Ways To Dis­cour­age Shadow Banks

To avoid re­peat of IL&FS in­ci­dent in fu­ture, the RBI can al­low the short-term rates to be mar­ket-de­ter­mined; it would in­crease the risk in roll-over of short-term fund­ing

The Day After - - CONTENT - By dAnFEs

There are sev­eral as­pects of the In­fra­struc­ture Leas­ing & Fi­nan­cial Ser­vices Ltd (IL&FS) story, which has been in the news for a while now. One of th­ese is the role of short-term fund­ing, which has not re­ceived much at­ten­tion. Why do bor­row­ers such as IL&FS rely so much on short-term fund­ing even though their in­vest­ments are pri­mar­ily long term?

The usual an­swer is that the short-term in­ter­est rate is less than the long-term in­ter­est rate, and so it is prof­itable to bor­row as much on a short-term ba­sis as pos­si­ble.

There is merit in this an­swer ex­cept that it takes for granted the fact that there is usu­ally not much of a roll-over risk. But we need to look at this more closely.

Now it turns out that the Re­serve Bank of In­dia (RBI) uses short-term in­ter­est rate as its key pol­icy tool. This means that the RBI typ­i­cally sets the short-term in­ter­est rate for two months. It may change the in­ter­est rate, if re­quired, at its next bi- monthly meet­ing but un­til then, it is al­most cer­tainly fixed. Even if the in­ter­est rate does get changed in the sub­se­quent meet­ing, there is not much of a sur­prise – at least not a big sur­prise. This is be­cause the RBI pro­vides for­ward guid­ance on pos­si­ble changes in the short-term in­ter­est rate in the near fu­ture.

This has an in­ter­est­ing im­pli­ca­tion. For short-term bor­row­ers, there is lit­tle risk in so far as the in­ter­est cost in the roll-over of fund­ing is con­cerned. This en­cour­ages them to bor­row short-term at low in­ter­est rate rather than bor­row longterm at a high in­ter­est rate; the pro­por­tion of funds borrowed short-term then gets higher than what it would have been oth­er­wise.

What is the way out?

A part of the new re­search by this au­thor on the wider is­sue of macro-fi­nan­cial sta­bil­ity pro­vides a new an­swer. The RBI can use base money in­stead of the short­term in­ter­est rate as a key pol­icy tool in con­duct­ing its mon­e­tary pol­icy.

It is true that there is no close con­nect be­tween base money and in­fla­tion (or other macroe­co­nomic tar­gets). How­ever, this is also true of the short-term in­ter­est rate as a key pol­icy tool. So, base money does not fare any worse than the short­term in­ter­est rate as a pol­icy tool in this re­gard. On the other hand, there is the ben­e­fit of us­ing base money as a key pol­icy tool. If the RBI uses base money as a pol­icy tool, it need not fix the short-term in­ter­est rate. In­deed, this can be de­ter­mined by mar­ket forces.

It is true that such a mar­ket-de­ter­mined price is very likely to fluc­tu­ate – pos­si­bly con­sid­er­ably (more so be­cause the price is de­ter­mined in a whole­sale mar­ket wherein fluc­tu­a­tions in price are the rule, rather than the ex­cep­tion). But that is in­deed the whole idea. If the short-term in­ter­est rate fluc­tu­ates, this in­creases the risk in rollover of short-term fund­ing.

This dis­cour­ages bor­row­ers like the non-bank fi­nan­cial com­pa­nies (NBFCs) in gen­eral and firms like IL&FS in par­tic­u­lar to avoid ex­ces­sive short-term fund­ing.

The op­er­a­tional part of the sug­gested pol­icy can be as fol­lows. The mon­e­tary pol­icy com­mit­tee (MPC) of the RBI can

take a de­ci­sion on changes in base money rather than on pos­si­ble changes in short­term in­ter­est rates.

If in­fla­tion is more than the tar­get in­fla­tion, the MPC can re­duce the growth rate of base money. Con­versely, if in­fla­tion is low, the MPC can some­what raise the rate of growth of base money. As we know, the RBI has adopted flex­i­ble in­fla­tion tar­get­ing. This means that the RBI may, as far as pos­si­ble, take care of ob­jec­tives other than in­fla­tion. Ac­cord­ingly, if there is a slow­down in the real econ­omy, then it may raise the rate of growth of base money. And if there is a boom, it may some­what de­crease the rate of growth of base money.

What is im­por­tant for the real sec­tor of an econ­omy is the sta­bil­ity of fund­ing rather than the sta­bil­ity of short-term in­ter­est rates.

It is, as re­search by Gary B. Gor­ton and An­drew Met­rick (and oth­ers) has shown, the in­sta­bil­ity of such short-term fund­ing that ag­gra­vated the global fi­nan­cial cri­sis in 2007; it was not the be­hav­iour of short­term in­ter­est rates that were at the cen­trestage then.

There is a les­son from that ex­pe­ri­ence, which is that the pol­i­cy­mak­ers need to let the short-term in­ter­est be de­ter­mined by the mar­ket so that ex­ces­sive short-term fund­ing is avoided.

Con­sider an anal­ogy. In the past, many coun­tries used to op­er­ate with fixed ex­change rates and that was con­sid­ered a good idea but the ac­tual ex­pe­ri­ence was very dif­fer­ent. Fixed ex­change rate had, as Mau­rice Ob­st­feld (then at the Uni­ver­sity of Cal­i­for­nia, Berke­ley) and Ken­neth Ro­goff (then at Prince­ton Uni­ver­sity) ar­gued, turned out to be a mi­rage.

In­deed, an im­por­tant rea­son be­hind the East Asian Fi­nan­cial Cri­sis in 1997-98 was that the coun­tries in­volved had fixed ex­change rates. Sub­se­quently, they shifted to flex­i­ble ex­change rates.

Yes, th­ese ex­change rates fluc­tu­ate but that is a small price to pay for avoid­ing a pos­si­bly huge fi­nan­cial cri­sis. We have a sim­i­lar story with re­gard to short-term in­ter­est rates. It is bet­ter to let th­ese fluc­tu­ate ac­cord­ing to mar­ket con­di­tions; such fluc­tu­a­tions can re­duce ex­ces­sive short-term fund­ing, which can be a source of in­sta­bil­ity for the real sec­tor (projects may get de­layed, if not aban­doned al­to­gether).

The ac­claimed au­thor, Nas­sim Ni­cholas Taleb, in his well-known book An­tifrag­ile, has ar­gued force­fully that some fluc­tu­a­tions, here and there, now and then, can, in fact, con­trib­ute to mak­ing the whole sys­tem anti-frag­ile. Let­ting the short-term in­ter­est rates fluc­tu­ate can be use­ful in this con­text.

Note that large fluc­tu­a­tions in the short­term in­ter­est rate need not im­ply any sig­nif­i­cant volatil­ity in long-term in­ter­est rates. The rea­son is sim­ple. The lat­ter is linked to not only the pre­vail­ing short­term in­ter­est rate but also the ex­pected fu­ture short-term in­ter­est rates. While the ac­tual short-term in­ter­est rates can in­deed fluc­tu­ate, there is hardly any rea­son for ex­pec­ta­tions of fu­ture short-term in­ter­est rates to be­come volatile; this is par­tic­u­larly true if the RBI is com­mit­ted to pro­vid­ing a sta­ble frame­work for mon­e­tary pol­icy now and in the fu­ture.

If base money is so much bet­ter than the short-term in­ter­est rate as a key pol­icy tool, then why are cen­tral banks (in­clud­ing the RBI) not us­ing this? Ben­nett T. McCal­lum made an in­ter­est­ing state­ment in the Hand­book of Macroe­co­nomics (vol­ume 1, p. 1514).

It is worth quot­ing him, “One hy­poth­e­sis is that in­ter­est rate in­stru­ments and in­ter­est rate smooth­ing are prac­ticed be­cause fi­nan­cial com­mu­ni­ties dis­like in­ter­est rate vari­abil­ity and many cen­tral banks cater to the wishes of the fi­nan­cial in­sti­tu­tions with which they have to work in the course of their cen­tral-bank­ing du­ties.”

The above state­ment was made even when the is­sue of short-term fund­ing for shadow banks in In­dia (or the US) was not in the pic­ture.

With the ex­pe­ri­ence of the global fi­nan­cial cri­sis in 2007 and the rel­a­tively small ex­am­ple of un­sta­ble fund­ing for NBFCs (like the IL&FS) in In­dia, the case against the cen­tral bank’s use of short­term in­ter­est rate as a key pol­icy tool has be­come even stronger.

Union Fi­nance Min­is­ter Arun Jait­ley chairs the 19th meet­ing of FSDC at Fi­nance Min­istry

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