It is my pleasure to bring you the third issue of the year, with all its articles and features. This issue also contains an announcement of the eighth IMR Doctoral Conference (IMRDC) scheduled on January 11 and 12, 2017. I look forward to your participation in IMRDC 2016-2017.
Banks play an important role in the education of skilled professionals by providing education loans for higher education. However, the level of credit risk in education loans has been very high in recent years. In the paper “Studying Borrower Level Risk Characteristics of Education Loan in India”, Professor Arindam Bandyopadhyay uses borrower level data of a cross-section of 5000 borrowers, randomly selected, from four major public sector banks in India, to study the micro-level risk of education loan and identify key risk factors of such loans across various geographies and constitutions. The paper examines education loan default risk using logistic regression and loss given default using Tobit censored regression in a multivariate analysis framework. The findings are that borrower defaults on education loan payments are mainly influenced by security, borrower margin, and repayment periods. The likelihood of default is lower if the loan is secured and the borrower’s own contribution is higher. The socioeconomic characteristics of borrowers and their regional locations also act as important factors in education loan defaults. As regarding loss given default, the study findings are that smaller defaulted outstanding loans have better chances of loan recovery; the presence of guarantor/co-borrower and collateral security increases the chances of loan recovery; the longer the repayment period, lower is the loss rate. The study also suggests measures to reduce risk in education loans that includes strengthening credit risk assessment techniques as one of the factors. By segmenting borrowers by probability of default and loss given default, banks can adopt better risk mitigation and pricing strategy to resolve borrower problems.
In their paper, “Subordinate Debt, Deposit Insurance and Market Oriented Monitoring of Banks”, Professor Gaurav Singh Chauhan and co-author Dr. Satyam Shivam Sundaram, present a model of a bank with endogenous risk choices, where delegated monitoring by an active market in subordinate debt helps to contain risk shifting by banks in the presence of deposit insurance. When banks with risk shifting proclivities operating in a closely interconnected bank system face liquidity pressures and solvency threats from information based bank runs by unsophisticated depositors, they threaten the systemic stability by sucking up the liquidity from the system, given that banks can choose a level of risk that is socially suboptimal. In this context, according to the extant literature, deposit insurance by government backed agents could be the remedy. However, government backed agents are not well equipped to estimate the risk sensitivity, and hence, risk based premiums. Further even with deposit insurance the issue of risk shifting incentives of banks still remains unresolved. In such a situation, greater participation from market forces, in the form of provision of subordinate debt, and an active market of subordinate debt to delegate the monitoring of the risk shifting incentives of banks is warranted to contain the risk shifting incentives of banks. The model in this paper builds on past studies and envisages an active market for subordinate debt which can continuously impart signals to the regulators and other at-risk stakeholders. This provides the necessary discipline for banks so that they may conform to solvency consistent behaviour. Such active monitoring leads to better allocation of risk by a bank and provides endogenous incentives to do so. The model also depicts the relevance of subordinate debt in eliminating the distortions in deposit insurance pricing. The paper argues that active monitoring by subordinate debt can induce incentives for counter-cyclical asset allocation by banks for their risky portfolios. The model leads banks to choose risk levels consistent with the first best as envisaged by social planners.
On reviewing the empirical research on idiosyncratic volatility, Professors Sanjay Sehgal and Vidisha Garg observe that there is no consensus on the relationship between idiosyncratic volatility and asset returns. They also observe that the role of cross sectional higher order moments in predicting returns as well as forming profitable portfolio strategies is relatively unexplored, and that literature has focussed mainly on mature markets. In their paper, “Cross Sectional Moments and Portfolio Returns: Evidence for Select Emerging Markets”, they attempt to fill these research gaps using emerging market data from BRIICKS economies (Brazil, Russia, India, Indonesia, China, South Korea, and South Africa), using cross sectional variance of stock returns (CSV) as a measure of idiosyncratic risk, which has the advantage of being calculated at any frequency.Specifically, their objectives are to estimate non-model and model based measures of idiosyncratic risk and check their degree of association; to assess the return predictability power of CSV and higher order moments, i.e. cross sectional skewness (CSS) and cross sectional kurtosis (CSK); to investigate if more profitable portfolios can be formed by using the information contained in the cross sectional higher order moments vis-a-vis cross sectional variance; and to check whether the returns on these portfolios can be explained by asset pricing models like CAPM and the Fama French (FF) model. They develop testable hypotheses accordingly. The data for the study is from the Thomson Reuters . Results show that, consistent with prior literature, the CSV measure is highly correlated with alternative measures constructed as variance of errors from the CAPM and the FF three factor model. CSV has a significant positive relationship with market returns only in some sample countries. The relationship of CSS and CSK with future market returns is normally positive; the results are stronger for the daily data compared to the monthly data. Results show no consistent relationship between CSV sensitivity and portfolio returns, as also with CSK sensitivity sorted portfolios. More consistent results are obtained for CSS measure. Asset pricing models satisfactorily explain portfolio returns with some exceptions. On risk adjusted basis, among the sample countries, South Africa offers the most profitable trading strategy based on CSS sorted portfolios. The study provides important implications for investment managers as well as researchers.
The relationship between executive pay and firm performance has been widely studied in the corporate governance literature. Of late, the academic literature on agency theory and executive compensation has argued that CEO compensation should be aligned to firm performance. Professors Mehul Raithatha and Surenderrao Komera in their paper “Executive Compensation and Firm Performance: Evidence from Indian Firms’’, contribute to the literature by (i) examining the pay-performance relationship using the PROWESS database for the period 2002-12 when disclosure of executive compensation became mandatory for Indian firms; (ii) examining emerging markets while extant literature focussed on Anglo-Saxon economies; and (iii) discussing the effect of persistence in executive compensation practices. After excluding all the financial services firms, firms controlled by the state, and joint sector firms, the final sample consisted of 21,834 firm year observations, consisting of 3,100 firms with an average of 7.04 years each. Of the sample firms, 36.37% were business group affiliated firms and the remaining 63.63% were standalone firms. The study considers consolidated executive compensation as the proxy for pay, and both accounting measures (return on equity and return on assets) as well as the market performance measures (Tobin’s Q and annual stock return) to study firm performance. Further, the study considers firm specific variables such as size, leverage, and risk. The study attempts to empirically validate the heterogeneity in the magnitude of pay-performance relationship by classifying the observations according to the firm size and type of ownership. The study reports significant persistence in executive compensation among the sample firms, even among the sub-samples of firms, classified on size and ownership. Findings also suggest the existence of significant pay-performance relationship among the sample firms. However, this is not the case when performance is measured using market based measures, leading to an argument that sample firms determine their executive compensation based on accounting measures. The pay-performance relationship was absent among the business group affiliated firms, whereas their standalone counterparts reported significant pay-performance relationship. The study also finds that the pay-performance relationship is absent among small sample firms, but the relationship is significant among larger sample firms. The authors attribute the contrast in their observation to the underdeveloped nature of institutional mechanisms and weak investor activism in India.
The Round Table in this issue is on “India Emerging: New Financial Architecture”, with an Academic Note by Professor Sankarshan Basu of IIMB which first lays out the fundamental challenges to the global financial system that were brought about by the global financial crisis of 2007–2008. The note then delineates the form of the new financial architecture that India needs to build, given its requirements, to deal with the demand for larger levels of deregulation of its markets, and the high growth rate of 8% - 9% to sustain the economy. The new financial architecture would need to integrate the banking sector; the mutual funds sector; the non – banking finance sector; and organisations that collate and provide relevant financial information, channelised towards risk management and risk mitigation in particular. The challenges of building the new financial architecture is discussed by a panel of eminent senior practitioners from the different fields. The panel comprises Mr. T Keshav Kumar, Chief General Manager, Commercial Banking, State Bank of Mysore; Mr. Imtaiyazur Rahman, Chief Financial Officer, UTI Mutual Fund; Mr. Sriram Ramnarayan, Country Head, Financial Markets, Thomson Reuters; and Mr. G. S. Sundararajan, Group Director, Shriram Group. The panel discussion is chaired by Professor R Vaidyanathan of IIM Bangalore.
This issue carries a book review by Kshitij Awasthi, doctoral student at IIM Bangalore, of “Who Cheats and How? Scams, Fraud and the Dark Side of the Corporate World”, by Robin Banerjee, 2015, Sage Publications, New Delhi.
With best wishes,
Nagasimha Balakrishna Kanagal
Editor-in-Chief
IIMB Management Review
India
