The Scourge of Ratings Agencies

This is from the archives written over two days in August and September this year and meant as part of the weekly digest for PFPAC (FB).

Some days back, a friend, asked a question on Ratings Agencies (RAs hereafter), and if there is anything viable or subsequently pliable of these? So, this is a delving into the world of RAs, with a due note of caution that the piece is liable to technical morass. I don’t think I can help emaciate that, and so readers not too glued to technicalities can happily “skip” this. Another caveat here is the number of loose ends rooting and branching out to nowhere, or rather everywhere, for, the political of the neoliberal is an all-encompassing compass far larger than adherence to revolutionary struggles of the peripherals, and rooted in nodal points and events that bring such thoughts to fruition in the first place. RAs’ political economy ties in perfectly with the neoliberal and financialisation of capital in stitching these loose ends. So, it is time to go back to man is the political animal (Reasoning) of Aristotle from the present-day cow is the political animal of scores and scores (Pun intended!)….

Lets begin with indemnities, the technical parlance for insurance, wind and wade through probabilities and reach a designated ‘credit police‘, for this is where historical roots of RAs lie. Edmund Halley (Yes, the same astronomer giant credited with the eponymously-named comet!) in 1693 is credited with publishing the first-ever mortality tables based on the parish records for the Polish-German town of Breslau showing a mortality rate of 1 in 30 every year. These figures corroborated to a setting aside of a thirtieth of a company towards life insurance and annuities, whereby anyone investing in to this fraction by a company would be a policyholder, a member of the population subject to patterns of death and disease, and measured, averaged and thus risk-managed. Below is the original table that Halley came out with.

Now, if an insurance company brought together a large enough pool of policyholders, individual uncertainty was almost magically eliminated, so long as the actuary did his math correctly. The math isn’t really subjected to individual vagaries, but culminates in an objective reality, an often debated and nuanced extreme of statistical probability theory based on data analysis. So far, so good. But, how does this augur with banking and finance?  Analogising the death-disease parametric of insurance with bankruptcy and default of banking and finance, there is a relationship of equivalence to be drawn here. Just like insurance is subject to probability over long periods of time, a bank with a loan portfolio is played upon equivalently by probability over long periods of time, and both of these draw parallels in alleviating anxieties, or eliminating risks.

Jumping over from insurance. There is a catch here. Actuaries could potentially be instrumental in reducing risks or anxieties through their mathematical genius, but would that mean a trade-off with risk assessments, or due diligence as the latter is gaining currency? As in the case of insurers, who would require a bonafide ‘health certificate’ before bestowing policies, banks too would require such certification (at least ideally that is how it is supposed to work). Enter “Credit Police“. As Nicholas Dunbar in his The Devil’s Derivatives says of them: these might be the credit officers at a bank or, more ubiquitously, a credit ratings agency paid by the borrower to provide them with “health certificate”. Instead of an actuary counting deaths, lenders can turn to a RA to count defaults and crunch the numbers.

This brings us to the definition of RAs: Rating agencies, or credit rating agencies, evaluate the creditworthiness of organisations that issue debt in public markets.  This includes the debts of corporations, nonprofit organisations, and governments, as well as “securitised assets” – which are assets that are bundled together and sold as a security to investors.  Rating agencies assign a letter grade to each bond, which represents an opinion as to the likelihood that the organisation will be able to repay both the principal and interest as they become due.

The first ratings agent (credit police) in the world is often considered to be a financial journalist, who went by the name John Moody, whose interests in the American railroads in the earliest part of the 1900s led him analytically to opining on uncertainty on bonds, wherein all it required was scouring public records in determining what was really owned and how was it being performed. But, there seemed to be a parallel action in the form of Henry Poor’s firm that had been doing something similar fifty years before Moody sprang on to the scene. But, what really distinguished Moody from Poor and made the former a credit police was categorising the companies into creditworthiness. These categories is what is almost followed universally even today, and were alphabetically-based. 3 As (Triple A) was the elitist of these categories with a credit standing to the mighty USA itself. This was followed by 2 A (Double A), 1 A or just A (Single A), and B (similar sub-divisions), C (similar sub-divisions) and finally D, or Default. But, Moody drew another distinction, viz. Bonds above Ba rating were called investment grade, whereas below Ba were termed speculative grade. It is to be noted that investment graded-Bonds have a minimal risk of default, whereas speculative grade issue or issuer ratings are all ratings below BB+ or Ba+ included, down to CC-. Speculative grade or sub-investment grade issues can be considered “less vulnerable in the short run but face major uncertainties and exposures to adverse business, financial and economic conditions” (BB) or “subject to substantial credit risk” (Ba), to “a marked shortcoming has materialised” or ’typically in default’ (C). Speculative grade ratings are also called junk bonds. Moving on, what Moody did was sort sheep from the goats, in that, he promulgated investment grades as having a less chance of defaulting compared to speculative ones, and sold his bond ratings via a subscription newsletter winning trust through his analysis.

So, how does statistics/probability that tames uncertainty also quantify and qualify the loss? Dunbar makes a compelling argument. A portfolio of bonds of a particular grade would need to pay an annual spread higher than that of a risk-free cash investment, to compensate for the average default rate for bonds. In the same way that life insurance premiums vary according to the age of the policyholder, there is a credit spread for a particular rating of a bond – so, for example, bonds rated Baa by Moody’s should pay about a quarter of a percentage (Caution: pdf) in additional interest to make up for expected defaults over time.  If you make it your business to lend money to a large number of Baa-rated companies, then on average, over time, your business will theoretically break even – as long as you charge these companies at least a quarter of a percent more a year than the loan rate enjoyed by the Government. Investment grade companies re happy to pay this premium in return for borrowing money, and the spread earned on corporate bonds or loans is typically a multiple of the statistical default loss rate. Such actuarial approaches work if investments are not given up on prematurely. Moreover, default rates could fluctuate year-to-year even under the consideration of the stability of long-term average, but helps in riding out a recession by waiting for the good loans in your portfolio balancing out the losses over time. This is where RAs get political, for the actuarial approach set forth by them is through the cycle to describe their ratings, to legitimise their analysis, to reassure the implication  that their actuarial approaches were recession-proof.

This political toning isn’t really a theoretic, as journeying back into history has ample attributions to elevating RAs in tune with their stellar reputations to a sinecure by US regulators. Forwarding by six decades, the integrity of these RAs twisted from charging investors to charging issuers. As the value of the rating agencies derives from their reputation for independent credit analysis and reporting, the issuer-pay model poses definite problems for independence, at least in appearance, starting with the questions of partiality. The perception of such potential conflicts of interest may partly explain why S&P did not choose to follow Moody’s and extend its issuer-pay model to corporate bond issuers in 1970. At the time of Moody’s announcement, S&P declared, “the income from the publications that carry our ratings and the expansion of our commercial paper rating activity enable us to provide corporate bond ratings without charge at this time”. Moody’s and S&P’s ability to successfully implement an issuer-pay model reflects their market power and reputational capital. However, when the SEC (US Securities and Exchange Commission) recognized Moody’s and S&P as Nationally Recognized Statistical Ratings Organizations in 1975, this directly increased the regulatory use of credit ratings and gave the two agencies enormous power and prestige. Very likely, this designation also made the issuer-pay model sustainable. Although many technological and economic factors led to the switch from investor-pay to issuer-pay fees for credit ratings three decades ago, the question of whether this revenue model is associated with actual conflicts of interest remains an empirical one. Recent rating down- grades for bonds rated Aaa prior to the financial crisis have led some to speculate that the issuer-pay model has weakened rating agencies’ due diligence and led to poor quality ratings. Both Congress and the SEC have considered ways to change the issuer-pay model. Although the newly passed Dodd–Frank Wall Street Reform and ConsumerProtection Act does not address the issuer-pay model, it requires the Government Accountability Office to prepare a study of alternative ways of compensating rating agencies. It also asks the SEC to adopt new rules concerning the conflicts of interest that arise from rating agencies’ sale and marketing practices.

In light of the above controversy, rating agencies contend that their concerns for reputation discourage them from engaging in any short-term opportunistic behavior. Indeed, Moody’s claims, ‘‘We are in the integrity business’’, and S&P takes it one step further, claiming, ‘‘Our reputation is our business’’ The SEC concurs: “The ongoing value of a rating organization’s business is wholly dependent on continued investor confidence in the credibility and reliability of its ratings, and no single fee or group of fees could be important enough.”…….

 

But, what of countries? How are they given sovereign ratings and why should they even matter? Countries are issued sovereign credit ratings. This rating analyzes the general creditworthiness of a country or foreign government. Sovereign credit ratings take into account the overall economic conditions of a country including the volume of foreign, public and private investment, capital market transparency and foreign currency reserves. Sovereign ratings also assess political conditions such as overall political stability and the level of economic stability a country will maintain during times of political transition. Institutional investors rely on sovereign ratings to qualify and quantify the general investment atmosphere of a particular country. The sovereign rating is often the prerequisite information institutional investors use to determine if they will further consider specific companies, industries and classes of securities issued in a specific country. More governments with greater default risk and more companies domiciled in riskier host countries are borrowing in international bond markets. Although foreign government officials generally cooperate with the agencies, rating assignments that are lower than anticipated often prompt issuers to question the consistency and rationale of sovereign ratings. How clear are the criteria underlying sovereign ratings? Moreover, how much of an impact do ratings have on borrowing costs for sovereigns?

 

Ratings Agency is a company that specialises in evaluating a company’s or government’s ability to repay debts, which in a technical jargon is creditworthiness. Although, they mainly give ratings to debt instruments like corporate and sovereign bonds, they could also be involved in doing something similar to commercial loans. These agencies are sustained by charging fees from corporations or governments and selling their analysis to public at large. Although credit rating agencies are private firms, their role in financial regulatory frameworks has expanded since the 1970s – especially as a result of an international agreement to assess bank portfolios based on the risk of their assets and set capital requirements accordingly. This so-called Basel II Accord sought to add nuance to regulatory standards. A key justification for the incorporation of rating agencies’ credit assessments was the belief that they offered a more sophisticated approach to measuring credit risk than did the simpler regulatory practice of basing capital requirements on a fixed percentage of total assets – the approach in the earlier Basel I Accord, which allowed for much less differentiation.

Prior to the era of project financing, debt financing by banks was the mainstay of funding, where the onus of assessing the risks associated with credit lay ultimately with the funders/lenders, i.e. the banks themselves. But, one of the bridges that linked debt financing to project financing was the instrument of bonds, whose meteoric rise has been coterminous with RAs’ density of indispensability. When any prospective bond buyer assesses the risks involved with  transacting bonds, she would rely on the analysis provided by these RAs. So, if one looks keenly into this logic of transactions, it becomes quite sensible to derive the fact that corporations would indeed want to be rated according to their aspirations to stay on in the business. But, when Governments take this leap, it is a slight misnomer to feel it that way common-sensical. But, alas! no, governments become part of the process of ratings simply by way of fact that many of these sovereign entities raise money on capital markets.

A borrower’s economic outlook is taken into consideration by performing industry studies to assess how a particular industry would evolve and how profitable a company will be in future. It is then culled with borrower’s management. For instance, a country with massive debts and a government that is unlikely to take actions to reduce them would attract a lower rating. Now, why is this important is by ascribing to the fact that it affects expressivities of investment climate by fluctuating between borrowing costs. For example, pension funds are often allowed to hold bonds rated at investment grade. A lowering in a na insurer’s rating can thus have an enormous effect if pension funds have to sell those assets. Interestingly, while the talks are on about Basel III, it is the Basel II framework that dictates how banks can use data from RAs to determine how risky loans would be, and thus outline the amount of reserves a bank has to hold against those loans. But, the obvious question being begged here would be: do these RAs never fail? The answer is exactly not as affirmative as it should be. Enron, for instance was never rated to default, but only after a true picture of its financial state emerged, was it lowered. Enron was a giant corporation, and probably didn’t have the domino impact that a country, or a group of countries would have had if these RAs went berserk with their determination. Since, for a country, the loss is gargantuan, as it is likely aggravated by directly impacting investors’ confidence resulting in an immediate pull out of the region.

The postcrisis debate over the role of credit rating agencies in financial regulation has focused primarily on issues such as conflict of interest and adequacy of performance. Among the questions are how the rating agencies assign ratings, what they rate, and whether ratings fueled the precrisis lending boom and resulting asset bubbles and provoked an opposite and pernicious effect after the crisis. These are valid concerns, but they also underscore how credit rating agencies have become an essential part of the financial system – “hardwired” if you will, in such a way that they take the place of due diligence rather than supplement informed decision making. This hardwiring results, in part, from the investment strategies of banks, investment funds, and other private entities. Primarily, though, it stems from credit rating agencies’ institutionalized role in public policy activities – chiefly in banking regulation, but also in areas such as determination of the eligibility of collateral in central bank operations and investment decisions of publicly controlled or operated funds, such as pension funds. The use of agency ratings in financial regulation amounts both to privatization of the regulatory process – inherently a government responsibility – and to abdication by government of one of its key duties in order to obtain purported benefits such as lower regulation costs and greater efficiency and nuance. So, was really is the issue here or what really is the problematic?

1. Credit rating agencies aim to maximize profits and shareholder value. Although they have a powerful incentive to provide trustworthy information, they do not have the same mandate as a regulatory agency charged with providing information in the interest of the public. When the private motive and the public imperative are not fully compatible, there is potential for conflict and confusion. One or both may suffer. If the public imperative suffers, it undermines the credibility of the regulatory process.

2. Even if a rating agency enjoys an excellent track record, the credibility of the regulatory process risks erosion because ratings are inherently fallible; they depend on judgments. In the marketplace, if a credit rating agency crosses a threshold of unreliability, it will lose customers and eventually fail. However, if it is part of the regulatory framework, its mistakes may have severe implications, and even if a poor performer can eventually be removed, how can a credit rating agency fail as long as it is part of the regulatory framework? Who will be liable if the agency’s opinions result in distortions – especially if financial institutions end up holding too little capital?

3. Rating changes move markets, affecting the value of assets and thus capital requirements. They also affect whether those assets can be used as collateral. This is not inherently bad (indeed such changes are intended to affect assessments of riskiness and asset prices), but a change may cause sudden destabilization, unnecessarily raise volatility, and/or lead to overshooting of the asset’s value, particularly in the event of a downgrade. Ratings changes, then, can cause regulation-induced crises. Moreover, the due diligence of investors whose decisions are tied to ratings (for example, certain pension funds) is diminished or even overridden because of the overwhelming importance of credit ratings.

4. Credit rating agencies have long enjoyed considerable influence over market movements because of the faith placed in them by those who demand their services. The enshrinement of their role in regulation multiplies their potential power. It further distorts competition in an industry that has oligopolistic tendencies, because consumers benefit not only by being able to compare different asset classes under one rating system but also by not having to decipher the methodologies of numerous credit rating agencies.

But, then is a reform possible? And if yes, in what direction?

 

a. Regulatory enhancement: This would involve modifying existing rules, but keeping credit rating agencies in essentially the same regulatory role. Regulations could be tighter. For example, authorities might require rating agencies to be more open about how they operate. The way they are remunerated might also be changed to resolve conflicts of interest. Fees might be regulated. Governments could establish more effective evaluation and accreditation processes for rating agencies and their methodologies and enhance quality control. Investor boards could be established to request credit ratings, which would keep clients and rating agencies separate. Regulators could acknowledge fallibility and establish acceptable levels of accuracy, although this would raise questions about recourse or compensation when inaccuracy occurs. An alternative might be to regulate private credit rating agencies so extensively that they would become essentially public utilities. This approach would substantially reduce conflict of interest and would cost much less than establishing a new public credit rating agency. It would also raise important questions about how to select a rating agency. Would prospective borrowers be compelled to use a particular agency? Would agencies be asked to volunteer? Would there be a competitive selection process.

 

b. The public solution: One or more of the private credit rating agencies could be brought under public control, or all private agencies could be excluded from regulatory activity and replaced by a new public agency. The new agency would follow a transparent and approved rating methodology. It would be paid to cover its operating costs, but instead of profit maximization, provision of accurate information to optimize the regulatory process would be its main objective. Setting up such an agency may be beyond the ability of individual countries and could lead to other problems, such as regulatory protectionism. At the same time launching such an agency at the supranational level would be complicated, requiring international cooperation and considerable good faith. The public solution would resolve certain conflict of interest problems, but arguably would generate new ones with respect to the rating of sovereigns, which would be rating themselves or being rated by an entity they own (wholly or partially). Moreover, a public agency would have to establish credibility and independence from political influence and prove itself a reliable source. It would be costly because it would involve establishment of one or more new institutions. It would also not be immune to problems such as regulatory capture, fallibility of ratings, failures of timeliness, moral hazard, and political repercussions emanating from its decisions. Existing rating agencies would likely suffer a drop in business.

 

c. Return to simpler capital rules: The role of rating agencies could also be eliminated and regulators could return to a few simple and predetermined capital requirements for borrowers. What is lost in nuance and sophistication would be offset by greater simplicity, and therefore transparency. It would also be more predictable and easier for regulators to apply and monitor. A return to static ratios would eliminate errors in judgment arising from ratings changes, although determination of the ratios would be a significant point of contention. Without private rating agencies’ conflicts of interest, transparency and predictability would improve. Greater simplicity would also likely reduce the potential for market participants to evade regulations. However, the simplified capital rules could increase the cost of raising funds and make it harder for some entities to do so, which would curtail financial activity and could impair economic growth. Moreover, because the simpler rules would not differentiate among risks, they could create a perverse incentive for banks to lend more to riskier entities, thus increasing the likelihood of future financial crises. So a simple-rules approach would have to be monitored carefully and implemented in conjunction with other regulatory tools and indicators. Its relative simplicity and lack of institutions render it the cheapest proposal for governments to implement. From a political point of view, any return to simple rules could suggest the failure of the Basel II approach, which supported risk-based capital charges.

 

d. Market-linked capital charges: This approach would turn to the market to determine the level of capital an institution must hold to support an asset. Instead of a credit rating, the market price would be used to gauge the asset’s risk profile. In essence, the amount of capital required to hold a fixed-income security would be related to its yield. The capital required for a security would rise in proportion to its spread over a designated benchmark: the market would determine the risk. Such an approach would remove credit rating agencies from regulation while retaining a sophisticated, transparent, and market-friendly process. Indeed, because market determinations change frequently, capital adjustments could be made more often in a more gradual and nuanced fashion than the credit rating agencies’ grade changes, which often lead to sudden, destabilizing movements. But this approach requires deep and liquid markets and might have to be supplemented with minimum and maximum capital charges – turning it into a variant of the simple capital rules option. Additional safeguards during periods of market crisis would require regulators to intervene when prices cross certain thresholds and diverge significantly from underlying values. The market could serve as a guide to regulators, without removing them from the regulatory process – as happens when they rely on credit rating agencies. But there is the potential for manipulation, especially when liquidity is constrained or an asset is traded infrequently and therefore susceptible to volatile movements.

But, who bells the cat after all? Governments have worked to introduce tighter regulation after the Enron collapse in 2001, a case of massive fraud that the rating agencies did not signal. Governments themselves are affected by the ratings they receive from the agencies they regulate. Some suggest this opens up the opportunity for a conflict of interest.The frameworks for bank ratings have become more transparent. When rating government finances, the agencies argue that they are balanced and impartial. Downgrading a country’s rating inevitably puts an agency in the firing line, but this doesn’t mean they are necessarily wrong to do so. No one can predict the future, and it gets really murky on the financial scene. Credit ratings are assessed by modelling risk of default, not by predicting the unforeseeable. Experience, combined with rigorous procedures, can finely tune risk modelling and increase its reliability, but, ultimately, investors act at their own risk and according to their own judgment. However, credit ratings have the potential for significant social, economic and political fall out. Governments are shaken if their ratings drop. The cost of borrowing rises, interest rates may be affected, and it has an impact on the value of a nation’s currency. Many are asking for more transparency in how the agencies evaluate banks and whether this high impact public service should remain in the hands of private operators.

The drawbacks and costs of each option must be weighed against expected benefits—which must be identified and, where possible, quantified. In some ways, it is a case of pick your poison because there will always be risks associated with regulation, and those who are regulated will always find creative ways to evade or subvert rules not to their liking. Any reform of credit rating agencies must be part of a broader revamping of regulation, because many regulatory failings were identified in the aftermath of the 2008 global financial crisis. Moreover, the transition costs of moving to a new system must be examined carefully, because they will surely be considerable. Cost, however, should not become an excuse for inaction – which would perpetuate government failure and erode the credibility of financial regulation. That could jeopardize the health of the financial sector and the economy – both nationally and globally. There is need to strengthen the accuracy of credit ratings agencies and thus reduce systemic risks, which could be brought about by a regulatory authority required to rate them in terms of their performance; such regulatory bodies facilitating the ability of investors to hold RAs accountable in civil lawsuits for inflated to deflated credit ratings safeguarding against the reckless conduct of these RAs; ensuring that RAs institute internal controls and ratings methodologies; and most importantly, these regulatory bodies ensuring that RAs give higher risks to financial instruments whose performance cannot be reliably predicted due to their novelty or complexity, or that rely on assets from parties with a record of issuing poor quality assets. Until then, we are subject to thee vagaries and accompanying cause-effects.

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Recapitalisation and Demonetisation. Is the link exaggerated?

What has been witnessed in the aftermath of demonetisation is the declining yield on Government securities, and as a consequent of which treasury gains for public sector banks have already surpassed capital infusion. With a sluggish economy, high levels of stressed assets and eroding bottom-lines, banks have been pushed to the corner to regulate lending. The aim of recapitalisation, and/or capital infusion is geared towards shoring up the lending capacities of banks, public sector banks in this case as countenance  against these erosions. To understand what recapitalisation is, let us take a jaunt to Indradhanush 2015, the seven colours or A2G meant for reviving the banking industry in the country. The seven colours talked about are: Appointments, Bank Board Bureau, Capitalisation, De-stressing PSBs, Empowerment, Framework of Accountability, and Governance reforms. The third colour, i.e. capitalisation (Capital Infusion or Recapitalisation) is an exercise to estimate the capital requirements based on credit growth rate of 12% for the current year and 12 to 15% for the next three years depending on the size of the bank and their growth ability. It has been presumed that the emphasis on PSBs financing will reduce over the years by development of vibrant corporate debt market and by greater participation of Private Sector Banks. Based on this exercise, it is estimated that as to how much capital will be required this year and in the next three years till FY 2019, despite the banks being under a lot of stress and still adequately capitalised and meeting all Basel-III and RBI norms. It must be noted that under Basel III, a bank’s tier 1 and tier 2 capital must be at least 8% of its risk-weighted assets. The minimum capital adequacy ratio (including the capital conservation buffer) is 10.5%. The capital conservation buffer recommendation is designed to build up banks’ capital, which they could use in periods of stress; where tier-1 capital is the core capital and includes equity and disclosed reserves, while tier-2 capital are hybrid capital instruments, loan-loss and revaluation reserves as well undisclosed reserves.

After excluding the internal profit generation which is going  to be available to PSBs (based on the estimate of average profit of the last three years), the capital requirement of extra capital for the next four years up to FY 2019 is likely to be about huge amount of Rs.1,80,000 crore.

Out of the total requirement, the Government of India proposes to make available Rs.70,000 crores out of budgetary allocations for four years as per the figures given below:

(i)	Financial Year 2015 -16	–	Rs. 25,000 crore
(ii)	Financial Year 2016-17	–	Rs. 25,000 crore
(iii)	Financial Year 2017-18	–	Rs. 10,000 crore
(iv)	Financial Year 2018-19	–	Rs. 10,000 crore
	Total	–	Rs. 70,000 crore

According to the document itself, PSB’s market valuations will improve significantly due to (i) far-reaching governance reforms; (ii) tight NPA management and risk controls; (iii) significant operating improvements; and (iv) capital allocation from the government. Improved valuations coupled with value unlocking from non-core assets as well as improvements in capital productivity, will enable PSBs to raise the remaining Rs. 1,10,000 crore from the market.  Moreover, the government is committed to making extra budgetary provisions in FY 18 and FY 19, to ensure that PSBs remain adequately capitalized to support economic growth. The banks can raise capital from the capital markets as well be availed of tranche facilities running over three tranches, and nowhere is there any mention of such budgetary allocations meant for capital infusion or recapitalisation on the substitute for the process of demonetisation. Before moving on to demonetisation, it must be remembered that capitalisation, recapitalisation or capital infusion (the first two are generally used interchangeably and depends on who the user is, with the former lying squarely with the banks, while the latter with academics, if that wasn’t too generic a distinction, I be forgiven!) is through budgetary allocations. Let us underline this.

Demonetisation is when the Central Bank, RBI in our case strips the bill of its legal tender. What happened post November 8 was stripping bills of Rs. 500 and Rs. 1000 of their legal tender, thus rendering them invalid.

Almost everyone seems to be collaging demonetisation and black money, terror funding, illicit and counterfeit money flows. Not that there isn’t correlation between these, but the whole of argumentation is getting reducible to these aspects and what seems to be totally sent to oblivion is tax evasion. Though, some talks do touch upon these, many of these commit the folly of citing tax havens like Mauritius and Singapore and black money hoarded and channeled through there. A populist line of thought, without considering the fact that a recently concluded tax treaty between India and Mauritius has choked the tax haven significantly. One with Singapore is in the pipeline, and once that gets concluded, the two tax havens would then need to seep through populist discourse as no longer the culprits before the narrative changes sense. A tall order from a half-baked recipe.

On the other hand, even if terror funding is caused by higher denominations, one shouldn’t belittle other ingenious ways of carrying out the same. Though, flushing the economy of higher denominations could trickle down to curbing such illicit fundings, the government should not be gung-ho over this as the be-all end-all to choke such flows, for such denominational crushes would only exaggerate Kosher funds, funds through oil economics, extortion and crucially politically-motivated funds slipping through religiously-fundamentalist and right-wing techno geeky consortiums.

So, whether the move is short-term distress or long-term satisfactory should not be decided on subjectivities, but rather on economic complexities, the answers to which sadly the Government doesn’t have at the moment and no wonder crying foul over any resistances to its move. The same goes true for even those calling the government to dock, for the problem is economics should not be totally (read: wholly) studied sociologically anymore, but all the more importantly, sociology needs to be studied as a consequence of economics, and once the order goes for a tailspin, its only fertile for such sentimental concerns, not that anythings wrong with such concerns, but for the fact these have tendencies to become authoritarian. By authoritarian, what is meant is surely Prime Minister’s grand designs. Unlikely entities in the form of Ratings Agencies is stifling PM’s grand designs. But, all of that could change. With demonetisation of notes and GST, hopefully not this quarter but over the next six-seven quarters, there will be an improvement in the fiscal debt-to-GDP ratio by virtue of expansion of denomination, and improvement in the fiscal tax-to-GDP ratio by virtue of better tax collection. Meaning, a possible upgrade from Baa2 (Moody’s) and BBB- (S&P), a notch over the junk. Consequentially, it’d mean all the big three seeing this war on people capitalistically profitable. a sort of double bind, ain’t it? And, here I am guilty of parsimonious arguments, for reasons that most of these are in liberal supply on the media. So, the basis is to look out at connectors and/or disconnectors between recapitalisation and demonetisation, which is still within approaching distance from here on.

With demonetisation has come massive exchanging of old currency for new denominations of Rs. 2000 and Rs. 500 on one hand and depositing old currency in accounts till 30th of December 2016. The deposits have spiked and banks are faced with surplus liquidity, which they are finding hard to find avenues to disburse, say in the form of investments. The cause, which has been reactionary has left the effect no less reactionary, and the culpability lies squarely with planning and implementation of the scheme. Well, thats a different matter, and thus at best put aside. But, the fractures within the social fabric caused due to this lack of implementation has had fatalities that have been extremely costly. As the Financial Express was prescient in noting, there was ecstasy with deposits rising just at beginning of the busy season. Consumerism had shown strong signs in the period leading to Diwali and the good times were to come along supported by banks, which were running tight on deposits. In fact, RBI has been supplying funds through OMOs all through, and it is against this background that banks became ecstatic as deposits rolled in. Most households were in a panic mode and were just keen on getting rid of old notes safely and, hence, most of this money went into savings deposits. The consequences were significant. First, banks automatically started lowering the deposits rates as they no longer had to wait for RBI to announce changes in the repo rate. This also meant that the lending rates could be reduced without a prod, which was a win-win situation for the system. The transmission mechanism became smooth under the compulsion of market forces. In fact, some sections of the market believed that RBI need not lower the repo rate in the December policy, as circumstances have already delivered the result unobtrusively. Banks were also pepped up as the G-Sec yields had crashed with the 10-years paper going down to 6.3% with sentiment providing a guidance of sub-6%. This meant there were capital gains to be had, which would prop up income and banks would be better able to manage provisioning for their NPAs. But, the downside is that the banking sector does not have the capacity to absorb so much of liquidity, and with a low demand for credit, the alternative is to approach G-sec (Government Securities) market. Now, the catch. With stringency to the fiscal target, having additional paper in the primary segment would be self-defeating, and thus another turn, which happens to be the secondary segment for banks to target. This has led to the yields coming down sharply. Given that banks have been paying a minimum of 4% interest on deposits, a positive net return is what they would have wanted. The reverse repo window has been used widely to park these funds where the return could go to 6.25%, which would just about cover their operating cost to assets ratio of 2-2.5%.However, RBI has limited G-Secs in its balance sheet, which is around R7.5 lakh crore, and in case deposits do shoot up to R10 lakh crore, it would not be possible to satiate the market. One option is seeking recourse to MSS bonds (market stabilisation bonds), which have been used in the past when money supply increased mainly due to the influx of foreign currency in the system leading to sharp appreciation in currency. But given the quantum involved (between Rs. 5-10 lakh crore ultimately if the target is reached and cannot be used for lending), this would push up government debt substantially. In fact, it will also add directly to the fiscal deficit, which is not acceptable.

So, what has the RBI proposed? Locking in liquidity on an ex-post basis. It has increased Cash Reserve Ratio (CRR) by 100% of net demand and time liabilities (NDTL),  which is the difference between the sum of demand and time liabilities (deposits) of a bank and the deposits in the form of assets held by another bank. Formulaically,

NDTL = demand and time liabilities (deposits) – deposits with other banks.

The amount specified as the CRR is held in cash and cash equivalents, is stored in bank vaults or parked with the Reserve Bank of India. The aim here is to ensure that banks do not run out of cash to meet the payment demands of their depositors. CRR is a crucial monetary policy tool and is used for controlling money supply in an economy. towards the end of November, the RBI hiked the incremental CRR by 100%. The incremental cash reserve ratio (CRR) prescribes the reserve ratio based on the extent of growth in resources (deposits). It im­mobilises the excess liquidity from where it is lodged (the banks which show high growth), unlike the average ratio which impounds from the banks which are slow-growing as well as banks which are fast-growing. It also avoids the jerkiness of the average ratio. This means it has literally mopped the surplus liquidity that has gone into the banks as deposits in the wake of demonetisation. So, banks do not have capital to lend.  There is a formula on how much a bank could lend. It is:

Lending = Deposits – CRR – SLR (statutory liquidity ratio) – provisioning

; SLR is the amount of liquid assets such as precious metals (Gold) or other approved securities, that a financial institution must maintain as reserves other than the cash.
Formulaically,

SLR rate = (liquid assets / (demand + time liabilities)) × 100%

As of now, the CRR and SLR rates are 4% and 23% respectively. Hence, the bank can only use 100-4-23= 73% of its total deposits for the purpose of lending. So, with higher CRR, banks can give less money as loan, since with higher interest rates, it becomes expensive to lend. This can curb inflation (and this is one of the main arguments of pro-demonetisation economists), but may also lead to slowdown in economy, because people wait for the interest rates to go down, before taking loans.

To reiterate: This move by RBI was necessitated by the fact that the central bank at present holds Rs 7.56 lakh crore of rupee securities (G-Secs and T-Bills) and will soon run out of options of going in for reverse repo auctions, where it sells G-Secs in return for cash from banks, which have surplus deposits. These transactions have been reckoned at rates between 6.21%-6.25%. There are expectations that the volume of deposits will increase by up to Rs10 lakh crore by December because of the demonetisation scheme. The present equation of Rs3.24 lakh crore impounded by CRR and Rs7.56 lakh crore to be used as open market option (OMO) or reverse repo auctions broadly covers this amount, leaving no extra margin. There are two implications out of this: One being, as the level of deposits keep increasing, banks may have to park the increments as CRR with RBI which will affect their profit and loss (P&L). The expectation till today morning had been that the RBI would lower the repo rate aggressively in the December policy by 50 basis points (bps), i.e. today, which it did not do. This surely is deferred till stability due to demonetisation is achieved in the system. The other being on interest rate transmission. Banks could have delayed cutting their lending rates given that they had promised at least 3-4% interest rate to savings account depositors, and not be receiving any interest on the deposits impounded for CRR, which they haven’t as on individual levels, they have been cutting lending rates to approach RBI rates. This culminates into liquidity to tighten and send bond yields on a northward blip, and this is where lending would shrink automatically. And, that is the connector spoken about above, where when the lending spigots are tightly controlled due to tightening of liquidity, the logic behind capital infusion, which anyways comes in through budgetary allocations gets defeated. The real constraining factor could arise when Large Exposure Framework (LEF) gets kickstarted next financial year confining banking sector’s exposure to highly leveraged corporates through a cap scanning risk environs along the way. But, these consequences are still in a speculative realm, though definitely geared to life via demonetisation. 

 

Natural topography of Hilbert Spaces as a generator of free will?

There is a theory that goes by the name Margenau’s Theory, which tries its hand at reducing human consciousness to a field of probabilities in what is termed a Fock Space, which is an algebraic construction in quantum mechanics to construct the quantum states space of a variable or an unknown number of identical particles from a single particle Hilbert Space, H.

Hilbert space extends the notion of Euclidean geometry from a two-dimensional space to a three-dimensional space, and is talked about as an abstract vector space possessing the structure of an inner product that allows the length and the angle to be measured. Now, such a space could be created by an electrical activity at the synaptic level. Normal behaviour could therefore be seen as the elasticity of the field, and free will as a rupture within it. But, in what topology begs the question? Since, there is nothing in the natural topography of Hilbert Spaces that could be the generator of free will….

Three states of the Hilbert space of the quantum dimer model. There are off-diagonal matrix elements in the effective Hamiltonian which connect state ͑ a ͒ to state ͑ b ͒ , and state ͑ a ͒ to state ͑ c ͒ , by a resonance between pairs of horizontal and vertical dimers around a plaquette. The latter matrix element differs from the former because only the latter has a diagonal link across the resonating plaquette. Also shown are the corresponding values of the heights h a on the sites of the dual lattice. Credit

Quantum Mechanics and Reality

Physics is quite familiar with macroscopic properties that can’t be possessed by individual atoms or molecules. As Susan Stebbing questioned in her philosophy and the physicists, where the common sense notion of solidity imply the metaphysics of continuous substances, and whether scientific substances by the scientific account of the solidity of macroscopic objects is incompatible with the common sense notion of it. Science is not concerned with the underlying truth of the theories but at the same time is concerned with the comprehensive explanation of its appearance. A theory is empirically plausible if the observational effects are true. Many differ from positivists, who hold that theoretical statements can be translated into purely observational ones, and instrumentalists, who hold that theoretical statements are merely part of meaningless algorithms that enable us to get from true observation statements to other true observational statements, and hence to predictions.

Take the case of quantum mechanics:

Bell proved a theorem in the form of an inequality, called the Bell’s inequality.

This inequality would hold if the amount of correlation was due to the probability of spin ½ in the right expression correlating with –½ in the left hand expression because they depended ( perhaps probabilistically ) on earlier sharp values of the spin when the atoms shot out particles in the opposite directions originally. Bell also showed that if Bohr’s idea did not have sharp values in the absence of experimental determination of them was correct, the correlation would be greater for certain infinite classes of values of the variable @

1) Bell’s argument requires as a premise an axiom of locality, to the effect that there is no sort of action at a distance, whereby what happens in an experiment at a space time point X can’t affect what happens at a space time point Y where XY lies outside the light-cone. The arbitrariness of simultaneity in special relativity makes this locality principle very much plausible; if there is action at a distance, we may have to ask what type of axes in the Minskowski space determines the simultaneity of the events X and Y. Even so locality could be denied, there might be preferred set of inertial axes in the Minkowski space. It might be singled out by cosmological considerations, as a frame of reference in which the cosmic background radiation is equal in all directions. Admittedly this would be worrying as electromagnetic and mechanical phenomenon would be Lorentz invariant and Bell type phenomenon would not be Lorentz invariant, but it would not be impossible.

2) Even though non-commuting quantum mechanical variables might not simultaneously have sharp values something might be made up of real propensities.

3) Even on the Bohr view, the tree in the quad exists when no one saw it, it did not combine this view with mind-body dualism and if one merely regarded an experiment as an interaction in the macroscopic object.

4) Theoretical physicists seem to disagree with one another on quantum mechanics as much as philosophers do on the issue on realism and idealism.

 Natural history is the study of rough generalizations and not of tight laws. Consistency is a necessary condition for truth , but is it the sufficient one?