WEATHER DERIVATIVES – CONCEPT, CHALLENGES, AND FEASIBILITY

By  Ishan Kekre & Girish C

Introduction

A weather derivative is a tool for managing weather risk. It is a financial contract that allows a firm to hedge itself against unexpected and adverse weather. A weather derivative contract or WD derives its value from future weather conditions. Contrary to stereotypical weather insurance, the payout of this kind of derivative is based on a parametric weather index. For instance, the index could be centimeters or millimeters of rainfall. The index could also be a cumulative frequency distribution of temperatures across many locations. The underlying of WD could also be related to snowfall or hurricanes.

Origin of Weather Derivatives

The weather derivative market as compared to other financial instruments is relatively young. The first transaction in the WD market dates back to 1997. The sector developed due to the severe repercussions of El Niño. These events were forecasted correctly by the meteorological community. Firms that had their revenues linked to weather realized the importance of protecting themselves against seasonal weather risks. Many companies who were in the business of dealing with financial futures and options saw WDs as attractive tools to hedge weather risks.

The insurance sector achieved substantial financial consolidation. As a result, there was significant capital to hedge weather risks. Insurance firms started writing options with payoffs linked to weather events. This, in turn, elevated the liquidity for the development of a WD market. Thus, the WD market evolved over the years into a strong over-the-counter market.

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EFFECTS OF DEMONETIZATION ON THE FINANCIAL SECTORs OF INDIA

By The Editorial Board of TJEF

(Anil Shankar, Gandhali Inamdar and Isha Varma)

Introduction

Demonetization has been the buzz word since November 8th 2016 when our Prime Minister made the historic announcement about the decision to discontinue the 500 and 1000 rupee notes. This historic decision has affected almost all the sectors. Some have benefited while others have suffered. This paper intends to analyze the effects of demonetization on the major financial institutions and the Indian economy in general.

Effects of Demonetization on Banking sector

Since the advent of asset quality review (AQR), there has been a rise in the number of NPAs. To get an idea, the GNPA of banks is 6 lakh crore as of June, 2016 which is 8.2% of the total loans1. These are only the NPAs as there are an equal number of restructured loans which might transform to NPAs in future.

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Figure 1: Total NPAs as of March 2016, Source: Finance Ministry

A recent data provided by the Finance ministry, which has been depicted in Figure 1, shows that 5.3 lakh crore of the 6 lakh crore NPAs are under the public sector banks. It’s clearly visible that there has been a rise in the NPAs from October 2015. This can be attributed to the ever greening of loans which led to the creation of a distorted picture of the banks. Though the asset quality review led to the identification of such NPAs which were previously classified as standard, the problem of NPAs existed since the 2008 financial crisis but remained hidden due to the above mentioned reason.

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Which of the following events of 2016 would have a significant impact on Indian economy in 2017?

Should NBFCs be regulated in the same way as Banks in India?

By Nayan Saraf

Indian banking sector has played a crucial role in developing the Indian economy, but if there is one segment, which would significantly make a big difference in coming years, it would be the Non-banking financial services sector. The total asset base for NBFC’s stood at more than Rs. 14.5 Lac Crore and the profit of Rs. 30,000 Cr. in the year 2015 with a CAGR of about 13% over last 3 years. This enormous growth of NBFC segment has resulted in more regulations from RBI which in effect have opened the debate whether NBFCs should be regulated in the same way as banks or not.

Over the years, RBI has changed its stance on NBFC from no regulations to over regulations. This over regulation has come into the picture in recent years after the global financial crisis where the fall of systematically important FI, Lehman Brother, resulted in systematic risk across the financial world. But many economists have argued that these over regulations are nothing but overly cautious measures by the RBI which are hampering the growth of the NBFC segment.

One reasonable argument that goes in the favour of lesser regulations for NBFCs is that unlike banks they don’t have any unsophisticated depositors. The bank’s depositors are unsophisticated as they can withdraw money from the bank at any time and the bank is liable for that. Even for fixed deposits, the principal is protected in the case of premature withdrawal. Hence, banks run the risk of having ‘Run on the bank’. On the other hand, NBFC’s do not have unsophisticated depositors as they raise money by issuing bonds and promoter’s contribution. Hence, NBFCs do not run the risk of having ‘Run on the bank’.

Second argument that goes in favour of lesser regulations for NBFCs is the low risk of asset liability mismatch. Since, NBFCs lend money which was raised through bonds and promoter’s contribution rather than depositors’ money (as they cannot accept deposits); there’s a very little chance of having asset liability mismatch. In their balance sheet, the liability would be due only on maturity. Hence they can easily manage the asset liability mismatch. On the other hand, banks that lend depositors’ money, run a higher risk of asset liability mismatch as in their balance sheet the liability can be due at any time.

These two arguments question the importance of stringent regulations on NBFCs by RBI. When NBFCs are different from banks, then why should they have the same stringent regulations? NBFCs should be more risk seeking in nature for the growth of Indian economy.

Scope of Islamic Banking

By Durgesh Desai

Islamic banking is a type of a banking system which is in accordance with the Sharia law that prohibits paying any interest or fee for renting money. It also has rules about the type of businesses where money can be invested. These businesses have to function according to the principles of Islam. So investments cannot be made in companies or projects that deal with alcohol, drugs, war weapons etc.

Banking without interest

It is quite difficult to imagine any banking system functioning without paying or receiving interest on any transaction, but in Islamic banking, there is a concept of profit and loss sharing where banks invest the deposited money in Shariat compliant businesses and divide the profit and loss equally or as per the terms agreed with the depositor. Therefore Islamic banks act as a sort of equity funds. Islamic banks also provide many products like Musharaka (resources are equally shared), Mudarbah (finance provided by one party and expertise by the other) etc.

Islamic Banking in the World

The IMF in April 2015 endorsed the Islamic financial system saying that it could provide a safer alternative to conventional modes of finance. Islamic banking is common in Islamic countries and is starting to grow in other non – Islamic countries as well. The UK was the first non – Islamic country to issue license to the Islamic Bank of Britain which is in accordance with the Sharia law. The Dow Jones had started an Islamic Market Index in 1999 which had only Shariat compliant companies listed on it.

Islamic Banking in India

The RBI is mulling over the idea of introducing an Islamic window in conventional banks in India. This could help attract huge funds from Gulf countries and other investors who want to invest only in Shariat compliant businesses. It would also help in financial inclusion among the members of the Indian Muslim community who possibly shied away from investing in conventional banks due to its non – compliance with Sharia Law. State Bank of India had launched an Islamic equity fund in December 2014 with the mandate to only invest in Shariat compliant companies. To open an Islamic window in banks, the Banking Regulation Act needs to be amended. This will require Parliament’s approval which could be difficult in light of the political nature of this subject.  Islamic Banking offers an alternative investment option for investors. It would help broaden the Indian financial system.

FALL IN BANK DEPOSITS

By Garima Singhal & Vishnu Pillai

INTRODUCTION

Reserve Bank of India’s bimonthly report in March revealed that the deposit growth in the fiscal year 2015-16 has slipped to 9.9%, the lowest in the last five decades. India is an economy, which is considered as saving centric, and the country’s banking system provides the depositor with one of the highest interest rates ranging from 4.5%-7.5% on time and demand deposits (up to Rs. 1 Crore). Inflation has seen a downward trend and the economy is moving towards faster growth. In spite of all these reasons, Indian banks are facing liquidity crunch due to low deposit growth that has also led to an increase in the credit-to-deposit ratio to 77.6% in March 2016 from 76.5% in the previous year.

In all this debate, the question arises why deposits in banks are so important for India’s growth and if the nation is really growing at a high growth rate then why are deposits in the banking system decreasing to such a large extent?

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                              Figure 1: Growth in bank deposits (in %), Source: RBI

NEED FOR DEPOSITS

India is a developing country rapidly moving towards better technology and efficient ways of working. Similarly is the financial market of the country, which is currently in its growing phase. A financial market is a market where direct trading takes place in equity, bonds, currency, commodities etc. Here the investors and people in need of funds meet directly without the need of intermediary like banks. As the financial market of the nation grows and become more efficient, the need for banking sector becomes less important. However, in India where financial markets cope with the problem of adverse selection and moral hazard, banks play an important role in transferring funds from investors to borrowers.

Moreover, banks work on the principle of spread, which is the difference between the interest paid on deposits and interest earned on loans. As deposit growth falls and demand for the loans increases, banks need to increase the rate of interest on their deposits resulting into less spread for banks and reduction in profitability.

Also, with the current credit-to-deposit ratio of 77.6%, banks are lending 77.6 rupees for each of Rs. 100 of deposit. As banks need to maintain other reserves under CRR and SLR, lending such a high amount can lead banks to run into a liquidity shortage, which is not a favorable situation for the banking system as a whole.

As a result of all these factors, deposits have become a crucial component in the banking system to facilitate the smooth flow of funds from investors to borrowers.

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                  Figure 2: Prime Lending Rate in India from April 2015 – March 2016,

                                              Source: www.tradingeconomics.com

REASONS FOR FALLING DEPOSITS

In countries like India and China people tend to save more for the future than consuming today. As a result of this saving habit of citizens, the Indian economy was hit to a lesser extent during the Financial Crisis of 2008, but what has led to the reversal of this trend in current times? Though there is no sure answer for this question, few factors explain the reversal to some extent.

In the past when the country was facing a double-digit inflation, banks were providing high-interest rates on deposits, to reduce the impact of inflation on people’s savings. But as inflation eased, interest rates on deposits have not reduced in the same proportion providing people with a higher real rate of interest. This has resulted in people earning same returns with fewer funds parked in the banks. This could have resulted in the reduction of deposits in banks.

Moreover, the behavior of present generation is changing, as people want to fulfill more of their present demands than saving for the future. The availability of various insurance schemes in the market to face future uncertainties has made this task of present consumption more attractive, preventing people from worrying about future thereby saving less.

Second of all, as the financial market in the country is growing and becoming more efficient, new and better products like Mutual Funds, Equity Traded Funds, Bonds, Real Estates etc. are becoming available to people to earn more profit with the same amount of money invested. Also, the returns provided by these investments are far above the inflation rate resulting in more returns in nominal as well as in real terms. Another reason for the growing popularity of financial products is the liquidity they provide. As a result, people who are willing to take risks to earn higher profits are moving towards these products rather than parking their funds in banks.

Another reason that can also be considered as one of the factors for falling deposits growth is an increase in the maximum limit under the Liberalized Remittance Scheme. Under this scheme, the RBI defines the maximum permissible amount that Indians can remit to other countries. The maximum amount under this scheme has been raised to $250,000. As a result of this, people have started sending more money to their parents, children or relatives in foreign countries instead of saving them in bank accounts. This can be validated from the fact that the transactions under this scheme have seen a jump from $106mn to $449mn from May 2015 to Feb 2016.

The largest factor that is contributing to this rise is the amount sent by parents to children who are studying abroad. This shows that our education system is not only incapable of retaining its talent but also is one of the major causes of money leaking out of the economy.

The points discussed above identify the fact that people presently are reluctant to put money in banks. But what if in the previous years the funds deposited by people was just higher deposit growth than normal rate and presently that trend is only getting reversed to attain its normal pace. This can be inferred from the fact that during the period of Financial Crisis, markets were facing great uncertainty and the economy was experiencing double-digit inflation. People were losing jobs and were more focused on saving to secure their future consumption as much as possible, which led to very high growth in deposits. As the economy recovered from recession over the years and inflation rates have fallen, people have reverted to their actual rate of spending bringing the deposits growth down.

The other factor that is more perplexing is that in the situation when deposit growth is at its all-time low, currency in circulation is seeing a high growth of 14.6% as compared to 11.32% growth over the previous year.

In the scenario where not only advance ways of doing banking are coming up every day resulting in improvement in efficiency of transactions but also schemes like Pradhan Mantri Jan Dhan Yojana(PMJDY) which are trying to put ideal money into circulation by opening up bank accounts, high growth in currency in circulation despite fall in bank deposits raises questions. Though this increase can be described by few factors, actual reasons remain uncertain.

Elections could be seen as one of the reasons for the rise in currency, as it is a phase where a large amount of money is spent by political parties for funding their campaigns and to lure the voters by offering them cash. The rumor of each voter in Tamil Nadu getting somewhere between Rs.3000 to Rs.6000 during the Assembly Election in April – May 2016 added fuel to this fire. Even Mr. Raghuram Rajan hinted this as a possible reason for an increase of Rs. 50,000 crores more money in the hands of the public than what was expected by the Central bank. Another interesting fact that came to light during this period was that the amount of money with the people had not only increased in the poll-bound states but also the neighboring states.

But if we were to believe the above reasoning then didn’t we have more states going for elections last year? Why didn’t the level of deposits fall in the last year or the year before it during the elections? Or is it that the states that went to polls last year (Bihar, Delhi- 2015) or in 2014 (Parliament, Maharashtra, Haryana, Andhra Pradesh, Jammu & Kashmir, Jharkhand) had a better follow-up of electoral policy than the states that had elections this year (Kerala, Tamil Nadu, Assam and West Bengal).

Another factor which gives rise to the possibility of high currency in circulation is the rise in service tax from 12.36% to 14% and with the introduction of the Swachh Bharat cess and Krishi Kalyan cess, it reaches to 15%. Because of this rise, people may be seen as reluctant to put large sums in banks due to increase in transactions costs or ATM charges. Though the cost may be lower on transaction basis but combined cost may result in keeping people away from depositing in banks. Moreover, with the rise in service tax people may be more willing to pay for services in cash instead of through bank accounts as transactions from accounts are recorded whereas cash payments cannot be traced and can be used as a means of saving tax.

All this presents one side of the picture that concludes that people are not depositing at the same rate as of before but there is a second angle to the picture. What if people are still saving at the same rate but they do not have enough income to save which is leading to the fall in deposits growth?

The data based on Quarterly Employment Survey (QES) of  the number of jobs created in select eight industries shows that the number of jobs generated in 2015 is only 135,000 which are very low as compared to that of jobs created in 2014 that were 421,000. This fact puts another problem in picture that though the economy is growing at a rate of 7.4% currently it is facing difficulty in translating the growth into increased jobs to accommodate the growing workforce of the country. Moreover, in the rural area the fall in income due to crop failures caused by two successive droughts is aggravating the problem. This has resulted in farmers losing their crops and worsening the situation in both urban as well as rural areas.

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                Table 1: Changes in employment in selected sectors (in lakh numbers)

                                                       Source: Labour Bureau

The actual reason for such a high fall in growth of deposits is still unknown. In a scenario, where the economy is booming and with the pressure from industry to reduce the interest rates is continuously growing, banks will be required to reduce the interest rate on their deposits as well so as to maintain their Net Interest Margins (NIMs). However, as banks are already facing the problem of lower deposit growth, reducing deposit interest rate may make the situation worse forcing banks to face a highly constrained situation from both low deposits as well as high loan demands. Therefore the banks will be required to come up with schemes that can give investors attractive payoffs to deposit money in the bank and to focus on making the banking system more robust so as to not only reduce the growing NPAs but also control the increasing growth of currency and inject back the money which is currently out of the system.

Post March 2016, the deposit growth has increased in banks. So this fall in deposits growth in FY2015 may be considered as one time phenomenon but if such a trend continues to persist in the future, banks should not only focus on finding the root cause of such a high decrease but also try to find new avenues to earn its income so as to bear the brunt of its reduced NIMs.

Bibliography

Damodaran, H. (2016, May 2). The Indian express. Retrieved September 29, 2016, from http://indianexpress.com/article/explained/why-growth-in-bank-deposits-is-at-a-53-year-low-2779714/

Dugal, I. (2016, April 1). The curious case of rising currency in circulation. Retrieved September 29, 2016, from Money, http://www.livemint.com/Money/5iGPiveWOKHyZx7n0g9qLP/The-curious-case-of-rising-currency-in-circulation.html

Bhattacharya, S. (2016, April 15). India’s job growth lowest since 2009: Where are the jobs PM Modi? Business. Retrieved September 29, 2016, from http://www.firstpost.com/business/where-are-the-jobs-mr-modi-2731002.html

Das, S., & Nayak, G. (2016, April 7). Article: Banks in a fix as deposit growth hits 50-year low, loan disbursement rises – the economic times. Retrieved September 29, 2016, from http://articles.economictimes.indiatimes.com/2016-04-07/news/72132317_1_deposit-growth-saugata-bhattacharya-indian-banks

Bureau, O. (2016, April 12). “Higher spending, remittances hurting deposit growth.” Retrieved September 29, 2016, from Money & Banking, http://www.thehindubusinessline.com/money-and-banking/higher-spending-remittances-hurting-deposit-growth/article8467576.ece

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