By Ajay Shah, on May 6th, 2013
by Renuka Sane.
Retail finance in India is once again in the news for reasons of fraud, this time in the form of the Saradha Group in West Bengal. There is a general sense that such schemes proliferate because of the failure of financial inclusion, and that better supervision by current regulators will bring us back on track. The problems of mis-selling however, are not confined to the unregulated chit-fund industry. For many years now, problems of consumer protection have been gathering prominence. While there is concern about the collision between hard-driving financial firms and the average unsophisticated investor, it has been over-ridden with the argument that the problems are minor, sporadic and over-stated by a sensationalist media.
Evidence on mis-selling
There may not be consensus in policy circles on the pervasiveness of mis-selling, but the incipient academic literature on the problems of consumer protection in household financial choice in India reflects otherwise. The following papers are of note:
- Anagol and Kim (2010) study a 22 month period in which closed-end mutual funds were allowed to charge an arguably shrouded amortized fee whereas open-end funds were forced to charge standard entry loads. They find that inflows into the more expensive funds were much higher, and that investors paid approximately 500 million dollars in extra fees in this period.
- Sane and Thomas (2013) discuss the failure of consumer protection in the micro-finance crisis in Andhra Pradesh in 2010.
- Anagol, Cole and Sarkar (2013) conduct audit studies of insurance agents. They find that insurance agents overwhelmingly recommend products which provide high commissions to the agent and are unsuitable for the customers. This is exacerbated for customers who appear to be less financially literate.
- Halan, Sane and Thomas (2013) study the lapsation in insurance policies after the introduction of unit-linked insurance plans (ULIPs) and find that investors lost more than a trillion rupees from mis-selling over the 2005-2012 period. This shows us that while chit funds are a problem in India, (regulated) ULIPs have imposed bigger losses upon households than (unregulated) chit funds.
These papers offer hard evidence about the problems of consumer protection across products and income-groups and establish that the magnitudes of money involved are substantial. It is not easy to now argue that the problems are sporadic and small and of second-order importance.
Weak regulation
These problems have not taken place in an environment of unregulated finance. The regulation in India is product oriented, focuses on form and not function, and places great emphasis on prudential regulation. While protection of customer interests is a key part of the mandate of all regulators, there is no framework on how to bring this about. Each regulator has its own procedures for licensing and registration of intermediaries, expected code of conduct, caps on commissions, grievance redress procedures. The focus is on inputs, and checking the correct boxes, and not on outcomes. This often leads to instances of regulatory arbitrage, or leaves open the possibility that several entities slip through the cracks and get regulated by no one regulator. The system does not clearly identify the rights of the customer, or place responsibility of outcomes on the distributor. There is no basic definition of whether a product is suitable for a specific customer and no standard to which distributors can be held responsible for what they sell. Once investors get duped into signing consent forms, redress seems unlikely. The evidence that the current redress systems are effective in providing relief to customers is also very weak.
Early regulatory responses
The response from Indian regulators has been in the form of policy changes that should prevent mis-selling that has been seen in the past decade. The key milestones are:
- Ban on entry loads on mutual funds , SEBI, August 2009
- Cap on ULIP commissions, IRDA, October 2009
- Order on regulation of ULIPs, pointing out that ULIPs are inherently fund management products, SEBI, April 2010
- Changes in ULIP product rules, including surrender charges, IRDA, September 2010
- New rules for NBFC-MFIs for lending in micro-finance, RBI, July 2012.
- Regulations on investment advice, SEBI, January 2013.
Each of these initiatives is an incremental response by a regulatory agency that became uncomfortable with the status quo. However, they do not add up to a comprehensive and internally consistent strategy for consumer protection, and they are not adequately rooted in law. One regulator has banned commissions for a product, while similar products are permitted to charge commissions under a different regulator. Various distributors such as banks come under far less scrutiny on distribution because they fall under a different banking regulator. SEBI regulations on investment advisors do not apply to agents who provide advice solely on one financial product. This implies that the existing network of agents, including banks, can continue to function in the current framework which does not require agents to act in a fiduciary capacity towards their clients.
Considering the low financial literacy and low access to finance in India, perhaps it is also not advisable to require each agent to have a fiduciary responsibility. There is a strong case to be made for simple products that may be sold without the imposition of high suitability standards. However, no such provision exists in the current regulations. The micro-finance regulations focus predominantly on prudential regulation, even when the problems in the sector arose on issues of customer protection. There is also no understanding of whether the measures imposed have brought about the desired change. A framework for evaluation of the costs and benefits of various regulatory interventions is completely missing from the current regulatory discourse in India, and the response so far has continued to ignore its importance.
The Indian Financial Code will yield transformative change
The Indian Financial Code (IFC) is an important landmark in financial regulation in that it identifies customer protection as a central goal of regulation. The draft law enshrines the customer with rights to prevent mis-selling at the time of sale, and provides for a redress system after an event has occurred. In the IFC, the consumer has a right to get fair disclosure and suitable advice from financial service providers. This recognises that the market for financial products is an uneven playing ground with customers not being in a position to evaluate financial products, especially over long horizons. The code also requires the regulator to undertake measures to promote financial awareness.
The IFC has appreciated the possibility that excessive regulation may have its costs which ultimately get borne by the customer. It has put in place several checks to ensure that regulation is not stifling the market, including that of continuous evaluation of outcomes brought about by policy. Section 54, of Chapter 13 specifies that the financial agency is required to measures the costs and benefits of regulations by using the best available data and the best scientific method when such data is available. There are important connections between the incipient literature on household finance in India, and the requirements for analysis that are embedded in the IFC.
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By Ajay Shah, on May 2nd, 2013
by Suyash Rai and Smriti Parsheera
The first task in dealing with ponzi schemes is correctly defining the scope of financial regulation. Once a firm is classified as a financial service provider, the appropriate regulator must choose a regulatory strategy for it. Assuming SEBI had clear jurisdiction with Sahara or MMM, what would SEBI do?
Safety and soundness regulation (also called micro-prudential regulation) is an expensive form of regulation, which includes requirements relating to maintenance of capital, investment restrictions, corporate governance, risk management systems, etc. This type of regulation can not apply equally to every financial institution. For example, the regulator should be able to distinguish between small member-controlled chit funds and larger chit funds.
Differences also need to be drawn based on the nature of the activity being carried out. Micro-prudential regulation should be less stringent for investment schemes as compared to deposit-takers, given the difference in the nature of promises being made to consumers. However, at the very least, the scheme would require authorisation from the regulator. In the MMM India example, had the scheme sought such approval, its promoters would have to satisfy basic fit and proper person requirements. Given that the scheme has been floated by Sergey Mavrodi, a convicted fraudster and the man behind Russia’s largest Ponzi scheme, it is likely that the scheme would have failed on this count.
This points to the need for a sophisticated approach to ensure optimal regulation. The law should allow the regulators to apply safety and soundness regulation wherever required, but the decision can’t be left to the regulators unconditionally. The law must provide some guidance to them, to make them accountable. What could be the form of this guidance?
Consider the following examples:
- A bank with Rs. 10,000 crores of deposits from 1 crore depositors.
- A local chit fund with Rs. 10,000 from 20 members.
- A chit fund with Rs. 1000 crores from 1 crore members.
- A hedge fund investing Rs. 1,000 crores, from 50 investors.
- A mutual fund investing 10,000 crores, from 1 crore investors.
Where should safety and soundness regulation apply, and what should be the intensity of the regulation? A closer look reveals a few distinctions on four dimensions.
The bank and the large chit fund are more opaque than the others – most of the important information about their asset quality is not visible. That is why we are often taken aback when they fail. In small chit funds, people have reasonable visibility, since the money is with one of the members and is distributed regularly. Hedge funds and mutual funds are also quite easy to monitor, as long as they report fairly, because they invest in securities that visible in the market on a real time basis.
Bank and the chit funds make promises that are inherently more difficult to fulfill – they must return money, irrespective of their financial position. Banks more so, because the deposits are callable at par. Hedge funds and mutual funds invest on behalf of investors, with no guaranteed rate of return and so the market risk stays with the investors. Institutions making promises inherently more difficult to fulfill are at a greater risk of failing to keep the promises.
There is a difference in the influence the consumers can wield over the institution. In a small chit fund, members have significant influence over each other. In game theory terms, they are in a repeated game over a long horizon – small amounts are saved over short periods, and this is repeated. When a few people become managers of funds for a large number of people, the moral hazard problem increases exponentially, and the consumers’ ability to influence the institution drops. Similar difference can be seen in the hedge fund (small number of high value investors), and the mutual fund (large number of small value investors).
The institutions differ in terms of consequences of their failure. If a bank or a chit fund fails, many poor and middle class people lose their savings and many suffer significant hardships. We are seeing this in Saradha’s case.
Each of these four distinctions is relevant for deciding where safety and soundness regulation should apply. They can be stated in terms of principles, but do not translate into a set of ex-ante rules in terms of institution-types. If the law states them in terms of rules, it may be gamed. The principles, therefore, must be in the law.
Section 151(1) of the Indian Financial Code provides four principles-based tests, based on the four distinctions discussed above, that will help the regulators decide where and to what extent safety and soundness regulation should apply. The regulators will use a combination of these principles to take the decision. For example, it is not enough that the promise is inherently more difficult to fulfill, the institution should score high on some other tests as well. From the five examples listed earlier, the bank and the large chit fund will be intensely regulated for safety and soundness, and the mutual fund would attract some regulation to ensure that it is acting prudently and reporting fairly. The small chit fund and the hedge fund may be largely exempt.
Handling failure
Even among the licensed and regulated deposit-taking institutions, some will become weak. In such situations, there are ways of stemming the decline, and if the institution fails, minimising the loss to depositors. Dealing with failure requires a sound resolution and deposit insurance system. Deposit insurance covers deposits, upto a limit, against the risk of failure of the institution.
At present, banks in India are covered by a deposit insurance system, which, as demonstrated by the experience of many urban cooperative banks, often takes a long time to settle claims. Bank-like institutions, such as deposit-taking NBFCs, are not covered by deposit insurance. Countries like US and Canada have elaborate systems of resolution, which may include sale of the firm, management through a bridge institution, and temporary public ownership. The agencies responsible for resolution are also empowered to take corrective action if a firm’s soundness declines. In India, there is no system for resolving failing firms, and no structured framework for corrective action.
Part VII of the IFC provides for a resolution corporation, which will provide deposit insurance to certain institutions, take corrective actions on firms becoming weak and resolve institutions before they become insolvent, by arranging a sale of the firm, managing it through a bridge institution, or facilitating temporary public ownership. Section 260 enables extension of deposit insurance to institutions taking deposits. The regulators, in consultation with the resolution corporation, will decide which institutions will be covered by deposit insurance. This decision will be taken based on tests like the ones proposed for deciding where safety and soundness regulation will apply.
Enhanced consumer protection
The operators of the MMM scheme claim to make full disclosures to their members about the uncertainty of returns and the risk to their funds. But is mere disclosure sufficient to absolve Ponzi scheme operators from all liability? Certainly not. While disclosure and transparency requirements are integral components of an effective consumer protection regime, research shows that when faced with complex financial decisions, consumers often suffer from cognitive biases which can result in sub-optimal decision making.
It is for this reason that IFC contains additional protections when retail consumers are advised on financial products. This is in the form of suitability assessment requirements that compel the managers and distributors of financial products to assess the relevant personal circumstances of individual scheme members and the suitability of the product for their purposes before advising them to join such schemes.
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By Ajay Shah, on March 21st, 2013
Most of us have enormous respect for the achievements of Axis Bank, HDFC Bank and ICICI Bank. But as Monika emphasises, there are also genuine problems there. We saw it first with the hard-driving mis-selling in recent years, particularly with ULIPs, and now we see it here, with staffpersons supporting illegal activities.
Ordinarily, a media outlet in India bringing such information out has to worry about brazen strong-arm tactics being deployed against them, such as filing of criminal cases. In this case, luckily, there is a certain decency about these three organisations which precludes such concerns. It is ironic that the Indian media vigorously reports on the misdeeds of civilised people, and tends to be silent about uncivilised people.
In India, most of us are reverential about the power of incentives. To make people work, we think, you have to have high powered incentives. We revere incentive packages, stock options, stock grants, which whip the staffperson into a frenzy of hard work.
Economists led this charge, starting with Jensen and Murphy, 1990. The notion that high powered incentives are a good thing came out of academia and went into the real world. But increasingly, it has become clear that there are problems. By 2004, Jensen and Murphy themselves were saying that we should be more circumspect about using high powered incentives.
A person facing high powered incentives tends to focus on one thing. There is an excessive pursuit of that one thing, and all other considerations tend to evaporate. Similarly, when there are quantitative goals alongside qualitative goals, high-powered incentives will generate a focus on quantitative goals and tend to crowd out qualitative goals. Employees of a bank that are given powerful incentives to hit targets for deposit growth (sacked if you don’t, given a 100% bonus if you do) are more likely to try to pull in that deposit growth by hook or by crook. If the internal controls of an organisation are weak, then employees are likely to achieve their targets by dubious means.
For all of us in India, coming from a backdrop of socialism and State, it is natural to have extreme hostility to the absence of incentive for a civil servant to do his job. We have seen how private organisations have triumphed by giving employees more incentive. But it’s easy for us to overdo this message. In many situations, I feel it’s better to go from no incentive to low-powered incentives, but not all the way to high powered incentives.
These issues are widely discussed in the global debate. When we transplant these ideas into India, a big difference lies in the weak governance environment. Super-charged employees in private firms seem to be willing to break laws in their pursuit of profit. Since CEOs weigh the costs and benefits of unethical behaviour, we may argue that when, in a weak governance environment, the expected punishment is small, an increase in the gains from unethical behaviour (through high-powered incentives) results in reduced fairplay.
This suggests two things. First, HR managers needs to be more sophisticated in how the objectives of an employee are defined. If we could be more nuanced in clarifying what the employee is to maximise, this could yield better results. The second issue is about internal controls. When internal controls are strong, they become a non-negotiable constraint within which growing sales or profit has to be done. Unfortunately, once the top managers of an organisation are really hard-driving, chasing growth and profitability, these kinds of niceties (of both kinds) tend to fall by the wayside.
One of the most important mechanisms through which we get high powered incentives is : an entrepreneur who manages a company with family members, and who has dominant shareholding. The one area where this gets us into the most trouble is: Finance. A series of papers that have analysed the Great Recession have found that financial firms where CEOs had more high powered incentives got into more trouble. I am a great advocate of less public sector and more private sector in finance, but we have to be cautious about high powered incentives e.g. those that go with dominant entrepreneurs in a family business.
A prominent example of this debate has been `financial market infrastructure institutions’ (FMIIs), a category that comprises organisations like exchanges, depositories, clearing corporations, all of which produce public goods for the financial system. In all these areas, the organisation is unique in that, alongside the goal of maximising profit, there is a regulatory function. This tiny handful of firms is unique, when compared with essentially any other part of capitalism, in that some government functions of regulation and supervision are placed in private, profit-maximising hands. High powered incentives to produce profit or valuation will lead to a dilution or worse of regulatory and supervisory functions. If profit-seeking owners/managers of these organisations under-emphasise or abuse the regulatory and supervisory functions in the quest for profit, this has far-ranging externalities. Failures of regulation and supervision at exchanges have given macroeconomic crises in India in 1992 and 2001. Hence, even though the revenues and profits of these firms is truly tiny on the scale of the economy, this conflict of interest is an important issue for policy makers.
Similarly, there has been a vigorous debate about entry by private banks. As a working approximation, we have to assume that RBI supervision is less than perfect. In this case, I feel that we should be quite circumspect about banks led by entrepreneurs.
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By Ajay Shah, on March 12th, 2013
by Bindu Ananth and Kshama Fernandes
Over 2006-12, RBI and SEBI have created a strong and conducive regulatory environment for securitisation, listing of securitised debt instruments, and standards of transparency and reporting. Securitisation volumes have picked up and we recently witnessed the first listed transaction.
In October 2011, the income tax authorities issued a claim on certain securitisation special purpose vehicles (SPVs), stating that the gross income of such SPVs was liable to tax. The matter is presently under sub judice with the Bombay High Court. Several industry participants approached the Ministry of Finance (MoF) to seek clarity and reinforce the “pass through” status of a securitisation SPV.
The Finance Bill, 2013, has sought to clarify the tax position by stating that securitisation SPVs are not liable to pay income tax. However, the Bill also states that trustees of such SPVs must pay tax on distributed income.
The above amendment has an unintentional and significantly negative implication, on account of which taxable investors would be disincentivised from participating in securitisations.
This memo explains the issues and the unintended implications caused by the present draft of the Finance Bill in relation to securitisation SPVs, and provides a possible solution for addressing these issues.
Objectives of the MoF with respect to taxation of Securitisation SPVs
The Finance Minister (FM) in his speech presenting the Budget for the year 2013-14, set out his intent in presenting the proposed changes to the taxation of Securitisation SPVs: “In order to facilitate financial institutions to securitise their assets through a special purpose vehicle”.
The depth and vibrancy of the asset securitisation market is an essential building block in transfer of risk and transmission of capital from well capitalised investors to high quality originators. The framework for a well-functioning securitisation market has been laid down in considerable detail by the Reserve Bank of India (in 2006, further strengthened in 2012) and the Securities and Exchange Board of India (detailed guidelines in 2008 and listing guidelines in 2011).
It is our understanding that the objective of the Ministry of Finance in providing the basis of taxation of securitisation SPVs, is to clarify and establish the pass-through status of securitisation.
Changes proposed by the Finance Bill, 2013
Given below is the text proposed to be introduced into the Income Tax Act, 1961 by the Finance Bill, 2013:
CHAPTER XII-EA
SPECIAL PROVISIONS RELATING TO TAX ON DISTRIBUTED INCOME BY SECURITISATION TRUSTS
115TA
- Notwithstanding anything contained in any other provisions of the Act, any amount of income distributed by the securitisation trust to its investors shall be chargeable to tax and such securitisation trust shall be liable to pay additional income-tax on such distributed income at the rate of–
- twenty-five per cent. on income distributed to any person being an individual or a Hindu undivided family;
- thirty per cent. on income distributed to any other person:
Provided that nothing contained in this sub-section shall apply in respect of any income distributed by the securitisation trust to any person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act.
- The person responsible for making payment of the income distributed by the securitisation trust shall be liable to pay tax to the credit of the Central Government within fourteen days from the date of distribution or payment of such income, whichever is earlier.
- The person responsible for making payment of the income distributed by the securitisation trust shall, on or before the 15th day of September in each year, furnish to the prescribed income-tax authority, a statement in the prescribed form and verified in the prescribed manner, giving the details of the amount of income distributed to investors during the previous year, the tax paid thereon and such other relevant details, as may be prescribed.
- No deduction under any other provisions of this Act shall be allowed to the securitisation trust in respect of the income which has been charged to tax under sub-section (1).
115TB.
Where the person responsible for making payment of the income distributed by the securitisation trust and the securitisation trust fails to pay the whole or any part of the tax referred to in sub-section (1) of section 115TA, within the time allowed under sub-section (2) of that section, he or it shall be liable to pay simple interest at the rate of one per cent. every month or part thereof on the amount of such tax for the period beginning on the date immediately after the last date on which such tax was payable and ending with the date on which the tax is actually paid.
115TC.
If any person responsible for making payment of the income distributed by the securitisation trust and the securitisation trust does not pay tax, as referred to in sub-section (1) of section 115TA, then, he or it shall be deemed to be an assessee in default in respect of the amount of tax payable by him or it and all the provisions of this Act for the collection and recovery of income-tax shall apply.
Explanation. — For the purposes of this Chapter,–
- “investor” means a person who is holder of any securitised debt instrument or securities issued by the securitisation trust;
- “securities” means debt securities issued by a Special Purpose Vehicle as referred to in the guidelines on securitisation of standard assets issued by the Reserve Bank of India;
- “securitised debt instrument” shall have the same meaning as assigned to it in clause (s) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956;
- “securitisation trust” means a trust, being a-
- “special purpose distinct entity” as defined in clause (u) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956, and regulated under the said regulations; or
- “Special Purpose Vehicle” as defined in, and regulated by, the guidelines on securitisation of standard assets issued by the Reserve Bank of India, which fulfils such conditions, as may be prescribed.”
The following additions of Section 10 (23DA) and Section 10(35A) are also proposed to exempt from income tax certain income related to Securitisation SPVs:
(23DA) any income of a securitisation trust from the activity of securitisation.
Explanation.”For the purposes of this clause,”
- “securitisation” shall have the same meaning as assigned to it -
- in clause (r) of sub-regulation (1) of regulation 2 of the Securities an<>d Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956; or
- under the guidelines on securitisation of standard assets issued by the Reserve Bank of India;
- “securitisation trust” shall have the meaning assigned to it in the Explanation below section 115TC;”
And
“(35A) any income by way of distributed income referred to in section 115TA received from a securitisation trust by any person being an investor of the said trust”
Unanticipated implications of the proposed text
Securitisation of assets by financial institutions requires the existence of a wide range of investors for whom investment in Securitisation SPVs is a viable option. Currently, predominant investors in the securitisation market in India (particularly in the securitisation related to financial inclusion) are banks. Banks are sophisticated investors and sit on large pools of capital that they must deploy appropriately. Securitisation has been an important way for banks to efficiently and effectively deploy capital where it is needed.
Other investors in securitisation, such as Mutual Funds and private investors currently provide significant but far less capital through securitisation. Yet other investors, such as insurance companies and pension funds, are yet to join the market.
However, it appears that the proposed changes would make the investment in Securitisation SPVs unviable for all but a certain class of income tax exempt investors (such as Mutual Funds). To elaborate on this, given below is a brief synopsis of the tax position of an investor in such SPVs, along with that of the SPVs themselves, as well as the issues arising out of the proposed amendments in the Finance Bill:
- The current language of the proposed provision states that “any amount of income distributed by the securitisation trust to its investors shall be chargeable to tax and such securitisation trust shall be liable to pay additional income-tax on such distributed income” but as SPVs are designed to be mere mechanisms to route payments. It is not clear how its “income distributed” will be determined for the purpose of Section 115TA.
- The language used in Section 115TA clearly indicates that the liability to pay “additional” income tax is placed upon the SPVs. It is not clear what this tax is in addition to.
- Howsoever its income may be determined, as a result of Section 14A, no deduction will be permitted for expenses out of its total income.
- Income under Section 10 (23DA) or under Section 10 (35A) is income not includable in total income.
- In terms of Section 14A, no deduction is permitted with respect of income described in Section 10 (23DA) or Section 10 (35A).
- Investors, other than “any person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act”, however, often do have incomes and incur expenses in raising money to invest in securitisation transactions.
Illustration:
- A bank uses Rs. 1,000 of money it has accepted as deposits at the rate of 7.5% to invest in PTCs with a principal amount of Rs. 1,000 with a term of one year.
- The PTC offers a yield of 13%, translating into a sum of Rs. 1,130 of which (assuming the taxable “income distributed” is Rs. 130) Rs. 39 will be deducted as tax in terms of Section 115TA leaving Rs. 1,091
- But the bank has to return INR 1,075 to the depositors. Under Section 14A, the interest cost of Rs 75 is not deductible
- For a pre-tax profit of Rs 55, the post-tax profit of the bank is Rs. 16 i.e. a profit of 1.6 percent. The tax paid in this transaction is Rs. 39. Effectively, the rate of taxation relative to income in the hands of the investor is over 70%.
For the investor, Section 10(23DA), Section 10 (35A) and Section 14A have an effect similar to the taxation of revenue rather than taxation of income.
On the other hand, if the investment in the SPVs was treated, as it was traditionally, as pass-through, the bank would treat the income from investment as any other income and pay tax on its net income (in the example above: Rs 130 – Rs 75 = Rs 55), with an effective rate determined by the net income of the bank, which would be far less than the 70 percent indicated by the proposed language of the Finance Bill, 2013.
Therefore, the unanticipated consequences of the present draft of the Finance Bill are:
Higher effective rate of taxation of income from securitisation, when compared to other sources of income of an investor
Tax paying investors will stay away. Banks, NBFCs etc. may not be willing to invest in securitised debt instruments, unless compensated for the higher tax payable
Severe impact on market depth and liquidity. Banks are presently the largest investors in securitisations and their absence would severely inhibit the growth of the market
No incentive for new investor classes to participate. Investors such as private wealth, corporate treasuries, AIFs etc. may find securitisation an unviable investment option
An alternative draft
It may be noted that the taxation of private trusts is well understood and has been relatively stable for a significant period of time. If we wish to avoid the unanticipated consequences as outlined above, we would require reinforcement and restatement the existing position of law.
Attention may also be drawn to the provisions of Section 160, relating to representative assessees, which would also apply to trustees of private trusts, including Securitisation SPVs. The proposed addition of Section 10 (23DA) and Section 10 (35A) should be removed and no changes must be made to Section 10 in this regard.
It may be beneficial if the proposed Section 115TA read (in a restatement of the existing law) as follows:
CHAPTER XII-EA
PROVISIONS RELATING TO INCOME FROM INVESTMENT IN SECURITISATION TRUSTS
115TA.
(1) Any amount of income received by an investor from a securitisation trust shall be chargeable to tax as part of the total income of such investor.
Provided that nothing contained in this sub-section shall apply in respect of any income distributed by the securitisation trust to any person in whose case income, irrespective of its nature and source, is not chargeable to tax under the Act.
Explanation.–For the purposes of this Chapter, –
- “investor” means a person who is holder of any securitised debt instrument or securities issued by the securitisation trust;
- “securities” means debt securities issued by a Special Purpose Vehicle as referred to in the guidelines on securitisation of standard assets issued by the Reserve Bank of India;
- “securitised debt instrument” shall have the same meaning as assigned to it in clause (s) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956;
- “securitisation trust” means a trust, being a-
- “special purpose distinct entity” as defined in clause (u) of sub-regulation (1) of regulation 2 of the Securities and Exchange Board of India (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 made under the Securities and Exchange Board of India Act, 1992 and the Securities Contracts (Regulation) Act, 1956, and regulated under the said regulations; or
- “Special Purpose Vehicle” as defined in, and regulated by, the guidelines on securitisation of standard assets issued by the Reserve Bank of India, which fulfils such conditions, as may be prescribed.”
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By Ajay Shah, on October 30th, 2012
by Harsh Vardhan.
The CEO of a leading bank recently caused a flutter in the banking community by demanding the abolition of the Cash Reserve Ratio (CRR). RBI has promptly appointed a committee to look at this issue. The reserve ratios, CRR and SLR (Statutory Liquidity Reserve), are an important feature of Indian banking regulation. Alongside the debate about CRR, and new thinking about how monetary policy should be conducted, we should also review the SLR. SLR is a much bigger burden on the banking system and has no role in monetary policy.
What is SLR?
SLR is the requirement imposed by the regulator on commercial banks that compels them to invest a percentage (currently 24%) of their Net Time and Demand Liabilities (NDTL) in approved government securities. Through this, today, 24% all the resources – deposits and borrowings – mobilised by commercial banks are invested in government securities. Currently bank deposits and borrowings are Rs.7 trillion which means that SLR places Rs.1.8 trillion into purchases of government securities. SLR creates a significant captive source of financing its borrowing program. This has three important implications:
- SLR reduces the resources available for commercial lending by banks. Every rupee deployed in SLR is a rupee not invested in a private enterprise that needs capital. There is no free lunch: when capital given to the government, it comes at the cost of capital available to the private sector. Any reduction in the SLR (as in the CRR) will yield more capital for the Indian private sector. It is hence important to critically analyse both.
- By creating a large captive source of deficit financing, SLR effectively subsidises government at the cost of savers and commercial borrowers. When a government has to borrow at a competitive rate in the market, the market exerts a check on irresponsible fiscal behavior of the government. When there is a large captive source of borrowing, the government is shielded from the pressures of the bond market and is more likely to engage in fiscal imprudence.
- Such a large scale preemption of savings by the government through SLR fundamentally distorts the interest rate structure in the economy by artificially depressing the yield curve. This complicates the pricing of all assets in the economy.
If we want to “right-size” SLR we have to ask some important questions:
- What is the rationale for imposing SLR?
- What is the right level of SLR, that is consistent with this rationale and does not result in preemption of resources from the banking system?
- Are there other conditions that need to be imposed on SLR so that it achieves the objectives?
The rationale for SLR
What is the conceptual foundation for the regulator to impose SLR? The answer is: prudence. Banks raise public deposits with a promise to redeem them at par or more. To reduce the risk of the portfolio of the bank, the regulator ensures through SLR that at least some part is deployed in the safest assets available. But if prudence is the reason, what is the right level of such reserves that will ensure adequate prudence? Could it be that imposing a requirement as high as 24% is beyond prudence, and is actually a means for the government to preempt savings in the economy? It is hence important to ask the next question: What SLR do we need?
What is the right level of the SLR?
Banks are in the business of taking risk. These risks are taken by deploying public deposits. The most potent weapon that the regulators have used against excessive risk taking is “risk capital” which the equity capital committed by the banks owners. In fact, the entire edifice of modern day bank regulation is based on provision of risk capital as a buffer against risk taking by banks. If we believe, as do most regulators, in risk capital as the buffer against risks, then it makes eminent sense for banks to hold this capital safely. This would logically lead us to conclude that prudence should demand that the bank’s risk capital be held in very safe assets. In India, the risk capital requirement is 9% of risk assets which translates roughly to 6.5% of NDTL (given that the risk assets are typically 70% of NDTL). Therefore, the policy prescription should be: Banks must hold their entire risk capital in safe assets which should include both CRR and SLR.
Even if we assume the CRR is zero, this means that the theoretically right level of SLR would be around 6.5% of NDTL. If we scan the international landscape, this is the sort of number that we see in most countries. It is reasonable to argue that an SLR value above 6.5% of NDTL is motivated by pre-emption and not prudence. When the regulator prescribes a level of 24% for SLR, 6.5 percentage points are for prudence and the remaining 17.5 percentage points is really preemption by the government.
The composition of SLR
The next important question about SLR is about its composition – what investments should qualify as SLR investments? Currently securities issued by the sovereign (Central and State Government bonds) are the only ones that are allowed as SLR investments. But if we accept prudence as the logic for SLR, then the regulation must make sure that these investments are as safe as they can be. This raises concerns about the rating threshold and of concentration risk. If Indian government securities are rated BBB and that of New Zealand government are AAA, it makes sense for banks to hold SLR in New Zealand Govt securities. Also, there should be limits on any individual issuer of securities, reflecting the standard risk management practice followed by any portfolio manager.
The ideal SLR
Putting all the arguments above provides us an ideal construct of SLR as follows:
- SLR is imposed for the purpose of prudence and hence the operative principle is that banks should hold all the regulatory required risk capital in SLR
- The level of SLR should be consistent with the objective of prudence and anything over such a prudential level should be considered as preemption, which should be gradually eliminated.
- SLR should be invested in top rated securities available globally; furthermore there should be concentration limits on single security and issuer
Dual limits structure for SLR
In the short term, it would be hard to come close to the ideal SLR outlined above. But there are some incremental changes that can be made without fundamentally altering the current framework that could provide banks with much greater flexibility. The regulator could prescribe 2 separate limits as follows:
- L1: is the minimum level of SLR that a bank would normally maintain
- L2: “core” SLR – a minimum below L1 that the banks can go down on SLR as long as the difference is only through repo arrangement on SLR with another bank
What does this mean? Let us assume that L1 is pegged at the currently prescribed level of 24%. We then define another limit, L2, which is closer to the prudential requirement of 6.5%. For simplicity, let us assume that L2 is set at 10%. This policy would demand that all banks maintain SLR at 24% but could go down this level upto 10% if and only if they enter into a repurchase agreement (repo) with another bank. Such a policy will mean that the banking system as a whole will continue to hold 24% SLR and so the government will continue to have access to this captive source of funding deficit. However, individual banks would be able to go down to lower levels if they have commercially viable opportunities to do so. Without diluting the overall investment by the banking system in government securities, it would provide significant flexibility to individual banks on commercial lending. In this respect, it is analogous to the idea of tradeable certificates for priority sector lending.
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By Ajay Shah, on October 12th, 2012
Harsh Vardhan’s excellent blog post on this subject made me think further about the questions.
Finance policy makers in India are often proud of the fact that India has avoided a large systemic crisis in which substantial fiscal resources have been put into rescuing financial firms. I think this optimism is overstated. If we look back into the last 20 years, there has been a steady process of government money going into financial firms. On one hand, we have big events like UTI or IFCI or Indian Bank where large sums of public money were put into financial firms. Equally important is the regular flow of government money into PS Banks.
India is in the midst of a business cycle slowdown. This has come after the biggest-ever credit boom in India’s history: in 2007, year-on-year growth of non-food credit was nudging 35%. As we know well, a boom in credit is followed by a boom in NPAs when a downturn comes about. We may well be at the cusp of an upsurge of NPAs. In this case, the pressure on capital in PS banks is going to be acute. If government thoughtlessly continues on the path of putting public money into PS banks then it would involve large sums of money.
As Harsh remarks, the striking feature of this annual resource flow is the way it has become commonplace. Nobody even notices this any more. In a time where government does not put equity capital into any other PSUs, the scale at which this is taking place is quite remarkable.
When the government builds a highway, the cost-benefit analysis is straightforward. Do we want to spend Rs.5000 crore in order to get a 1000 kilometre highway? A tangible result — the highway — is the fruit of the fiscal labour. In contrast, capital infusions into PS banks are not animated by a clear goal. What are we doing? Why is this wise? What is the cost benefit analysis? Are there other mechanisms through which the same objectives can be obtained at a lower cost? As the approach paper of the FSLRC has emphasised, perhaps the most important element of the public policy process that we require in India is clarity on objectives, and a clear demonstration that the proposed policy initiative is the best way to achieve the objective. I would classify the annual fiscal transfers to PS banks as part of the larger problem, that the edifice of Indian financial economic policy has been grounded in inadequate analysis. I am almost certain that 1000 kilometres of highway is a better use of public money than putting it into the equity capital of a PSU.
Once objectives are articulated, it becomes possible to measure the extent to which those objectives are being achieved. Evidence can be brought to bear about the extent to which the claimed objectives are being pursued. As an example, Shawn Cole did a beautiful paper which demonstrates the extent to which PS banks are a tool for rigging elections in India [journal link, ungated pdf]. If this is what PS banks do, are we better off if PS bank assets would decline, as a fraction of GDP?
Harsh’s calculations treat one key number — 1.1% return on assets for Indian banks as a whole — as a given. If this number is given, the average Indian bank is not generating enough retained earnings to support growth, and then there is an inexorable need for fresh equity capital. I would attenuate this discussion in two dimensions:
- A key feature of a world where banks are required to have equity capital is that not all banks get this equity capital. Some banks do well, they build up their balance sheets, they have good prospects and are able to raise equity capital, and they are able to grow. Alongside them, weaker banks fail to grow. This is perfectly appropriate and a desirable feature of the system: a healthy banking system must be one where only some banks are able to grow. The fact that a bank with the average ROA requires capital for growth does not mean that we should be putting public money into all banks that require capital for growth. Many, many banks in India do not deserve to grow and hanging tough is the right way to deal with them. Growth is not a birthright: a bank must do well, and pass the market test, and thus earn the right to grow.
- There are many elements of banking policy which are driving down the return on assets. Easing these constraints is a better path for policy rather than putting in public money.
Banks in India are facing a combination of swelling NPAs, and difficulties in finding capital to grow. It is not fair for private banks to face competition from PS banks that get equity capital for free. I am reminded of Kingfisher. As long as Kingfisher was around, with an artificially low cost of capital, this exerted downward pressure on air fares, and hurt all healthy airlines. The exit of Kingfisher was of essence in bringing the rest of the industry back to health. This is the story of Japan’s `zombie firms’: when failed firms were kept alive using public money for capital infusions, this infected healthy firms. Percy Mistry famously pointed out that Indian finance suffers from the presence of `zombie banks’, who only walk the world on the life support of public money. This is a deeper consequence of easy access to capital for public sector companies that we in India should be worrying about.
Harsh is undoubtedly right in suggesting that government should be willing to accept a reduced shareholding in PS banks while retaining control under the Bank Nationalisation Acts. But this leaves the residual question: if PS banks have a low ROA, the share price that this can support is low, if investors see no possibility of true privatisation in the years to come. The amount of equity capital which will come by going down this route is limited. The real story has got to be to ask PS banks to demonstrate that their claim on public money is backed by a good possibility of using capital better than NHAI.
Suppose we suggest that the government should be stingy in giving equity capital to PS banks. In the short term, the partial equilibrium analysis suggests that this will hold back the growth of banks and thus the size of Indian banking. We should bring two different perspectives to this. First, the very absence of free capital for PS banks will increase the profitability and thus equity capital access for private and foreign banks. The overall impact for India will thus be attenuated. In addition, it’s easy for government to have entry of 20 new private banks. Suppose each is asked to bring in Rs.500 crore as equity capital. Using the rough 20x leverage that’s found in Indian banking, this gives us new bank assets of 2% of GDP or Rs.2 trillion.
By Ajay Shah, on October 10th, 2012
by Harsh Vardhan.
What would you say if someone was borrowing money at 8% and investing it to earn around 3%? “Uninformed!”, “financially illiterate!” or even outright “foolish”! And yet this is what our government has been doing with trillions of rupees over the last many years and has committed to continue to do so in the future. The process by which this is done is called capitalisation of public sector (PS) banks. Such capitalization is not only a bad idea economically as it puts enormous stress on the government resources, but also one which affects that behavior of banks and hence the robustness of the whole banking sector.
Commercial banks need capital to grow. Capital adequacy requirements ask all banks to keep a minimum amount of shareholder capital in proportion to their balance sheet size. Currently, in India this requirement is 9% of “risk weighted assets” of banks. Roughly, it means that banks are expected to have equity capital which is 9% of their commercial loans.
As banks grow their business, their risk weighted assets also grow. This means that banks has to increase their capital base in line with the growth of their loan book. Such increase in capital can come from exactly two sources – retained profits that are added to the capital base, or fresh infusion of capital from shareholders (old or new). In India, given the overall profitability of the banks (~1.1% return on assets) and the amount of dividend that they pay (~20%) of post-tax profits, banks do not have enough retained profits to support their business growth. Therefore, every now and then, they go to shareholders to raise fresh capital.
PS banks pose a peculiar challenge for the government. Being the majority owner of these banks and having committed to stay the majority owner, government has to infuse capital into these banks proportional to its ownership stake. Since the government wants to maintain its ownership at 51%, it has to supply atleast 51% of the fresh capital that PS banks need. RBI governor Dr. Subbarao, in a recent speech, said that the capital infusion by government into PS banks over the next decade will be of the order of Rs.0.9 trillion. I have read estimates of other analysts where this number is as high as Rs.2.50 trillion. These estimates depend on the assumptions one makes about a number of factors – the rate of growth of banks (which in turn depends on the growth of the overall economy), the profitability of banks, their dividend policy, their ability to raise other forms of capital (especially tier II capital), regulatory requirements on capital, etc. No matter how you estimate it, the number is very large. In other words, the government will be compelled to invest a very large amount of capital into PS banks over coming years.
Why is this a problem? Let’s look at the some simple public finance issues. India is in a deep fiscal crisis, and it is not easy to find trillions of rupees to put into PS banks. If such resources were injected into PS banks, it is not conducive to healthy public finance, since these injections are not a good deal for the government. The Indian government currently borrows long term money at over 8%. The dividend yield on PS banks shares has been between 2% and 3% over the last decade. This means that the government earns between 2% and 3% on its investments in PS banks. There is a 5% “negative carry” or loss that government bears on these investments.
A private investor also earns a low dividend yield from investing in PS banks, but can benefit from capital gains – a potential increase in the value of shares which the investor can obtain when she sells the shares. Government has never sold shares of PS banks (except when it initially listed some banks) and will not do so if it has to maintain majority ownership which is its stated policy. Hence, for the government, the financial analysis of a proposal to put money into PS banks should hinge on a comparison between the flow of dividends versus the cost of borrowing.
Capitalisation of PS banks is, thus, bad for government finances. It’s a double whammy! On the one had government has to raise vast resources to be invested into banks and then carries a loss of around ~5% on these investments year after year.
Ownership and behavior of banks
Government capitalisation of PS banks is not just a fiscal challenge. It also impacts the competitive dynamics of the banking industry. Most privately owned banks are under constant scrutiny of investors and analysts. When they go to external investors for raising capital, they have to satisfy these investors on number of critical aspects of the business – profitability and its sustainability, efficiency of capital use, quality of management team, cost efficiency, etc. In other words, private banks face a market test; they do not get capital for free. Only well run private banks get equity capital that is required for growth.
None of these questions get asked when government puts capital into a PS bank. One has never heard a senior government official commenting on the Return on Asset (RoA) or Return on Equity( RoE) of PS banks. The decision to put capital into PS banks is treated as a mechanical and administrative decision. This absence of a market test has systemic consequences. PS banks have ~70% share of the Indian market. When the majority owner is asking no or very few questions on performance, and is assuring an almost unlimited supply of capital, these banks have little incentive to improve financial metrics such RoA and RoE. This hurts the overall banking industry. For example, PS banks can underprice loans compared to their private sector peers. Such behavior would migrate the whole business to lower returns. It is hard for a private bank to be profitable when facing rivals that are not concerned about return on capital.
Misplaced obsession with majority ownership
The source of this whole capitalization issue is the government’s obsession with retaining majority (over 51%) ownership of PS banks. This is often explained in terms of the need to maintain the “public sector character” of these banks. While there may be a separate debate on whether we need to maintain public sector character for all the 25 plus PS banks, the fact is that the government does not need majority ownership to achieve this objective.
All PS banks are not companies under the Companies Act. The notion of 51% giving majority control is enshrined in the Companies Act. PS banks were created under the Nationalisation Act (SBI has its own SBI Act). The Nationalisation Act provides the government untrammeled control over these bank. While it does prescribe 51% government ownership in the PS banks, the control of government is independent of the level of its ownership. Furthermore, there is a limit of a 5% (10% with prior approval of the RBI) stake owned by any single shareholder in all banks. There is no chance, therefore, of any external shareholder acquiring control in these banks. Even relatively minor changes to the functioning of PS banks require approval of the parliament. Where is then the question of diluting the public sector character if the government ownership were to drop to, let’s say 26%, which is the threshold for “significant” minority stake in a company?
In the long run, therefore, it makes no sense for the government to commit itself to the capitalisation of PS banks. Precious government resources can be better deployed in critical areas (such as power transmission and distribution) where private capital on large scale is hard to come by. In the medium term, it can use tactical measures such as merging banks where it has significantly high ownership with those where the ownership is already down to 51%. But these tactics will not solve the issue structurally. The only long term solution is to give up the majority obsession, explain to all the stakeholders the fallacy of this obsession and the resulting pressure on public finance, build a political consensus to enact necessary legislative changes and then dilute down to a reasonable level.
By Simon Grey, on September 19th, 2012
Here’s something that I would normally call irony if it weren’t so evil:
Wells Fargo Home Mortgage (WFC) has fired a Des Moines worker over a 1963 incident at a Laundromat involving a fake dime in the wake of new employment guidelines.
Richard Eggers, 68, was fired in July from his job as a customer service representative for putting a cardboard cutout of a dime in a washing machine nearly 50 years ago in Carlisle, the Des Moines Register reported Monday.
Warren County court records show Eggers was convicted of operating a coin-changing machine by false means. Eggers called it a “stupid stunt,” but questions his firing.
Big banks have been firing low-level employees like Eggers since new federal banking employment guidelines were enacted in May 2011 and new mortgage employment guidelines took hold in February, the newspaper said. The tougher standards are meant to clear out executives and mid-level bank employees guilty of transactional crimes — such as identity theft and money laundering — but are being applied across the board because of possible fines for noncompliance.
If using a fake dime is worthy of firing, then what penalty should await those who launder* billions of fake dollars on behalf of the Federal Reserve? It is simply reprehensible that Wells Fargo would fire a man for using a fake dime yet not dismantle their own company for laundering at least $2 billion* of fictitious money. This goes beyond mere irony, and even beyond hypocrisy. This is pure evil, and all those who work at Wells Fargo should lose their jobs, while those who are/were the heads of the company should go to jail for defrauding the American people, and the company should have its corporate status revoked and be disbanded.
* Wells Fargo received about $25 billion from TARP. The federal budget for 2008 was $2.9 trillion, while the deficit was $240 billion. This means that, proportionally, at least $2 billion of the $25 billion that Wells Fargo received from TARP was from the deficit. The federal deficit is nothing more than monetized debt, since federal services are paid for, but not always by the money from tax receipts. To make up the deficit, the federal treasury sells debt (issues bonds), which are then bought by investors, foreign nations, and the federal reserve. The federal reserve is the largest holder of US bonds, and the sale of US bonds to the federal reserve is referred to as monetizing the debt, because federal debt is converted into money, and the money is created out of thin air. Therefore, a significant portion of the federal debt is actually realized as inflation. And therefore it can be accurately claimed that Wells Fargo launders fictitious money because it receives funds that are nothing more than monetized debt, which is really money created out of thin air.
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By Simon Grey, on August 27th, 2012
The N.Y. Times (the New York freaking Times!) defends the big banks:
BANKS aren’t always popular even in the best of times, but the anger of recent years is unprecedented. The anger, while understandable, has fueled the misguided idea that we should break up the nation’s largest banks.
The argument is simple and sound-bite ready: In the years before the crisis, greedy bankers used their political muscle to grow from small, specialized banks into giant, all-purpose financial institutions. This transformation led to the financial crisis because banks became too big to manage and too big to fail. If we break them back up, we will eliminate the risk of future crises.
The problem is that every part of this argument is based on a fallacy.
Here’s another argument to consider: We should revoke the corporate charter of the big banks because every last one of them has committed massive amounts of fraud, thus trampling over innocent people’s property rights. Or, to state it another way, the mega-bank corporations should be broken up as a punishment for having broken the law.
Now, demonstrating that the government is serious about defending property rights by punishing the banksters for fraud will not ever eliminate future occurrences of fraud. But I have to think that it will reduce them substantially.
By Ajay Shah, on August 21st, 2012
Ila Patnaik in the Indian Express on the role of the Ministry of Finance in India’s growth. Pratap Bhanu Mehta in the Indian Express on India’s cabinet reshuffle. Anil Padmanabhan in the Mint about how things have changed at MoF after Chidambaram got back.
Bibek Debroy on a major problem that afflicts India today: Human capital obsolescence. Now that I’m safely past that age, I know the right answer for leadership positions: the right age is 40.
Theodore Dalrymple in the Wall Street Journal likes India’s Olympian detachment from the Olympics.
Trampling on the individual in India: Jayalalithaa vs. India Today. Also see Gopu Mohan in the Indian Express who shines the light on the systematic use of litigation.
Russell Green in Mint on the problems of priority sector lending.
Pramit Bhattacharya in Mint on Kaushik Basu’s tenure as CEA.
Mythili Bhusnurmath in the Economic Times on the difficulties of bank solvency that India now faces. The article refers to this RBI report on restructuring of bad debt.
The ghost of Abraham’s letter by N. Sundaresha Subramanian in the Business Standard.
Amol Sharma and Megha Bahree in the Wall Street Journal about Mukesh Ambani’s 4G plans. In it: “On one page there was a complex mathematical calculation of how fast each cell tower could carry data.”
Odd SDP data for Maharashtra, by Dilasha Seth in the Business Standard. Also see.
The man who saved capitalism by Stephen Moore in the Wall Street Journal.
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