Risk of undercapitalisation for state-owned institutions: Nobel winner

Noble-prize winning economist Robert Engle said that a number Indian financial institutions may require significant additional capital in the event of a financial shock.

The majority of financial institutions that show such signs of the need for additional capital were state-owned banks, he said in a talk in Mumbai on Tuesday.

He was speaking at the Dr R H Patil Memorial Lecture 2019 in Mumbai on Tuesday. Engle won the prize in 2003 for his work on a concept called autoregressive conditional heteroskedasticity (ARCH). His work helps researchers and analysts for asset pricing and also as a tool to measure portfolio risk. He won the prize with Clive W J Granger of the University of California at San Diego.

The issue of undercapitalisation could be dealt with through the new bankruptcy code which could help recovery of capital, and have the same effect as recapitalising them, he said. The sale of bad loans could also be an effective way to raise capital, according to him.

"That's another strategy," he said, though the market for such distressed loans would also have to be developed, he indicated.

A lot of the volatility in markets may be because of geopolitical risk, suggested Engle, speaking about another area of his research. Many indicators suggest that this risk is high. This is also the view going by commentary in the media. But the markets don't seem to reflect it, he pointed out. This is in contrast to the  measure of financial risk as measured by the undercapitalisation of financial institutions, which is extremely high across many key markets and in Asia in particular.

His work has previously highlighted a tendency to focus on short-term risks in financial risk management.

Financial risk management are generally focused on short-term risks rather than long-term risks, and arguably this was an important component of the recent financial crisis, he said in 'Long-Term Skewness and Systemic Risk', published in the Journal of Financial Econometrics in 2011. The paper suggested that 'short- and long-run risk can be separately measured'. Failure to pay attention to long-term risk may have explained the financial crisis as investors and institutions increased leverage and allocated capital to illiquid assets such as subprime Collateralized Debt Obligation (CDOs) since both strategies involved low short-term risk.

Engle currently works as Director of the NYU Stern Volatility Institute. He is also the Co-Founding President of the non-profit Society for Financial Econometrics (SoFiE).