Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Monthly Archives: March 2017

Why do economists ignore risk?

Cochrane writes on his Grumpy Economist blog:

Here’s how covered interest parity works. Think of two ways to invest money, risklessly, for a year. Option 1: buy a one-year CD (conceptually. If you are a bank, or large corporation you do this by a repurchase agreement). Option 2: Buy euros, buy a one-year European CD, and enter a forward contract by which you get dollars back for your euros one year from now, at a predetermined rate. Both are entirely risk free.

It is only an economist who today thinks of this trade as risk free. Before the global financial crisis many finance people would have thought so too, but not today. After the crisis, any serious finance professional would immediately think of the multiple risks in these trades:

  1. The US bank could default

  2. The European bank could default

  3. The forward contract counterparty could default

  4. There is euro redenomination risk. In that terrifying state of the world, depending on the nationality of the bank and the forward contract counterparty, one or both of these could be redenominated into some other currency – new francs, marks, liras or drachmas . Theoretically, you could end up being long new French francs (on the euro CD) and short new German marks (on the forward contract).

During the last decade, finance has moved on from simplistic notions of risk. I like to believe that in many top banks today, those who espouse Cochrane’s view of risk would be at risk of losing their job. Or at least they would be asked to enrol in a course on two curve (or multi curve) discounting. In today’s finance, there is return free risk, but no risk free return. Covered interest parity is today only an approximation that you may use for a back of the envelope calculation, but not for actually quoting a price. I wrote about this in a wonky blog post last year, and I have discussed two curve discounting in another wonky post half a dozen years ago.

The wonderful thing about finance is that it provides an opportunity to get rid of bad ideas by marking them to market. The problem comes when we distrust the market and start thinking of model errors as market inefficiencies. Cochrane writes about the violations of covered interest parity:

… this makes no sense at all. Banks are leaving pure arbitrage opportunities on the table, for years at a time. … But this is arbitrage! It’s an infinite Sharpe ratio!

Rather than accept that the covered interest parity model is wrong in a two curve world, Cochrane thinks that post crisis regulations are preventing the banks from doing this “arbitrage” and bringing the markets back to the old world. It is true that a Too Big to Fail (TBTF) can still do covered interest “arbitrage”. But what that tells us is that a TBTF bank can pocket the gains from the covered interest trade and palm off the risks to the tax payer. A TBTF bank can do the trade, because it is closer to being risk neutral (anybody can be risk neutral with other people’s money). Yes, the covered interest trade has a positive Sharpe ratio but not an infinite one, and perhaps not even a very large one. We need less TBTF banks doing low Sharpe ratio trades, keeping the gains and shoving the losses to the taxpayers.

And both economists and policy makers need to take risk more seriously than they do today.

Indian financial history

My blog post a couple of months ago on financial history books led to a lively discussion in the comments on a similar list for Indian financial history. There was so much useful material in these comments that I thought it useful to hoist it from the comments to a blog post in its own right. As you can see, very little of this post is my contribution. Most of the material is from my colleague at IIM Ahmedabad, Prof. Chinmay Tumbe who is deeply interested in business, economic and demographic history. All that I have done is to add hyperlinks wherever possible, and must in fact confess that I have not yet read most of the material listed here.

Amol Agrawal January 27, 2017 at 5:44 pm

I was also wondering whether you could recommend some books on India’s financial history as well. I guess you might say there are hardly any. But I guess history of RBI (Volume I), History of SBI, Indigenous Banking by LC Jain etc could be a part of the list. But these are just on banking, We have very little ideas on equity markets, insurance, funds etc. Could you please help me with a few titles?

Jayanth Varma January 27, 2017 at 9:07 pm

There are some excellent books on Indian economic history. The Cambridge Economic History of India is absolutely invaluable. There are some books and other material on the history of the East India Company and the Dutch VOC which are also relevant. Adam Smith’s [discussion](http://www.econlib.org/library/Smith/smWN20.html#B.V, Ch.1, Of the Expences of the Sovereign or Commonwealth) of the English East India Company in the Wealth of Nations is also worth reading. Angus Maddison’s Asia in the World Economy 1500–2030 AD is also useful.

But there is too little of financial history in all this. I would like to know more about the financial transactions of Jagat Seth for example though there is some material here.

Indian monetary history in the nineteenth century is absolutely fascinating: I think at one time or the other, India had every kind of exchange rate regime known at the time. Oscar Wilde famously advised a student to omit this chapter because it is too sensational. If you have access to JSTOR, I recommend: Laughlin, J. Laurence. “Indian Monetary History.” Journal of Political Economy, vol. 1, no. 4, 1893, pp. 593–596.

Way back in 2010, SEBI set up an Advisory Panel on History of Indian Securities Market of which I was a member and some material was collected and made available on the SEBI web site. I do not think that much progress has taken place after that.

Amol Agrawal January 28, 2017 at 8:58 am

I fully agree we have nothing much in financial history which is a puzzle. I have read the Lodewijk Petram work on World’s oldest Stock exchange. We need similar accounts for BSE and other Regional SEs which were important earlier. I have seen SEBI’s links but most are unreadable. Like RBI and SBI have commissioned their history, we need SEBI/IRDA etc to do the same for other markets. From these, students like me can pick up and build.

Likewise Sylla and Homer’s History of Interest Rates could be developed into History of interest rates in India using several RBI publications. There is some data which has to be all put together.

Having said this, I think following books do give some perspective on history of finance in India:
1) Industrial Organisation (1934) by PS Lokanathan
2) Organisation and Finance of Industries in India (1937) by D R Samant and M A Mulky
3) Financial Chapter in History of Bombay (1910) by DE Wacha

There are some others which are mainly on banking. I can add them but I think if one reads History of RBI and History of SBI (by Prof AK Bagchi), banking is pretty much covered.

We clearly need to expand this list and have more works on India’s financial history. I will try and add as and when I find more readings.

Jayanth Varma February 13, 2017 at 9:28 pm

Another useful book is
Raymond W. Goldsmith The financial development of India, Japan, and the United States : a trilateral institutional, statistical and analytic comparison, Yale University Press 1983.

Prof. Chinmay Tumbe March 1, 2017 5:10 pm

Adding a few that have not been covered above:

  1. Goldsmith has one book just on India called Financial Development of India, 1860-1977, which is a truly monumental work.

  2. A 2017 book by a friend of mine attempts to synthesise monetary history in India

  3. I have a paper in the Indian Economic and Social History Review on the history of the Post Office as a financial institution; not too many associate that with finance though it is the largest financial institution of India in terms of network and personal deposits.

  4. Tirthankar Roy has a recent paper on seasonality of interest rates in the money market of colonial India.

  5. Dwijendra Tripathi of IIMA wrote the biography of Bank of Baroda in the 1980s and updated that in the late 2000s.

  6. Amiya Bagchi’s edited volume on Money and Credit in Indian History in 2002 has wide ranging contributions to it

  7. P R Brahmananda’s Money, Income, Prices in 19th century India: A Historical, Quantitative and Theoretical Study.

  8. On the 1860-65 Bombay episode, see Wacha’s Financial Chapter; or any
    biography of Premchand Roychand as in Lakshmi Subramanian’s Three Merchants
    of Bombay

  9. Some Books:

    Of course, several other banking histories can be added to this list.

The Financial History Review does not have a single piece on India, which
goes to show the huge scope for research in this field. Amol’s thesis on
south Indian banking history will add to our knowledge.

Towards bank cartelization in India?

I have begun to wonder whether Indian banks have stopped competing aggressively with each other and have started forming an implicit cartel. Rising non performing assets have reduced the appetite for bank lending to a level even lower than the severely depressed demand for bank credit. Obviously, banks do not need to raise much deposits if they are not lending much. It is easier (at least in the short run) to try and charge higher fees from a smaller depositor base than to spend time and money acquiring and retaining customers. And that is what we are seeing. More ominously, some of the attempts to raise fees and user charges seem to a casual observer to be coordinated across banks. If that is the case, then of course these are serious issues for the Competition Commission.

I think demonetization has played some role in this for multiple reasons. First, it boosted the liquidity of the banks virtually overnight and accelerated trends that had been building up slowly over several months. Second, demonetization turned banks into an extended arm of the state: bank officers became quasi government officials with substantial powers. Long after that stage passed, many banks have not gone back to being service organizations again. Anecdotal evidence suggests that this transformation from customer service to bureaucratic conduct has happened in the private sector banks to the same if not a greater extent.

In the long run, this change in the behaviour of the management and employees of the banks would be disastrous for the banking system. On the deposit side, payment banks and mutual funds might find a once in a lifetime opportunity to disrupt banking. On the advances side, non bank finance companies have gained valuable customers turned away by the banks. In the long run, the bond markets could also take business away from the banks.

The first 25 years of economic reforms saw the banking system grow to dominate the financial system previously dominated by the development financial institutions. Shortsighted management and staff could erode this dominance very quickly.