Skeletal of the Presentation on AIIB and Blue Economy in Mumbai during the Peoples’ Convention on 22nd June 2018

Main features in AIIB Financing

  1. investments in regional members
  2. supports longer tenors and appropriate grace period
  3. mobilize funding through insurance, banks, funds and sovereign wealth (like the China Investment Corporation (CIC) in the case of China)
  4. funds on economic/financial considerations and on project benefits, eg. global climate, energy security, productivity improvement etc.

Public Sector:

  1. sovereign-backed financing (sovereign guarantee)
  2. loan/guarantee

Private Sector:

  1. non-sovereign-backed financing (private sector, State Owned Enterprises (SOEs), sub-sovereign and municipalities)
  2. loans and equity
  3. bonds, credit enhancement, funds etc.

—— portfolio is expected to grow steadily with increasing share of standalone projects from 27% in 2016 to 39% in 2017 and 42% in 2018 (projected)

—— share of non-sovereign-backed projects has increased from 1% in 2016 to 36% of portfolio in 2017. share of non-sovereign-backed projects is projected to account for about 30% in 2018

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Why would AIIB be interested in the Blue Economy?

  1. To appropriate (expropriate) the potential of hinterlands
  2. increasing industrialization
  3. increasing GDP
  4. increasing trade
  5. infrastructure development
  6. Energy and Minerals in order to bring about a changing landscape
  7. Container: regional collaboration and competition

AIIB wishes to change the landscape of infrastructure funding across its partner countries, laying emphasis on cross-country and cross-sectoral investments in the shipping sector — Yee Ean Pang, Director General, Investment Operations, AIIB.

He also opined that in the shipping sector there is a need for private players to step in, with 40-45 per cent of stake in partnership being offered to private players.

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Projects aligned with Sagarmala are being considered for financial assistance by the Ministry of Shipping under two main headings:

1. Budgetary Allocations from the Ministry of Shipping

    a. up to 50% of the project cost in the form of budgetary grant

    b. Projects having high social impact but low/no Internal Rate of Return (IRR) may be provided funding, in convergence with schemes of other central line ministries. IRR is a metric used in capital budgeting to estimate the profitability of potential investments. It is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. NPV is the difference between the present value of cash inflows and present value of cash outflows over a period of time. IRR is sometimes referred to as “economic rate of return” or “discounted cash flow rate of return.” The use of “internal” refers to the omission of external factors, such as the cost of capital or inflation, from the calculation.

2. Funding in the form of equity by Sagarmala Development Co. Ltd.

    a. SDCL to provide 49% equity funding to residual projects

    b. monitoring is to be jointly done by SDCL and implementing agency at the SPV level

    c.  project proponent to bear operation and maintenance costs of the project

     i. importantly, expenses incurred for project development to be treated as part of SDCL’s equity contribution

     ii. preferences to be given to projects where land is being contributed by the project proponent

What are the main financing issues?

  1. Role of MDBs and BDBs for promotion of shipping sector in the country
  2. provision of long-term low-cost loans to shipping companies for procurement of vessels
  3. PPPs (coastal employment zones, port connectivity projects), EPCs, ECBs (port expansion and new port development), FDI in Make in India 2.0 of which shipping is a major sector identified, and conventional bank financing for port modernization and port connectivity

the major constraining factors, however, are:

  1. uncertainty in the shipping sector, cyclical business nature
  2. immature financial markets

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Transmission of Eventual Lending Rates: MCLRs. Note Quote.

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Given that capital market instruments are not subject to MCLR/base rate regulations, the issuances of Commercial Paper/bonds reflect the current interest rates as banks are able to buy/subscribe new deposits reflecting extant interest rates, making transmission instantaneous. 

The fundamental challenge we have here is that there is no true floating rate liability structure for banks. One can argue that banks themselves will have to develop the floating rate deposit product, but customer response, given the complexity and uncertainty for the depositor, has been at best lukewarm. In an environment where the banking system is fighting multiple battles – asset quality, weak growth, challenges on transition to Ind AS accounting practice, rapid digitization leading to new competition from non-bank players, vulnerability in the legacy IT systems –  creating a mindset for floating rate deposits hardly appears to be a priority. 

In this context, it is clear that Marginal Costs of Funds Based Lending Rates (MCLRs) have largely come down in line with policy rates. MCLR is built on four components – marginal cost of funds, negative carry on account of cash reserve ratio (CRR), operating costs and tenor premium. Marginal cost of funds is the marginal cost of borrowing and return on net worth for banks. The operating cost includes cost of providing the loan product including cost of raising funds. Tenor premium arises from loan commitments with longer tenors. Some data indicate that while MCLR has indeed tracked policy rates (especially post-demonetization), as liquidity has been abundant, average leading rates have not yet reflected the fall in MCLR rates. This is simply because MCLR reset happens over a period of time depending on the benchmark MCLR used for sanctioning the loans. 

Before jumping the gun that this is a flaw in the structure as the benefit of lower interest rates is significantly lagging, the benefit will be to the borrower when the interest cycle turns. In fact, given that MCLR benchmarks vary from one month to one year, unlike base rate, banks are in a better situation to cut MCLRs, as not the entire book resets immediately. The stakeholders must therefore want for a few more months before concluding on the effectiveness of transmission on eventual lending rates. 

Infrastructure and Asian Infrastructure and Investment Bank. Some Scattered Thoughts.

What is Infrastructure?

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Infrastructure, though definitionally an elusive term, encompasses an economic standpoint consisting of large capital intensive natural monopolies. The term attains it heterogeneity by including physical structures of various types used by many industries as inputs to the production of goods and services. By this, it has come to mean either social, or economic infrastructure, wherein, in the former, are schools, hospitals etc, while in the latter are energy, water, transport, and digital communications, often considered essential ingredients in the success of the modern economy. Conceptually, infrastructure may affect aggregate output in two main ways: (i) directly, considering the sector contribution to GDP formation and as an additional input in the production process of other sectors; and (ii) indirectly, raising total factor productivity by reducing transaction and other costs thus allowing a more efficient use of conventional productive inputs. Infrastructure can be considered as a complementary factor for economic growth. How big is the contribution of infrastructure to aggregate economic performance? The answer is critical for many policy decisions – for example, to gauge the growth effects of fiscal interventions in the form of public investment changes, or to assess if public infrastructure investments can be self-financing.

Let us ponder on this a bit and begin with the question. Why is infrastructure even important? Extensive and efficient infrastructure is critical for ensuring the effective functioning of the economy, as it is an important factor determining the location of economic activity and the kinds of activities or sectors that can develop in a particular economy. Well-developed infrastructure reduces the effect of distance between regions, integrating the national market and connecting it at low cost to markets in other countries and regions. In addition, the quality and extensiveness of infrastructure networks significantly impact economic growth and affect income inequalities and poverty in a variety of ways. A well-developed transport and communications infrastructure network is a prerequisite for the access of less-developed communities to core economic activities and services. Effective modes of transport, including quality roads, railroads, ports, and air transport, enable entrepreneurs to get their goods and services to market in a secure and timely manner and facilitate the movement of workers to the most suitable jobs. Economies also depend on electricity supplies that are free of interruptions and shortages so that businesses and factories can work unimpeded. Finally, a solid and extensive communications network allows for a rapid and free flow of information, which increases overall economic efficiency by helping to ensure that businesses can communicate and decisions are made by economic actors taking into account all available relevant information. There is an existing correlation between infrastructure and economic activity through which the economic effects originate in the construction phase and rise during the usage phase. The construction phase is associated with the short-term effects and are a consequence of the decisions in the public sector that could affect macroeconomic variables: GDP, employment, public deficit, inflation, among others. The public investment expands the aggregate demand, yielding a boost to the employment, production and income. The macroeconomic effects at a medium and long term, associated with the utilization phase are related to the increase of productivity in the private sector and its effects over the territory. Both influence significantly in the competitiveness degree of the economy. In conclusion, investing in infrastructure constitutes one of the main mechanisms to increase income, employment, productivity and consequently, the competitiveness of an economy. Is this so? Well, thats what the economics textbook teaches us, and thus governments all over the world turn to infrastructure development as a lubricant to maintain current economic output at best and it can also be the basis for better industry which contributes to better economic output. Governments, thus necessitate realignment of countries’ infrastructure in tune with the changing nature of global political economy. Infrastructure security and stability concerns the quantity of spare capacity (or security of supply). Instead of acting on the efficiency frontier, infrastructure projects must operate with spare capacity to contribute to economic growth through ensuring reliable service provisions. Spare capacity is a necessary condition for a properly functioning system. To assure the level of spare capacity in the absence of storage and demand, the system needs to have excess supply. However, no rational profit-seeker will deliberately create conditions of excess supply, since it would produce a marginal cost lower than the average cost, and to circumnavigate this market failure, governments are invested with the responsibility of creating incentives ensuring securities of supply. This is seeding the substitutability of economics with financialization. 

So far, so good, but then, so what? This is where social analysts need to be incisive in unearthing facts from fiction and this faction is what constitutes the critique of development, a critique that is engineered against a foci on GDP-led growth model. This is to be done by asking uncomfortable questions to policy-makers, such as: What is the most efficient way to finance infrastructure spending? What are optimal infrastructure pricing, maintenance and investment policies? What have proven to be the respective strengths and weaknesses of the public and private sectors in infrastructure provision and management, and what shapes those strengths and weaknesses? What are the distributional consequences of infrastructure policies? How do political forces impact the efficiency of public sector provision? What framework deals best with monopoly providers of infrastructure? For developing countries, which have hitherto been plagued by weaker legal systems making regulation and enforcement more complicated, the fiscally weak position leads to higher borrowing costs. A most natural outcome is a systemic increase in financial speculation driven by deregulation transforming into financial assets. Contrary to common sense and what civil society assumes, financial markets are going deeper and deeper into the real economy as a response to the financial crisis, so that speculative capital is structurally being intertwined with productive capital changing the whole dynamics of infrastructure investment. The question then is, how far viable or sustainable are these financial interventions? Financialization produces effects which can create long-term trends (such as those on functional income distribution) but can also change across different periods of economic growth, slowdown and recession. Interpreting the implications of financialization for sustainability, therefore, requires a methodological diverse and empirical dual-track approach which combines different methods of investigations. Even times of prosperity, despite their fragile and vulnerable nature, can endure for several years before collapsing due to high levels of indebtedness, which in turn amplify the real effects of a financial crisis and hinder the economic growth. 

Role of Development Banks and AIIB

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Where do development banks fit into the schema as regards infrastructure investment? This question is a useful gamble in order to tackle AIIB, the new kid on the bloc. As the world struggles to find funds to meet the Sustainable Development Goals (SDGs), development banks could be instrumental in narrowing the gap. So, goes the logic promulgated by these banks. They can help to crowd-in the private sector and anchor private-public sector partnerships, particularly for infrastructure financing. However, misusing development banks can lead to fiscal risks and credit market distortions. To avoid these potential pitfalls, development banks need a well-defined mandate, operate without political influence, focus on addressing significant market failures, concentrate on areas where the private sector is not present, monitor and evaluate interventions and adjust as necessary to ensure impact, and, finally, be transparent and accountable. All of these are the ideals, which more often than not go the other way. China-led Asian Infrastructure Investment Bank (AIIB), despite having no track record still enjoys the highest ratings on par with the World Bank. This has fueled debates ranging from adding much-needed capital augmenting infrastructure to leniency in observing high standards of governance, and possibly ignoring environmental and societal impacts.

The AIIB was officially launched in Beijing on January 16th, 2016, with 57 founding members, including 37 in Asia and 20 non-regional countries. Being the largest shareholder of the AIIB, China has an initial subscription of $29.78 billion in authorized capital stock in the AIIB out of a total of $100 billion, and made a grant contribution of another $50 million to the AIIB Project Preparation Special Fund on January 16th, 2017. India is the second-largest shareholder, contributing $8.4 billion. Russia is the third-largest shareholder, contributing $6.5 billion, and Germany is the largest non-regional shareholder (also the fourth largest shareholder), contributing $4.5 billion. While being open to the participation of non-regional members, the AIIB is committed to and prioritizes the ownership of Asian members. This is reflected in the capital structure requirement and the requirements for the composition of Board of Governors in the AIIB’s Article of Agreement (AOA), which requires no less than 75 percent of the total subscribed capital stock to be held by regional members unless otherwise agreed by the Board of Governors by a Super Majority vote. The AOA also requires that 9 out of the AIIB’s 12 members be elected by the Governors representing regional members, and 3 representing non-regional members. The prioritization of Asian-members’ ownership of the AIIB does not necessarily mean that the AIIB’s investment is restricted only to Asia. According to its AOA, the AIIB aims to “improve infrastructure connectivity in Asia,” and it will invest in Asia and beyond as long as the investment is “concerned with economic development of the region.” The bank currently has 64 member states while another 20 are prospective members for a total of 84 approved members. 

The AIIB’s EU/OECD members potentially could have some positive influence over the institutional building and standard setting of the young institution. The European Commission has recognized that an EU presence in China-driven institutions would contribute to the adoption of best practices and fair, global standards. Adherence to such standards will be promoted by the AIIB entering into partnership with existing Multilateral Development Banks. It has also been argued that joining the AIIB would give the European countries access to the decision-making process within the AIIB, and may even allow the European countries to play a role in shaping the AIIB’s organizational structure. As an example of EU/OECD members’ activism in monitoring the AIIB’s funds allocation, both Denmark and the UK, who are AIIB’s OECD members, proposed that contributions to the AIIB would qualify as official development aid (ODA). After a thorough review of AIIB’s AOA, mandate, work plan and other available materials, the OECD’s Secretariat of the Development Assistance Committee (DAC) recommended including AIIB on the List under the category of “Regional development banks,” which means the OECD would recognize the AIIB as one of the ODA-eligible international organizations. Once approved, the Secretariat of DAC will be able to “monitor the future recipient breakdown of the AIIB’s borrowers through AIIB’s future Creditor Reporting System and thereby confirm that the actual share of funds going to countries on the DAC List of ODA Recipients is over 90%.” That is to say, if approved, there would be additional external monitor to make sure that the funds channeled through the AIIB to recipient countries are used properly. 

The AIIB’s initial total capital is $100 billion, equivalent to about 61 percent of the ADB’s initial total capital, 43 percent of the World Bank’s, 30 percent of the European Investment Bank’s (EIB), and more than twice of the European Bank for Reconstruction and Development’s (EBRD). Of this $100 billion initial capital, 20 percent is to be largely paid-in by 2019 and fully paid-in by 2024, and the remaining 80 percent is in callable capital. It needs to be noted that according to the AOA, payments for paid-in capital are due in five installments, with the exception of members designated as less developed countries, who may pay in ten installments. As of any moment, the snapshot of AIIB’s financial sheet includes total assets, members’ equities and liabilities, the last of which has negligible debt at the current stage since the AIIB has not issued any debenture or borrowed money from outside. However, to reduce the funding costs and to gain access to wider source of capital, the AIIB cannot rely solely on equity and has to issue debenture and take some leverage, particularly given that the AIIB intends to be a for-profit institution. In February 2017, the AIIB signed an International Swaps and Derivatives Association (ISDA) Master Agreement with the International Finance Corporation (IFC), which would facilitate local currency bond issuance in client countries. Moreover, AIIB intends to actively originate and lead transactions that mobilize private capital and make it a trusted partner for all parties involved in the transactions that the Bank leads. In the long term, the AIIB aims to be the repository of know-how and best practices in infrastructure finance. 

It is widely perceived that the AIIB is a tool of Chinese foreign policy, and that it is a vehicle for the implementation of the Belt and Road (One Belt, One Road) Initiative. During a meeting with global executives in June 2016, the AIIB President Jin Liqun clarified China’s position, saying the AIIB “was not created exclusively for this initiative,” and that the AIIB would “finance infrastructure projects in all emerging market economies even though they don’t belong to the Belt and Road Initiative.” It is worth pointing out that despite the efforts on trying to put some distance between the AIIB and the Belt and Road Initiative, there is still a broad perception that these two are closely related. Moreover, China has differentiated AIIB projects from its other foreign assistance projects by co-financing its initial projects with the preexisting MDBs. Co-financing, combined with European membership, will make it more likely this institution largely conforms to the international standards” and potentially will steer the AIIB away from becoming solely a tool of Chinese foreign policy. This supports China’s stated intention to complement existing MDBs rather than compete with them. It also means that the AIIB can depend on its partners, if they would allow so, for expertise on a wide range of policy and procedural issues as it develops its lending portfolio.

Although AIIB has attracted a great number of developing and developed countries to join as members and it has co-financed several projects with other MDBs, there is no guarantee for any easy success in the future. There are several formidable challenges for the young multilateral institution down the road. Not all the infrastructure investment needs in Asia is immediately bankable and ready for investors’ money. Capital, regardless it’s sovereign or private, will not flow in to any project without any proper preparation. Although Asia faces a huge infrastructure financing gap, there is a shortage of ‘shovel-ready’ bankable projects owing to the capacity limitations. The young AIIB lacks the talent and expertise to create investor-ready bankable projects, despite that it has created a Project Preparation Special Fund thanks to $50 million by China. The AIIB aims to raise money in global capital markets to invest in the improvement of trans-regional connectivity. However, infrastructure projects are not naturally attractive investment due to huge uncertainties throughout the entire life cycle as well as unjustified risk-profit balance. Getting a top-notch credit rating is just a start. The AIIB has to find innovative ways to improve the risk-adjusted profitability of its projects. This issue itself has been a big challenge for many MDBs who engage in infrastructure financing for a long time. It is uncertain if the AIIB could outperform the other much more matured MDBs to find a solution to tackle the profitability problem in infrastructure financing. The highest rating it has received from ratings agencies could pose a challenge in itself. The high rating not only endorses the bank’s high capital adequacy and robust liquidity position, but also validates the strong political will of AIIB’s members and the bank’s governance frameworks. A good rating will help the AIIB issue bonds at favorable rate and utilize capital markets to reduce its funding costs. This certainly will contribute to AIIB’s efforts to define itself as a for-profit infrastructure investment bank. However, there is no guarantee that the rating will hold forever. Many factors may impact the rating in the future, including but not limited to AIIB’s self-capital ratio, liquidity, management, yieldability, risk management ability, and its autonomy and independency from China’s influence. 

Global Significance of Chinese Investments. My Deliberations in Mumbai (04/03/2018)

Legends:

What are fitted values in statistics?

The values for an output variable that have been predicted by a model fitted to a set of data. a statistical is generally an equation, the graph of which includes or approximates a majority of data points in a given data set. Fitted values are generated by extending the model of past known data points in order to predict unknown values. These are also called predicted values.

What are outliers in statistics?

These are observation points that are distant from other observations and may arise due to variability in the measurement  or it may indicate experimental errors. These may also arise due to heavy tailed distribution.

What is LBS (Locational Banking statistics)?

The locational banking statistics gather quarterly data on international financial claims and liabilities of bank offices in the reporting countries. Total positions are broken down by currency, by sector (bank and non-bank), by country of residence of the counterparty, and by nationality of reporting banks. Both domestically-owned and foreign-owned banking offices in the reporting countries record their positions on a gross (unconsolidated) basis, including those vis-à-vis own affiliates in other countries. This is consistent with the residency principle of national accounts, balance of payments and external debt statistics.

What is CEIC?

Census and Economic Information Centre

What are spillover effects?

These refer to the impact that seemingly unrelated events in one nation can have on the economies of other nations. since 2009, China has emerged a major source of spillover effects. This is because Chinese manufacturers have driven much of the global commodity demand growth since 2000. With China now being the second largest economy in the world, the number of countries that experience spillover effects from a Chinese slowdown is significant. China slowing down has a palpable impact on worldwide trade in metals, energy, grains and other commodities.

How does China deal with its Non-Performing Assets?

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China adopted a four-point strategy to address the problems. The first was to reduce risks by strengthening banks and spearheading reforms of the state-owned enterprises (SOEs) by reducing their level of debt. The Chinese ensured that the nationalized banks were strengthened by raising disclosure standards across the board.

The second important measure was enacting laws that allowed the creation of asset management companies, equity participation and most importantly, asset-based securitization. The “securitization” approach is being taken by the Chinese to handle even their current NPA issue and is reportedly being piloted by a handful of large banks with specific emphasis on domestic investors. According to the International Monetary Fund (IMF), this is a prudent and preferred strategy since it gets assets off the balance sheets quickly and allows banks to receive cash which could be used for lending.

The third key measure that the Chinese took was to ensure that the government had the financial loss of debt “discounted” and debt equity swaps were allowed in case a growth opportunity existed. The term “debt-equity swap” (or “debt-equity conversion”) means the conversion of a heavily indebted or financially distressed company’s debt into equity or the acquisition by a company’s creditors of shares in that company paid for by the value of their loans to the company. Or, to put it more simply, debt-equity swaps transfer bank loans from the liabilities section of company balance sheets to common stock or additional paid-in capital in the shareholders’ equity section.

Let us imagine a company, as on the left-hand side of the below figure, with assets of 500, bank loans of 300, miscellaneous debt of 200, common stock of 50 and a carry-forward loss of 50. By converting 100 of its debt into equity (transferring 50 to common stock and 50 to additional paid-in capital), thereby improving the balance sheet position and depleting additional paid-in capital (or using the net income from the following year), as on the right-hand side of the figure, the company escapes insolvency. The former creditors become shareholders, suddenly acquiring 50% of the voting shares and control of the company.

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The first benefit that results from this is the improvement in the company’s finances produced by the reduction in debt. The second benefit (from the change in control) is that the creditors become committed to reorganizing the company, and the scope for moral hazard by the management is limited. Another benefit is one peculiar to equity: a return (i.e., repayment) in the form of an increase in enterprise value in the future. In other words, the fact that the creditors stand to make a return on their original investment if the reorganization is successful and the value of the business rises means that, like the debtor company, they have more to gain from this than from simply writing off their loans. If the reorganization is not successful, the equity may, of course, prove worthless.

The fourth measure they took was producing incentives like tax breaks, exemption from administrative fees and transparent evaluations norms. These strategic measures ensured the Chinese were on top of the NPA issue in the early 2000s, when it was far larger than it is today. The noteworthy thing is that they were indeed successful in reducing NPAs. How is this relevant to India and how can we address the NPA issue more effectively?

For now, capital controls and the paying down of foreign currency loans imply that there are few channels through which a foreign-induced debt sell-off could trigger a collapse in asset prices. Despite concerns in 2016 over capital outflow, China’s foreign exchange reserves have stabilised.

But there is a long-term cost. China is now more vulnerable to capital outflow. Errors and omissions on its national accounts remain large, suggesting persistent unrecorded capital outflows. This loss of capital should act as a salutary reminder to those who believe that China can take the lead on globalisation or provide the investment or currency business to fuel things like a post-Brexit economy.

The Chinese government’s focus on debt management will mean tighter controls on speculative international investments. It will also provide a stern test of China’s centrally planned financial system for the foreseeable future.

Global Significance of Chinese investments

Banking Assets Depreciation, Insolvency and Liquidation: Why are Defaults so Contagious?

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Interlinkages across balance sheets of financial institutions may be modeled by a weighted directed graph G = (V, e) on the vertex set V = {1,…, n} = [n], whose elements represent financial institutions. The exposure matrix is given by e ∈ Rn×n, where the ijth entry e(i, j) represents the exposure (in monetary units) of institution i to institution j. The interbank assets of an institution i are given by

A(i) := ∑j e(i, j), which represents the interbank liabilities of i. In addition to these interbank assets and liabilities, a bank may hold other assets and liabilities (such as deposits).

The net worth of the bank, given by its capital c(i), represents its capacity for absorbing losses while remaining solvent. “Capital Ratio” of institution i, although technically, the ratio of capital to interbank assets and not total assets is given by

γ(i) := c(i)/A(i)

An institution is insolvent if its net worth is negative or zero, in which case, γ(i) is set to 0.

A financial network (e, γ) on the vertex set V = [n] is defined by

• a matrix of exposures {e(i, j)}1≤i,j≤n

• a set of capital ratios {γ(i)}1≤i≤n

In this network, the in-degree of a node i is given by

d(i) := #{j∈V | e(j, i)>0},

which represents the number of nodes exposed to i, while its out-degree

d+(i) := #{j∈V | e(i, j)>0}

represents the number of institutions i is exposed to. The set of initially insolvent institutions is represented by

D0(e, γ) = {i ∈ V | γ(i) = 0}

In a network (e, γ) of counterparties, the default of one or several nodes may lead to the insolvency of other nodes, generating a cascade of defaults. Starting from the set of initially insolvent institutions D0(e, γ) which represent fundamental defaults, contagious process is defined as:

Denoting by R(j) the recovery rate on the assets of j at default, the default of j induces a loss equal to (1 − R(j))e(i, j) for its counterparty i. If this loss exceeds the capital of i, then i becomes in turn insolvent. From the formula for Capital Ration, we have c(i) = γ(i)A(i). The set of nodes which become insolvent due to their exposures to initial defaults is

D1(e, γ) = {i ∈ V | γ(i)A(i) < ∑j∈D0 (1 − R(j)) e(i, j)}

This procedure may be iterated to define the default cascade initiated by a set of initial defaults.

So, when would a default cascade happen? Consider a financial network (e, γ) on the vertex set V = [n]. Set D0(e, γ) = {i ∈ V | γ(i) = 0} of initially insolvent institutions. The increasing sequence (Dk(e, γ), k ≥ 1) of subsets of V defined by

Dk(e, γ) = {i ∈ V | γ(i)A(i) < ∑j∈Dk-1(e,γ) (1−R(j)) e(i, j)}

is called the default cascade initiated by D0(e, γ).

Thus Dk(e, γ) represents the set of institutions whose capital is insufficient to absorb losses due to defaults of institutions in Dk-1(e, γ).

Thus, in a network of size n, the cascade ends after at most n − 1 iterations. Hence, Dn-1(e, γ) represents the set of all nodes which become insolvent starting from the initial set of defaults D0(e, γ).

Consider a financial network (e, γ) on the vertex set V = [n]. The fraction of defaults in the network (e, γ) (initiated by D0(e, γ) is given by

αn(e, γ) := |Dn-1(e, γ)|/n

The recovery rates R(i) may be exogenous or determined endogenously by redistributing assets of a defaulted entity among debtors, proportionally to their outstanding debt. The latter scenario is too optimistic since in practice liquidation takes time and assets may depreciate in value due to fire sales during liquidation. When examining the short term consequences of default, the most realistic assumption on recovery rates is zero: Assets held with a defaulted counterparty are frozen until liquidation takes place, a process which can in practice take a pretty long time to terminate.

BASEL III: The Deflationary Symbiotic Alliance Between Governments and Banking Sector. Thought of the Day 139.0

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The Bank for International Settlements (BIS) is steering the banks to deal with government debt, since the governments have been running large deficits to deal with the catastrophe of BASEL 2-inspired mortgaged-backed securities collapse. The deficits are ranged anywhere between 3 to 7 per cent of the GDP, and in cases even higher. These deficits were being used to create a floor under growth by stimulating the economy and bailing out financial institutions that got carried away by the wholesale funding of real estate. And this is precisely what BASEL 2 promulgated, i.e. encouraging financial institutions to hold mortgage-backed securities for investments.

In comes the BASEL 3 rules that implore than banks must be in compliance with these regulations. But, who gets to decide these regulations? Actually, banks do, since they then come on board for discussions with the governments, and such negotiations are catered to bail banks out with government deficits in order to oil the engine of economic growth. The logic here underlines the fact that governments can continue to find a godown of sorts for their deficits, while the banks can buy government debt without any capital commitment and make a good spread without the risk, thus serving the interests of the both parties involved mutually. Moreover, for the government, the process is political, as no government would find it acceptable to be objective in its viewership of letting a bubble deflate, because any process of deleveraging would cause the banks to offset their lending orgy, which is detrimental to the engineered economic growth. Importantly, without these deficits, the financial system could go down the deflationary spiral, which might turn out to be a difficult proposition to recover if there isn’t any complicity in rhyme and reason accorded to this particular dysfunctional and symbiotic relationship. So, whats the implication of all this? The more government debt banks hold, the less overall capital they need. And who says so? BASEL 3.

But, the mesh just seems to be building up here. In the same way that banks engineered counterfeit AAA-backed securities that were in fact an improbable financial hoax, how can countries that have government debt/GDP ratio to the tune of 90 – 120 per cent get a Standard&Poor’s ratings of a double-A? They have these ratings because they belong to a apical club that gives their members exclusive rights to a high rating even if they are irresponsible with their issuing of debts. Well, is that this simple? Yes and no. Yes, as is above, and no is merely clothing itself in a bit of an economic jargon, in that these are the countries where the government debt can be held without any capital against it. In other words, if a debt cannot be held, it cannot be issued, and that is the reason why countries are striving for issuing debts that have a zero weighting.

Let us take snippets across gradations of BASEL 1, 2 and 3. In BASEL 1, the unintended consequences were that banks were all buying equity in cross-owned companies. When the unwinding happened, equity just fell apart, since any beginning of a financial crisis is tailored to smash bank equities to begin with. Thats the first wound to rationality. In BASEL 2, banks were told to hold as much AAA-rated paper as they wanted with no capital against it. What happened if these ratings were downgraded? It would trigger a tsunami cutting through pension and insurance schemes to begin with forcing them to sell their papers and pile up huge losses meant to absorbed by capital, which doesn’t exist against these papers. So whatever gets sold is politically cushioned and buffered for by the governments, for the risks cannot be afforded to get any more denser as that explosion would sound the catastrophic death knell for the economy. BASEL 3 doesn’t really help, even if it mandated to hold a concentrated portfolio of government debt without any capital against it, for absorption of losses in case of a crisis hitting would have to exhumed through government bail-outs in scenarios where government debts are a century plus. So, are the banks in-stability, or given to more instability via BASEL 3?  The incentives to ever more hold government securities increase bank exposure to sovereign bonds, adding to existing exposure of government securities via repurchase transactions, investments and trading inventories. A ratings downgrade results in a fall in value of bonds triggering losses. Banks would then face calls for additional collateral, which would drain liquidity, and which would then require additional capital as way of compensation. where would this capital come in from, if not for the governments to source it? One way out would be recapitalization through government debt. On the other hand, the markets are required to hedge against the large holdings of government securities and so short stocks, currencies and insurance companies are all made to stare in the face of volatility that rips through them, of which the net resultant is falling liquidity. So, this vicious cycle would continue to cycle its way through any downgrades. And thats why the deflationary symbiotic alliance between the governments and banking sector isn’t anything more than high-fatigue tolerance….