Monetary Policy

Monetary policy intends to achieve a balance between excess and shortage of money supply in the market/economy. These policies are concerned to the supply/control of money. It influences the pace and direction of economic activity, money supplies, interest rates, borrowing and price level.

In the case of shortage of money on the economy the growth gets hampered which has negative impact on the prosperity of people. On the other hand if there is excess of money in the market, the prices of goods and services goes up and severely impacts the poor. The government/RBI needs to make sure that the sufficient money is available with market for the growth without affecting the poor.

The main objectives of monetary policy are –

Maintaining the price stability

Inflation has strong negative impact on social welfare and needs to be maintained at lower level.

High and stable employment

Employment opportunities could be increased by higher investment and economic activities, which in turn requires availability of credit at reasonable interest rates.

Economic growth

Adequate credit is required for the productive activities and hence sound monetary policy is required for supporting the growth in an economy

Stability of exchange rates

Exchange rate (amount of dollars per Rupees) is a crucial factor determining a country’s position in the international trade (import and export). Increase in the exchange rate () discourages export and enhances imports and vice versa. The current increase in exchange rate(appreciation of rupees against dollars) had a negative impact on the IT industry which is mainly based on export.

Fluctuation in exchange rates makes the planning difficult for the traders and hence monetary policy should aim on preventing any sharp fluctuation in the exchange rate.

Sectoral deployment of finds

Depending upon the priorities laid down in the plans/by government, Monetary Policy (RBI) determines the allocation of funds and interest rates among different sectors. Examples: Priority sector lending; recent move to increase interest rate on housing loans.

Are Indian Banks Ready for Basel II ?

As the days approaching for the implementation of Basel II in India, it becomes important evaluating the impact of the norms on Indian banking system.

As per RBI guidelines, Indian banks having foreign branches and foreign banks operating in India will have to adopt the regulations under Basel II by March 31, 2008. Except local area banks and regional rural banks, all the other commercial banks will have to migrate to Basel II by March 31, 2009.

After the implementation of these norms(more on these norms here ), banks will have to adopt Standardised Approach for credit risk and Basic Indicator Approach for operational risk for computing their capital requirements for these risks. In the later stage banks can move to Internal Rating-Based approach for credit risk and Advanced Measurement or Standardised Approach for operational risk with due permission from RBI.

Bank in India are going to witness significant impact on credit risk weight and operational risk weight with the implementation of Basel II. The norm provides an opportunity to Indian banks to reduce the required regulatory capital for credit risk by reducing the credit risk weight. As the RBI has lowered the credit risk for retail exposure to 75% as against current risk weight of 125% for personal/credit card loans and 100% for other loans, bank can change their portfolio accordingly to minimise the regulatory capital and increase their business. Apart from this, Indian banks have large short term portfolio which includes cash credit, overdraft and working capital demand loans, which are currently unrated and hence carry a risk weight of 100%. The RBI guidelines for short term investment provide for lower risk weights and that gives further reduction in the regulatory capital reserve. Hence this norm does bring an opportunity for Indian banks to reduce their credit risk weights and reduce their required regulatory capital. But, looking at the operational risk, the Basic Indicator Approach specifies a capital charge of 15% of annual positive gross income over the past three years, which does not help banks in reducing the required capital for operational risk.

The NPA has largely been reduced by provisioning for bad debt or by infusion of capital from government or other sources. But, with the implementation of Basel II norms, banks would need more capital and it would have to arrange for capital outside of their own or the government resources. In ICRA’s estimates, Indian banks would need additional capital of up to 120 billion Rs to meet the capital requirement for operational risk. Looking at the asset growth witnessed in the past and the expected growth trend, the capital charge requirement for operational risk will grow by 15-20% annually over three years. To meet this additional capital, large number of banks have been forced to turn to capital market with IPOs and FPOs. This further has its own impact on the banking structure as it demands for dilution of government ownership on these banks. Government was forced to increase the FDI limit by 74% in banking sector to help these banks raise the required capital. These moves in the sector have grown pressure to consolidate domestic banks to make them capable of facing international competition. Given the significant dominance of foreign banks over the domestic counterparts, even after the consolidation of domestic banks the threat of takeover remains if the FDI limit is further relaxed.

Thus, the large scale presence of foreign banks and consolidation of Indian banks are inevitable post Basel II.

Sub-prime fallout on banks

Effect on third quarter results:

Citigroup
CEO Chuck Prince likely to resign
Net profit of $ 2.4b against profit of $5.5b in the same quarter last year

Bank of America (BofA)
Slashed 3,000 jobs
The company is also exiting the wholesale mortgage business.
Net profit of $ 3.7b against profit of $5.4b in the same quarter last year

Merrill Lynch
CEO Stanley O'Neal resigned from his post on Oct. 30
Net loss of $ 2.2b against profit of $3.1b in the same quarter last year

Deutsche Bank (biggest private German bank)
Third-quarter write-downs of €2.16 billion($3.17 billion)
Investment arm reported a pre-tax loss of €179m
Total earnings up y 31% at €1.62 billion(US$2.3 billion)

Bear Stearns
Co-president and COO Warren Spector had to exit because of two Bear Stearns hedge funds meltdown.
600 job cuts in mortgage and investment banking businesses.
New York-based Bear booked a $200 million loss in the third quarter related to the hedge funds. Quarterly net income in the period ending August 2007 dropped 61% to $171.3 million.
Revenue fell to $1.3 billion from $2.13 billion last year.

Lehman Brothers
Closed its subprime mortgage unit BNC Mortgage in August and cut down 1,200 jobs.
$700 million write-down in third-quarter
Third quarter results to be declared on November 8

Morgan Stanley
Cut 600 jobs, scaled down its residential mortgage business.
Income fell to $1.47 billion from $1.59 billion.

Wachovia
Net Income decreased to $1.7b from $1.9 billion Quarter on Quarter basis while it was $2.3 billion in previous quarter of this year.

UBS (biggest Swiss bank)
Third-quarter loss of 830 million Swiss francs ($712 million) vs. a profit of 2.2 billion

Credit Suisse (the second-biggest Swiss bank)
Write-downs of 2.2 billion Swiss francs in the third
decline in net income to $1.1 billion, down 31 percent from the previous quarter.

Countrywide
Loss of $1.2b in third quarter against profit of $0.6b previous year.
First Quarterly Loss in 25 Years

Goldman Sachs
Reportedly made money on subprime business due to short positions

Are Basel norms really complicated?

The core business of banks is to take deposit from public and lend to individuals, industries, business etc. These loans carry risk of becoming bad debt (debtor is unable to return its debt) and hence non-performing. Since the major deposit of bank comes from public, the government and regulatory authorities are worried that the bank might be tempted to operate on thin capital and expose the depositors to undue credit risk. Therefore, banks all over world are required to keep a specified percentage of their loan portfolio as capital and if some loan goes bad, the loss is borne by the capital and not by depositors. Banks hence are required to maintain a capital adequacy ratio specified by the regulatory bodies.

Basel norm is a framework of capital adequacy for banks. These norms set the guidelines to estimate the amount of capital assets of specified kind should bank hold to absorb losses. The assessment of such losses that bank can incur decides the proportion of liquid asset banks must have at hand to meet those losses in case they are incurred. The loss can be based on the risk exposure i.e. credit, operational or market risks etc. The higher the risk of loss associated with an investment, the more of liquid asset will have to be maintained. A 100 percent risk-weight loss implies that the whole of the investment can be lost under certain conditions and a zero percent risk-weight indicates that the concerned asset is risk-free.

The Basel II norms is improvement over the earlier Basel I norms. India had adopted Basel I in 1999 and subsequently based upon recommendation of Steering committee , the Reserve Bank of India (RBI) issued draft guidelines for Basel II in 2005. Three major inadequacy of Basel I norms were –

1. Non-differentiation: The norms treated all borrowers alike.
2. No weightage was given to availability of security for credit facility.
3. It treated loans of varying maturity in the same manner.

Regarding the first issue, in Basel I, banks were required to keep 8 percent of loan as capital, whether the borrower is a first class blue chip company, with little or no risk, or it is a third rate company with poor track record. Basel II introduced the concept of 5 different risk weights, 20%, 30%, 50%, 100% and 150%. For the highest rated borrower, banks need to keep only 20% of 8 percent or 1.6 percent (8x 20%) of the credit exposure as capital. The RBI has retained the higher base level of 9 percent against world level of 8%.

For the second issue, value of security has been given due consideration while computing the capital charge for a loan.

Taking the last point, the Basel I rule prescribed the same amount of capital whether the loan was for a short period or for a very long period. As the period gets longer the risk associated with the loan increases. Basel II has made some distinction between short and long-term loans given by one bank to another.

The “credit worthiness” is to be determined by the rating accorded by independent credit rating agencies. And over a period of time, the credit rating given by banks themselves for borrowers could be adopted.

The operational risk is covered by Basic Indicator Approach which prescribes a capital charge of 15 per cent of the average gross income for the preceding three years to be maintained.

The revised framework of Basel II, consists of three-mutually reinforcing pillars –

1. Minimum capital requirements,
   
2. Supervisory review of capital adequacy and
   
3. Market discipline.

The first pillar offers three distinct options for computing capital requirement for credit risk and three other options for computing capital requirement for operational risk. The different options for credit risk are Standardized approach, Foundation Internal Rating-Based approach and Advanced Internal Rating-Based Approach. The available options for computing capital for operational risk are Basic indicator approach, Standardized approach and Advanced Measurement approach.

The second pillar is concerned with supervisory review process by national regulators for ensuring assessment of risk and associated capital adequacy of banking institutions.

The third pillar provides norms of disclosure by banks of key information regarding their risk exposure & capital positions and hence aims at improving market disciple.

Gyaan on Banking sector

Banks - how they function - they basically take money from people who have money and give to those who need it on a higher interest

First Indian bank was started way back in 1786 around. But that bank is not functioning now

Oldest Indian bank which is functioning now is SBI, established in 1806, which was known at that time as "Bank of Bengal"

Most of the old banks were headquartered at Calcutta, as it was prime centre of trade

After Independence, most of the banks were nationalised. In 1991 private banks were also allowed to function.

Some Public sector banks – SBI and its subsidiaries, Bank of India, Allahabad Bank, Bank of Baroda etc

Some Private owned banks – ICICI, HDFC, UTI Bank etc.

Banking Terminology
CAR – cash adequacy ratio – basically, government wants banks to keep some amount of money in cash.

CRR – cash reserve ratio – presently 6.75% in India – it is the ratio of cash to net demands and time liabilities (NDTL) of bank. RBI asks bank to keep a certain percent of amount of NDTL in form of cash. This ratio varies between 3 to 20%

SLR – statuary liquidity ratio - It is the amount of money that bank has to deposit to RBI. This rate varies from 25% to 40%

Securitization

This article tries to explain what is securitization. Lets consider what a bank does? A bank gives loans to its borrowers. If it is a small bank we call it as a sub originator and this small bank transfers these loan to a bigger bank which is called as originator. Now, this originator can sell off this loans to a trust and get money. And this trust sells of these loans in form of bonds to various bond holders

Now this trust collects money from the bondholders and gives it to Originator. And now this originator can lend of this money to more borrowers. Selling off the loans to a trust is known as Securitization.