-selling scandals in retail finance in India have brought into focus the dangers of unregulated, or lightly regulated financial intermediation. Financial intermediaries include banking correspondence agents, micro-finance institutions, insurance agents and other such players. They extend the reach of formal finance to a vast under-served population that is dispersed and not yet electronically enabled. Under-served populations with low access to finance are likely to be economically vulnerable, and may also have low levels of financial literacy. This makes them more dependent on the financial intermediaries they interact with, and more vulnerable to mis-selling and outright fraud. Such populations are also likely to have poor access to grievance redress mechanisms, courts and social safety nets.

The micro-finance crisis in Andhra Pradesh in 2010 shows what happens when regulators get it wrong. Loan collection agents in Andhra Pradesh were accused of engaging in large-scale coercive practices. This resulted in a political backlash, from which the industry is still reeling. It is therefore extremely important that India's financial regulators get it right when it comes to regulation of financial intermediation. This includes placing an appropriate emphasis on consumer protection.

Like loan collection agents in the case of micro-finance, aggregators in the pensions industry are a major interface with low income households in the informal sector. Aggregators are used to implement the NPS-Swavalamban (NPS-S) scheme run by the Pension Fund Regulatory and Development Authority (PFRDA). Under this scheme, if a subscriber in the informal sector contributes a minimum of Rs.1000 into her NPS-S account in a financial year, she will receive a co-contribution of Rs.1000 from the government. Aggregators market the scheme, enroll members and continue to service members post enrollment. They also make the investment choice for their customers. Aggregators thus act as execution agents of the NPS-S and as advisors to consumers. This means that aggregators potentially have considerable influence over financial choices of low-income households. Regulators should be very alert to the risk of fraud or mis-selling by these aggregators for three reasons:

  1. The consequences of fraud or mis-selling in the case of a product such as the NPS-S will probably only be detected far in the future, at the time of receipt of benefits.
  2. Older people are less likely to be able to recover from a sudden loss of income, especially if they have chosen to rely on income from the NPS-S.
  3. Public sector involvement in commercial products often gets construed as an official endorsement of the product. This exacerbates the risk of mis-selling.

Any regulation of aggregators must therefore place great emphasis on the goal of consumer protection.

The Draft Aggregator Regulations, 2014

Consumer protection is one of the pillars of the draft Indian Financial Code (IFC). The PFRDA, along with the rest of India's financial sector regulators, has committed itself to voluntarily implementing the consumer protection dimensions of the IFC, as articulated in the Handbook on adoption of governance enhancing and non-legislative elements of the draft Indian Financial Code . The recently released Draft Aggregators Regulation, 2014 are viewed in this context.

The Draft Regulations do recognise the importance of consumer protection as described in the IFC. They set out registration details of the aggregators, their duties and responsibilities and the inspection and disciplinary procedures that the PFRDA may initiate. Schedule VI of the regulations provides the aggregators with a code of conduct. However, we believe the regulations do not go far enough. Here is where the regulations fall short:

  • The regulations do not provide well-defined standards of skill and care that aggregators will be expected to exercise towards a customer. The beauty of simple, well-designed products is that they can be sold by agents with even basic financial literacy. However, it is important to specify what that basic level is for a given activity, or at least the standard that will be used to determine that level.
  • The regulations do not define what constitutes unfair and misleading conduct by aggregators. The Handbook discusses the need for regulations defining unfair and misleading conduct. India's experience with coercive and unfair practices by intermediaries should highlight the need for such definitions to be carefully researched and well-thought through.
  • The regulations do not place obligations on the aggregator regarding protection of consumers' personal information. In the context of digitisation and aggregation of information by private and public entities, it is increasingly important for regulators to specify these obligations.
  • The regulations do not provide adequate guidance for avoiding conflicts of interest. Subscribers of the NPS-S often purchase the pension scheme at the time of taking a micro-finance loan. The aggregator may be the intermediary for both these products. This scenario is entirely plausible, and is a foreseeable circumstance in which there may be a conflict of interest. However, the draft guidelines are silent on providing guidance on how aggregators should think about this issue, or the information that they must provide to clarify such conflicts.
  • The regulations do not provide adequate guidance regarding disclosures. Most NPS-S sales today rest on the co-contribution by the Government. It is not certain that this co-contribution will continue after 2017. This is information known to the aggregators, which is highly relevant to potential purchasers of the pension scheme. However, the regulations do not contain any details about such initial and continuing disclosures.
  • The regulations do not require any suitability or appropriateness checks before selling the NPS-S. The NPS-S is a market-linked, illiquid product. An illiquid product with a minimum contribution may not be appropriate for consumers who require cash in hand in the near future. By extension, investing in the NPS-S and simultaneously taking a micro-finance loan may not be a prudent decision for many consumers. Suitability analysis is an important part of the draft IFC's consumer protection for retail consumers. The regulator may take a view that the NPS-S is not a complex product, and therefore does not require suitability checks. In this case, the regulator needs to articulate the reasons why suitability checks are not mandatory. Absent such a justification, the regulations should feature some guidance on the issue of suitability.

The UK's experience with financial regulation shows that broad principles of consumer protection need to be translated into detailed guidance notes, such that both the regulator and the industry understand what is expected.

PFRDA has not used the appropriate processes for framing regulations.

In addition to the substantive concerns listed above, the regulations fail to abide by the procedural requirements of the Handbook, for framing regulations. The PFRDA should have provided the following:

  1. A clear statement of objectives;
  2. A list of problems the regulation seeks to solve; and
  3. A cost benefit analysis of each of the provisions.

The Handbook places major emphasis on the process of soliciting public comments via a well-designed web interface. Examples of such interfaces include the US Commodities Futures Trading Commission public comments page. There is as yet no information about the public comments received by the PFRDA.

Conclusion: Re-do with better public participation

The role of the aggregators, and the vulnerability of their customers should have led the PFRDA to accord a high importance to consumer protection when framing these regulations. The PFRDA needs to revisit these regulations and revise them in accordance with the substantive and procedural requirements of the Handbook. In particular, it would be advisable for PFRDA to quickly upgrade its ability to receive and display public comments on draft regulations. The PFRDA might consider extending the period for public commentary, and engaging more actively with the public to obtain high-quality feedback on this important subject.