Viral V. AcharyaNYU Stern, CEPR and NBER

(based on “State Ownership and Systemic Risk: Evidence from the Indian Financial Sector during 2007-09”, with

Nirupama Kulkarni, Hass School of Business, UC Berkeley, and

Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance, with Stijn van Nieuwerburgh, Matthew Richardson and Larry White, Harper Collins (India))

July 2011

Is State Ownership in the Indian Banking Sector Desirable?

India: Crisis of 2008 Triggered by global financial crisis of August 2007NIFTY fell nearly 60% from its peak in January 2008.

Strong performance of Indian financial firms. Capitalization: High CRAR of 13% (globally 8.2% to

17.7%).Quality of assets: NPL ratio decreased to 2.3% 2008.Profitability: Higher ROA of 1% as of March, 2008.

Attributed to high regulation preventing excessive risk taking.

Attributed also to the presence of state-owned banks.

Crisis of 2008

Jan-0

7

Feb-07

Mar-0

7

Apr-07

May-

07

Jun-0

7

Jul-0

7

Aug-07

Oct

-07

Nov-07

Dec-07

Jan-0

8

Feb-08

Mar-0

8

Apr-08

May-

08

Jun-0

8

Aug-08

Sep-08

Oct

-08

Nov-08

Dec-08

Jan-0

9

Feb-09

0100020003000400050006000700080009000

1000011000120001300014000

0

5000

10000

15000

20000

Stock Index Performance for NSE NIFTY and BSE Sensex be-tween Jan '07-Feb '09

NIFTY SENSEX

Public and Private Sector Performance

0

50

100

150

200

250

300

350Ja

n-07

Feb-

07

Mar

-07

Apr

-07

May

-07

Jun-

07

Jul-0

7

Aug

-07

Sep-

07

Oct

-07

Nov

-07

Dec

-07

Jan-

08

Feb-

08

Mar

-08

Apr

-08

May

-08

Jun-

08

Jul-0

8

Aug

-08

Sep-

08

Oct

-08

Nov

-08

Dec

-08

Jan-

09

Feb-

09

Ave

rage

Re

turn

s

Indexed Equally Weighted ReturnsIndex=100 on January 2, 2007

Public Sector Private Sector

Policy (Political!) Implications

The ruling party leader, claimed that “public sector financial institutions have given our economy the stability and resilience we are now witnessing in the face of the economic slowdown.”

Finance minister echoed these sentiments by claiming India’s PSBs were strong pillars in the world’s banking industry.

Source: Frontline, 2008

The emerging pre-crisis consensus for privatization of the financial sector appears – at least for now – to have turned on its head…

An Inquiry and Concern

Inquiry: Did government ownership help PSBs outperform the private-sector counterparts or was it government guarantees? (Indian Bank Nationalization Act: Explicit guarantee for PSBs)We compare public and private sector performance during

the crisis period of Jan 2007-Feb 09.We relate systemic risk exposure of financial firms to crisis

based on Realized returns; Deposit Growth; GOI capital injections

Concern: The PSBs through crisis-time guarantees may have captured significant market-share and crowded out private sectorHow will the private sector respond?Will there be a risk of a “race to the bottom” in risk-taking?

DataRelate pre-crisis systemic risk to crisis

performance:

Realized Returns (stock return data):70 financial institutions: Public (19 firms), Private

(51 firms)

Deposit growth (annual RBI data):39 banks: PSBs (17), Private sector banks (22)

Impact of GOI guarantees (World Bank report + returns)

Key Results

I. Ex ante systemic risk (exposure to market-wide crash) and ex post performance for the two sectors are strikingly different.

Public sector firms had greater ex ante systemic risk and yet outperformed private sector firms.

II. There was a flight of deposits from private firms to PSBs

Surprisingly, public sector firms with greater systemic risk performed better.

III. PSBs with greater systemic risk received greater GOI support.

I. Systemic Risk measure: MES

Marginal Expected Shortfall (MES) measureCaptures tail dependence of stock return on the market as a

whole. Negative of the average returns for a given bank in the 5%

worst days for the market returns (S&P CNX NIFTY index) during the pre-crisis period from Jan-Dec 2007.

Contribution of each firm to systemic risk in the event of a crisis.

Found in a series of research papers at NYU-Stern to help explain performance in a crisis of banks across the world (but as in the Indian study, less so for state-owned banks)

Overall average MES of 3.79% for all firms in our analysis.PSB : 4.34%Private sector banks : 3.58%.

Realized Returns: Private Sector Firms

0.00 0.02 0.04 0.06

-1.0

-0.8

-0.6

-0.4

MES

Re

aliz

ed

Re

turn

ICICI

HDFC HF

HDFC

RELCAP

GMR

BAJAJ HOLD

POWERFIN

IDFC

AXIS

INDBULLSINDINFOLINENETWORK18JM FIN

IFCI

KRNTKA

LIC

M&MFIN

ING V

IL&FS

KARUR

TATA INV

SUNDARAM

SHRIRAM

SREIBAJAJAUTO

SOUTHINDGEOJIT

CHOLAMANDAL

DEWAN

EMKAYSHARYANS

JINDAL

BALMER

OSCAR

IL&FS INV

GIC

CAN FIN

APOLLO

TRANS

NETWORTH

GRUH

INDBANK MER

MOTOR&GEN

AKCAP

VASINFRAHB

JKSYN

SUAVEJRG SECKHANDWALA

JOINDRE

Realized Returns: Public Sector Firms

0.02 0.03 0.04 0.05 0.06

-0.7

-0.6

-0.5

-0.4

MES

Re

alize

d R

etu

rn

SBI

PNB

CANARA

BOI

BOB

UNION

OBC

SYNDICATE

CORP

INDIAN

ALLHBD

ANDHRA

VIJAYA

UCO

J&K

DENA

FED

BOMAHRSHTRA

A Case in Point

0

200

400

600

800

1000

1200Ja

n-07

Mar

-07

May

-07

Jul-0

7

Sep-

07

Nov-

07

Jan-

08

Mar

-08

May

-08

Jul-0

8

Sep-

08

Nov-

08

Jan-

09

Mar

-09

May

-09

Jul-0

9

Sep-

09

Nov-

09

Jan-

10

Mar

-10

CDS

Prem

ium

1 YR CDS Spread

STATE BANK OF INDIA ICICI BANK

Robustness Checks

Same banks were systemically important in 2006 and 2007.MES Ranking for 2006 strongly related to 2007 (R2 of 17.6%).$MES Rankings even more stable(R2 of 92.5%).

Similar results obtained with BSE SENSEX.Results are robust to controlling for

Greater past performanceLeverage SizeGlobal beta (as the Indian crisis was partly due global

problems)Placebo tests outside of the crisis

2004, 2005, 2006 and 2007 do not show similar trends.Confirms the intuition that government guarantees are more

important during crises.

II. Deposit GrowthHelps understand the relationship between realized

returns and systemic risk.

Depositors shifted capital out of private banks to PSBs. New results also suggest maturity-shortening for

private banks.“Flight-to-Safety”: Following Lehman, Infosys

transferred Rs. 10 billion in deposits from ICICI to SBI in Q3-2008*.

*Economic Times (2009).

BUT: Depositors shifted capital out of high-MES private banks to high-MES PSBs!

Public vs Private Sector Performance: Deposit Growth

Public Sector Banks

Private Sector Banks

Foreign Banks Scheduled Commercial

Banks

22.9%19.9%

29.1%

22.4%24.1%

8.0% 7.8%

19.8%

Deposits Growth

As on March 28, 2008 (y-o-y)

As on March 27, 2009 (y-o-y)

Deposit Growth: Private Sector Firms

2.00% 2.50% 3.00% 3.50% 4.00% 4.50% 5.00% 5.50% 6.00% 6.50%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

34%

10%

28%

-24%

38%

24%

42%

-11%

16%

22%

19%

20%

-5%

31%

19%

22%

MES

Cri

sis

De

po

sit

Gro

wth

Deposit Growth: Public Sector Firms

0.00% 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00%0%

10%

20%

30%

40%

50%

60%

38%

15%

20%19%

19%20%

27% 26%25%

21%19%

33%

27%

19%

19%

26%26%

22%25%

34%

15%14%

54%

MES

Cri

sis

De

po

sit

Gro

wth

III. Capital Injection in PSBsGOI announced fiscal stimulus in December 2008. Promised capital to PSBs to help maintain CRAR of

12%. Dec. 2008: GOI requested Rs.1700 cr. from World BankDec .2008-Feb. 2009, announced capital injection in 4

PSBs: UCO Bank (Rs. 450 cr.), Central Bank of India (Rs. 700 cr.) and Vijaya Bank (Rs. 500 cr.).

2008-2009: Injected Rs. 250 cr. in United Bank of India. 2010-11 budget allocates Rs. 16,500 cr. to help

maintain Tier- 1 capital ratio of 8%. IDBI Bank (Rs. 3,119 cr.), Central Bank (Rs. 2,016 cr.),

Bank of Maharashtra (Rs. 590 cr.), UCO Bank (Rs. 375 cr.) and Union Bank (Rs. 111 cr.)

Explicit government guarantee

Capital injections determined based on PSB funding requirements.

Poor performing PSBs more likely to receive GOI support.

PSBs receiving capital (except Union Bank) had Tier-1 capital < 8%. Bank of Maharashtra (6.1%), Central Bank of India

(7.0%), UCO Bank (6.5%), Union Bank of India (8.2%), Vijaya Bank (7.7%), IDBI Bank (6.8%).

Among the riskier banks. MES: IDBI (6.67%), Union Bank of India (5.41%),Vijaya

Bank (5.02%), UCO (4.26%) IDBI: Received highest capital injection of Rs 3,119

crores.

Effect on credit growth:

Public Sector Banks

Private Sector Banks

Foreign Banks Scheduled Commercial

Banks

22.5%19.9%

28.5%

22.3%20.4%

10.9%

4.0%

17.3%

Credit Growth

As on March 28, 2008 (y-o-y)

As on March 27, 2009 (y-o-y)

Eventually, full-scale fiscal stimulus stabilized private-sector banks too…

2007 Q1 2007 Q2 2007 Q3 2007 Q4 2008 Q1 2008 Q2 2008 Q3 2008 Q4 2009 Q1

9.3%

2.2%

7.2%

3.1%

10.4%

1.7%

5.5% 5.2%

12.0%13.2%

6.2%2.2%

2.6%

10.3%

0.0%

1.0%

-0.3%

8.2%

Q-o-Q Deposit Growth

Public Private

Government-Sponsored Enterprises: United States and India

Fannie Mae, Freddie Mac, Ginnie Mae, FHLBs, FHA, …GSEs in the US set up in the 1930’s (Fannie Mae,

e.g.) to support housing marketsStrengthened over time through newer GSEs

“Affordable housing goals” since early 1990’sImplicit guarantee conferred through special status

of GSE debt and securities (“flight to safety”)Among the riskier “banks”, especially since 1990’s

Financial inclusion goals; Risk-taking on the government put

Hard landing in crisis, BUT NOT FOR GSE CREDITORS…

Crowding out of private market in mortgages post-crisis

Historical Perspective on US GSEsA brief tour through their history

The great depression

Privatization in 1968

Securitization & deregulation of mortgage markets in the early 80s

FHEFSSA of 1992

GSE Growth – How?

1980 1985 1990 1995 2000 2005 20100

500

1000

1500

2000

2500

3000

3500

4000

4500

0

5

10

15

20

25

30

35

40

45

50

Mtg Portfolio MBS guarantees F&F %share

Year

$ billions % share ofmortgage mkt

When Did the GSEs Start Taking on “Risky” Mortgages?

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 20020

5

10

15

20

25

30

35

40

0

100

200

300

400

500

600

700

800

%loans with LTV>90

Source: Fannie Mae

1990 1992 1994 1996 1998 2000 2002 2004 2006 20080

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0

500

1000

1500

2000

2500

3000

3500

4000

4500

Non-GSE F & F GNMANon-Seczd Originations

Year

% share

$ billions

The Sub-prime Securitization Market Took Off: A Race to the Bottom

27

RMBS GSE vs. Non-GSE Issuances

$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011*

GSE

Non-GSE

GSEs: Last Mortgage Man Standing

Source: SIFMA, CreditSightsIn $ billions. *2011 YTD through May, 2011

“The shapers of the American mortgage finance system hoped to achieve the security of government ownership, the integrity of local banking and the ingenuity of Wall Street. Instead they got the ingenuity of government, the security of local banking and the integrity of Wall Street.”

- David Frum (columnist, and former speechwriter for President George W. Bush), National Post, July 11, 2008

Finance Reform in the US and India

General agreement that a mostly private mortgage market in the United States is the right way to go. But…How do we get there from here?Such a transition was left to private forces in 1990’s and

2000’sOutcome was not an efficient oneLack of level-playing field created perverse downward spiral

A similar transition is being (possibly) envisaged in India Expand private sector firms; greater variety; greater scope;

freer branchingBut should we be concerned about lack of level-playing

field?Why not privatize the PSBs, improve prudential regulation

across board, and manage the transition better