Demystifying Monetary Systems CA. Sunny Sabharwal

Some basics Financial Market A market where funds (finance) are taken from those who have surplus (investors) and provided to those who need it (business) Who are financial intermediaries? Banks, insurance companies, NBFCs, etc. What is relevance of financial market? An efficient financial market encourages & channelizes investments and hence fuels business growth Shares and bonds markets most crucial; major funding sources for corporates

Financial Market

A market where funds (finance) are taken from those who have surplus (investors) and provided to those who need it (business)

Who are financial intermediaries?

Banks, insurance companies, NBFCs, etc.

What is relevance of financial market?

An efficient financial market encourages & channelizes investments and hence fuels business growth

Shares and bonds markets most crucial; major funding sources for corporates

Monetary System Investors SEBI RBI Regulators Financial Intermediary Business NBFCs Insurance Cos. Banks Investment Loan Control Interest Return

Responsibilities of a Bank Head Liquidity Management : Ensuring enough liquidity to honoring liabilities Liability Management : Acquire funds at low cost Asset Management : The risk-profile, tenure and class of assets in which to invest funds Capital Management : Match requirement of capital (of RBI and Reserves) Principle in Banking: Borrow Long, lend short Source : RBI

Liquidity Management : Ensuring enough liquidity to honoring liabilities

Liability Management : Acquire funds at low cost

Asset Management : The risk-profile, tenure and class of assets in which to invest funds

Capital Management : Match requirement of capital (of RBI and Reserves)

Typical Balance Sheet of a Bank LIABILITY (OUTFLOWS) ASSET (INFLOWS) 1 Capital 1 Cash & Balances with RBI 2 Reserves & Surplus 2 Balances with Banks & Money at call/Short-notice 3 Deposits 3 Investments 4 Borrowings 4 Advances 5 Other Liabilities & Provisions 5 Fixed Assets 6 Contingent Liabilities 6 Other Assets

Major factors that affect money Interest Rate Inflation Monetary Policies Business Growth Investor Sentiment

Interest Rate

Inflation

Monetary Policies

Business Growth

Investor Sentiment

Interest Rate Consists of – TVM (Cost of money) Inflation Risk Premium Determined by: Monetary Policy Inflation Risk Demand & Supply of Money (bonds and money market) Fall/increase in interest rate -> increases/decreases bonds prices Repercussions Expected return on bonds falls Investors switch from bonds to other assets Overall borrowing increases Bond Price (P) = CP1 + FV (1+ r ) 1 (1+r) 2 Factor Relation Effect 1 Monetary Policy Both Easing Policy: Low Interest Rate Tight Policy: High 2 Inflation Direct 3 Risk Direct 4 Demand of Money Direct 5 Supply of Money Indirect

Consists of –

TVM (Cost of money)

Inflation

Risk Premium

Determined by:

Monetary Policy

Inflation

Risk

Demand & Supply of Money (bonds and money market)

Fall/increase in interest rate -> increases/decreases bonds prices

Repercussions

Expected return on bonds falls

Investors switch from bonds to other assets

Overall borrowing increases

1

Monetary Policy

2

Inflation

3

Risk

4

Demand of Money

5

Supply of Money

Inflation Abnormal inflation results in higher interest rates Why: Mathematically : (1+Real Rate) x (1+ Inflation Rate ) = (1+ Nominal Rate ) For people : Reduces incomes & investments Investors now require more return (impetus to invest) For businesses : increases cost of capital; affects ongoing operations reduces expansion plans In-turn is affected by – Demand & Supply: Actual & speculation Expectations Tools for taming – Monetary Policies : tight or easing Government Policies E.g. BPLR

Abnormal inflation results in higher interest rates

Why:

Mathematically : (1+Real Rate) x (1+ Inflation Rate ) = (1+ Nominal Rate )

For people :

Reduces incomes & investments

Investors now require more return (impetus to invest)

For businesses :

increases cost of capital; affects ongoing operations

reduces expansion plans

In-turn is affected by –

Demand & Supply: Actual & speculation

Expectations

Tools for taming –

Monetary Policies : tight or easing

Government Policies

Monetary Policies Purpose : to govern economic variables Mainly used – Policy Rates Repo & Reverse Repo Bank rate CRR, SLR Open market transactions Source : RBI Liquidity Adjustment Facility (LAF) a short-term discretionary instrument for smooth equilibrating of liquidity in the system. The repo and reverse repo interest rates are key signaling rates in the system Policy Tool Meaning Repo Rate at which banks borrow from RBI : Short-term Reverse Repo Rate at which RBI borrows from Banks Bank rate Rate at which banks borrow from RBI : Long-term CRR Amount of cash as a % of deposits to be kept with RBI SLR % of money (after reducing CRR) to be invested in govt. securities

Purpose : to govern economic variables

Mainly used –

Policy Rates

Repo & Reverse Repo

Bank rate

CRR, SLR

Open market transactions

Investor Expectations How different investors’ expectations cause change in prices Using Dividend Discount Model Two investors : A & B Past Dividend : Rs. 10 K e : 15% Different growth rates expected : A (retail investor) = 5% B (industry expert) = 10% Result : Price (A) = Rs.105 Price (B) = Rs. 220 Why different expectations – Asymmetric Information (lack of correct and complete information to some) Personal bias : e.g. a previous loss may prevent from making riskier investments Price (P) = D * (1+g) (K e – g)

How different investors’ expectations cause change in prices

Using Dividend Discount Model

Two investors : A & B

Past Dividend : Rs. 10

K e : 15%

Different growth rates expected :

A (retail investor) = 5%

B (industry expert) = 10%

Result :

Price (A) = Rs.105

Price (B) = Rs. 220

Why different expectations –

Asymmetric Information (lack of correct and complete information to some)

Personal bias : e.g. a previous loss may prevent from making riskier investments

THE CRISIS

The Sub-prime Crisis

Worst hit sectors Information Technology Clients in US/elsewhere going bust Realty Hit from supply side – non-availability of funds Slack sales – high interest rates and job losses Auto SME due to reduced demand from parent industries

Information Technology

Clients in US/elsewhere going bust

Realty

Hit from supply side – non-availability of funds

Slack sales – high interest rates and job losses

Auto

SME

due to reduced demand from parent industries

The Crisis Begun with sub-prime crisis in developed countries Marking to market reduced B/S Led to worldwide liquidity crunch Since capital is required by all businesses; affected all Observed to start affecting India in Sept ’08 “ Lemon Problem” Buyer does not know whether what he is buying is a peach or lemon. In recessionary times, when buyers are more risk-averse, one might forgo a peach fearing of a lemon. This leads to a contagious fear in the market of holding on cash or invest in short-term assets. Experts say : “ 2008 was a recessionary year; 2009 to be consolidating” Source : RBI 2008 2009 GDP 8.9 5.3 Industrial 8.8 2.8 Infra 5.8 3.0

Begun with sub-prime crisis in developed countries

Marking to market reduced B/S

Led to worldwide liquidity crunch

Since capital is required by all businesses; affected all

Observed to start affecting India in Sept ’08

Investor Sentiment The one thing that AFFECTS the MARKET the MOST Main reason behind extreme losses after any crisis Functions both ways – Buyer (Businesses) : Aggressive or Defensive Seller (Lenders) : Risk-takers or Risk-averse Bad thing for the depressed markets – Falls geometrically Recovers arithmetically Till Mid 2008 Markets Since then Buyer (Defensive) Buyer (Aggressive) Seller (Risk-taker) Seller (Risk-averse)

The one thing that AFFECTS the MARKET the MOST

Main reason behind extreme losses after any crisis

Functions both ways –

Buyer (Businesses) : Aggressive or Defensive

Seller (Lenders) : Risk-takers or Risk-averse

Bad thing for the depressed markets –

Falls geometrically

Recovers arithmetically

What RBI is doing Policy rates lowered – Repo, CRR, SLR BPLR Housing loan – Lowering of interest rates Increasing the tenure Relief package for NBFCs thru SPV More loans at lower rates Other measures Permitted banks to issue guarantees for > 10 years SPV : Industrial Development Bank of India Stressed Asset Stabilization Fund (IDBI SASF) One of the main problems faced by banks in India is issue of long-term liabilities at high interest rates

Policy rates lowered –

Repo, CRR, SLR

BPLR

Housing loan –

Lowering of interest rates

Increasing the tenure

Relief package for NBFCs thru SPV

More loans

at lower rates

Other measures

Permitted banks to issue guarantees for > 10 years

What to expect 2009 to be a consolidating year Increased Government expenditure Banking & Infra to be see favorable future Sectors like Realty and Manufacturing to take time More focus on agriculture and MSME sector Balancing of portfolio of banks rather than expansion Things to be more clearer after General Elections

2009 to be a consolidating year

Increased Government expenditure

Banking & Infra to be see favorable future

Sectors like Realty and Manufacturing to take time

More focus on agriculture and MSME sector

Balancing of portfolio of banks rather than expansion

Things to be more clearer after General Elections

Thank You ! Please feel free to contact me at Cell : +91 99586 77766 Email: sabharwal.sunny@yahoo.com