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Financial Innovation, Did it really help!

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Bob Litan of Brookings Institution has come out with a very provocative paper   “ In Defence of Much, But Not all Financial Innovation.” Therein he discusses “good vs bad” that has happened with financial innovations.

Kevin Drum at Motherjones has summarized the paper beautifully for all of us who don’t want to give time to understand the details of paper, and intricacies of the argument.

Financial Innovation, Source

Written by SK

March 8, 2010 at 4:00 pm

Aligning Scores

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Past few days, IITs have been in news again. HRD minister Kapil Sibal wants to give weightage to class twelfth performance also for selection.  He wants minimum marks to be eighty percent to qualify for the test.  While this proposal has been topic of hot discussion, I kept thinking about the execution of this proposal from statistical perspective.

The burning question, we all will agree, is that not two board examination is similar in terms of  strictness in awarding marks. While, it’s easier, I mean relatively easier, to get 90% in CBSE and ICSE , it’s next to impossible to get similar marks in a few state boards, like Bihar Intermediate examination.

Now, if we want the screening rule to be unbiased, we need to account for the reality that 80% in one board examination is not 80% in another board examination. This can be done by creating a unbiased methodology to  project all the scores on same axis – that is by aligning the scores of different board examination.

Before getting into the details of approaches to accommodate the bias, let us list down few business scenarios where we might have to do similar task.

Competitor Analysis:

a) An auto finance company gets number of request for refinance of auto loans. In this situation, the company would have data of interest rate charged by previous financier. It would have complete application data and bureau data for the customer. Interest rate charged is function of application data and internally developed risk score based on bureau data.  Now if an auto finance company is able to align its internal risk score with competitors risk score, it certainly has an edge over competitor. The detail will be clear from the paper linked below.

b) A similar problem for insurance company:  Please have a look at this patented method for aligning two scores. It can potentially help company to align the premium it will charge with competitor’s premium. Unfortunately, like all the patent filing document, it’s not very easy to get hold of methodology at one reading. Allow me to digress for a while; but it would be really helpful if law enforces patentee to file an easy- to- understand document along with the usual patent filing. It’s understandable why patentees constructs the claim the way they do, it’s necessary to prove infringement.

There are various examples in competitor analysis domain where we would have to perform similar task. Other scenario could be,  lets say risk team has developed a risk scorecard that is one of the input for pricing. Earlier risk team used traditional FICO score, but in newer model they have used Nextgen score for internal risk scorecard. Pricing team applies rule on FICO score and Internal risk score. With new risk score, pricing team has to apply rule on Nextgen score and internal score, but they don’t have access to Nextgen score of previous customers to reprice them.

Having explained few examples where aligning score is of paramount importance, we have to solve the problem of aligning marks. The details would be there in next post.

Written by SK

October 20, 2009 at 7:05 pm

How to Reform the Credit Rating agencies

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Major credit rating agencies are severely criticized for beautifying the bad credits of financial institutions with AAA ratings that led to financial crisis. There has been lots of discussion on reform of CRAs. There was a round table organized by SEC to examine oversight of agencies. Recently, they met on September and came up with a paper with adopted rule and proposed rule. World bank maintains a page devoted to ideas on CRAs reform. There has been deluge of working papers identifying the loophole in earlier set up, and proposing remedial measures.

The major problem has been the obvious conflict of interest. CRAs are paid by institution who they have to rate, and to attract more businesses CRAs began assigning superior ratings to financial products and institution. A recent paper suggests that CRAs are more prone to inflate rating when there is a larger fraction of naive investors, and reputation risk of getting caught of CRAs is lower.

There has been suggestion like CRAs revenue source should be people who benefit from their service, that is investors. But, due to practical difficulty in implementing a model like this, the idea don’t have much supporter. The second idea that came to fore is, why shouldn’t we have number of small CRAs like equity research teams.  Now, we have only three CRAs, Moody’s, S&P and Fitch rating. The proposed suggestion relies on assumption that number of CRAs will make the market competitive, hence it will become efficient and honest. The concept was correct, but unfortunately it has not worked properly for equity research as well, and retail investors continue to be fed with misinformation.

Another idea is to have rotating raters. It says that every tenth rating  by a CRA would be subjected to back rating. The idea is good, but yet again it adds to complexity and there is a possibility of back rating agencies to be as lenient as first rating agency. Some are suggesting joint liability scheme where if one rating agency is sued and can’t pay investor restitution, then other rating agency should be forced to pick up the tab. They say it will force all three to raise their bar, but few doubt that it would have opposite effect, as rating agencies are getting insured for it’s bad performance.

We have to wait and watch that what are the measures SEC adopts to reform credit rating agencies.

Written by SK

October 9, 2009 at 3:50 pm

40 Years of Bank Nationalization

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Here are  major points raised by Ashok V Desai on an article written on telegraph on forty years of bank nationalization. Ashok V. Desai is consultant editor of The Telegraph, and a columnist in Businessworld. He was my favorite columnist in 2002-03, when I used to read BW. Later on I came to know that he is a highly respected personality, and I took pride in myself that I do have an eye for talent. 🙂

1) Recently banks declared that their NPA are not over Rs 20k crore, and government announced that they are writing off loans of Rs 60k crore issued to farmers. These two figures of 20k and 60k crore imply that either banks have understated their NPA (20k is total NPA, not loans only to farmers) or government has written off loans to farmers who were diligently paying their debt.  Third possibility is major chunk of money those 60k crore is warming pockets of politicians and bureaucrats. (from BW editorial)

2) Banks were nationalized to give credit to government’s favorite sectors (agriculture and small industries). But they didn’t do so. Later on government imposed them to lend 40% of their credit to these sectors, they did so for a while, but ironically soon ran out of worthy borrowers.

3) In last ten years, banks have been financing infrastructure sectors – power, telecommunication, roads, ports. Almost 25% of their loan goes to these sectors. This goes against traditional rules that required banks to give short term loans against liquid collateral. These sectors should have raised loan from capital market. On pretext of it’s lack of development in India nationalized bank financed long term loans to them, though for long term financing government had created -IDBI,ICICI,UTI.  Consequently, these three entities got converted into banks.

4) It was envisaged that nationalized bank will expand their operation in rural areas. They did expanded their business, but more in urban area than in rural areas.

Note: One may question, why should we raise question over what they have done as long as they are profitable. The point is they are not profitable, and they have not done what they have been nationalized (insurance of getting bailed out) for.

He concludes his article with following words.

My findings are based on a cursory analysis of easily available banking statistics. So much more could be inferred from the masses of statistics accumulated by the Reserve Bank of India. All it needs is a good, elementary economist. The RBI employs economists by the hundreds; the finance ministry gives generous grants to many more. But their minds are focused on higher matters; looking at easily available figures and calculating simple ratios would not occur to them. So we continue to have one of the world’s best documented and least analysed banking systems.

Written by SK

September 17, 2009 at 7:49 pm

SBI’s Expansion Plan

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SBI is in process of transforming itself from senile, laggard observer to an enterprising youth who is not afraid to try novel things to achieve unachievable dreams ( for government owned arms by their own set standard).

Year 2006, O.P.Bhat took command of SBI as the new chairman. He identified three major cancerous concerns that were keeping SBI far behind private banks. ( Source O.P.Bhat’s interview from Mckinsey Quarterly)

1:  Most skillful, experienced professional of SBI were taking VRS, and they were joining private sector banks with their vast grassroot level experience. He stopped the VRS scheme.

2: SBI was not ready to serve the upwardly mobile , high earning young generation of the country. It consisted a bunch of unmotivated, directionless group of workers. He started to instill a sense of ownership in employees. Few programs were launced with successful results. Senior professional from all over India were invited for brainstroming sessions.

3: SBI were lacking in treasury operations. he realigned it’s treasury operations.

Yesterday, I saw his interview in CNBC TV18. The major points that come to mind:

1: He is looking for consolidation. ICBS, a chinese bank, is ten times larger than SBI. SBI in it’s current form is too small to serve large corporates of India. If things has to go by his pace, he would like all SBI’s ( SBI mysore, indore..) to be consolidated under one umbrella.

2: The world is getting globalised. So he would like to serve at least the indian MNC abroad also. Now SBI’s business in india compared to abroad business is  88 to 12.  He would like this ratio to be 75:25. For that they might need to acquire some foreign banks.

3: Goverment is looking for divestment, they might decrese their holding to 51%.

4: Grandchildren have more freedom. All subsidiary of SBI like SBI cap, they don’t have to adhere rules like parent SBI. They hire people in market rate, and for all practical purposes work as private organization.  I don’t know why and how is this the case, but that’s what I learned.

In the end, it really gives satisfaction to know that a bank that we always, since childhood, considered synonyms with banking is doing good. Logically, if we apply Bastitiats’ teachings, I am not sure would it really matter for economy, country or us, whether SBI or any private bank does well. But, nonetheless, it is a satisfying news.

Written by SK

August 3, 2009 at 5:17 pm

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