How to get low overheads in finance
In a bird's eye view, there are exactly two features of the financial sector. First, the financial sector is the "brain" of the economy; it is the planning commission that decides what industries and what management teams get capital. Second, the financial sector incurs costs when doing so. Hence, the broadest goal of public policy is: How can we obtain good information processing? How can we obtain the minimum costs of intermediation?
Banking. The cost of Indian banking works out to roughly 2.75% of assets. Many countries have numbers which are much smaller than this. In the last five years, the cost of Indian banking has dropped by roughly 40 basis points, which may reflect the impact of greater competition and improved technology.
We should not see the cost in isolation. In principle, we might be willing willing to pay higher costs in return for sufficiently superior processing. In the case of banking, it is difficult to measure the quality of information processing embedded in the credit decisions of banks. A narrow focus on NPAs alone is inaccurate, for India is a high-risk economy where it may be quite appropriate to follow investment strategies which enjoy high risk if they offer sufficiently high returns. The non-transparency of banking prevents us from thinking about these issues more effectively.
Mutual funds. As with banks, there are two roles which mutual funds perform: the operational role of running portfolios such as processing of settlement, dividends, etc., and the "brain" function of thinking about resource allocation. Mutual funds are more transparent than banks, so it is more feasible to obtain some estimates of their performance on information processing: this is the extent to which actively managed portfolios outperform benchmarks.
It is difficult to measure the complete expenses of the mutual fund industry. Uma Shashikant of UTI ICM, who has worked in this field, feels the number is around 1.6%. This is a rather large number, considering that mutual funds do not operate a large branch network or a gigantic labour force. Further, this number excludes market impact cost, which is one of the most important costs in fund management.
The international evidence suggests that when securities markets are liquid and transparent, mutual funds do not add value through active management; that the anonymous securities market does superior information processing when compared with fund managers. The fund industry in India is young, and it is difficult to obtain sound evidence on these questions, but the preliminary evidence on the equity market is similar to that seen internationally, where three-quarters of funds are beaten by passive benchmarks. On the bond market, mutual funds may still be useful, since RBI's design of the bond market favours non-transparency and entry barriers.
This suggests that where equities are concerned, the economy may be better off utilising MFs for the efficiencies of their back-office, rather than for their stock-picking. This is done by investing in index funds, which should have much lower costs. For large investors, index funds are incredibly cheap. Internationally, the fee for a $1 billion portfolio placed with an index fund manager is 0.01%. While the fees and expenses of index funds in India today are lower than those of actively managed funds, they are amongst the costliest index funds in the world.
Scale economies. There are very important scale economies with both banks and mutual funds, in two respects. The first is the fixed costs of the organisation as a whole. Broadly speaking, with $0.5 trillion of GDP, India is a large enough economy so that the banking and mutual fund sectors do not face serious bottlenecks when it comes to aggregate market size. However, the second problem, that of small transactions and small portfolios is a severe constraint. The portfolio size of the typical individual, and the transaction size, faced in India is extremely small by world standards. Mutual funds in India accept contributions by individuals of $10, which would not be acceptable transactions elsewhere in the world. The fixed cost of the transaction looms large for such small transactions.
Obtaining low overheads while having small value accounts and small value transactions is the real challenge in doing process engineering in Indian finance. Many solutions which work acceptably in other countries do not work in India because of the tiny transaction sizes that are faced here. This is where the IT revolution is a real boon. The average trade value at NSE is one--tenth of that seen on the NYSE, yet the costs of NSE can be lower than those seen at NYSE since NSE uses computers for roles where the NYSE uses human beings.
Political economy. There is a basic conflict between the viewpoint of the financial industry and that of public policy. The financial industry revels in fees, expenses, illiquidity, non-transparency and inefficient markets. The financial sector dislikes commoditised products, such as index funds and exchange-traded derivatives. In contrast, from the viewpoint of the economy, we seek transparent, liquid, efficient markets dominated by commoditiesed products where profit rates are near zero.
This has one direct ramification in terms of the political economy of public policy: Good policies on the financial sector will almost always be unpopular amongst employees of the financial sector; they will always elicit hostility in the "south Bombay club" which traditionally dominated finance. Bond dealers will always argue in favour of non-transparent OTC markets. Yet, it is the job of RBI to cater to the interests of the economy and not of the bond dealers.
The second tool which can be used to obtain a more efficient Indian financial sector is globalisation. To the extent that India's financial sector faces global competition, it would exert competitive pressure which would help generate lower costs. For example, FIIs can compare the charges faced when doing Nifty futures trades at NSE versus the charges faced when doing Nifty futures trades at SGX (in Singapore), and this exerts competitive pressure upon NSE. The pressure upon NSE would be even greater if every Indian citizen could trade in Singapore, without currency controls.
Implications for the pension sector. India's pension sector should plan on participants making contributions of Rs.100 to Rs.1000 per month, into a pension account. This presents tremendous challenges in terms of dealing with small value transactions and accounts.
In order to deal with this, Project OASIS has proposed (a) exploiting banks and post offices as points of presence (b) the use of a depository to obtain economies of scale in record keeping, and (c) an intensive use of modern IT. Without this institutional machinery, the overheads of dealing with small value contributions and portfolios will be extremely large.
The overheads of fees and expenses of fund management can knock off 25% to 60% of the pension wealth unless great care is taken to control them. Many countries with private pension fund managers are now implementing policies to combat the overheads of fund management. Project OASIS has proposed that an auction should take place, where bidders pre-commit to a level of fees and expenses, and the lowest six bids are admitted as pension fund managers. This is obviously extremely unpopular amongst fund managers. Yet, it is a crucial element of the design of a low-overhead pension system.
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