Financial Fragility in the Margins. Thought of the Day 114.0

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If micro-economic crisis is caused by the draining of liquidity from an individual company (or household), macro-economic crisis or instability, in the sense of a reduction in the level of activity in the economy as a whole, is usually associated with an involuntary outflow of funds from companies (or households) as a whole. Macro-economic instability is a ‘real’ economic phenomenon, rather than a monetary contrivance, the sense in which it is used, for example, by the International Monetary Fund to mean price inflation in the non-financial economy. Neo-classical economics has a methodological predilection for attributing all changes in economic activity to relative price changes, specifically the price changes that undoubtedly accompany economic fluctuations. But there is sufficient evidence to indicate that falls in economic activity follow outflows of liquidity from the industrial and commercial company sector. Such outflows then lead to the deflation of economic activity that is the signal feature of economic recession and depression.

Let us start with a consideration of how vulnerable financial futures market themselves are to illiquidity, since this would indicate whether the firms operating in the market are ever likely to need to realize claims elsewhere in order to meet their liabilities to the market. Paradoxically, the very high level of intra-broker trading is a safety mechanism for the market, since it raises the velocity of circulation of whatever liquidity there is in the market: traders with liabilities outside the market are much more likely to have claims against other traders to set against those claims. This may be illustrated by considering the most extreme case of a futures market dominated by intra-broker trading, namely a market in which there are only two dealers who buy and sell financial futures contracts only between each other as rentiers, in other words for a profit which may include their premium or commission. On the expiry date of the contracts, conventionally set at three-monthly intervals in actual financial futures markets, some of these contracts will be profitable, some will be loss-making. Margin trading, however, requires all the profitable contracts to be fully paid up in order for their profit to be realized. The trader whose contracts are on balance profitable therefore cannot realize his profits until he has paid up his contracts with the other broker. The other broker will return the money in paying up his contracts, leaving only his losses to be raised by an inflow of money. Thus the only net inflow of money that is required is the amount of profit (or loss) made by the traders. However, an accommodating gross inflow is needed in the first instance in order to make the initial margin payments and settle contracts so that the net profit or loss may be realized.

The existence of more traders, and the system for avoiding counterparty risk commonly found in most futures market, whereby contracts are made with a central clearing house, introduce sequencing complications which may cause problems: having a central clearing house avoids the possibility that one trader’s default will cause other traders to default on their obligations. But it also denies traders the facility of giving each other credit, and thereby reduces the velocity of circulation of whatever liquidity is in the market. Having to pay all obligations in full to the central clearing house increases the money (or gross inflow) that broking firms and investors have to put into the market as margin payments or on settlement days. This increases the risk that a firm with large net liabilities in the financial futures market will be obliged to realize assets in other markets to meet those liabilities. In this way, the integrity of the market is protected by increasing the effective obligations of all traders, at the expense of potentially unsettling claims on other markets.

This risk is enhanced by the trading of rentiers, or banks and entrepreneurs operating as rentiers, hedging their futures contracts in other financial markets. However, while such incidents generate considerable excitement around the markets at the time of their occurrence, there is little evidence that they could cause involuntary outflows from the corporate sector on such a scale as to produce recession in the real economy. This is because financial futures are still used by few industrial and commercial companies, and their demand for financial derivatives instruments is limited by the relative expense of these instruments and their own exposure to changes in financial parameters (which may more easily be accommodated by holding appropriate stocks of liquid assets, i.e., liquidity preference). Therefore, the future of financial futures depends largely on the interest in them of the contemporary rentiers in pension, insurance and various other forms of investment funds. Their interest, in turn, depends on how those funds approach their ‘maturity’.

However, the decline of pension fund surpluses poses important problems for the main securities markets of the world where insurance and pension funds are now the dominant investors, as well as for more peripheral markets like emerging markets, venture capital and financial futures. A contraction in the net cash inflow of investment funds will be reflected in a reduction in the funds that they are investing, and a greater need to realize assets when a change in investment strategy is undertaken. In the main securities markets of the world, a reduction in the ‘new money’ that pension and insurance funds are putting into those securities markets will slow down the rate of growth of the prices in those markets. How such a fall in the institutions’ net cash inflow will affect the more marginal markets, such as emerging markets, venture capital and financial futures, depends on how institutional portfolios are managed in the period of declining net contributions inflows.

In general, investment managers in their own firms, or as employees of merchant or investment banks, compete to manage institutions’ funds. Such competition is likely to increase as investment funds approach ‘maturity’, i.e., as their cash outflows to investors, pensioners or insurance policyholders, rises faster than their cash inflow from contributions and premiums, so that there are less additional funds to be managed. In principle, this should not affect financial futures markets, in the first instance, since, as argued above, the short-term nature of their instruments and the large proportion in their business of intra-market trade makes them much less dependent on institutional cash inflows. However, this does not mean that they would be unaffected by changes in the portfolio preferences of investment funds in response to lower returns from the main securities markets. Such lower returns make financial investments like financial futures, venture capital and emerging markets, which are more marginal because they are so hazardous, more attractive to normally conservative fund managers. Investment funds typically put out sections of portfolios to specialist fund managers who are awarded contracts to manage a section according to the soundness of their reputation and the returns that they have made hitherto in portfolios under their management. A specialist fund manager reporting high, but not abnormal, profits in a fund devoted to financial futures, is likely to attract correspondingly more funds to manage when returns are lower in the main markets’ securities, even if other investors in financial futures experienced large losses. In this way, the maturing of investment funds could cause an increased inflow of rentier funds into financial futures markets.

An inflow of funds into a financial market entails an increase in liabilities to the rentiers outside the market supplying those funds. Even if profits made in the market as a whole also increase, so too will losses. While brokers commonly seek to hedge their positions within the futures market, rentiers have much greater possibilities of hedging their contracts in another market, where they have assets. An inflow into futures markets means that on any settlement day there will therefore be larger net outstanding claims against individual banks or investment funds in respect of their financial derivatives contracts. With margin trading, much larger gross financial inflows into financial futures markets will be required to settle maturing contracts. Some proportion of this will require the sale of securities in other markets. But if liquidity in integrated cash markets for securities is reduced by declining net inflows into pension funds, a failure to meet settlement obligations in futures markets is the alternative to forced liquidation of other assets. In this way futures markets will become more fragile.

Moreover, because of the hazardous nature of financial futures, high returns for an individual firm are difficult to sustain. Disappointment is more likely to be followed by the transfer of funds to management in some other peripheral market that shows a temporary high profit. While this should not affect capacity utilization in the futures market, because of intra-market trade, it is likely to cause much more volatile trading, and an increase in the pace at which new instruments are introduced (to attract investors) and fall into disuse. Pension funds whose returns fall below those required to meet future liabilities because of such instability would normally be required to obtain additional contributions from employers and employees. The resulting drain on the liquidity of the companies affected would cause a reduction in their fixed capital investment. This would be a plausible mechanism for transmitting fragility in the financial system into full-scale decline in the real economy.

The proliferation of financial futures markets has only had been marginally successful in substituting futures contracts for Keynesian liquidity preference as a means of accommodating uncertainty. A closer look at the agents in those markets and their market mechanisms indicates that the price system in them is flawed and trading hazardous risks in them adds to uncertainty rather than reducing it. The hedging of financial futures contracts in other financial markets means that the resulting forced liquidations elsewhere in the financial system are a real source of financial instability that is likely to worsen as slower growth in stock markets makes speculative financial investments appear more attractive. Capital-adequacy regulations are unlikely to reduce such instability, and may even increase it by increasing the capital committed to trading in financial futures. Such regulations can also create an atmosphere of financial security around these markets that may increase unstable speculative flows of liquidity into the markets. For the economy as a whole, the real problems are posed by the involvement of non-financial companies in financial futures markets. With the exception of a few spectacular scandals, non-financial companies have been wary of using financial futures, and it is important that they should continue to limit their interest in financial futures markets. Industrial and commercial companies, which generate their own liquidity through trade and production and hence have more limited financial assets to realize in order to meet financial futures liabilities in times of distress, are more vulnerable to unexpected outflows of liquidity in proportion to their increased exposure to financial markets. The liquidity which they need to set aside to meet such unexpected liabilities inevitably means a reduced commitment to investment in fixed capital and new technology.

Public Sector Banks Lending, Demonetisation and RBI Norms: an adumbration

How far is it true that in the current scheme of things with stressed assets plaguing the Public Sector Banks on one hand and the recent demonetisation rendering bills of Rs. 500 and Rs. 1000 legally invalid has fuelled once again the debate of these public banks with excess deposits or surplus liquidity in their kitty are roaring to go on a relentless lending, thus pressurising the already existing stressed assets into an explosion of unprecedented nature hitherto unseen? Now, that is quite a long question by a long way indeed. Those on the civil sector spectrum and working on financials leave no stone unturned in admitting that such indeed is the case, and they are not to be wholly held culpable for India’s Finance Minister has at least on a couple of times since the decision to demonetise on 8th November aided such a train of thought by calling upon banks to be ready for such lending to projects, which, if I were to speculate would be under project finance and geared towards the crumbling infrastructure of the country. Assuming if such were the case, then, it undoubtedly stamps a political position for these civil actors, but it would hardly be anything other than a cauldron, since economics would fail to feed-forward such claims.

So, what then is the truth behind this? This post is half-cooked, for it is as a result of an e-mail exchange with a colleague of mine. The answer to the long question above in short is ‘NO’. Let us go about proving it. Reserve Bank of India in no different manner has been toying the switch of a flip-flop in policy makeovers in the wake of demonetisation. But, what the Central Bank and the Regulator of India’s monetary policy has done increase 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.

Moving on, what civil actors perceive, and not totally wrongly is that in the wake of demonetisation, deposits going into the banks are some form of recapitalisation, or capital infusion, which is technically and strictly speaking, not the case. For capital infusion in India happens through a budgetary allocation, and not this route. The RBI even came out with reverse repo, so that banks could purchase government securities from the RBI and thus lend money to the regulator. Thereafter, CRR was raised to 100, which, though incremental in nature would be revised 2 days from now, i.e. on the 9th. This incremental CRR is intended to be a temporary measure within RBI’s liquidity management framework to drain excess liquidity in the system. Though, the regular CRR would be 4, this incremental CRR is precisely to lock down lending going out from surplus deposits/liquidity as a result of Demonetisation. This move by the RBI was necessitated by the fact it at present holds Rs. 7.25 lac crore of rupee securities (G-Secs and T-Bills) and will soon run out of options of going in for reverse repo options, 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 Rs. 10 lac crores by December due to demonetisation. The present equation of Rs. 3.24 lac crore impounded due to CRR and Rs. 7.56 lac crore to be used as open market option (OMO) or reverse repo options 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, i.e. the 7th December, 2016 had been that the RBI would lower the repo rate aggressively by 50 basis points (bps), 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’s. This culminates into liquidity to tighten and send bond yields on a northward blip, and this is where lending would shrink automatically. Hence the banks cannot go after relentless lending, either in the wake or otherwise of demonetisation. QED.