Uma Shashikant
There is the danger of too much information being made available to the common reader on the National Spot Exchange Limited (NSEL) crisis. However, it's difficult to let go of a live example to illustrate fundamental principles. There is no magic or mystery in finance. The premise for sustainable, stable and good quality structures in finance is actually quite simple. Without adequate capital from investors willing to take risks, it is not possible to keep the promises to other investors who expect fixed returns.
This principle plays out in various ways in balance sheets of households, companies, clearing corporations and banks. Building assets requires funding, and the return to the provider of capital depends on how these assets work. If we accept that all asset portfolios, without exception, are risky, we have made a good start. There is no way of finding out in advance how assets will behave, but not all those who provide the funding may be comfortable with this risk. They may expect a fixed rate of return even if the value of the assets they have funded goes up and down. A good portion of the capital available for funding assets may not be able to participate in this economic activity if the promise of a fixed income and repayment of capital after a specific date is not met.
The investors in bank deposits understand that the bank makes risky loans with the money they provide. However, they expect a fixed rate of interest and no risk of default. The investors in the bonds of a company understand that the assets that a company builds may not result in profitable production, sales and profit. Yet, they expect that their bond would be redeemed as promised, and pay the interest as indicated. If the underlying asset is risky, how does one make such promises? If a bank does not know upfront whether the loan will be good or bad, how can it hope to not default on its deposits?
Enter risk capital. Equity investors, who watch this play of risky assets that a business needs to create, and fixed return that an investor wants to earn, see the opportunity. If the assets are risky, it means they may fall or, importantly, rise in value. If the assets turn out to be good and manage to generate a return higher than that wanted by the fixed return investor, there is money to be made. Equity investors, therefore, agree to provide capital to risky businesses, and they accept that there is no promise they will end up holding the assets, whatever the value. Unless the equity investor comes in and accepts the risk of assets, there is no way a business can pay the lenders who seek a fixed return. In return for accepting this risk, equity investors seek liquidity, information disclosure and voting rights.
How much of equity does a business need so that it does not default on the borrowed capital it takes to build assets? If it is possible to evaluate the assets consistently, the fluctuation in their value should determine the equity capital needed. Equity is but an option on the assets of a business, whose exercise price is the value of the liabilities. The implied volatility of the assets will determine the value of the option. In simpler terms, if it can be realistically estimated that the assets may move up or down by 20%, that is the minimum equity capital a business needs, to be able to service its lenders. This is broadly the basis for determining capital adequacy norms for a bank. The methodology to determine the risk in assets is quite sophisticated, and comes under criticism and debate, but the principle is simple. Someone covers the risk of fluctuating asset values so that others can get a fixed return.
Now, cut to the NSEL. In the marketplace, where assets (shares, bonds, commodities) are bought and sold, there is a time gap between trade date and settlement date. This means the sellers and buyers have actually funded one another until the settlement is made, and the underlying asset whose value changes dynamically, is risky. The big difference in this market is that the value of the asset is visible in the traded price. There is no estimation and opinion, but traded price is a verifiable fact. The buyer paying Rs 100 may find that the asset he bought has moved down to Rs 96 when he has to settle. He may have the propensity to default since he has to pay Rs 100 for something that is only worth Rs 96. The seller receiving Rs 100 may similarly have the propensity to default if the price was Rs 104. We now know that the only way this risk can be managed is to ask for a capital of Rs 4 to be committed before the transaction happens. That is the margin of the clearing corporation.
The settlement problem in the NSEL arose from the failure to implement this simple structure. A stable structure, which can guarantee all trades, will have risk management processes. It would ask for funds to be kept in a bank before beginning to trade; it would evaluate outstanding positions at market prices, and ask for additional money to be brought in; it would stop traders from taking fresh positions when the dues from them become too high. What NSEL did was to postpone the settlement to the future without imposing high margins that matched the risk of the underlying commodity. Now, it is struggling to sell the risky asset and make payments to those who were sold fixed rate products.
When a businessman invests all his money in a risky business, he fails to consider the default on fixed expenses and commitments for his family. If an investment corpus that buffers the risk of his business is not built, his family is at risk, should his business fail. A young professional who takes a career break without a contingency fund, will have to bear expense cuts, not earning what he should without the investment corpus to back him up. What is true for companies, banks and clearing corporations, is true for households too.
As is evident from the NSEL fiasco, there is little merit in allowing risky positions to be taken without adequate buffers. Perhaps, time has come to discard the audacity of the famed Indian jugaad and turn to righteousness.
The author is Managing Director, Centre for Investment Education and Learning.
There is the danger of too much information being made available to the common reader on the National Spot Exchange Limited (NSEL) crisis. However, it's difficult to let go of a live example to illustrate fundamental principles. There is no magic or mystery in finance. The premise for sustainable, stable and good quality structures in finance is actually quite simple. Without adequate capital from investors willing to take risks, it is not possible to keep the promises to other investors who expect fixed returns.
This principle plays out in various ways in balance sheets of households, companies, clearing corporations and banks. Building assets requires funding, and the return to the provider of capital depends on how these assets work. If we accept that all asset portfolios, without exception, are risky, we have made a good start. There is no way of finding out in advance how assets will behave, but not all those who provide the funding may be comfortable with this risk. They may expect a fixed rate of return even if the value of the assets they have funded goes up and down. A good portion of the capital available for funding assets may not be able to participate in this economic activity if the promise of a fixed income and repayment of capital after a specific date is not met.
The investors in bank deposits understand that the bank makes risky loans with the money they provide. However, they expect a fixed rate of interest and no risk of default. The investors in the bonds of a company understand that the assets that a company builds may not result in profitable production, sales and profit. Yet, they expect that their bond would be redeemed as promised, and pay the interest as indicated. If the underlying asset is risky, how does one make such promises? If a bank does not know upfront whether the loan will be good or bad, how can it hope to not default on its deposits?
Enter risk capital. Equity investors, who watch this play of risky assets that a business needs to create, and fixed return that an investor wants to earn, see the opportunity. If the assets are risky, it means they may fall or, importantly, rise in value. If the assets turn out to be good and manage to generate a return higher than that wanted by the fixed return investor, there is money to be made. Equity investors, therefore, agree to provide capital to risky businesses, and they accept that there is no promise they will end up holding the assets, whatever the value. Unless the equity investor comes in and accepts the risk of assets, there is no way a business can pay the lenders who seek a fixed return. In return for accepting this risk, equity investors seek liquidity, information disclosure and voting rights.
How much of equity does a business need so that it does not default on the borrowed capital it takes to build assets? If it is possible to evaluate the assets consistently, the fluctuation in their value should determine the equity capital needed. Equity is but an option on the assets of a business, whose exercise price is the value of the liabilities. The implied volatility of the assets will determine the value of the option. In simpler terms, if it can be realistically estimated that the assets may move up or down by 20%, that is the minimum equity capital a business needs, to be able to service its lenders. This is broadly the basis for determining capital adequacy norms for a bank. The methodology to determine the risk in assets is quite sophisticated, and comes under criticism and debate, but the principle is simple. Someone covers the risk of fluctuating asset values so that others can get a fixed return.
The settlement problem in the NSEL arose from the failure to implement this simple structure. A stable structure, which can guarantee all trades, will have risk management processes. It would ask for funds to be kept in a bank before beginning to trade; it would evaluate outstanding positions at market prices, and ask for additional money to be brought in; it would stop traders from taking fresh positions when the dues from them become too high. What NSEL did was to postpone the settlement to the future without imposing high margins that matched the risk of the underlying commodity. Now, it is struggling to sell the risky asset and make payments to those who were sold fixed rate products.
When a businessman invests all his money in a risky business, he fails to consider the default on fixed expenses and commitments for his family. If an investment corpus that buffers the risk of his business is not built, his family is at risk, should his business fail. A young professional who takes a career break without a contingency fund, will have to bear expense cuts, not earning what he should without the investment corpus to back him up. What is true for companies, banks and clearing corporations, is true for households too.
As is evident from the NSEL fiasco, there is little merit in allowing risky positions to be taken without adequate buffers. Perhaps, time has come to discard the audacity of the famed Indian jugaad and turn to righteousness.
The author is Managing Director, Centre for Investment Education and Learning.
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