Jamal Mecklai: Time for another Sodhani Committee?

MARKET MANIAC

The RBI's focus on risk-based supervision for banks, although in itself certainly worthy, seems somewhat incongruous when you look at how their own management of forex market volatility is actually making risk management much more difficult for corporate users. Increased risk leads to a reduction of competitiveness and the RBI needs to act to address this problem immediately.

First off, it is clear that the RBI does focus on forex market volatility""they frequently say that they have no specific target for the rupee and that their primary goal is to manage volatility. Over the past two years, the average volatility of the rupee (against the dollar) has risen more than five times""from 1.3 per cent to 7.2 per cent. Over the same period, the volatility of the euro (again, against the dollar) has also risen, but more modestly, from 9 per cent to 13.5 per cent.

Now, make no mistake, I am not suggesting that the rupee volatility is too high""on the contrary, I think it is at a reasonable level. However, the problem is that the volatility itself is quite unstable, shooting higher quite frequently""quite clearly, the RBI's stated goal of managing rupee volatility is not working too well and could be causing more problems than it is resolving.

To get a sense of the problem, let's look at the ratio of peak to average volatility. I would say that the average volatility in a market provides a measure of the background level of risk""a level that users of a market get accustomed to and, one would hope, are able to manage without too much adverse impact.

The peak volatility, of course, represents the "terror points" that all markets get to, where decision-making becomes much more difficult. A well-managed market""one where risks can be readily managed""should have a relatively low peak to average volatility.

For instance, in the case of the euro, this ratio was fairly stable over the past two years, with the peak seldom 20 per cent more than the average. There was one episode (in February this year, when the euro peaked at 1.29 dollars) when the ratio shot higher, briefly breaching the 20 per cent mark.

On the other hand, the ratio for the rupee has been hugely volatile, breaking through this 20 per cent mark""let's call it the "stable for risk management" range""no fewer than five times over the same period. The most recent episode""in early April ""pushed the peak volatility to nearly twice the average.

More significantly, the peak volatility was outside this "stable" range almost 25 per cent of the time; by comparison, the peak volatility of the euro was outside the range merely 3 per cent of the time.

Now, we all know that managing risk in the Indian forex market has become increasingly difficult in recent times. These numbers show that it is now even more difficult than managing risk in global markets. To my mind, this difficulty is a direct result of inadequate deregulation.

Just as a little knowledge is sometimes worse than no knowledge at all, I believe we have reached a point where the quasi-deregulated market we have is worse (for market users) than the fully controlled market we had before. It is time to move forward.

These sharp spikes in peak volatility, which is what makes meaningful risk management virtually impossible, would be brought down sharply if we had a substantially more liquid market.

And, of course, the only way to achieve this is to lift constraints on existing market participants""say, increasing the 25 per cent of Tier I capital cap on bank borrowings from the global market""and to broaden the participation in the forex markets.

In addition to the problems created by inadequate liquidity, companies are further hogtied by some clearly out-of-date regulations and a regime that is still glacial in making change.

For instance, it is clear that options, particularly structured options, can provide companies with a very useful tool in managing risk. The RBI has permitted rupee options, but there are so many constraints that the market has barely been able to flutter its ill-developed wings.

On interest rate derivatives, too, there are some unseemly constraints. Most egregious, of course, is the regulation that prohibits "derivatives on a derivative".

As a result, a company which has swapped its rupee liability into dollars is not permitted to reduce the resultant risk by, say, buying an FRA. Note, it is not permitted to reduce its risk""isn't that amazing? It is, of course, permitted to reverse the transaction, thereby eliminating all risk and, possibly, eliminating the very reason for the initial transaction.

It is clear that the constraining regulations mentioned here are not in place because they fulfil a specific or particular goal of the deregulation process.

Rather, I believe they are leftovers from the earlier regime, which were not cleaned up when certain broad areas were deregulated""the RBI's quite sensible one-step-at-a-time process. The point is that we need to take another step""no, several more steps.

Risk management is a crucial element of running a business and one of the regulator's key jobs is to create an environment that enables effective risk management.

My sense is that the RBI has really not had the time (or bandwidth) to focus on some of these micro issues, the resolution of which would release another bolus of deregulation, enable the markets to become more efficient, and enable Indian companies to really reach for the sky.

It's time for another Sodhani Committee.

jamal@mecklai.com